Farm-credit patronage dividends were excluded from REIT income tests

Plain-English summary

A publicly held timber REIT borrowed from farm-credit cooperatives to finance timberland acquisitions and refinance related debt. The cooperative lenders paid patronage dividends based on the amount of business the REIT conducted with them, and the REIT had to include those dividends in gross income under § 1385. Economically, the payments reduced the REIT's borrowing costs and were reported as reductions of interest expense for financial accounting. The IRS concluded that excluding the patronage dividends from the REIT's gross income tests was consistent with the statutory policy favoring passive income. Under § 856(c)(5)(J)(i), the dividends were excluded from gross income for both the 95 percent and 75 percent tests.

Ruling snapshot

• Question: Could patronage dividends from farm-credit cooperative lenders be excluded from the REIT gross income tests?
• Outcome: Approved, excluded from both income tests
• Key authorities: IRC §§ 856(c)(2), 856(c)(3), 856(c)(5)(J), 1385, and 1388

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201418022
Third Party Communication: None
Release Date: 5/2/2014
Date of Communication: Not Applicable
Index Number: 856.01-00
Person To Contact:
-----------------------
---------------------, ID No. -----------------
--------------------------
Telephone Number:
---------------------------------------------- ---------------------
---------------------------------------
Refer Reply To:
--------------------------------
CC:FIP:B01
PLR-133228-13
Date:
January 28, 2014

Legend

Taxpayer = ----------------------------------------------.
------------------------

Bank A = ---------------------------------------------------

Bank B = ----------------------------------------------------

Bank C = ---------------------------------

Bank D = -------------------

State A = -------------

State B = -------------

State C = ---------------

Date 1 = ---------------------------

Date 2 = -----------------

Date 3 = ---------------------------

Year 1 = -------

Year 2 = -------

Year 3 = -------

Year 4 = -------
PLR-133228-13
2

Year 5 = -------

a = --------------

b = --------------

c = --------------

d = ------

e = ------

f = -----------

Dear -----------------:

This responds to a letter dated July 29, 2013, submitted on behalf of Taxpayer.
Taxpayer requests a ruling under section 856(c)(5)(J)(i) of the Internal Revenue Code (“Code”) that patronage dividends included in its gross income under section 1385 are excluded from its gross income for purposes of sections 856(c)(2) and (c)(3).

FACTS

Taxpayer elected to be treated as a real estate investment trust (“REIT”) for federal income tax purposes beginning with its taxable year ended Date 1. Taxpayer is a calendar year taxpayer that uses the overall accrual method of accounting.

Taxpayer is a publicly held REIT whose primary business is to own and manage timberlands for the production and sale of timber. Taxpayer regularly purchases timberlands in connection with its business of owning timberlands and growing timber.

In Year 1, Taxpayer entered into a $a term credit agreement (“Year 1 Credit Agreement”). The proceeds were used for the following purposes: to acquire timberlands; to repay debt consisting of a senior note and a senior mortgage from Year 2, senior notes from Year 3 that were used to acquire timberlands, and a loan from Year 4; and to repurchase some Taxpayer shares.

In Year 5, Taxpayer borrowed $b under a new term credit agreement (“Current Credit Agreement”). The proceeds were used to repay the Year 1 Credit Agreement in full. The remaining proceeds were used to repay borrowings outstanding under Taxpayer’s line of credit, which had been drawn down by $c to purchase standing mature and near-mature timber located in States A, B, and C. Current Credit
PLR-133228-13
3

Agreement matures on Date 2 and had an interest rate of d percent as of Date 3. The interest rate on the Current Credit Agreement is based on LIBOR plus e percent.

The banks that entered into the Credit Agreement with Taxpayer are farm cooperatives subject to taxation under sections 1381-1388 that provide financing to their patrons, and are subject to regulation by the Farm Credit Administration. They include Banks A, B, C, and D. Taxpayer anticipates that in the future it may refinance these farm credit loans with new farm credit loans and/or enter into additional, new farm credit loans.

Although the mechanics vary from lender to lender, each year Taxpayer expects to receive a “patronage dividend” from each farm credit bank. Patronage dividends are generally paid either in cash or in both cash and equity. Taxpayer represents that with respect to the patronage dividends it expects to receive, each will be a “patronage dividend” within the meaning of the term provided in section 1388(a). For federal tax purposes, the patronage dividends received by Taxpayer are required to be included in gross income pursuant to section 1385. However, for financial reporting purposes, Taxpayer represents that it reduces its interest expense by the amount of patronage dividends received. During Year 5, Taxpayer recorded $f in expected patronage dividends as reducing its interest expense for financial reporting purposes.

LAW & ANALYSIS

Section 856(c)(2) provides that in order for a corporation to qualify as a REIT, at least 95 percent of the corporation’s gross income (excluding gross income from prohibited transactions) must be derived from sources that include dividends, interest, rents from real property, and gain from the sale or other disposition of stock, securities, and real property (other than property in which the corporation is a dealer).

Section 856(c)(3) provides that in order for a corporation to qualify as a REIT, at least 75 percent of the corporation’s gross income (excluding gross income from prohibited transactions) must be derived from rents from real property, interest on obligations secured by real property, gain from the sale or other disposition of real property (other than property in which the corporation is a dealer), dividends from REIT stock and gain from the sale of REIT stock, abatements and refunds of taxes on real property, income and gain derived from foreclosure property, commitment fees to make loans secured by mortgages on real property or to purchase or lease real property, gain from certain sales or other dispositions of real estate assets, and qualified temporary investment income.

Section 856(c)(5)(J) provides that to the extent necessary to carry out the purposes of Part II of subchapter M of the Code, the Secretary is authorized to determine, solely for purposes of such part, whether any item of income or gain which –
PLR-133228-13
4

(i) does not otherwise qualify under sections 856(c)(2) or (c)(3) may be considered as not constituting gross income for purposes of sections 856(c)(2) or (c)(3), or (ii) otherwise constitutes gross income not qualifying under sections 856(c)(2) or (c)(3) may be considered as gross income which qualifies under sections 856(c)(2) or (c)(3).

Section 301(a) provides that in general, except as otherwise provided in this chapter (chapter 1 of subtitle A of the Code, which chapter and subtitle include, among other sections, sections 301, 316, 317, 856, and section 1388), a distribution of property (as defined in section 317(a)) made by a corporation to a shareholder with respect to its stock shall be treated in the manner provided in section 301(c).

Section 301(c) provides, in part, that in the case of a distribution to which section 301(a) applies, that portion of the distribution which is a dividend (as defined in section 316) shall be included in gross income.

Section 316(a) provides that for purposes of this subtitle (subtitle A, which subtitle, as noted, includes, among other sections, both section 856 and section 1388), the term “dividend” means any distribution of property made by a corporation to its shareholders-- (1) out of its earnings and profits accumulated after February 28, 1913, or (2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made.

Section 316(a) provides in the flush language that, except as otherwise provided in this subtitle, every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits. The flush language provides further that to the extent that any distribution is, under any provision of this subchapter (subchapter C of chapter 1 of subtitle A of the Code), treated as a distribution of property to which section 301 applies, such distribution shall be treated as a distribution of property for purposes of this subsection.

Section 1388(a) provides that, for purposes of subchapter T, the term “patronage dividend” means an amount paid to a patron by an organization to which part I of subchapter T applies--

(1) on the basis of quantity or value of business done with or for such patron,

(2) under an obligation of such organization to pay such amount, which obligation existed before the organization received the amount so paid, and
PLR-133228-13
5

(3) which is determined by reference to the net earnings of the organization from business done with or for its patrons.

The flush language of section 1388(a) provides that such term does not include any amount paid to a patron to the extent that (A) such amount is out of earnings other than from business done with or for patrons, or (B) such amount is out of earnings from business done with or for other patrons to whom no amounts are paid, or to whom smaller amounts are paid, with respect to substantially identical transactions. The flush language provides further that, for purposes of paragraph (3), net earnings shall not be reduced by amounts paid during the year as dividends on capital stock or other proprietary capital interests of the organization to the extent that the articles of incorporation or bylaws of such organization or other contract with patrons provide that such dividends are in addition to amounts otherwise payable to patrons which are derived from business done with or for patrons during the taxable year.

Section 1385(a)(1) provides, in part, that, except as otherwise provided, each person shall include in gross income the amount of any patronage dividend which is paid in money, a qualified written notice of allocation, or other property (except a nonqualified written notice of allocation), and which is received by him during the taxable year from an organization described in section 1381(a).

The legislative history underlying the tax treatment of REITs indicates that a central concern behind the gross income restrictions is that a REIT’s gross income should largely be composed of passive income. For example, H.R. Rep. No. 2020, 86th Cong., 2d Sess. 4 (1960) at 6, 1960-2 C.B. 819, at 822-23 states, “[o]ne of the principal purposes of your committee in imposing restrictions on types of income of a qualifying real estate investment trust is to be sure the bulk of its income is from passive income sources and not from the active conduct of a trade or business.”

Patronage dividends paid by a subchapter T cooperative are a return of earnings to its cooperative patrons based on the amount of business that the patron transacts with the cooperative. The patronage dividends paid by a subchapter T financing cooperative effectively reduce the costs that its patrons incur to borrow funds from the cooperative. The amounts paid by Banks A, B, C, and D represent earnings that those cooperatives are able to refund to Taxpayer based on the average amounts that Taxpayer borrowed from those banks during the prior year. Thus, while Taxpayer must include patronage dividend income in its gross income under section 1385(a)(1), the patronage dividends Taxpayer receives effectively reduce Taxpayer’s interest expense paid during the prior year. Under the facts of the instant case, exclusion of these patronage dividends from gross income for purposes of sections 856(c)(2) and (c)(3) does not interfere with Congressional policy objectives in enacting the income tests under those provisions.
PLR-133228-13
6

CONCLUSION

Accordingly, pursuant to section 856(c)(5)(J)(i), we conclude that the patronage dividends included in Taxpayer’s gross income under section 1385 are excluded from its gross income for purposes of sections 856(c)(2) and (c)(3).

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, copies of this letter are being sent to your authorized representatives.

The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.

Sincerely,

Andrea M. Hoffenson
Assistant to Branch Chief, Branch 1
Associate Chief Counsel
(Financial Institutions & Products)

cc: