New Rules on NJ REIT Dividends Taxation
By Fred R. James
Certain banks operating in New Jersey may see an increase in their state income tax expense beginning in 2006 as a result of recently released regulations from the New Jersey Division of Taxation.
In the long-waited response to the New Jersey Tax Court’s opinion in UNB Investment Co. Inc. v. Director, Division of Taxation (Tax 2004), the division issued regulations on Feb. 6 that set forth its interpretation of the New Jersey corporation business tax statute covering the exclusion of certain dividend income from taxable income.
That interpretation, as expressed in UNB Investment Co., is that dividends received from companies electing to be taxed as real estate investment trusts (REITs) are not eligible for the dividend exclusion rules set forth in N.J.S.A. 54:10A-4(k)(5) because such ineligibility is consistent with the federal treatment of dividends from REITs. The effect of the adoption of this regulation is a New Jersey state tax increase for corporations, including many banks owning 50 percent or more of a REIT’s stock.
Under New Jersey’s corporation business tax statutes, taxable income specifically excludes dividends which were included in taxable income for federal tax purposes to the extent the dividends come from 80 percent or more owned subsidiaries (a 50 percent exclusion exists for 50 percent or more owned subsidiaries).
In 1997, UNB Investment Co. received dividends from a greater than 80 percent owned subsidiary that had elected REIT status. In accordance with the New Jersey statutes and with the instructions to Form CBT-100, the company excluded the dividends from taxable income.
Upon audit, the Division disallowed the dividend exclusion, reasoning that dividends from REITs should be taxable because allowing corporations the dividend exclusion provided for in the statute could result in income that is not taxed at either the REIT or the shareholder level.
THE TAX COURT’S VIEW
The Tax Court held that the disallowance of the dividend exclusion for REIT dividend recipients was consistent with the legislative history of the state’s corporation business tax, and it also held that the division’s interpretation of the federal provisions disallowing the dividend exclusion was a reasonable interpretation of New Jersey law.
However, the Tax Court explained that the disallowance of the REIT dividend exclusion amounted to an administrative rule, and although the court agreed that this interpretation was within the division’s realm of authority, such an interpretation could only be implemented through the formal rulemaking process.
Accordingly, the court rendered summary judgment in favor of the taxpayer. In other words, the court would not enforce the division’s assessment because the division never formally told taxpayers of its interpretation that REIT dividends did not qualify for the dividend exclusion provided for in the statute.
In rendering its opinion, the Tax Court laid the groundwork for the division to promulgate a regulation changing the taxability of REIT dividends.
THE N.J. REGULATORY RESPONSE
The statute setting forth New Jersey’s dividend exclusion rules has not changed. But, with a green light from the Tax Court, the division adopted an amendment to its regulation, N.J.A.C. 18:7-5.2, on Feb. 6. The amendment adds a paragraph which states that dividends from an entity qualified as a real estate investment trust are ineligible for inclusion in the dividends-received deduction for corporations.
As noted in the division’s response to public comments, the amended rule will apply to dividends paid on and after Feb. 6, and will not apply to dividends paid before that date. This effective date is consistent with the guidelines set forth in the UNB Investment Co. decision, and is a welcomed change from views previously expressed by the division, which had suggested that the new rules would apply to any tax returns filed after the date of adoption.
Notably absent from the final adoption is the proposal to tax dividends received “directly or indirectly” from a REIT. As originally proposed when the first draft of the regulations was issued on Nov. 7, 2005, this provision would potentially subject the same income to New Jersey taxation multiple times as dividends are paid higher up in a chain of legal entities.
The division’s published response to comments regarding this proposal state that adoption of this approach requires additional study of its potential impact, so it will not be adopted at this time. Further, taxpayers will not be required to trace REIT distributions through multiple tiers of an ownership chain. This response leaves open the possibility that the “direct or indirect” proposal could be adopted in the future.
However, because this proposal goes beyond the existing federal dividend rules, it may require implementation by the Legislature, rather than through an administrative regulation, in order to remain consistent with the division’s regulatory authority, as acknowledged by the Tax Court in UNB Investment Co.
While many banking groups that include REIT structures may not be pleased with their increase in New Jersey tax, the cloud of uncertainty as to when and how the Division of Taxation would change the rules in the wake of UNB Investment Co. has been lifted. The issue of direct or indirect dividends remains on the horizon, but it is realistic to expect that its resolution will ultimately rest with the legislative rather than the administrative arm of state government.
Fred R. James is a partner of KPMG LLP and a member of the NJBankers Financial Officers Committee. He can be reached via e-mail at firstname.lastname@example.org. The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser. The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG LLP.