Data-center REIT receives rulings on property, income, distributions, and hedges
Apply this to your situation
This page covers one taxpayer's ruling from 2015, which can't be cited as precedent. Ezel answers your situation under the current Code and IRS guidance, with citations.
Plain-English summary
A publicly traded data-center company planned to reorganize and elect real estate investment trust status. The IRS ruled that its buildings, integrated building components, and specified real-estate-related intangibles qualified as real property under section 856. Payments for space, customary core services, and limited personal property qualified as rents from real property, while services performed by taxable REIT subsidiaries did not create impermissible tenant service income. The letter also approved the described treatment of secured loans, related-party rent, cost-sharing reimbursements, foreign subsidiary income, currency gains, accounting adjustments, earnings and profits, stock-and-cash distributions, convertible-debt adjustments, and pre-existing hedges. These rulings depended on the taxpayer's detailed representations and did not decide whether the taxpayer otherwise qualified as a REIT.
Ruling snapshot
- Question: How would the REIT rules apply to the company's data-center property, tenant arrangements, foreign income, accounting adjustments, distributions, and hedges?
- Outcome: Approved
- Key authorities: IRC §§ 301, 305, 312, 481, 562, 856, 857, 951, 956, 986, 1221, 1291, 1293; Treas. Reg. §§ 1.856-3, 1.856-4
Full text (IRS public release)
Internal Revenue Service Department of the Treasury
Washington, DC 20224
Number: 201537020 Third Party Communication: None
Release Date: 9/11/2015 Date of Communication: Not Applicable
Index Number: 301.00-00, 305.01-00,
305.04-00, 856.00-00 Person To Contact:
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PLR-151324-12
Date:
May 22, 2015
LEGEND:
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PLR-151324-12 2
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Dear --------------:
This is in reply to a letter dated November 29, 2012, and subsequent
correspondence, in which Taxpayer requests rulings in connection with its election to
qualify for taxation as a real estate investment trust (“REIT”) under sections 856-860 of
the Internal Revenue Code of 1986, as amended (the “Code”).
FACTS:
Currently, Taxpayer is a publicly traded State A corporation that is the common
parent of an affiliated group of corporations that files a consolidated Federal income tax
return. Taxpayer is a calendar-year, accrual-basis taxpayer that, together with its
subsidiaries (together referred to as the “Company”), acquires, leases, purchases,
develops, and builds data center buildings throughout the United States and in several
foreign countries and then leases space within those buildings to unrelated tenants.
Company intends to reorganize so that Taxpayer can elect to be taxed as a REIT under
sections 856-860 commencing with the taxable year beginning Date 1. As of Date 1,
Taxpayer will no longer be the common parent of a consolidated group for Federal
income tax purposes, and Taxpayer will jointly elect with some of its subsidiaries to treat
those subsidiaries as taxable REIT subsidiaries (“TRSs”). The TRSs will do business in
some or all of the jurisdictions in which Company does business.
Company provides space in colocation data centers for its tenants’ information
technology systems. In some locations, Company occupies “campuses” consisting of
multiple buildings that are close together (although not necessarily adjacent) and
connected by dedicated conduits, ducts, or pipes. In other locations, Company leases
exclusive space in multi-tenanted buildings, where the other tenants are other data
center providers or carriers. These buildings offer “meet me” rooms where Company’s
tenants can interconnect with other tenants, including tenants of other landlords within
PLR-151324-12 3
the building. Company’s freestanding buildings (including buildings that constitute a
campus) and its spaces within multi-tenanted buildings are collectively referred to as
“Buildings.”
The major components of a Building include the following integrated systems: (1)
electrical distribution and redundancy system (the “Electrical Components”), (2) HVAC
and redundancy system (the “HVAC Components”), (3) humidification system (the
“Humidification Components”), (4) security system (the “Security Components”), (5) fire
protection system (the “Fire Protection Components”), and (6) telecommunications
infrastructure (the “Telecommunications Components”). Each of these systems and
their integrated components (collectively, the “Core Systems”) is designed and
constructed to remain permanently in place, is integrated into the Building to which it is
a part, and is unlikely and not intended to be moved or removed.
The Electrical Components are designed to (i) provide power for use in the
tenant space and (ii) ensure uninterrupted power through the use of redundant electrical
systems, including battery backup, backup diesel generators, and diesel fuel tanks, so
that the system can operate for a minimum of g hours before needing refueling. The
HVAC Components are designed to (i) maintain acceptable room temperature levels
and (ii) ensure uninterrupted cooling through such components as back-up water
chillers and above-ground water storage towers. The Humidification Components are
designed to maintain humidity levels in the tenant space. The Security Components are
designed to meet the heightened security requirements of data center tenants, by
protecting both the Building and the individual tenant spaces from unauthorized access
and by monitoring all access. The Fire Protection Components include both detection
and suppression systems. The Telecommunications Components provide access and
rights of way for tenants to connect to third-party telecommunications providers’
equipment and other tenants’ equipment through integrated building systems such as
conduits and “meet me” rooms. Interconnectivity Assets, as defined below, are not
Telecommunications Components. Buildings also contain the following components:
doors, walls, building wiring, structural steel support posts, and special flooring (together
with the Core Systems, “Components”).
Data center buildings differ from ordinary office buildings in the magnitude,
reliability, and quality of the Core Systems that are furnished to tenants and the
redundancies built into the Core Systems. Each Core System is designed and
constructed specifically for the particular Building of which it is a part and is intended to
remain in place indefinitely.
Additionally, the Buildings have structural steel support posts permanently affixed
to the floors of Buildings. These posts are installed during the build-out of floor space
that occurs either during construction of a Building or upon retrofitting an existing
Building to be a data center. The posts are among the first components installed in a
Building, because they support overhead components of the Core Systems such as
overhead cable trays, electrical power conduits, lighting, and security components.
PLR-151324-12 4
Thus, the structural steel support posts are bolted into the floor in a manner that can
support the overhead Core System components. The posts are also used to anchor the
mesh panels that form a cage, the perimeter of a tenant’s space (as described below),
and because the structural steel support posts are installed with the design and
intention of remaining in place indefinitely, cages are configured around the existing
structural steel support posts. In rare instances when the structural steel support posts
are removed, a laborious demolition process is required including bracing or removal of
the overhead Core System components, and the steel is not reusable.
Each tenant of Company leases space ranging in size from a cabinet to several
cages pursuant to a license and services agreement (“Agreement”). Each tenant space
is prepared by Company, or an independent contractor hired by Taxpayer, in
accordance with the Agreement terms, including the installation of mesh paneling into
the structural steel support posts to set a perimeter around the tenant’s leased space for
a tenant leasing one or more cages. Individual cages typically enclose between a to b
square feet of space, may contain multiple cabinets, and generally employ biometric
access controls to ensure that the cages automatically lock and can only be accessed
by authorized persons. The Agreements have initial terms that are generally more than
c years; thereafter, the contracts typically renew automatically on a d, e, or f basis.
Tenants generally use the tenant space to locate telecommunications, computing, and
electronic data storage equipment and, occasionally, personnel. Tenants may lease
rooftop space on the data center building for placement of antennas or other
communication equipment that transmit through satellite, microwave, or other means, or
may lease (on either an exclusive basis, or on a shared basis with other building
tenants) secure shelf or secure office space or business recovery stations. Taxpayer
may also receive additional payments from tenants that opt to reserve square footage
within a Building for future expansion of their operations.
Tenants may also lease from Company an incidental amount of personal
property under or in connection with their rental of space in a Building. Additionally,
tenants may have access to common area space used for staging and storage as well
as loading dock space for receipt and shipping of equipment.
The Agreements generally provide for a monthly recurring fee for the use of
space in the data center as well as payments for the provision of uninterrupted, stable
electrical power. The fee amount includes a tenant’s lease of space along with receipt
of associated Core Services, discussed below, and a lease of any incidental personal
property. Taxpayer represents that the rent attributable to leased cages, cabinets, and
any other personal property leased by Taxpayer to each tenant under, or in connection
with, a lease of real property for a taxable year will constitute less than 15 percent of the
total rent, based on the average fair market values of the real property and personal
property, for the taxable year attributable to both the real and personal property leased
by Taxpayer to the tenant under, or in connection with, each Agreement.
PLR-151324-12 5
Taxpayer represents that the services it will provide to tenants under the
Agreements consist of ordinary, necessary, usual, and customary services in
connection with the operation and maintenance of the Buildings. These services will not
include any personal services, noncustomary services, or services that are primarily for
the convenience of a particular tenant. These services include controlled utilities
(including electrical power and basic telephone); controlled temperature and humidity;
security; fire protection; common area maintenance (including cleaning and
maintenance of public areas); reservations of space within the Buildings; accepting
shipments; landscaping; management, operation, maintenance, and repair of the major
building systems and components (including the Core Systems); pest control;
unattended parking; and site preparation of tenant space (together with the
telecommunications and interconnectivity services described below, the “Core
Services”).
Taxpayer also offers to connect tenants to telecommunication carriers and other
tenants through interconnection. Interconnections use wires, cables, “meet me” rooms,
and other transmission components to provide tenants with connectivity to third-party
telecommunications providers’ equipment, to TRS servers and routers, to other
Buildings, to properties owned by third-parties, and to other tenants’ equipment.
Tenants pay a one-time installation fee for the service of connecting a tenant by setting-
up wires or cables to establish an interconnection and a recurring, right-of-way charge
to use the corridor through which the dedicated wire or cable connecting tenant
equipment travels in the Building. Taxpayer represents that all of its interconnectivity
offerings constitute services that are ordinary, necessary, usual, and customary for
comparable buildings in the geographic market in which the Buildings are located, and
that no interconnectivity offering constitutes personal services, noncustomary services,
or services that are primarily for the convenience of a particular tenant. Taxpayer
represents that interconnectivity assets that route, logically handle, or control access
among tenants’ data, including servers, routers, switches, and ports, are owned and
operated by a TRS (“TRS Interconnectivity Assets,” together with the wires or cables
that connect tenant equipment within a Building, the “Interconnectivity Assets”). For
those tenants who connect to TRS Interconnectivity Assets, the recurring charge is both
for the right-of-way and for the services provided by the TRS through the TRS
Interconnectivity Assets. Other tenants may connect only to interconnectivity assets
owned by others, to other tenants, or to the tenant’s own antenna.
Another service that is provided to Building tenants, particularly in markets
outside of the United States, is the resale of telecommunications bandwidth to tenants
who prefer to purchase these utilities from Taxpayer in connection with the lease of
Building space rather than deal with the local telecommunications utilities. In these
situations, Taxpayer will acquire bandwidth from local telecommunications utilities and
resell that bandwidth to tenants for a price either less than, equal to, or above that
charged to Taxpayer by the local utility. Taxpayer represents that markups average h
percent, and any markup for reservation and resale will not exceed i percent. Taxpayer
represents that in a Building where Taxpayer offers to resell or reserve bandwidth for
PLR-151324-12 6
tenants, such resale or reservation of bandwidth or the provision of similar
telecommunications utility services constitute services customarily offered to tenants in
similar classes of buildings in the geographic location in which such Building is located.
Installation and set-up of Building infrastructure such as installation and set-up of
the cage with cabinets and similar items and connection of these items to the Building’s
Core Systems, as well as physical interconnections, may be performed by Taxpayer, by
an independent contractor, or by a TRS, at the determination of Taxpayer. Taxpayer
represents that these site preparation services are rendered in connection with the
operation and maintenance of the Building or as a service that is ordinary, necessary,
usual, and customary for the Buildings, and are not rendered for the convenience of a
particular tenant. As part of an Agreement, Taxpayer will charge tenant for these site
preparation services. Charges for interconnection will include a one-time set up fee as
well as a monthly charge for the right-of-way through the Building and for the services
provided by the TRS through the TRS Interconnectivity Assets. Taxpayer will not
provide move-in or move-out services for tenants, but may supervise such activities to
ensure compliance with building codes and uninterrupted operation of the data center.
Services involving tenant equipment, including installation requested by the tenant, will
be performed by an independent contractor or a TRS.
Additionally, after receiving specific orders from tenants, a TRS of Taxpayer may
provide smart hand services. These smart hand services may include, for example: set
up of tenants’ telecommunications, computing, and electronic data storage equipment;
tape maintenance for tape drives within a cage; emergency maintenance; network
management; and various system checks and labeling. In addition, other noncustomary
services or personal services requested by tenants will be provided by TRSs (together
with the smart hand services, the “TRS-Provided Services”) or through independent
contractors from whom Taxpayer derives no income. However, Taxpayer expects to
collect all or nearly all the amounts owing from tenants, including amounts for services
done by a TRS or independent contractor.
Space Rental to TRSs
Some TRSs will rent space in a Building from Taxpayer to use for supplying
services to tenants. In such cases, at least 90 percent of the leased space at such
Building will be leased to persons other than TRSs and other than related persons
described in section 856(d)(2)(B). The rental charge paid by a TRS for rental space will
represent an arm’s length charge and will be substantially comparable to the rents paid
by unrelated tenants for comparable space in the Building or, where no comparable
space exists in the Building, for comparable space either in one of Taxpayer’s other
Buildings, or in other properties, in the same geographic area.
PLR-151324-12 7
Real Estate Intangibles
Taxpayer will have certain intangible assets recorded on its books resulting from
purchase price allocations made under Generally Accepted Accounting Principles
(“GAAP”) when accounting for acquisitions. Taxpayer’s intangible assets are those that
relate to Taxpayer’s acquisition of real estate assets. Intangibles associated with TRS
assets are not assets of the Taxpayer and, therefore, are not Real Estate Intangibles,
as defined below. Generally, identifiable intangible assets are recorded under GAAP if
they arise from contractual or legal rights, regardless of whether those rights are
transferable or separable from the underlying physical business assets. Identifiable
intangible assets acquired through these transactions that are related to real estate
include customer contracts, favorable leases, and trade names.1 Taxpayer represents
that the remaining amount of the purchase price, after allocation to identifiable tangible
and intangible assets, is allocated to goodwill (“residual value goodwill”). Collectively,
Taxpayer’s customer contracts, favorable leases, and residual value goodwill are
referred to herein as “Real Estate Intangibles.”
The intangible asset for customer contracts represents the expected value to
Taxpayer of the tenant leases in place at the time of an acquisition of another data
center lessor, including estimated lease renewals by those tenants. The intangible
asset for favorable leases represents the expected value to Taxpayer of acquiring
leaseholds that charge Taxpayer, at the time of the acquisition, rent that is less than fair
market rental values. Finally, the intangible asset for residual value goodwill represents
the difference between the amounts assigned to identified net tangible and intangible
assets and the amount that Taxpayer actually paid for the acquired Buildings based on
its expectation of being able to lease space within the Buildings at attractive rental rates.
Taxpayer represents that for Federal income tax purposes, the value attributable to the
residual value goodwill under GAAP is properly included as part of the depreciable tax
basis of the acquired Buildings under sections 197(e)(2) and (f)(8). Taxpayer
represents that the residual value goodwill is inextricable and inseparable from
Taxpayer’s underlying physical real estate. Taxpayer further represents that any
residual value goodwill of Company that is not inextricably linked to and inseparable
from Taxpayer’s real estate assets will become an asset of a TRS and is not a Real
Estate Intangible.
The amount of Real Estate Intangibles is based upon GAAP principles and is
derived from the real property that has been acquired by Taxpayer. Taxpayer
represents that the Real Estate Intangibles are inseparable from the Buildings or leases
to which they relate, and have no value separate and apart from the value of these
assets.
1
While trade names are an identifiable intangible of Taxpayer, they are not included as part of this ruling
request.
PLR-151324-12 8
Shared Costs
For administrative convenience and to avail itself of economies of scale with
respect to employment costs, Taxpayer intends to have certain employees who will
perform services both for Taxpayer and for its TRSs. Taxpayer and its TRSs will enter
into employee sharing agreements under which these employees will be shared and the
employing entity will be reimbursed for an allocable share of the employee costs,
including salaries, benefits, and other compensation, costs associated with payroll
administration, and allocable overhead costs including office supplies, furniture and
equipment. The reimbursement will be solely for costs, determined on the basis of the
relative amount of time such employees spend performing services on behalf of each
employer or a similar reasonable allocation method.
Taxpayer also contemplates that it and one or more TRSs may share certain
equipment. With respect to such shared equipment, Taxpayer and the applicable TRS
will enter into an agreement, which will provide that each party pays its allocable share
of the costs associated with the shared equipment, based upon the relative use of the
equipment.
Reimbursements for shared personnel and equipment will be at cost and will be
deducted or capitalized, as applicable, only by the party ultimately bearing such costs
under the cost-sharing arrangement. Neither Taxpayer nor any TRS will be in the
business of providing to third parties any service or equipment that is the subject of
reimbursement at cost.
Domestic and Foreign TRSs
Taxpayer will operate in foreign countries through one or more foreign
subsidiaries and associated intermediate holding companies (each, a “Foreign Sub”). A
Foreign Sub may either be partially or wholly owned by Taxpayer and its affiliates.
Taxpayer is expected to jointly elect TRS status with some Foreign Subs that are
corporations for United States Federal income tax purposes (each, a “Foreign TRS”).
Taxpayer will make loans to its domestic TRSs and Foreign TRSs that are secured by
assets that are “interests in real property” under section 856 and are held by that
borrower. When made, the amount of each secured loan will be less than the fair
market value of the real property securing such loan, and the applicable security
interests will be mortgages or deeds of trust under United States state law or, in the
case of foreign real property, comparable to mortgages or deeds of trust under United
States state law.
Some Foreign TRSs will be controlled foreign corporations (“CFCs”) within the
meaning of section 957(a), with respect to which Taxpayer will be a United States
shareholder within the meaning of section 951(b) (a “United States Shareholder”).
Additionally, with regard to Foreign TRSs that are CFCs, Taxpayer will occasionally (i)
pledge shares of one or more Foreign TRSs, (ii) cause one or more Foreign TRSs to
PLR-151324-12 9
pledge assets, or (iii) cause one or more Foreign TRSs to guarantee obligations of
Taxpayer, in each case as collateral or support for certain debt of Taxpayer incurred to
finance Taxpayer’s acquisition, improvement, or development of interests in real
property that produce qualifying income under section 856(c)(2).
Taxpayer expects that the CFCs with respect to which Taxpayer is a United
States Shareholder will earn the following types of income: (a) interest income on
working capital; (b) rental income from leasing space in colocation data centers; and (c)
interest, dividend, or rental income that is not excepted from foreign personal holding
company income within the meaning of section 954(c) (“FPHCI”).
Additionally, Taxpayer will own entities treated as passive foreign investment
companies under section 1297(a) (“PFICs”) with respect to which it is a shareholder.
Taxpayer expects that a majority of the income of its PFICs will be passive income as
defined in section 1297(b)(1). In some cases, Taxpayer may make an election under
section 1295(a) to treat a PFIC as a qualified electing fund (“QEF”).
In light of the above, Taxpayer expects to have gross income under sections
951(a), 986(c), 1291(a), and 1293(a).
Depreciation and Earnings & Profits
On Date 2, Taxpayer filed a Form 3115, Application for Change in Accounting
Method, under Rev. Proc. 2011-14, 2011-4 I.R.B. 330, (automatic change procedures)
for the taxable year ended Date 3, to change for Federal income tax purposes (1) its
method of depreciating the Core Systems predominantly used in the United States
under the general depreciation system (“GDS”) in section 168(a) to treat these assets
as real property, and (2) its method of depreciating Real Estate Intangibles to treat
these assets as real property. Taxpayer’s Form 3115 was intended to change to a
method of accounting that was consistent with the characterization of these assets as
real property and as interests in real property for purposes of section 856.
Under Taxpayer’s method of accounting for Federal income tax purposes for
taxable years ended before Date 3, Taxpayer classified the Core Systems
predominantly used in the United States as 5- or 7- year property, as applicable, under
section 168(e)(1), and depreciated the property under the GDS in section 168(a). Also,
for Federal income tax purposes, Taxpayer amortized the Real Estate Intangibles under
section 197(a).
Under Taxpayer’s method of accounting for Federal income tax purposes
beginning with taxable years ended Date 3, Taxpayer classifies the Core Systems
predominantly used in the United States that were placed in service after 1986 and the
Real Estate Intangibles as nonresidential real property under section 168(e)(2) and
depreciates the assets under the GDS, using the straight-line method of depreciation,
the mid-month convention, and a 39-year recovery period. Sections 168(b)(3)(A), (c),
PLR-151324-12 10
and (d)(2)(A). The changes in methods of accounting for Federal income tax purposes
resulted in net positive section 481(a) adjustments (“Section 481(a) Adjustments”) that
are taken into account ratably over four taxable years, beginning with the taxable year
ended Date 3, in computing Taxpayer’s taxable income.
On Date 4, Taxpayer filed a Form 3115 under Rev. Proc. 97-27, 1997-1 C.B.
680, (advance consent procedures) for its taxable year ending Date 3, to change the
depreciation for these same items for earnings and profits (“E&P”) purposes. The
Service declined to rule on this issue because no consent was required, as discussed
under Taxpayer’s ruling request number ten.
For E&P purposes, for taxable years ended before Date 3, Taxpayer depreciated
the Core Systems predominantly used in the United States using the alternative
depreciation system under section 168(g) (“ADS”) pursuant to section 312(k)(3), and
amortized the Real Estate Intangibles using a 15-year period and the straight-line
method of depreciation pursuant to section 312(k)(1).
Beginning with its taxable year ended on Date 3, Taxpayer depreciates, for E&P
purposes, the Core Systems and Real Estate Intangibles predominantly used in the
United States under the ADS in accordance with section 312(k)(3), using the straight-
line method of depreciation, a 40-year recovery period, and the mid-month convention.
Stock and Cash Distributions
Taxpayer has one class of voting common stock outstanding (“Taxpayer Stock”),
which is publicly traded and listed on the Exchange. As mentioned above, Taxpayer
intends to elect under section 856 of the Code to be treated as a REIT, effective Date 1
(“First REIT Taxable Year”).
In connection with the REIT election, Taxpayer intends to distribute all of its E&P
that were, or will be, accumulated by Taxpayer for all taxable periods ending prior to the
First REIT Taxable Year (“C Corporation E&P”) as required by section 857(a)(2)(B).
These distributions are expected to be made to Taxpayer’s shareholders with respect to
Taxpayer Stock both before and during the First REIT Taxable Year (“Purging
Distributions”). The tax consequences of Purging Distributions to be made during the
taxable years prior to the First REIT Taxable Year are the subject of a previously issued
private letter ruling (PLR-117298-13). The tax consequences of the Purging
Distributions to be made during the First REIT Taxable Year are the subject of this letter
ruling.
In its First REIT Taxable year, Taxpayer will have Section 481(a) inclusions
related to the depreciation method changes made in anticipation of the First REIT
Taxable Year and will have to make a Purging Distribution. Taxpayer expects to make
distributions in its First REIT Taxable year to cover both taxable income for that year
PLR-151324-12 11
and undistributed C Corporation E&P. Such distributions may be made in a
combination of stock and cash (“Stock and Cash Distributions”).
With respect to each Stock and Cash Distribution, Taxpayer will give each
shareholder an election to receive its portion of the distribution (i) entirely in cash (the
“Cash Option”) or (ii) entirely in Taxpayer Stock (the “Equity Option”). In the event that
a shareholder does not make an election, that shareholder will be considered to have
chosen the Equity Option.
In no event will the total amount of cash available in a Stock and Cash
Distribution (the “Cash Amount”) be other than a specified percentage of the aggregate
value of the Stock and Cash Distribution or be less than 20 percent of the aggregate
value of the Stock and Cash Distribution. If the number of shareholders that elect the
Cash Option would result in the payment of cash in an aggregate amount that is less
than or equal to the Cash Amount, then all shareholders electing the Cash Option will
receive cash equal to the amount elected; if the payment of cash would exceed the
Cash Amount, then each shareholder that elects the Cash Option will receive a pro-
rated portion of the Cash Amount, which will not be less than 20 percent of its entire
entitlement under the distribution, and the remaining balance in Taxpayer Stock.
Taxpayer also anticipates paying cash in lieu of fractional shares of Taxpayer Stock,
although cash paid in lieu of fractional shares will not count against the Cash Amount.
Taxpayer also has two classes of convertible debentures, one class that was
issued on Date 5 (the “Date 5 Convertible Debt”) and one class that was issued on Date
6 (the “Date 6 Convertible Debt”). The initial conversion rate for the Date 5 Convertible
Debt was w shares of Taxpayer Stock per $y principal amount and for the Date 6
Convertible Debt was x shares of Taxpayer Stock per $y principal amount. In
connection with each Stock and Cash Distribution and pursuant to the terms of each of
the Convertible Debts, the conversion rates applicable to the Convertible Debts will be
increased (the “Adjustments”), which will entitle the holders of Convertible Debt (the
“Holders”) to receive upon conversion a greater number of shares of Taxpayer Stock
than they otherwise would be entitled to receive if the Adjustments to the Convertible
Debts’ conversion rates were not made. Accordingly, the Adjustments will entitle the
Holders to receive upon conversion a greater proportionate interest in the assets or
E&P of Taxpayer than they otherwise would receive if the Adjustments were not made.
Taxpayer represents that the calculation of the number of Taxpayer Shares to be
received by any shareholder will be determined, over a period of up to two weeks
ending as close as practicable to the payment date, based upon a formula utilizing
market prices that is designed to equate in value the number of shares to be received
with the amount of money that could be received instead. Similarly, Taxpayer
represents that the Adjustment to the conversion rate on each class of the Convertible
Debt is typical for comparable convertible debt, in accordance with market practices and
norms, and designed to adjust the conversion rate so that a Holder of the Convertible
Debt receives value comparable to the distribution he would have received had he
PLR-151324-12 12
previously converted his notes into Taxpayer Stock and thus received the distribution
paid on that stock.
Hedging
Prior to the time that Taxpayer becomes a REIT, Taxpayer will have some pre-
existing hedges. In addition, prior to the time that Taxpayer converts one or more of its
TRSs to either partnerships, qualified REIT subsidiaries (“QRSs”), or other disregarded
entities, some of these TRSs will also have entered into hedges. Finally, some entities
that Company acquires in merger and acquisition transactions (“M&A Target Entities”)
also will have entered into hedges prior to acquisition. Such hedges are thus expected
to be pre-existing as of the first day that these entities are included as part of Taxpayer
for REIT income or asset testing purposes.
Some of the pre-existing hedges will have been clearly identified by the entity
that entered into them pursuant to section 1221(a)(7). With respect to any pre-existing
hedging transaction that has not been clearly identified prior to the time it becomes part
of Taxpayer, Taxpayer represents that it intends to identify each hedge pursuant to
section 856(c)(5)(G) on the first day the hedge is included as part of Taxpayer for REIT
income or asset testing purposes.
LAW AND ANALYSIS:
Ruling Request #1: Whether Taxpayer’s Buildings, including the Components,
will be treated as “real property” for purposes of section 856.
Section 856(c)(4)(A) provides that at the close of each quarter of its tax year, at
least 75 percent of the value of a REIT’s total assets must be represented by real estate
assets, cash and cash items (including receivables), and Government securities.
Section 856(c)(5)(B) defines the term “real estate assets,” in part, to mean real
property (including interests in real property and interests in mortgages on real property)
and shares (or transferable certificates of beneficial interest) in other REITs.
Section 1.856-3(b)(1) provides that the term “real estate assets” means real
property, interests in mortgages on real property (including interests in mortgages on
leaseholds of land or other improvements thereon), and shares in other qualified REITs.
Section 1.856-3(d) provides that the term “real property” means land or
improvements thereon, such as buildings or other inherently permanent structures
thereon (including items that are structural components of those buildings or structures).
In addition, real property includes interests in real property. Local law definitions do not
control for purposes of determining the meaning of the term real property as used in
section 856 and the regulations thereunder. The term includes, for example, the wiring
PLR-151324-12 13
of a building, plumbing systems, central heating or central air-conditioning machinery,
pipes or ducts, elevators or escalators installed in the building, or other items that are
structural components of a building or other permanent structure. The term does not
include assets accessory to the operation of a business, such as machinery, printing
press, transportation equipment which is not a structural component of the building,
office equipment, refrigerators, individual air-conditioning units, grocery counters,
furnishings of a motel, hotel, or office building, etc., even though those items may be
termed fixtures under local law.
Rev. Rul. 75-424, 1975-2 C.B. 269, concerns whether various components of a
microwave transmission system are real estate assets for purposes of section 856. The
system consists of transmitting and receiving towers built upon pilings or foundations,
transmitting and receiving antennae affixed to the towers, a building, equipment within
the building, and waveguides. The waveguides are transmission lines from the
receivers or transmitters to the antennae, and are metal pipes permanently bolted or
welded to the tower and never removed or replaced unless blown off by weather. The
transmitting, multiplex, and receiving equipment is housed in the building. Prewired
modular racks are installed in the building to support the equipment that is installed
upon them. The racks are completely wired in the factory and then bolted to the floor
and ceiling. They are self-supporting and do not depend upon the exterior walls for
support. The equipment provides for transmission of audio or video signals through the
waveguides to the antennae. Also installed in the building is a permanent heating and
air-conditioning system. The transmission site is surrounded by chain link fencing. The
revenue ruling holds that the building, the heating and air-conditioning system, the
transmitting and receiving towers, and the fence are real estate assets. The ruling
holds further that the antennae, waveguides, transmitting, receiving, and multiplex
equipment, and the prewired modular racks are assets accessory to the operation of a
business and therefore not real estate assets.
Rev. Rul. 73-425, 1973-2 C.B. 222, considers whether a mortgage secured by a
shopping center and its total energy system is an obligation secured by real property. A
total energy system is a self-contained facility for the production of all the electricity,
steam or hot water, and refrigeration needs of associated commercial or industrial
buildings, building complexes, shopping centers, apartment complexes, and community
developments. The system may be permanently installed in the building, attached to
the building, or it may be a separate structure nearby. The principal components
consist of electric generators powered by turbines or reciprocating engines, waste heat
boilers, heat exchangers, gas-fired boilers, and cooling units. In addition, each facility
includes fuel storage tanks, control and sensor equipment, electrical substations, and
air handling equipment for heat, hot water, and ventilation. It also includes ducts, pipes,
conduits, wiring, and other associated parts, machinery and equipment. The revenue
ruling holds, in part, that a mortgage secured by the building and the system is a real
estate asset, regardless of whether the system is housed in the building it serves or is
housed in a separate structure apart from the building it serves. This is because the
PLR-151324-12 14
interest in a structural component is included with an interest held in a building or
inherently permanent structure to which the structural component is functionally related.
Similar to the properties and structural components described in Rev. Rul. 75-
424 and Rev. Rul. 73-425 that qualify as real property for purposes of section 856, the
Buildings are inherently permanent structures and the Components are structural
components of the Buildings. Although the Buildings and Components may facilitate
the technology businesses of the tenants of such buildings, the Buildings and
Components themselves are not assets accessory to the operation of a business under
section 1.856-3(d). Accordingly, based on the information submitted and
representations made, we conclude that the Buildings and Components, as described
above, constitute real property for purposes of section 856(c)(5)(B).
Ruling Request #2: Whether payments received by Taxpayer from tenants under
the Agreements will qualify as “rents from real property” under section 856(d).
Whether amounts received for the TRS-Provided Services give rise to
impermissible tenant service income.
Section 856(c)(3) provides that at least 75 percent of a REIT's gross income
must be derived from, among other sources, "rents from real property." Section
856(c)(2) provides that at least 95 percent of a REIT's gross income must be derived
from a broader group of sources which also includes "rents from real property."
Section 856(d)(1) provides that “rents from real property” include (subject to
exclusions provided in section 856(d)(2)): (A) rents from interests in real property; (B)
charges for services customarily furnished or rendered in connection with the rental of
real property, whether or not such charges are separately stated; and (C) rent
attributable to personal property leased under, or in connection with, a lease of real
property, but only if the rent attributable to the personal property for the taxable year
does not exceed 15 percent of the total rent, based on the average fair market values of
the real property and personal property, for the taxable year attributable to both the real
and personal property leased under, or in connection with, such lease.
Section 1.856-4(a) provides, in relevant part, that the term "rents from real
property" means, generally, the gross amounts received for the use of, or the right to
use, real property of the REIT.
Section 1.856-4(b)(1) provides that, for purposes of sections 856(c)(2) and (c)(3),
the term “rents from real property” includes charges for services customarily furnished
or rendered in connection with the rental of real property, whether or not the charges
are separately stated. Services furnished to tenants of a particular building will be
considered customary if, in the geographic market in which the building is located,
tenants in buildings of a similar class are customarily provided with the service. In
particular geographic areas where it is customary to furnish electricity or other utilities to
PLR-151324-12 15
tenants in buildings of a particular class, the submetering of those utilities to tenants in
the buildings will be considered a customary service.
Section 1.856-4(b)(5)(ii) provides that the trustees or directors of a REIT are not
required to delegate or contract out their fiduciary duty to manage the trust itself, as
distinguished from rendering or furnishing services to the tenants of its property or
managing or operating the property. Thus, the trustees or directors may do all those
things necessary, in their fiduciary capacities, to manage and conduct the affairs of the
trust itself.
Section 856(d)(2)(C) provides that any impermissible tenant service income is
excluded from the definition of “rents from real property.” Section 856(d)(7)(A) defines
“impermissible tenant service income” to mean, with respect to any real or personal
property, any amount received or accrued directly or indirectly by the REIT for services
furnished or rendered by the REIT to tenants of such property, or for managing or
operating the property.
Section 856(d)(7)(C) provides certain exclusions from impermissible tenant
service income. Section 856(d)(7)(C) provides that for purposes of section
856(d)(7)(A), services furnished or rendered, or management or operation provided,
through an independent contractor from whom the REIT does not derive or receive any
income or through a TRS of the REIT shall not be treated as furnished, rendered, or
provided by the REIT, and there shall not be taken into account any amount which
would be excluded from unrelated business taxable income under section 512(b)(3) if
received by an organization described in section 511(a)(2).
Section 512(b)(3) provides, in part, that there shall be excluded from the
computation of unrelated business taxable income all rents from real property and all
rents from personal property leased with such real property, if the rents attributable to
such personal property are an incidental amount of the total rents received or accrued
under the lease, determined at the time the personal property is placed in service.
Section 1.512(b)-1(c)(5) provides that payments for the use or occupancy of
rooms and other space where services are also rendered to the occupant, such as for
the use or occupancy of rooms or other quarters in hotels, boarding houses, or
apartment houses furnishing hotel services, or in tourist camps or tourist homes, motor
courts, or motels, or for the use or occupancy of space in parking lots, warehouses, or
storage garages, do not constitute rent from real property. Generally, services are
considered rendered to the occupant if they are primarily for his convenience and are
other than those usually or customarily rendered in connection with the rental of rooms
or other space for occupancy only. The supplying of maid service, for example,
constitutes such service; whereas the furnishing of heat and light, the cleaning of public
entrances, exits, stairways, and lobbies, and the collection of trash are not considered
as services rendered to the occupant.
PLR-151324-12 16
In Rev. Rul. 2002-38, 2002-2 C.B. 4, a REIT pays its TRS an arm’s length rate to
provide non-customary services to tenants. The REIT does not separately state
charges to tenants for the services. Thus, a portion of the amounts received by the
REIT from tenants represents an amount received for services provided by the TRS.
TRS employees perform all of the services and TRS pays all of the costs of providing
the services. The TRS also rents space from the REIT for carrying out its services to
tenants. The revenue ruling concludes that the services provided to the REIT’s tenants
are considered to be rendered by the TRS, rather than the REIT, for purposes of section
856(d)(7)(C)(i). Accordingly, the services do not give rise to impermissible tenant
service income and do not cause any portion of the rents received by the REIT to fail to
qualify as “rents from real property” under section 856(d) of the Code.
Under an Agreement, Taxpayer will rent to the tenant physical space, which may
include colocation space within a Building for tenant equipment, rights-of-way for the
wires or cables needed for the tenant’s interconnectivity (including interconnectivity to
TRS-operated, logical or managed network systems), office suites, secure shelf space,
rooftop space, or business recovery stations within a Building. In conjunction with the
rental of physical space within a Building, Taxpayer may also rent to the tenant
incidental personal property that satisfies the 15% standard of section 856(d)(1)(C) and
provide Core Services to the tenant.
Taxpayer represents that the Core Services Taxpayer will provide to tenants, as
described above, are usual or customary services that are rendered in connection with
the leasing and maintenance of space in data centers and are not rendered primarily for
the convenience of tenants. Taxpayer also represents that rent for personal property
leased by Taxpayer to a tenant under, or in connection with, a lease of real property for
a taxable year will constitute less than 15 percent of the total rent, based on the average
fair market values of the real property and personal property, for the taxable year
attributable to both the real and personal property leased by Taxpayer to the tenant
under, or in connection with, Taxpayer’s Agreement with the tenant.
Accordingly, the rents from interests in real property, charges for Core Services,
and amounts for incidental personal property leased under, or in connection with, a
lease of real property by Taxpayer, are “rents from real property” under section 856(d).
Other services will be performed by an independent contractor from whom
Taxpayer receives no income or by a TRS. Taxpayer (on behalf of itself and its TRSs)
will collect all or nearly all the amounts owing from tenants under an Agreement. Some
TRS-provided services, such as set-up and installation and smart hands support, may
be listed as separate line items on invoices to tenants under the lease. When a TRS
performs services for Taxpayer’s tenants, the TRS will receive arm’s-length fees from
Taxpayer for such services.
As noted above, Taxpayer expects to collect all, or nearly all, of the amounts
owing from tenants. Some TRS-Provided Services may be listed as separate line items
PLR-151324-12 17
on invoices to tenants. All TRS-Provided Services will be performed by employees of a
TRS and a TRS will pay all costs of providing such services. In addition, the TRS will
receive arm’s-length fees from Taxpayer for providing TRS-Provided Services.
Consequently, the TRS, not the Taxpayer, is the provider of the impermissible services.
As a result, the amounts received for the TRS-Provided Services do not give rise to
impermissible tenant service income and thus do not cause any portion of the rents
received by Taxpayer to fail to qualify as “rents from real property” under section 856(d)
of the Code.
Ruling Request #3: Whether the Real Estate Intangibles will be treated as real
property for purposes of section 856.
Section 856(c)(5)(C) provides that the term “interests in real property” includes
fee ownership and co-ownership of land or improvements thereon, leaseholds of land or
improvements thereon, options to acquire land or improvements thereon, and options to
acquire leaseholds of land or improvements thereon, but does not include mineral, oil,
or gas royalty interests.
Section 1.856-2(d)(3) provides that in determining the investment status of a
REIT, the term “total assets” means the gross assets of the REIT determined in
accordance with GAAP. The customer contracts and favorable lease intangibles
recognized as assets by GAAP are attributable to the acquisition of leaseholds on real
property with below-market rent and the acquisition of lease contracts. These
intangibles must be analyzed to determine whether they qualify as “real property” for
purposes of section 856. To qualify as real property for this purpose, the customer
contracts and favorable lease intangibles must be inseparable from and inextricably and
compulsorily tied to real property or interests in real property.
GAAP requires an allocation of the excess purchase price over the value of the
tangible assets to identified intangible assets and then to residual value goodwill.
Taxpayer’s Real Estate Intangibles arose when Taxpayer acquired other colocation
data center lessors. Taxpayer represents that the Real Estate Intangibles are derived
from Taxpayer’s leases to its tenants or from Taxpayer’s leases of Buildings, and in
each case are inextricably and compulsorily tied to the Buildings. Taxpayer also
represents that the Real Estate Intangibles are inseparable from the Buildings or leases
to which they relate, and have absolutely no value separate and apart from the value of
these assets. Taxpayer further represents that intangibles associated with TRS assets
are not Real Estate Intangibles.
The customer contract intangibles represent tenant leases for space in data
centers that are in place at the time of acquisition of a Building. The customer contract
intangibles cannot exist without the underlying lease of real property in the data center,
supporting Taxpayer’s representation that the Real Estate Intangible of customer
PLR-151324-12 18
contracts are inseparable from and inextricably and compulsorily tied to the real
property rental element of the customer contracts.
The favorable lease intangibles represent below-market leases Taxpayer
assumes upon acquisition. The favorable lease intangibles cannot exist without the
underlying leaseholds, supporting Taxpayer’s representation that the Real Estate
Intangible of favorable leases are inextricably and compulsorily tied to the below-market
leaseholds. Both the customer contract and favorable lease Real Estate Intangibles are
derived from interests in real property and are inseparable from, inexplicably tied to, and
have no value separate and apart from the interests in real property from which they are
derived.
GAAP recognizes residual value goodwill as the excess purchase price over the
net tangible and identified intangible assets acquired. This residual value goodwill,
which is attributable to the purchase of real property, as opposed to goodwill that may
arise from the acquisition of a business, exists only because of the underlying real
property, supporting Taxpayer’s representation that the Real Estate Intangible of
residual value goodwill is inextricably and compulsorily tied to the Buildings.
In the present case, Taxpayer’s Real Estate Intangibles are inseparable from and
inextricably and compulsorily tied to Taxpayer’s real property or interests in real
property. Accordingly, we rule that Taxpayer’s Real Estate Intangibles (the identifiable
intangibles of customer contracts and favorable leases as well as the residual value
goodwill attributable to real property of the REIT, and not intangibles associated with
TRS assets, as described above) qualify as real property for purposes of section
856(c)(5)(B).
Ruling Request #4: Whether a loan by Taxpayer to a TRS that is secured by real
property of the TRS that qualifies as an “interest in real property” under section
856 will be treated as an “interest in real property” for purposes of section
856(c)(4)(B)(ii) rather than as a security.
Under section 856(c)(4)(B)(ii), a REIT is permitted to hold the securities of one or
more TRSs as long as such securities do not exceed 25% of the value of the REIT's
total assets (the “25% Value Test”). The question presented in this ruling request is
whether a loan to a TRS that qualifies as a real estate asset under section 856(c)(5)(B)
should be considered a “security” for purposes of the 25% Value Test under section
856(c)(4)(B)(ii).
Section 1.856-3(e) provides that the term “securities” for purposes of subchapter
M of the Code does not include “interests in real property” or “real estate assets” as
those terms are defined in section 856.
PLR-151324-12 19
The rule in section 1.856-3(e) applies for purposes of subchapter M, including the
25% Value Test under section 856(c)(4)(B)(ii). Thus, in applying the 25% Value Test,
the term “securities” does not include “interests in real property” or “real estate assets”
as defined in sections 856 and 1.856-3.
Rev. Rul. 74-191, 1974-1 C.B. 170, holds that foreign real estate acquired by a
REIT is a "real estate asset" for purposes of section 856(c) and that the term
"mortgages on real property" includes a security interest which, under the laws of the
jurisdiction in which the property is located, is the legal equivalent of a mortgage or
deed of trust in the United States. The ruling describes an unincorporated domestic
trust, otherwise qualifying as a REIT under section 856, that made short term
construction loans secured by security interests in real property located outside the
United States. Such security interests were legally equivalent to those created by
mortgages or deeds of trust in the United States. The trust also had direct interests in
real estate located abroad. The ruling reasons that neither section 856 nor the
regulations thereunder restrict the term "real estate assets" to those located within the
United States.
In the present situation, Taxpayer represents that the loans between Taxpayer
and any TRS that are secured by interests in real property owned by that TRS will be
adequately secured (based on the loan value of the real property under section 1.856-
5(c)(2)) by such interests in real property. Taxpayer has further represented that the
loans create a security interest in real property which, under the laws of the jurisdiction
in which the property is located, is the equivalent of a mortgage and in all cases
includes a traditional right of foreclosure against the real property.
Based on the information provided and the representations made, a loan by
Taxpayer to a TRS secured by a section 856 “interest in real property” of that TRS will
be treated as an “interest in real property” and will not be treated as a “security” under
section 856(c)(4)(B)(ii).
Ruling Request #5: Whether rents received by Taxpayer from a TRS for the
leasing of space in Taxpayer’s Buildings (where at least 90 percent of the leased
space at a Building is leased to persons other than a TRS or related person
described in section 856(d)(2)(B)) in connection with the TRS’s provision of
services to Taxpayer’s tenants will be treated as rents from real property under
section 856(d) through the application of section 856(d)(8)(A).
Section 856(d)(2)(B) provides that, except as provided in section 856(d)(8), the
term "rents from real property" does not include any amount received or accrued directly
or indirectly from any person if the REIT owns, directly or indirectly: (i) in the case of any
person that is a corporation, stock of such person possessing 10 percent or more of the
total combined voting power of all classes of stock entitled to vote, or 10 percent or
more of the total value of shares of all classes of stock of such person; or (ii) in the case
PLR-151324-12 20
of any person that is not a corporation, an interest of 10 percent or more in the assets or
net profits of such person.
Section 856(d)(8) provides that amounts received by a REIT from its TRS will not
be excluded from rents from real property under section 856(d)(2)(B) if the terms of the
limited rental exception of section 856(d)(8)(A) are met. The requirements of section
856(d)(8)(A) are met with respect to any property if at least 90 percent of the leased
space of the property is rented to persons other than TRSs of such REIT and other than
related parties described in section 856(d)(2)(B), but only to the extent that the amounts
paid to the REIT by the TRS as rents from real property (without regard to section
856(d)(2)(B)) are substantially comparable to such rents paid by the other tenants of the
REIT's property for comparable space.
Taxpayer represents that the rents paid by the TRS for space in a Building will be
arm’s length and will be substantially comparable to rents paid by unrelated tenants for
comparable space either in the Building itself, if there is comparable space leased to
unrelated tenants in such Building or, if there is no such comparable space, in
Taxpayer’s other Buildings or in properties in the same geographic area. Taxpayer also
represents that in substantially all instances in which a TRS enters into a lease with
Taxpayer for the occupancy of space within a Building, at least 90 percent of the leased
space of the Building will be leased to persons other than TRSs and other than related
persons described in section 856(d)(2)(B).
Accordingly, based on Taxpayer’s representations, and provided that at least 90
percent of the leased space in a Building is leased to persons other than TRSs or
related persons described in section 856(d)(2)(B), rents received by Taxpayer from a
TRS for the leasing of space in the Building in connection with the TRS’s provisions of
services to Taxpayer’s customers will be treated as rents from real property under
section 856(d) through the application of section 856(d)(8)(A).
Ruling Request #6: Any amounts received by Taxpayer as reimbursements under
a cost-sharing arrangement will not be included in Taxpayer’s gross income for
purposes of sections 856(c)(2) and (3).
In Rev. Rul. 84-138, 1984-2 C.B. 123, a regulated investment company (“RIC”)
and its wholly owned subsidiary shared facilities and some personnel. It was agreed
that the RIC would pay all the expenses for general and administrative overhead,
including personnel costs, and the subsidiary would reimburse the RIC for its pro rata
share of the expenses on an arm's length basis. The ruling, in distinguishing Jergens
Co. v. Comm’r, 40 B.T.A. 868 (1939), states that the RIC was not engaged in the
business of receiving compensation for services of the type that were reimbursed.
Instead, reimbursements to the RIC from the subsidiary were merely repayments of
advances made by the RIC on behalf of the subsidiary. Accordingly, the ruling holds
PLR-151324-12 21
that the reimbursements were not included in the RIC's gross income under section 61,
and, therefore, were not subject to the gross income requirement of section 851(b)(2).
In the present case, the reimbursement and cost sharing arrangements to be
executed between Taxpayer and its TRS are analogous to the situation in Rev. Rul. 84-
-
Taxpayer and the applicable TRS intend to enter into an employee sharing
agreement under which certain employees of Taxpayer will be treated as loaned or
advanced to the TRS and certain employees of the TRS will be treated as loaned or
advanced to Taxpayer. In addition, Taxpayer and a TRS will enter into equipment
sharing agreements whereby each party will bear allocable costs based on use and the
primary party will be reimbursed for the expenses related to use of the equipment by the
other party on an at-cost basis.Neither Taxpayer nor the TRS will profit under any cost-sharing arrangement.
Neither Taxpayer nor the TRS will be in the trade or business of providing to third
parties any service or equipment that is the subject of reimbursement under any cost-
sharing arrangement. Accordingly, based on the information provided and
representations made, reimbursement payments received under cost-sharing
arrangements will not be treated as gross income for purposes of sections 856(c)(2)
and (3). Additionally, neither Taxpayer nor TRS will be entitled to a deduction for
payment of the expenses that are reimbursed.
Ruling Request #7: Whether Taxpayer’s Subpart F Inclusions, PFIC Inclusions,
and Section 956 Inclusions (each defined below), will be treated as qualifying
income under section 856(c)(2).
As noted earlier, Taxpayer intends to own, either partially or wholly, Foreign Subs
for which TRS elections will be made. Such Foreign Subs are either CFCs within the
meaning of section 957(a) with respect to which Taxpayer is a United States
Shareholder within the meaning of section 951(a), PFICs for which Taxpayer intends to
make elections under section 1295(a) to treat as QEFs, or PFICs for which Taxpayer
has not made a QEF or mark-to-market election.
As a result of being a United States Shareholder with respect to CFCs, Taxpayer
is required by section 951(a)(1)(A)(i) to include in its gross income its pro rata share of
the subpart F income, as defined in section 952(a), of the CFCs. Taxpayer expects to
report section 951(a)(1)(A) inclusions with respect to one or more CFCs as a result of
the CFC earning passive rental income, interest, and dividends that constitute FPHCI
(the “Subpart F Inclusions”).
In addition, as a result of being a United States Shareholder with respect to
CFCs, Taxpayer is required by section 951(a)(1)(B) to include in its gross income the
amount determined under section 956. Taxpayer expects to report section 951(a)(1)(B)
inclusions as a result of its CFCs being pledgors or guarantors of Taxpayer’s obligations
PLR-151324-12 22
within the meaning of section 956(d) and section 1.956-2(c), but the obligations will be
limited to debt of Taxpayer that will be incurred to finance Taxpayer’s acquisition,
improvement, or development of interests in real property that produce qualifying
income under section 856(c)(2) (the “Section 956 Inclusions”).
As a result of being a shareholder in PFICs for which Taxpayer makes QEF
elections, Taxpayer is required under section 1293(a) to include in its gross income its
pro rata share of the E&P of each such QEF. Also, as a result of being a shareholder in
PFICs for which Taxpayer has not made QEF or mark-to-market elections, Taxpayer is
required to include amounts in its gross income (as ordinary income) pursuant to
section 1291(a)(1)(B). Taxpayer expects to report section 1293(a) income inclusions
attributable to passive income from numerous PFICs for which QEF elections have
been made (the “QEF Inclusions”), and include amounts in ordinary income under
section 1291(a) attributable to passive income from PFICs for which QEF or mark-to-
market elections have not been made (together with QEF Inclusions, the “PFIC
Inclusions”).
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
(i) does not otherwise qualify under sections 856(c)(2) or (3) may be considered as not
constituting gross income for purposes of sections 856(c)(2) or (3), or (ii) otherwise
constitutes gross income not qualifying under sections 856(c)(2) or (3) may be
considered as gross income which qualifies under sections 856(c)(2) or (3).
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. 86-2020,
2d Sess. 4, at 6 (1960), 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.”
Subpart F Inclusions
Section 957 defines a CFC as a foreign corporation in which more than 50
percent of the total combined voting power of all classes of stock entitled to vote, or the
total value of the stock, is owned by United States Shareholders on any day during the
corporation’s taxable year. A United States Shareholder is defined in section 951(b) as
a United States person who owns 10 percent or more of the total voting power of the
foreign corporation. Taxpayer represents that it is a United States Shareholder within
the meaning of section 951(b) with respect to certain subsidiaries that are CFCs.
Section 951(a)(1)(A)(i) generally provides that if a foreign corporation is a CFC
for an uninterrupted period of 30 days or more during a taxable year, every person who
PLR-151324-12 23
is a United States Shareholder of the corporation and who owns stock in the corporation
on the last day of the taxable year in which the corporation is a CFC shall include in
income the shareholder’s pro rata share of the CFC’s subpart F income for the taxable
year.
Section 952 defines subpart F income to include foreign base company income,
as determined under section 954. Under section 954(a)(1), foreign base company
income includes FPHCI. Section 954(c)(1)(A) generally defines FPHCI to include
(among other things) dividends, interest, royalties, rents, and annuities. Section
954(c)(1)(B) also includes gain from the sale or exchange of property which (among
other things) gives rise to income described in section 954(c)(1)(A) (after application of
paragraph (2)(A)) other than property which gives rise to income not treated as FPHCI
by reason of section 954(h) or (i) for the taxable year.
Taxpayer represents that it is a United States Shareholder within the meaning of
section 951(b) with respect to certain of its subsidiaries that are CFCs. As Taxpayer’s
CFCs earn subpart F income attributable to foreign base company income that is
FPHCI and such income is generally passive income, treatment of the section
951(a)(1)(A)(i) inclusion attributable to such passive income as qualifying income for
purposes of section 856(c)(2) does not interfere with or impede the policy objectives of
Congress in enacting the income test under section 856(c)(2). Accordingly, we rule that
under section 856(c)(5)(J)(ii), Subpart F Inclusions attributable to the FPHCI that is
passive income are considered as gross income that qualifies for purposes of section
856(c)(2).
PFIC Inclusions
Section 1297(a) defines a PFIC as a foreign corporation if either (1) 75 percent or
more of the gross income of such corporation for the taxable year is passive income, or
(2) the average percentage of assets (as determined in accordance with section
1297(e)) held by such corporation during the taxable year which produce passive
income or which are held for the production of passive income is at least 50 percent.
Section 1297(b) defines the term “passive income” as income of a kind that would be
FPHCI under section 954(c), subject to certain exceptions.
Section 1291(a)(1) provides that if a United States person receives an excess
distribution (as defined in section 1291(b)) in respect of stock in a PFIC, then – (A) the
amount of the excess distribution shall be allocated ratably to each day in the
shareholder’s holding period for the stock, (B) with respect to such excess distribution,
the shareholder’s gross income for the current year shall include (as ordinary income)
only the amounts allocated under section 1291(a)(1)(A) to – (i) the current year, or (ii)
any period in the shareholder’s holding period before the 1st day of the 1st taxable year
of the company which begins after December 31, 1986, and for which it was a PFIC,
and (C) the tax imposed by chapter 1 of the Code for the current year shall be increased
by the deferred tax amount (determined under section 1291(c)). Under section
PLR-151324-12 24
1291(a)(2), the rules of section 1291(a)(1) apply to any gain recognized on the
disposition of stock of a PFIC as if the gain were an excess distribution.
Section 1295(a) provides that a PFIC will be treated as a QEF with respect to a
shareholder if (1) an election by the shareholder under section 1295(b) applies to such
PFIC for the taxable year; and (2) the PFIC complies with such requirements as the
Secretary may prescribe for purposes of determining the ordinary earnings and net
capital gains of such company. Section 1293(a) provides that every United States
person who owns (or is treated under section 1298(a) as owning) stock of a QEF at any
time during the taxable year of such fund shall include in gross income – (A) as ordinary
income, such shareholder’s pro rata share of the ordinary earnings of such fund for
such year, and (B) as long-term capital gain, such shareholder’s pro rata share of the
net capital gain of such fund for such year.
Taxpayer represents that it is a shareholder of certain subsidiaries that are PFICs
and that it intends to make QEF elections with respect to certain of these PFICs, and
not make QEF or mark-to-market elections with respect to other of these PFICs. As
Taxpayer’s PFICs earn income that is FPHCI and such income is generally passive
income, treatment of the PFIC Inclusions as qualifying income for purposes of section
856(c)(2) does not interfere with or impede the policy objectives of Congress in enacting
the income test under section 856(c)(2). Accordingly, we rule that under section
856(c)(5)(J)(ii), Taxpayer’s PFIC Inclusions are considered as gross income that
qualifies for purposes of section 856(c)(2).
Section 956 Inclusions
Section 951(a)(1)(B) provides that if a foreign corporation is a CFC for an
uninterrupted period of 30 days or more during a taxable year, every person who is a
United States shareholder of the corporation and who owns stock in the corporation on
the last day of the taxable year in which the corporation is a CFC shall include in gross
income the amount determined under section 956 with respect to the shareholder for
such year (but only to the extent not excluded from gross income under section
959(a)(2)).
Section 956(a) provides that in the case of a CFC, the amount determined under
section 956 with respect to any United States shareholder for any taxable year is the
lesser of – (1) the excess (if any) of – (A) such shareholder’s pro rata share of the
average of the amounts of United States property held (directly or indirectly) by the CFC
as of the close of each quarter of such taxable year, over (B) the amount of E&P
described in section 959(c)(1)(A) with respect to such shareholder, or (2) such
shareholder’s pro rata share of the applicable earnings of such CFC. In general, the
amount taken into account in the preceding sentence under (1) with respect to any
property shall be its adjusted basis as determined for purposes of computing E&P,
reduced by any liability to which the property is subject.
PLR-151324-12 25
Section 956(c) provides that United States property includes an obligation of a
United States person. Section 956(d) states that a CFC shall, under regulations
prescribed by the Secretary, be considered as holding an obligation of a United States
person if such CFC is a pledgor or guarantor of such obligation. Section 1.956-2(c)(1)
provides that except as provided in section 1.956-2(c)(4), any obligation (as defined in
section 1.956-2(d)(2)) of a United States person (as defined in section 957(d)) with
respect to which a CFC is a pledgor or guarantor shall be considered for purposes of
section 956(a) and section 1.956-2(a) to be United States property held by such CFC.
Section 1.956-2(c)(2) provides that if the assets of a CFC serve at any time, even
though indirectly, as security for the performance of an obligation of a United States
person, then the CFC will be considered a pledgor or guarantor of that obligation.
As stated earlier, Taxpayer represents that it is a United States Shareholder
within the meaning of section 951(b) with respect to certain of its subsidiaries that are
CFCs. Taxpayer will recognize Section 956 Inclusions because Taxpayer is a debtor on
one or more obligations with respect to which one or more of its CFCs is a pledgor or
guarantor (including cases in which the assets of a CFC serve indirectly as security for
an obligation). Each of these pledges or guarantees is incurred to finance Taxpayer’s
acquisition of real property. Taxpayer represents that the Section 956 Inclusions occur
as a result of debt of Taxpayer that arose in connection with the acquisition,
improvement, or development of interests in real property that produce qualifying
income under section 856(c)(2). To the extent Taxpayer recognizes Section 956
Inclusions as a result of (i) the pledge of the assets of a CFC (including through the
pledge of CFC shares), (ii) a CFC’s pledge of assets, or (iii) a CFC’s guarantee of an
obligation of Taxpayer, and the pledge or guarantee secures debt of the Taxpayer that
is used to finance the acquisition, improvement, or development of real property from
which income is derived that qualifies under section 856(c)(2), it would not interfere with
or impede the policy objectives of Congress in enacting the income test under that
provision to consider the Section 956 Inclusions as gross income that qualifies for
purposes of section 856(c)(2). Accordingly, we rule that under section 856(c)(5)(J)(ii),
Taxpayer’s Section 956 Inclusions are considered as gross income that qualifies for
purposes of section 856(c)(2).
Ruling Request #8: Whether foreign currency gain with respect to distributions
of previously taxed E&P as described in section 986(c)(1) (including Subpart F
Inclusions and similar income under sections 951(a) and 1293(a)) will not be
taken into account for purposes of section 856(c)(2).
Sections 959(d) and 1293(c) provide that, when a United States shareholder of a
CFC or a United States person owning an interest in a QEF is taxed on undistributed
corporate earnings under the subpart F or QEF inclusion rules, subsequent distributions
of the previously taxed earnings to the shareholder are not treated as dividends for
purposes of chapter 1 of the Code.
PLR-151324-12 26
Section 986(c)(1) provides that foreign currency gain or loss with respect to
distributions of previously taxed E&P (as described in section 959 or section 1293(c))
attributable to movements in exchange rates between the times of the deemed inclusion
and the actual distributions shall be recognized and treated as ordinary income or loss
from the same source as the associated income inclusion.
Section 856(n)(1)(A) provides that “passive foreign exchange gain” for any
taxable year will not constitute gross income for purposes of section 856(c)(2).
Section 856(n)(3) defines passive foreign exchange gain as: (A) real estate
foreign exchange gain (as defined in section 856(n)(2)); (B) foreign currency gains (as
defined in section 988(b)(1)) which is not described in subparagraph A and is
attributable to (i) any item of income or gain described in section 856(c)(2), (ii) the
acquisition or ownership of obligations (other than foreign currency gains attributable to
any item described in clause (i)), or (iii) becoming or being the obligor under obligations
(other than foreign currency gain attributable to any item of income or gain described in
clause (i)); and (C) any other foreign currency gains determined by the Secretary.
While section 986(c) gain is not a foreign currency gain defined in section
988(b)(1), such section 986(c) gain is attributable to the Subpart F Inclusions and QEF
Inclusions, items of income that are qualifying income for purposes of section 856(c)(2).
Section 986(c) gain is substantially similar to passive foreign exchange gain described
in section 856(n)(3)(B)(i). Therefore, pursuant to section 856(n)(3)(C), section 986(c)
gains are excluded from gross income for purposes of section 856(c)(2) because these
currency gains are considered passive foreign exchange gain that is excluded from
gross income for purposes of section 856(c)(2).
Ruling Request #9: Whether positive Section 481(a) Adjustments will be
considered as not constituting gross income under sections 856(c)(2) and (3).
Taxpayer filed Form 3115 to automatically change its method of depreciating
certain assets on Date 2. The automatic change has resulted in positive Section 481(a)
Adjustments that will be includible in taxable income over a period of four years.
Section 856(c) lists the sources of permissible income under the Income Tests. Income
from a Section 481(a) Adjustment is not specifically enumerated in sections 856(c)(2) or
(3).
Section 481(a) provides that a taxpayer that changes its method of accounting
takes into account necessary adjustments in computing its taxable income.
Section 1.481-1(d) provides that a section 481(a) adjustment must be properly
taken into account for purposes of computing gross income, adjusted gross income, or
taxable income in determining the amount of any item of gain, loss, deduction, or credit
that depends on gross income, adjusted gross income, or taxable income.
PLR-151324-12 27
The legislative history underlying the tax treatment of REITs indicates that the
central concern behind the gross income restrictions is that 95% of a REIT’s gross
income should be passive income and 75% of a REIT’s gross income should be passive
real estate income. See H.R. Rep. No. 86-2020, supra, at 6.
Any income resulting from a Section 481(a) Adjustment constitutes gross income
that does not qualify under sections 856(c)(2) or (3). Pursuant to section 856(c)(5)(J),
that income may be considered either as not constituting gross income under sections
856(c)(2) or (3) or as qualifying gross income under those provisions. Under the facts
of the instant case, excluding the Section 481(a) Adjustments from gross income for
purposes of sections 856(c)(2) and (3) does not interfere with Congressional policy
objectives in enacting the income tests. Accordingly, pursuant to section 856(c)(5)(J)(i),
we rule that the Section 481(a) Adjustments will be considered not to constitute gross
income for purposes of sections 856(c)(2) and (3).
Ruling Request #10:
(a) A change in Taxpayer’s method of accounting for depreciation of the Core
Systems and the Real Estate Intangibles for taxable income purposes under
sections 446(e) and 481(a), in respect of domestic corporations within the
meaning of section 7701(a)(3)-(4), requires a correlative change in computing
depreciation of the Core Systems and the Real Estate Intangibles for E&P
purposes under section 312(k)(3). Accordingly, consent of the Service is not
required to make that change for E&P purposes, separate and apart from the
consent required to change Taxpayer’s method of accounting for depreciation
for taxable income purposes.
(b) Further, because the depreciation deduction for the Core Systems and the
Real Estate Intangibles for taxable income purposes is not the same for E&P
purposes, additional adjustments are required to account for the change in
computing depreciation for E&P purposes, which are made under section 312
and the accompanying regulations. Because Taxpayer must take into account
the positive Section 481(a) Adjustments arising from the change in method of
accounting for depreciation for taxable income purposes over four years,
Taxpayer, in computing E&P, shall take the correlative adjustments arising
from the change in computing depreciation for E&P purposes over the same
period of time (four years) as it takes into account such Section 481(a)
Adjustments.
Section 446(a) generally provides that taxable income shall be computed under a
method of accounting on the basis of which the taxpayer regularly computes income in
keeping its books. Section 1.446-1(e)(1) provides that a taxpayer filing its first return
PLR-151324-12 28
may adopt any permissible method of accounting in computing taxable income for the
taxable year covered by such return.
Section 446(e) generally provides that a taxpayer who changes the method of
accounting on the basis of which the taxpayer regularly computes the taxpayer’s income
in keeping the taxpayer’s books shall, before computing the taxpayer’s taxable income
under the new method, secure the consent of the Secretary. Section 1.446-1(e)(2)(i)
provides that a taxpayer who changes the method of accounting employed in keeping
the taxpayer’s books shall, before computing the taxpayer’s income upon such new
method for purposes of taxation, secure the consent of the Commissioner.
A change in method of accounting includes a change in the overall plan of
accounting for gross income or deductions or a change in the treatment of any material
item used in such overall plan. A material item is any item that involved the proper time
for the inclusion of the item in income or the taking of a deduction. Section 1.446-
1(e)(2)(ii)(a).
In determining whether a taxpayer’s accounting practice for an item involves
timing, generally the relevant question is whether the practice permanently changes the
amount of a taxpayer’s lifetime taxable income. If the practice does not permanently
affect the taxpayer’s lifetime taxable income but does or could change the taxable year
in which income is reported, it involves timing and is therefore a method of accounting.
See Rev. Proc. 91-31, 1991-1 C.B. 566, Rev. Proc. 2011-14, 2011-4 I.R.B. 330.
A change in method of accounting does not include correction of mathematical or
posting errors, or errors in the computation of tax liability (such as errors in the
computation of the foreign tax credit, net operating loss, percentage depletion, or
investment credit). Also, a change in method of accounting does not include adjustment
of any item of income or deduction that does not involve the proper time for the
inclusion of the item of income or the taking of a deduction. Section 1.446-1(e)(2)(ii)(b).
A change in the period of recovery, a change in the convention, or a change in
the depreciation or amortization method of a depreciable or amortizable asset generally
is a change in method of accounting under section 446(e). See section 1.446-
1(e)(2)(ii)(d)(2)(i).
Section 481(a) provides that in computing the taxpayer’s taxable income for the
taxable year (year of change) (1) if such computation is under a method of accounting
different from the method under which the taxpayer’s taxable income for the preceding
taxable year was computed, then (2) there shall be taken into account those
adjustments which are determined to be necessary solely by reason of the change in
order to prevent amounts from being duplicated or omitted, except there shall not be
taken into account any adjustment in respect of any taxable year to which this section
does not apply unless the adjustment is attributable to a change in method of
accounting initiated by the taxpayer.
PLR-151324-12 29
Rev. Proc. 2011-14, as modified by Rev. Proc. 2012-39, 2012-41 I.R.B. 470,
(automatic consent procedures) and Rev. Proc. 97-27, as amplified and modified by
Rev. Proc. 2002-19, 2002-1 C.B. 696, as amplified and clarified by Rev. Proc. 2002-54,
2002-2 C.B. 432, as modified by Rev. Proc. 2007-67, 2007-2 C.B. 1072, as modified by
Rev. Proc. 2009-39, 2009-38 I.R.B. 371, as modified by Rev. Proc. 2011-14 and as
modified by Rev. Proc. 2012-39, (advance consent procedures) provide the
administrative procedures to request consent to change a method of accounting under
section 446(e). For the applicable period, Rev. Proc. 2011-14 was the exclusive
procedure to request a change in method of accounting that is expressly described in its
Appendix.
Section 312(a) generally provides that on the distribution of property by a
corporation with respect to its stock, the E&P of the corporation (to the extent thereof)
shall be decreased by the sum of: (1) the amount of money, (2) the principal amount of
the obligations of such corporation (or, in the case of obligations having original issue
discount, the aggregate price of such obligations), and (3) the adjusted basis of the
other property, so distributed.
Section 1.312-6 provides that due consideration must be given to the facts, and
while mere bookkeeping entries increasing or decreasing surplus will not be conclusive,
the amount of the E&P in any case will be dependent on the method of accounting
properly employed in computing taxable income (or net income, as the case may be).
For instance, a corporation keeping its books and filing its income tax returns on the
cash receipts and disbursements basis may not use the accrual basis in determining
E&P.
Section 312(k)(1) generally provides that for purposes of computing E&P of a
corporation, the allowance for depreciation shall be determined using the straight-line
method of depreciation. Section 312(k)(3) generally provides that, in the case of
tangible property to which section 168 applies, the adjustment to E&P for depreciation
for any taxable year shall be determined under the ADS. Therefore, in the computation
of E&P, the recovery period for nonresidential real property is 40 years. Sections
168(g)(2)(C)(iii) and 312(k)(3).
Rev. Proc. 79-47, 1979-2 C.B. 528, provides the procedures outlining the effect
on E&P resulting from an adjustment required by section 481(a) for a change in method
of accounting for taxable income purposes under section 446(e). In order to prevent
distortions, when computing E&P (current and accumulated) available for the payment
of dividends, the taxpayer shall follow its new method for reporting taxable income and
shall take the applicable Section 481(a) Adjustments into account over the same period
as it does for purposes of computing taxable income.
In the instant case, for property subject to section 168, the depreciation
deduction for taxable income purposes is not the same as for E&P purposes. When
PLR-151324-12 30
Taxpayer changes its method of computing depreciation for taxable income purposes, it
is required to change its method of computing depreciation for E&P purposes.
(a) Whether separate consent of the Commissioner is required.
On Date 2, Taxpayer filed a Form 3115 under Rev. Proc. 2011-14 to change its
method of computing depreciation for the Core Systems and the Real Estate Intangibles
predominantly used in the United States for taxable income purposes. The changes in
Taxpayer’s depreciation method, recovery periods, and convention for the Core
Systems for taxable income purposes are changes in methods of accounting under
sections 446(e) and 481(a). See section 1.446-1(e)(2)(ii)(d)(2)(i) (changes in
depreciation method, convention and recovery period to compute taxable income are
changes in methods of accounting under section 446(e)). Moreover, the change in
Taxpayer’s recovery period and convention for the Real Estate Intangibles for taxable
income purposes are changes in methods of accounting under sections 446(e) and
481(a). Id.
(b) Adjustments to E&P.
When Taxpayer changed its method of accounting for depreciation for the Core
Systems and Real Estate Intangibles for taxable income purposes, a correlative change
to Taxpayer’s method of computing depreciation for E&P purposes for the Core
Systems and Real Estate Intangibles was required. Section 312(k)(3) and
section 1.312-6. Accordingly, when Taxpayer changed its method of accounting for
depreciation for taxable income purposes, no additional consent was required for
Taxpayer to make the required correlative change in computing its depreciation for E&P
purposes.
Rev. Proc. 79-47 recognizes that the section 481(a) adjustment resulting from a
change in method of accounting for taxable income purposes may create a distortion in
E&P available for distribution in the year of change, and provides that the required
section 481(a) adjustment for taxable income purposes shall be spread, for E&P
purposes, over the same adjustment period as that used for taxable income purposes.
However, as stated above, section 312(k)(3) requires Taxpayer to use a different
method of computing depreciation for the Core Systems and Real Estate Intangibles for
E&P purposes than is permitted for taxable income purposes. As such, additional
adjustments to E&P under section 312 and the accompanying regulations are
necessary to correctly compute Taxpayer’s current and accumulated E&P to comply
with section 312(k)(3).
In correcting this change in depreciation for E&P purposes, Taxpayer shall take
into account the adjustment that must be made to its E&P under section 312(k) due to
the change in computing E&P for depreciation of the Core Systems and the Real Estate
Intangibles over the same period of time as Taxpayer does for the Section 481(a)
Adjustments due to the change in method of accounting for depreciation of the Core
PLR-151324-12 31
Systems and the Real Estate Intangibles for taxable income purposes under
section 446(e).
Ruling Request #11: To the extent that the Section 481(a) Adjustments from the
change in computing depreciation and amortization for certain assets exceed the
correlative E&P adjustments, any distributions of such excess shall be treated as
dividends by Taxpayer.
As referenced above, Taxpayer filed Form 3115 to automatically change its
method of depreciating certain assets. As a result of this method change, Taxpayer has
positive Section 481(a) Adjustments that have been and will be included in Taxpayer’s
taxable income ratably over four taxable years, including Taxpayer’s First REIT Taxable
Year. See Rev. Proc. 97-27, sec. 5.02(3)(a), 1997-1 C.B. 680, 684.
Taxpayer previously received a private letter ruling allowing it to take correlative
adjustments arising from the change in computing depreciation for E&P purposes
ratably over the same period as the Section 481(a) Adjustments. Due to differences in
computing depreciation for E&P purposes versus income tax purposes, Taxpayer’s
correlative adjustments to its E&P are lower than its Section 481(a) Adjustments.
The Section 481(a) Adjustments are subject to the section 1374 built-in gains tax,
which is not eliminated or reduced by the dividends paid deduction. Under section
337(d), Treas. Reg. section 1.337(d)-7, and section 1374 and the regulations
thereunder, the Section 481(a) Adjustments are subject to corporate level taxation
pursuant to Treas. Reg. section 1.1374-4(b) and (d). The net amount after the
application of corporate level taxation is REIT taxable income (“REITTI”) subject to the
distribution requirements of section 857(a).
Section 561(a) provides that the deduction for dividends paid shall be the sum of
the dividends paid during the year and consent dividends for the taxable year.
Section 562(a) provides that the term “dividend” shall include only dividends as
described in section 316. Section 316(a) defines the term “dividend” to mean any
distribution of property made by a corporation to its shareholders out of either current
year or accumulated E&P.
Section 857(a)(1) requires, in part, that a REIT’s deduction for dividends paid for
a taxable year equals at least 90 percent of its REITTI for the taxable year, determined
without regard to the deduction for dividends paid (as defined by section 561) or any net
capital gains (such adjusted taxable income, “Pre-Distribution Ordinary Income”).
Section 857(a)(2) generally requires that, as of the close of a taxable year, a
REIT has no E&P accumulated in any non-REIT year.
PLR-151324-12 32
Section 857(b)(2)(B) provides that in determining a REIT’s taxable income, the
deduction for dividends paid (as defined in section 561) shall be allowed.
Section 857(d)(1) provides that the E&P of a REIT for any taxable year (but not
its accumulated earnings) shall not be reduced by any amount which is not allowable in
computing the REIT’s taxable income for such taxable year.
Section 857(d)(2) provides that a REIT is treated as having sufficient E&P to treat
as a dividend any distribution that it treats as a dividend to the extent the distribution,
when combined with other distributions in the same calendar year, does not exceed the
distributions required by section 4981.
Section 4981 generally levies an excise tax on REITs that do not make required
distributions during the calendar year. In general, a REIT’s required distribution equals
at least 85 percent of its current year ordinary income and at least 95 percent of its
current year capital gain net income. The remaining percentage of the REIT’s current
year ordinary income (up to 15 percent) and its current year capital gain net income (up
to 5 percent) are included in its required distribution in the following year. For purposes
of section 4981, “ordinary income” equals the REIT’s taxable income as determined
under section 857(b)(2) without regard to the section 857(b)(2)(B) dividends paid
deduction.
The House Conference Report for the Tax Reform Act of 1986 states the
following in discussing its rejection of a Senate amendment to section 857:
The conference agreement does not contain a provision from the Senate
amendment under which a REIT’s E&P for a taxable year would not be
less than its real estate [investment] trust taxable income for the taxable
year (without regard to dividends paid deduction), since the conferees
believe that this provision is a restatement of law.
H.R. Conf. Rep. No. 99-841, at 218 (1986). Therefore, the regime governing the
taxation of REITs, which requires distributions of taxable income, is intended to match
the REIT’s E&P to that income.
Therefore, to the extent that the Section 481(a) Adjustments exceed the
correlative E&P adjustments arising from Taxpayer’s changes in computing depreciation
and amortization, any distributions of such excess (that are distributed and treated as
dividends by Taxpayer in the year in which such excess arises) shall be treated as
made from E&P.
Ruling Request #12: Whether all of the cash and the Taxpayer Stock distributed
in any Stock and Cash Distribution will be treated as a distribution of property on
the Taxpayer Stock to which section 301 applies. Whether Convertible
PLR-151324-12 33
Adjustments shall constitute a deemed distribution of Taxpayer Stock to the
holders of the Convertible Debt to which section 301 applies by reason of
sections 305(b)(2) and (c), provided at least some cash is distributed in the
associated Stock and Cash Distribution. Whether if some shareholders receive a
distribution of all cash, all Taxpayer Stock, or a combination of cash and
Taxpayer Stock that differs from the distribution received by other shareholders
in the same Stock and Cash Distribution, or if the fair market value of the
Taxpayer Stock on the date of the Stock and Cash Distribution differs from the
amount of cash that could have been received, or if Convertible Adjustments use
a different valuation mechanism than that used in the Stock and Cash
Distribution, those differences will not cause any such Stock and Cash
Distribution and associated Convertible Adjustments to be treated as preferential
dividends under section 562(c).
Section 561(b) applies the rules of section 562 for determining which dividends
are eligible for the deduction for dividends paid under section 561(a).
Section 562(c) provides that the amount of any distribution will not be considered
as a dividend for purposes of computing the dividends paid deduction under section 561
unless the distribution is pro rata. The distribution must not prefer any shares of stock of
a class over other shares of stock of that same class.
Treas. Reg. section 1.562-2 provides that a corporation will not be entitled to a
deduction for dividends paid with respect to any distribution upon a class of stock if
there is distributed to any shareholder of such class (in proportion to the number of
shares held by him) more or less than his pro rata part of the distribution as compared
with the distribution made to any other shareholder of the same class. Nor will a
corporation be entitled to a deduction for dividends paid in the case of any distribution
upon a class of stock if there is distributed upon such class of stock more or less than
the amount to which it is entitled as compared with any other class of stock. A
preference exists if any rights to preference inherent in any class of stock are violated.
The disallowance, when any preference in fact exists, extends to the entire amount of
the distribution and not merely to a part of such distribution.
Based solely on the information submitted and the representations made, we rule
as follows:
(1) Any and all of the cash and Taxpayer Stock distributed in a Stock and
Cash Distribution by Taxpayer to holders of the Taxpayer Stock using the
election described above shall be treated as a distribution of property with
respect to the Taxpayer Stock to which section 301 applies (sections 301
and 305(b)(1)).
(2) The Adjustments shall constitute a deemed distribution of Taxpayer stock
to the holders of the Convertible Debt to which section 301 applies by
PLR-151324-12 34
reason of section 305(b)(2) and (c), provided at least some cash is
distributed in the associated Stock and Cash Distribution.
(3) The terms of the Stock and Cash Distribution will not cause the Stock and
Cash Distribution to be considered preferential under section 562(c).
Accordingly, if, under those terms, a stockholder receives a combination of
Taxpayer Stock and cash that differs from the combination received by
other stockholders, and if the fair market value of the Taxpayer Stock on
the date of distribution differs from the amount of money which could have
been received instead, or if conversion rates applicable to the Convertible
Debts use a different valuation mechanism than that used in the Stock and
Cash Distribution, those differences will not cause the distribution to be
considered preferential under section 562(c).
Ruling Request #13: Whether hedging identifications made by Company prior to
the first day of Taxpayer’s First REIT Taxable Year, or by a Company entity or
M&A Target Entity prior to its inclusion as part of Taxpayer for REIT income or
asset testing purposes, will be effective for purposes of section 856(c)(5)(G) to
the extent the hedging identifications would have so qualified had they been
made by a REIT. In addition, whether Taxpayer’s clear identification of an
outstanding hedge on the first day that Taxpayer becomes a party of the hedge
for REIT income or asset testing purposes, including through conversion of a
TRS to a QRS or a partnership of Taxpayer or through acquisition of an M&A
Target Entity that becomes a QRS or a partnership of Taxpayer, will be
considered timely identification for purposes of section 856(c)(5)(G).
Section 61(a) of the Code provides that, except as otherwise provided, gross
income includes all income from whatever source derived.
Section 856(c)(5)(G)(i) provides that, except to the extent determined by the
Secretary, income of a REIT from a hedging transaction (as defined in section
1221(b)(2)(A)(ii) or (iii)) that is clearly identified pursuant to section 1221(a)(7), including
gain from the sale or disposition of such a transaction, shall not constitute gross income
under section 856(c)(2) or (3) to the extent the transaction hedges indebtedness
incurred or to be incurred by the REIT to acquire or carry real estate assets.
Section 856(c)(5)(G)(ii) provides that, except to the extent determined by the
Secretary, income of a REIT from a transaction entered into by the REIT primarily to
manage risk of currency fluctuations with respect to any item of income or gain
described in section 856(c)(2) or (3) (or any property that generates such income),
including gain from the termination of such a transaction, shall not constitute gross
income under section 856(c)(2) or (3), provided that the transaction is clearly identified
as such before the close of the day on which it was acquired, originated, or entered into.
PLR-151324-12 35
Section 856(i)(1) provides that a corporation which is a QRS shall not be treated
as a separate corporation, and all the assets, liabilities, and items of income, deduction,
and credit of a QRS shall be treated as assets, liabilities, and such items (as the case
may be) of the REIT. Section 856(i)(2) defines QRS as any corporation if 100 percent
of the stock of such corporation is held by the REIT. Such term does not include a TRS.
Section 1221(b)(2)(A)(ii) and the regulations thereunder provide that a “hedging
transaction” includes any transaction entered into by the taxpayer in the normal course
of the taxpayer’s trade or business primarily to manage risk of interest rate or price
changes or currency fluctuations with respect to borrowings made or to be made, or
ordinary obligations incurred or to be incurred, by the taxpayer.
Section 1221(a)(7) and section 1.1221-2(f)(1) require a hedging transaction to be
clearly identified as such before the close of the day on which it was acquired,
originated, or entered into.
Section 1.1221-2(f)(2) requires a taxpayer that enters into a hedging transaction
to make a substantially contemporaneous identification of the item, items, or aggregate
risk being hedged, and provides that an identification is not substantially
contemporaneous if it is made more than 35 days after entering into the hedging
transaction.
Taxpayer will have entered into hedges prior to the commencement of
Taxpayer’s First REIT Taxable Year. In addition, prior to the time that Taxpayer
converts one or more of its TRSs that do business in foreign countries to either QRSs,
other disregarded entities, or partnerships, some of these TRSs will have entered into
hedges. Finally, some M&A Target Entities will have entered into hedges prior to the
acquisition of these M&A Target Entities by the Company. Such hedges will thus be
pre-existing as of the first day that Taxpayer is treated as a REIT or when pre-existing
hedges entered into by these entities are included as part of Taxpayer’s hedges for
REIT income testing purposes.
Some pre-existing hedges will have been clearly and timely identified by
Taxpayer, the TRS, or the M&A Target Entity pursuant to section 1221(a)(7). These pre-
existing hedges will have met the requirements of section 856(c)(5)(G) but for the fact
that these hedges were identified by, as applicable, Taxpayer prior to its becoming a
REIT, a TRS prior to its becoming a QRS, other disregarded entity, or partnership of
Taxpayer, or the M&A Target Entity prior to its becoming a QRS, other disregarded
entity, or partnership of Taxpayer.
With respect to any pre-existing hedge that has not been clearly identified prior to
the time Taxpayer becomes a REIT or the hedge is included by Taxpayer, Taxpayer
intends to identify each such hedge for section 856(c)(5)(G) purposes (i) on the first day
that Taxpayer or one of its QRSs, other disregarded entities, or partnerships becomes a
party to the hedge (including through conversion of a TRS to a QRS, other disregarded
PLR-151324-12 36
entity, or a partnership of Taxpayer or through acquisition of an M&A Target Entity that
becomes a QRS, other disregarded entity, or partnership of Taxpayer), or (ii) the first
day of the First REIT Taxable Year.
Based on the facts above and the representations of Taxpayer, pre-existing
hedges that were properly identified by, as applicable, Taxpayer prior to its becoming a
REIT, a TRS prior to its becoming a QRS, other disregarded entity, or partnership of
Taxpayer, or the M&A Target Entity prior to its becoming a QRS, other disregarded
entity, or partnership of Taxpayer will be treated as properly identified for purposes of
section 856(c)(5)(G). Accordingly, pursuant to the authority under section
856(c)(5)(J)(i), we rule that the income from these pre-existing hedges will be
considered as not constituting gross income under sections 856(c)(2) or (3) provided
that such pre-existing hedging transaction was properly identified by the entity that
acquired, originated, or entered into the hedge.
Based on the facts above and the representations of Taxpayer, excluding the
income with respect to any pre-existing hedge that has not been clearly identified prior
to the time Taxpayer becomes a REIT from Taxpayer’s gross income for purposes of
sections 856(c)(2) and (3) does not interfere with Congressional policy objectives in
enacting the income tests under those provisions. Therefore, pursuant to the authority
under section 856(c)(5)(J)(i), we rule that the income from a pre-existing hedge that was
not previously properly identified will be considered as not constituting gross income
under sections 856(c)(2) and (3), provided that Taxpayer clearly identifies such pre-
existing hedge (i) on the first day that Taxpayer or one of its QRSs, other disregarded
entities, or partnerships becomes a party to the hedge (including through conversion of
a TRS to a QRS, other disregarded entity, or a partnership of Taxpayer or through
acquisition of an M&A Target Entity that becomes a QRS, other disregarded entity or a
partnership of Taxpayer), or (ii) the first day of the First REIT Taxable Year.
CAVEATS:
The rulings contained in this letter are based upon information and
representations submitted by Taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. Any of the material submitted in support of
this request for rulings is subject to verification on examination.
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. Specifically, no opinion is expressed or implied as to whether
Taxpayer otherwise qualifies as a REIT under subchapter M of the Code. Additionally,
no opinion is expressed concerning whether any amounts received by Taxpayer will be
redetermined rents under section 857(b)(7)(B)(i). We also express no opinion regarding
whether the value that Taxpayer allocated to the Real Estate Intangibles was properly
determined or whether some of the value that Taxpayer ascribes to the Real Estate
PLR-151324-12 37
Intangibles is properly attributable to some other intangible that would not qualify as real
property for the purposes of section 856.
Except as expressly provided herein, no opinion is expressed or implied
concerning the tax treatment of Taxpayer’s proposed distributions under other
provisions of the Code and regulations or the tax treatment of any condition existing at
the time of, or effects resulting from, these distributions that is not specifically covered
by the above rulings. Specifically, rulings concerning Stock and Cash Distributions are
void, and we do not express any opinion on the tax consequences of such distributions,
if they are not completed during Taxpayer’s First REIT Taxable Year. In addition, no
opinion is expressed with regard to the validity of the valuation methodology chosen by
Taxpayer in determining the number of shares issued in a distribution or any tax
consequences resulting from the establishment of a dividend reinvestment plan in the
future.
Moreover, no opinion is expressed or implied as to whether: (i) the Core
Systems are nonresidential real property under section 168(e)(2)(B) for purposes of
computing depreciation under section 168 or 312(k); (ii) the cost of the Real Estate
Intangibles is taken into account as part of the basis of the tangible real or personal
property under section 1.197-2(c)(8)(i); and (iii) the Taxpayer’s method of accounting for
depreciation or amortization for any taxable year for the Core Systems or Real Estate
Intangibles are permissible for Federal income tax purposes. Further, no opinion is
expressed or implied regarding whether the section 481(a) adjustment period reported,
or the E&P adjustments made, by Taxpayer at the time of the REIT conversion were
proper.
This ruling is directed only to the taxpayer requesting it. Taxpayer should attach
a copy of this ruling to each tax return to which it applies. Section 6110(k)(3) of the
Code provides that this ruling may not be used or cited as precedent.
In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to your authorized representatives.
Sincerely,
Andrea M. Hoffenson_______________
Andrea M. Hoffenson
Chief, Branch 2
Office of Associate Chief Counsel
(Financial Institutions & Products)
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