Minnesota Supreme Court Gets it REIT: Rejects 'Economic Substance' Challenge

In a landmark decision issued yesterday, the Minnesota Supreme Court struck a blow for taxpayers by reversing a Minnesota Tax Court decision that had allowed the Minnesota Department of Revenue to disregard a taxpayer's captive-REIT structure on the basis that the transactions creating the structure lacked economic substance. Describing as "radical" the Department's attempt to disregard the structure as a sham, the Minnesota Supreme Court held for the taxpayer, explaining: "If Minnesota statutes allow a favorable tax treatment, neither our court nor the Commissioner has the power to disregard those statutes and impose a different tax treatment. And, if we conclude a taxpayer has complied with the relevant statutes, that ends our analysis." HMN Financial, Inc. and Affiliates v. Commissioner of Revenue, Supreme Court of Minnesota, Docket No. A09-1164 (decided May 20, 2010).

Background

The dispute involved a classic mortgage REIT with an 80/20 twist to make it effective within Minnesota's unitary-combined filing regime. Captive REIT structures are intended to produce a double deduction: a dividends-paid-deduction ("DPD") for the Real Estate Investment Trust that pays a dividend, and a dividends-received-deduction ("DRD") for the receiving shareholder. At the core, the structure works when a state (1) conforms generally to the Internal Revenue Code, and thus conforms to the IRC § 857(b)(2)(B) DPD for REITs, but (2) decouples from federal DRD rules and thus fails to follow the federal rule that denies a DRD to the shareholder who receives a dividend for which a DPD was taken.1

In its version of the REIT strategy, HMN Financial, Inc. ("HMN") was the holding company for Home Federal Savings Bank ("HF Bank"). In 2002, HF Bank incorporated two subsidiaries, Home Federal Holding, Inc. ("HF Holding") and Home Federal REIT, Inc. ("HF REIT"). HF Holding was an 80/20 foreign operating corporation. HF Holding held all of the stock of HF REIT, except for preferred shares held by 112 HF Bank employees.2 HF Bank secured and serviced commercial and residential loans. It then transferred certain participation interests in those loans to HF REIT (but continued to service the loans).

HF REIT earned income from the loans but paid all of its taxable income out as dividends to its shareholders. HF Holding, in turn, paid dividends to its sole shareholder, HF Bank. Under Minnesota and federal law, HF REIT, as a real estate investment trust, was entitled to a tax...