Carbon credits earned through partnerships qualify as REIT income

Plain-English summary

A timberland REIT indirectly owned interests in six partnerships developing forest carbon-offset projects under a state cap-and-trade program. The projects required long-term land-use restrictions, monitoring, inventories, independent verification, and repayment or replacement of credits if tree stocks declined. The IRS ruled that, unless section 451(b)(1)(A) required earlier inclusion, income from issued credits accrued when first earned, received, or due. Because the restrictions resembled term easements over real property, the IRS treated the REIT's proportionate share of the credit income as qualifying income for both REIT gross-income tests.

Ruling snapshot

• Question: When does partnership carbon-credit income accrue, and does it qualify for the REIT gross-income tests?
• Outcome: Approved: accrual occurs at the earliest of earning, receipt, or due date, and the REIT's share is qualifying income.
• Key authorities: IRC §§ 451 and 856(c)(2), (3), and (5)(J); Treas. Reg. §§ 1.856-3(g) and 1.856-4.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201949004 Third Party Communication: None
Release Date: 12/6/2019 Date of Communication: Not Applicable
Index Number: 856.00-00
Person To Contact:
------------------------------- ------------------, ID No. ------------------
----------------- Telephone Number:
--------------------------------------------- ----------------------
----------------------------------- Refer Reply To:
-------------- CC:FIP:B01
------------------------------------ PLR-103655-18
Date:
September 09, 2019

Legend

Taxpayer = ---------------------------------------------

Subsidiary = ------------------------------------------------------------------------

Partnership A = --------------------------------------

Partnership B = --------------------------------------

Partnership C = -------------------------------------

Partnership D = --------------------------------------------------------

Partnership E = ----------------------------------------

Partnership F = --------------------------------------------------

Manager = ------------------------------------------------------

Agency = -------------------------------------------

Act = -----------------------------------------------

Protocol = ------------------------------------------------------------------------

Country = ------------

State A = ---------------------
PLR-103655-18 2

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

States = ------------------------------------------------------------------------
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Year 1 = -------

Year 2 = -------

a = ----

b = --

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

d = ----------------

e = --

f = -----

g = ----

h = --------

i = ----

j = ------

k = ------

l = ----

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

  This responds to a letter dated February 7, 2018, and subsequent

correspondence, submitted on behalf of Taxpayer. Taxpayer requests certain rulings
regarding the treatment of income from credits issued by Agency, pursuant to the State
B Program, beginning in Year 2 and subsequently thereafter (“Credits”) for purposes of
PLR-103655-18 3

its status as a real estate investment trust (“REIT”) under section 856 of the Internal
Revenue Code (“Code”):

   (1) Unless section 451(b)(1)(A) requires earlier inclusion, income with
   respect to the issuance of Credits accrues under section 451 upon the
   earliest of the following events to take place: Credits are earned, Credits
   are received, or Credits are due, and

   (2) Pursuant to section 856(c)(5)(J)(ii), Taxpayer’s proportionate share of
   income from the issuance of Credits will be considered as qualifying
   income under section 856(c)(2) and (c)(3).

                                      FACTS

    Taxpayer is a State A limited liability company that has elected under section 856

to be treated as a REIT for federal income tax purposes.

   Taxpayer owns an a percent limited partnership interest in Subsidiary, a State A

limited partnership classified as a partnership for federal income tax purposes.
Manager owns a b percent general partnership interest in Subsidiary. Subsidiary owns
(including through limited liability companies classified as either partnerships or
disregarded entities for federal income tax purposes) approximately c acres of
timberlands located in Country and States with an aggregate estimated fair market
value of approximately $d. Manager directly or indirectly manages Subsidiary, which
realizes income and gain through timber sales and occasional sales of timberlands.

    Subsidiary indirectly owns a j percent membership interest in each of Partnership

A, Partnership B, Partnership C, Partnership D, and Partnership E. Partnership E, in
turn, owns an a percent membership interest in Partnership F. Partnerships A through
F are limited liability companies classified as partnerships for federal income tax
purposes (collectively referred to as “Partnerships”, and collectively with Subsidiary
referred to as “Entities”). Manager owns the remaining membership interests in
Partnerships. Taxpayer and Entities each employ the accrual method of accounting,
and the taxable year of each is the calendar year.

   Taxpayer represents that Entities have e projects under development on certain

portions of their existing U.S. landholdings that will qualify under the carbon offset
program described below.

   State B Program

PLR-103655-18 4

    In Year 1, State B enacted Act in an effort to reduce greenhouse gas (“GHG”)

emissions. Act created State B’s cap-and-trade program whereby State B sets a hard
cap on overall GHG emissions but allows certain businesses to buy, sell, and trade the
rights to produce emissions (the “State B Program”).

    Agency administers the State B Program on behalf of State B. Under the State B

Program, Agency issues Credits in exchange for a project developer engaging in
activities on U.S. landholdings that affirmatively reduce GHG emissions. Agency's
protocol describes the standards that each carbon offset project must satisfy
(“Protocol”). Each of Entities’ carbon offset projects is predicated on the use of a
specified parcel of Entities’ timberlands located in States to reduce atmospheric carbon
dioxide.

   Per the Protocol, Agency will issue to Entities one Credit for each metric ton of

carbon dioxide removed from the atmosphere by each project. To ensure that its
timberlands will process a sufficient amount of carbon dioxide to meet the requirements
of the State B Program, Entities must continuously monitor their compliance with the
Protocol. Agency holds each of Entities’ projects to rigorous reporting standards to
demonstrate that Entities’ efforts are effective. Thus, to qualify for Credits, Entities must
undertake certain affirmative obligations and agree to certain restrictions on the use of
the specified parcels of each project’s timberlands for f years, including:

   1. Demonstrating that the committed timberland is of a specified
   composition of tree species and ages, and the tree canopy covers at least
   k percent of any l-acre section of the committed timberland at all times;

   2. Submitting plans to Agency to show that the practices are sustainable;

   3. Demonstrating continuous compliance with the Protocol by conducting
   a complete forest inventory every g years that is fully verified by
   independent third parties authorized by State B;

   4. Conducting full verification of carbon sequestration by independent
   third parties in the h year between the complete inventories; and

   5. Obtaining less-intensive verifications of carbon sequestration annually.

   If the total stock of trees in a project decreases over any consecutive i-year

period, Entities are obligated to return some or all Credits they received for that project
(or acquire Credits to be relinquished). Land-use restrictions to which Entities agreed to
abide by under the State B Program are restrictions that could be recorded as
easements under local law, although Entities are not presently contemplating doing so.
PLR-103655-18 5

   In Year 2, Agency issued Credits to Partnership D. The other Entities expect to

be issued Credits in years beginning after Year 2.

   Taxpayer represents that Entities intend either to sell Credits in one or more

transactions to unrelated third-party purchasers or to transfer Credits to a taxable REIT
subsidiary of Taxpayer that will sell them to unrelated third-party purchasers. Taxpayer
further represents that neither Taxpayer nor Entities intend to hold Credits for purposes
of speculating on future appreciation.

                              LAW AND ANALYSIS

    Section 61(a) defines gross income as “income from whatever source derived,”

except as otherwise provided by law. See Treas. Reg. § 1.61-1(a). Gross income
includes income realized in any form, whether in money, property, or services. Id. This
definition encompasses all “accessions to wealth, clearly realized, and over which the
taxpayers have complete dominion.” Commissioner v. Glenshaw Glass Co., 348 U.S.
426, 431(1955).

   Section 451 and the regulations thereunder provide rules for determining the

taxable year of inclusion for items of gross income.

    Under an accrual method of accounting, unless section 451(b)(1)(A) requires

earlier inclusion, an item of gross income is generally includible when all the events
have occurred which fix the right to receive such income and the amount thereof can be
determined with reasonable accuracy. All the events that fix the right to receive income
generally occur upon the earliest of the following: (1) the required performance takes
place, (2) payment is due, or (3) payment is made. See Schlude v. Commissioner, 372
U.S. 128 (1963); Rev. Rul. 2003-10, 2003-1 C.B. 288. However, section 451(b)(1)(A)
sets forth special rules requiring earlier inclusion in the case of certain accrual-method
taxpayers.

    Section 856(c)(2) provides that for a corporation to qualify as a REIT for any

taxable year, at least 95 percent of its gross income (excluding gross income from
prohibited transactions) must be derived from sources that include dividends, interest,
rents from real property, gain from the sale or other disposition of stock, securities, and
real property (other than property in which the corporation is a dealer), abatements and
refunds of taxes on real property, income and gain derived from foreclosure property,
certain commitment fees, and gain from certain sales or other dispositions of real estate
assets.
PLR-103655-18 6

    Section 856(c)(3) provides that for a corporation to qualify as a REIT for any

taxable year, at least 75 percent of the corporation's gross income (excluding gross
income from prohibited transactions) must be derived from rents from real property,
interest on obligations secured by real property, gain from the sale or other disposition
of real property (other than property in which the corporation is a dealer), dividends from
REIT stock and gain from the sale of REIT stock, abatements and refunds of taxes on
real property, income and gain derived from foreclosure property, certain commitment
fees, gain from certain sales or other dispositions of real estate assets, and qualified
temporary investment income.

    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 for the taxable year attributable to both the
real and personal property leased under, or in connection with, the lease.

     Section 856(c)(5)(J) provides that to the extent necessary to carry out the

purposes of part II of subchapter M of Chapter 1 of the Code, the Secretary is
authorized to determine, solely for purposes of such part, (i) whether any item of income
or gain that does not otherwise qualify under sections 856(c)(2) or (c)(3) may be
considered as not constituting gross income for purposes of sections 856(c)(2) or (c)(3),
or (ii) whether any item of income or gain that otherwise constitutes gross income not
qualifying under sections 856(c)(2) or (c)(3) may be considered as gross income that
qualifies under sections 856(c)(2) or (c)(3).

  Section 1.856-4(a)(1) provides that, subject to the exceptions of section 856(d)

and § 1.856-4(b), 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.

   Under § 1.856-3(g), a REIT that is a partner in a partnership is deemed to own its

proportionate share of each of the assets of the partnership and to be entitled to the
income of the partnership attributable to that share. For purposes of section 856, the
interest of a partner in the partnership's assets is determined in accordance with the
partner's capital interest in the partnership. The character of the various assets in the
hands of the partnership and items of gross income of the partnership retain the same
character in the hands of the partners for all purposes of section 856.

   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
PLR-103655-18 7

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

    Unless section 451(b)(1)(A) requires earlier inclusion, income with respect to the

issuance of Credits will accrue under section 451 upon the earliest of the following
events to take place: Credits are earned, Credits are received, or Credits are due.
Taxpayer’s proportionate share of an Entity’s basis in a Credit will equal the
proportionate share of the fair market value of such Credit accrued as income by
Taxpayer. Cf. Philadelphia Park Amusement Co. v. United States, 126 F.Supp. 184,
188-189 (Ct. Cl. 1954). However, Taxpayer’s proportionate share of income with
respect to the issuance of Credits by the State B Program constitutes gross income that
is not listed as qualifying income under sections 856(c)(2) or (c)(3).

    Entities will earn Credits by agreeing to certain restrictions on the use of their

land for a specified term of years. The State B Program imposes land-use restrictions
by requiring Entities to abstain from certain uses of their land as well as to perform
certain actions on their land. Such land-use restrictions are restrictions that could be
recorded as easements under local law. Under the State B Program, Entities will incur
significant penalties if they do not abide by the restrictions to which they have agreed.
For these reasons, Credits are akin to receiving payment for granting an easement for a
term of years with respect to the real property. Cf. Wineberg v. Commissioner, 326
F.2d 157, 169-70 (9th Cir. 1963) (holding amount received for granting 10-year right to
use a road was rent rather than sale of an interest in land), aff’g T.C. Memo. 1961-336;
Nay v. Commissioner, 19 T.C. 114, 119 (1952) (concluding amount received for
granting a “right of way” for a term not to exceed three years is ordinary income
because such a “limited easement” does not constitute sale of real property). Under
these circumstances, treating Taxpayer’s proportionate share of income with respect to
the issuance of Credits as qualifying income does not interfere with or impede the
objectives of Congress in enacting section 856(c)(2) and (c)(3).

                                CONCLUSIONS

    Based on the information submitted and the representation made, we hereby rule

as follows:

   (1) Unless section 451(b)(1)(A) requires earlier inclusion, income with respect to

the issuance of Credits will accrue under section 451 upon the earliest of the following
events to take place: Credits are earned, Credits are received, or Credits are due; and
PLR-103655-18 8

   (2) Pursuant to section 856(c)(5)(J)(ii), Taxpayer’s proportionate share of income

from the issuance of Credits will be considered as qualifying income under section
856(c)(2) and (c)(3).

    This ruling's application is limited to the facts, representations, Code sections,

and regulations cited herein. 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. In particular, no opinion is expressed with
regard to whether Taxpayer otherwise qualifes as a REIT under subchapter M of the
Code. Nor is any opinion expressed with respect to the tax consequences of any
dispositions of Credits , including whether a sale of the Credits constitutes a prohibited
transaction as described in section 857(b)(6)(B)(iii). This letter ruling is prospective and
does not provide guidance regarding Credits issued directly or indirectly prior to Year 2.
Additionally, no opinion is expressed regarding whether Taxpayer or any Entity has
established a method of accounting through consistent treatment or whether application
of the rulings set forth above without obtaining the Commissioner’s consent for a
change of accounting method will result in an impermissible change of accounting
method. See Rev. Rul. 90-38, 1990-1 C.B. 57.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the

Code provides that it may not be used or cited as precedent.

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representatives.

                                   Sincerely,




                                   _____________________________
                                   Andrea M. Hoffenson
                                   Branch Chief, Branch 2
                                   Office of Associate Chief Counsel
                                   (Financial Institutions & Products)

Enclosure:
A copy of this letter

cc: