Internal Revenue Bulletin No. 2025–46

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Bulletin 2025-46: Sourcing Rules and REIT Foreign Control Changes

This edition of the Internal Revenue Bulletin (IRB) 2025-46 contains guidance relevant to cross-border financial transactions, particularly concerning the sourcing of income and the treatment of Real Estate Investment Trusts (REITs) under the Foreign Investment in Real Property Tax Act (FIRPTA). The two major items are Notice 2025-63, addressing the sourcing of certain fees arising from securities lending and sale-repurchase transactions, and REG-109742-25, which proposes a significant modification to the rules determining whether a Qualified Investment Entity (QIE), such as a REIT, is "domestically controlled" for FIRPTA purposes. Specifically, the IRS is issuing guidance clarifying the sourcing of "borrow fees" including "negative rebates" often associated with securities lending activities. Furthermore, the IRS is proposing a reversal of a recently implemented "look-through" rule applicable to domestic corporations in the context of REITs and the domestically controlled QIE determination under Section 897(h)(4)(B).

Deep Dive: New Sourcing Rules for Securities Lending Fees

In addition to clarifying the definition of a Qualified Investment Entity (QIE), such as a REIT, the IRS is issuing guidance clarifying the sourcing of "borrow fees" including "negative rebates" often associated with securities lending activities. Furthermore, the IRS is proposing a reversal of a recently implemented "look-through" rule applicable to domestic corporations in the context of REITs and the domestically controlled QIE determination under Section 897(h)(4)(B). Specifically, Notice 2025-63 addresses the long-standing uncertainty surrounding the source of income from "borrow fees" arising from securities lending transactions and sale-repurchase agreements (repos).

1. The Rule:

Notice 2025-63 announces the Treasury Department and the IRS's intention to issue proposed regulations providing a sourcing rule for certain "borrow fees". The core problem stemmed from the fact that neither the Internal Revenue Code (the "Code") nor existing Treasury regulations explicitly specified how to determine the source of payments referred to as "borrow fees" or "negative rebates" in securities lending transactions or sale-repurchase transactions. The IRS, using its authority under Section 863(a), which grants the Secretary the power to prescribe regulations allocating or apportioning items of gross income not otherwise specified in Sections 861(a) and 862(a) to sources within or without the United States, intends to remedy this. The solution is that these fees, including "negative rebates," will be sourced based on the residence of the recipient. The "residence of the recipient" is determined in the same manner as under Section 988(a)(3)(B). Section 988(a)(3)(B) provides rules for determining the residence of a taxpayer for purposes of determining the source of foreign currency gain or loss attributable to a section 988 transaction. For individuals, this is generally the country of their tax home (as defined in Section 911(d)(3)). For U.S. persons (corporations, partnerships, trusts), it's the United States. For non-U.S. persons, it's any country other than the United States.

2. The Context:

The lack of a clear sourcing rule for borrow fees has been a pain point for years. Securities lending transactions, where one party (the lender) lends securities to another (the borrower) in exchange for collateral, and sale-repurchase agreements (repos), where one party sells securities to another with an agreement to repurchase them later, are common in financial markets. These transactions often involve "borrow fees," explicit fees paid by the borrower to the lender, or "rebates" (interest) paid on cash collateral posted by the borrower. When the demand for a security is high, or when interest rates are very low, the "rebate" can become negative, meaning the borrower actually pays the lender a fee to borrow the securities; this is the "negative rebate." Without a clear sourcing rule, it was unclear whether these payments were U.S.-source income (potentially subject to U.S. withholding tax) or foreign-source income. This uncertainty impacted cross-border securities lending activities, potentially discouraging foreign entities from lending securities to U.S. borrowers.

3. The Implication:

The Notice provides much-needed clarity for tax practitioners and financial institutions involved in securities lending and repo transactions. By sourcing "borrow fees" based on the recipient's residence, the IRS has adopted a practical and administrable approach. This approach is generally consistent with the sourcing of other types of income, such as interest and dividends. For example, if a U.S. entity pays a borrow fee (including a negative rebate) to a foreign lender, the payment will generally be treated as foreign-source income, not subject to U.S. withholding tax, provided the foreign lender is not engaged in a U.S. trade or business and the income is not effectively connected with that business.

The scope of this rule is explicitly limited to transactions documented on industry-standard master agreements (such as the Master Securities Loan Agreement (MSLA) or the Master Repurchase Agreement (MRRA)) and entered into in the ordinary course of the taxpayer's business. This excludes one-off or structured transactions without standard market terms. Furthermore, the IRS clarifies that the label given to a payment is not determinative; the substance of the fee will govern its treatment for tax purposes.

The forthcoming proposed regulations will apply prospectively to taxable years ending after they are published in the Federal Register. However, the Notice provides that taxpayers may rely on the rules described in the Notice immediately with respect to securities lending transactions and sale-repurchase transactions entered into before the forthcoming proposed regulations are published.

Deep Dive: IRS Reverses Course on 'Look-Through' Rule for REITs

The previous section addressed new sourcing rules for securities lending fees. This section now delves into proposed regulations that significantly alter the landscape for Real Estate Investment Trusts (REITs) and the determination of whether they qualify as "domestically controlled." The new proposed regulation, REG-109742-25, represents a notable reversal of position by the IRS on the application of look-through rules for certain domestic corporations in determining the ownership of Qualified Investment Entities (QIEs).

1. The Rule: Reversal of the Domestic Corporation Look-Through Rule

The proposed regulation aims to amend existing regulations concerning the determination of whether a QIE is "domestically controlled." The crucial change is the removal of a rule that previously looked through the shareholders of certain domestic C corporations to ascertain if foreign persons held stock in the QIE, either directly or indirectly. This stems from modifications to Section 897, concerning the taxation of foreign investment in U.S. real property.

2. The Context: FIRPTA, QIEs, and the Domestically Controlled Exception

To understand the significance of this change, a review of the relevant code sections is necessary. Section 897, enacted as part of the Foreign Investment in Real Property Tax Act (FIRPTA), generally subjects foreign persons to U.S. tax on gains from the disposition of U.S. Real Property Interests (USRPIs). Section 897(a)(1) dictates that nonresident alien individuals or foreign corporations treat gain or loss from the disposition of a USRPI as effectively connected with a U.S. trade or business, making it taxable.

A USRPI, as defined in Section 897(c)(1)(A), includes an interest in real property located in the U.S., as well as any interest (other than solely as a creditor) in a domestic corporation, unless it is established that the corporation was not a United States Real Property Holding Corporation (USRPHC) at any time during a prescribed period. A USRPHC, defined in Section 897(c)(2), is essentially a corporation where the fair market value of its USRPIs equals or exceeds 50% of the combined value of its USRPIs, its real property interests located outside the U.S., and any other assets used or held for use in a trade or business.

Section 897(h)(1) addresses distributions by a Qualified Investment Entity (QIE). A QIE includes a Real Estate Investment Trust (REIT) or a Regulated Investment Company (RIC) which is a USRPHC or would be one if certain exceptions didn't apply, as outlined in Section 897(h)(4)(A). Under Section 897(h)(2), a key exception exists: a USRPI does not include an interest in a "domestically controlled QIE." This means that gain or loss on the disposition of stock in a domestically controlled QIE is not subject to Section 897(a).

A QIE is considered "domestically controlled" under Section 897(h)(4)(B) if less than 50% of the value of its stock is held directly or indirectly by foreign persons at all times during the testing period, generally the five-year period ending on the date of disposition. The determination of "indirect" ownership is what has been at issue here.

The IRS issued proposed regulations (REG-100442-22) on December 29, 2022, addressing how to determine if QIE stock is "held directly or indirectly" by foreign persons. These proposed regulations defined "indirect" ownership using a "look-through" approach. Only a "non-look-through person" was treated as holding QIE stock; stock held by "look-through persons" was attributed proportionally to the ultimate owners who were non-look-through persons. Critically, the 2022 proposed regulations generally treated "domestic C corporations" (excluding RICs, REITs, or S corporations) as non-look-through persons. However, a "domestic corporation look-through rule" existed for "non-publicly traded domestic C corporations" where foreign persons held a 25% or greater interest.

These rules were finalized on April 24, 2024, in TD 9992. The final regulations retained the look-through approach, but raised the foreign ownership threshold for the domestic corporation look-through rule from 25% to more than 50%.

3. The Implication: Easing the Burden on REITs

The new proposed regulation (REG-109742-25) removes the domestic corporation look-through rule entirely. All domestic C corporations will now be treated as "non-look-through persons" when determining whether a QIE is domestically controlled. In response to feedback received after the 2024 final regulations, the Treasury Department and the IRS determined that imposing look-through treatment based on a strict 50-percent foreign ownership threshold was not the correct interpretation of Section 897(h)(4)(B).

This proposed change is a direct response to concerns raised by taxpayers about the practical difficulties of tracing ownership, often lacking reliable data, creating legal uncertainty, and potentially discouraging investment in U.S. real estate. The IRS and Treasury now agree that this tracing was impractical and potentially inconsistent with Congressional intent, which aimed to provide the DC-QIE exception for QIEs controlled by U.S. persons. The IRS effectively agrees with the argument that Section 897(h)(4)(B) does not contain explicit corporate look-through rules, and that look-through rules for corporate owners of QIEs already exist in Section 897(h)(4)(E) for specific circumstances.

Upon finalization, the proposed regulations will apply to transactions occurring on or after October 20, 2025. However, taxpayers can choose to apply the final regulations to transactions occurring on or after April 25, 2024 (and certain transactions before that date resulting from entity classification elections). Taxpayers may also rely on the proposed regulations for transactions occurring before the date they are finalized. This change eases the burden on REITs and other QIEs in determining their domestic control status and provides greater certainty for foreign investors seeking to avoid FIRPTA tax on dispositions of REIT stock.