Carbon credits from two programs qualify as REIT income

Plain-English summary

A timberland REIT indirectly participated in two carbon-offset programs: a state cap-and-trade system for U.S. forest projects and a voluntary program for foreign timberland protected from deforestation. Both programs required long-term land-use restrictions, monitoring, inventories, independent verification, and possible credit cancellation or repayment. The IRS ruled that, unless section 451(b)(1)(A) required earlier inclusion, credit income 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 income from both programs as qualifying income for the 95-percent and 75-percent gross-income tests.

Ruling snapshot

• Question: When does income from the two carbon-credit programs 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: 201949005 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-103656-18
Date:
September 09, 2019

Legend

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

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

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

Partnership = ------------------------------------------------------------------------

DE 1 = ----------------------------------------------------------

DE 2 = ---------------------------------

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

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

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

Organization A = ------------------------------------

Organization B = ------------------------------------------------------------------------
-----------------

Category A = -----------------------------------------------------------
------------------

Country = ---------
PLR-103656-18 2

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

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

States = ------------------------------------------------------------------------
----------------------------------------

Year 1 = -------

Year 2 = -------

Year 3 = -------

Year 4 = -------

Year 5 = -------

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

a = ----

b = --

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

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

e = -----

f = ----

g = -------

h = ----

i = --------

j = --

k = --

l = ------
PLR-103656-18 3

m = ------

n = ----

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 5 (“Agency Credits”) and from credits issued by the
Organization A Program beginning in years after Year 5 (“Org A Credits,” together with
Agency Credits, “Credits”) for purposes of 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. Taxpayer and
Subsidiary each employ the accrual method of accounting, and the taxable year of each
is the calendar year.

   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.
PLR-103656-18 4

   Taxpayer represents that Subsidiary indirectly has k projects under development

on certain portions of its existing landholdings, and that the projects qualify or will qualify
under one of the two carbon offset programs described below.

   Subsidiary holds a l percent membership interest in Partnership, a limited liability

company classified as a partnership for federal income tax purposes. Manager owns
the remaining membership interest in Partnership. DE 1, a disregarded entity of
Partnership, currently has b carbon offset projects under development pursuant to the
State B Program. DE 2, a disregarded entity of Subsidiary, currently has b carbon
offset projects under development pursuant to the Organization A Program.

   State B Program

    In Year 2, 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 Agency 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 (the
“Protocol”). Each of DE 1’s carbon offset projects under the State B Program (the
“State B Projects”) are predicated on the use of specified parcels of DE 1’s timberlands
located in States to reduce atmospheric carbon dioxide.

    Per the Protocol, Agency will issue DE 1, one Agency 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, DE 1 must continuously monitor its compliance with the
Protocol. Agency will hold each of DE 1’s State B Projects to rigorous reporting
standards to demonstrate the effectiveness of its efforts. Thus, to qualify for Agency
Credits, DE 1 must undertake certain affirmative obligations and agree to certain
restrictions on the use of the specified parcels of each project’s timberlands for e 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
   m percent of any n-acre section of the committed timberland at all times;

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

PLR-103656-18 5

  3. Demonstrating continuous compliance with the Protocol by conducting
  a complete forest inventory every f 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 g 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 h-year

period, DE 1 will be obligated to return some or all Agency Credits issued to DE 1 (or
acquire Agency Credits to be relinquished). Land-use restrictions, to which DE 1
agreed to abide by under the State B Program, are restrictions that could be recorded
as easements under local law, although DE 1 is not presently contemplating doing so.

  In Year 5, Agency issued Agency Credits to DE 1. Taxpayer represents that DE

1 expects to be issued additional Agency Credits in years beginning after Year 5.

  Organization A Program

   Organization A, created in Year 1, is a third-party provider of GHG emission

standards. In Year 2, Organization A launched a voluntary GHG offset credit program
under which a project that removes GHGs from the atmosphere may receive Org A
Credits from Organization A that can be sold to individuals or entities that produce GHG
emissions (the “Organization A Program”).

   Org A Credits issued by Organization A are not tied to any specific cap-and-trade

program; they may not be used to satisfy the legal obligations of polluting businesses.
Instead, Org A Credits may be purchased by businesses or individuals that wish to
quantify and demonstrate their efforts to reduce their net emissions.

    The Organization A Program offers a number of eligible project categories, one

of which is Category A. Eligible Category A activities are those that reduce net GHG
emissions by reducing deforestation, degradation of forests, or both. These include
activities that are designed to stop planned deforestation.

    DE 2 owns and operates b projects, located in Country and comprised of i

hectares of mature timberland (“Property”), that adhere to the requirements and
restrictions applicable to projects described under Category A (the “Category A
Projects”).
PLR-103656-18 6

   Category A activities, designed to stop planned deforestation, include a

landowner’s agreement not to convert timberlands to a non-eligible Category A use
(“Non-Eligible Use”). Prior to initiation of DE 2’s Category A Projects, the Property was
under imminent threat of conversion to agriculture, a legally permitted, Non-Eligible Use.

   For the Category A Projects to be eligible for the issuance of Org A Credits from

the Organization A Program, DE 2 has undertaken certain affirmative obligations and
agreed to certain restrictions on the use of the Property for the duration of the crediting
period ending on Date 1 (“Crediting Period”). These include:

   (1) Applying for the Category A Projects to be listed on an approved
   Organization A credit registry;

   (2) Refraining from converting the Property to a Non-Eligible Use, such as
   agriculture;

   (3) Receiving verification through confirmation that the Property and the
   activities thereon confirm to the anticipated reductions in GHG emissions.

   (4) Registering and submitting an application for Org A Credits with
   Organization A once the Category A Projects’ initial validation and
   verification are successfully completed.

   (5) Submitting to independent validation of the Category A Projects’
   planned GHG reduction activities and methodology, including by taking
   inventories of the wood volume/carbon stocks every h years;

   (6) Conducting independent verification of the Category A Projects’
   anticipated GHG benefits verified every j years; and

   (7) Providing annual estimates of carbon stocks and reports of known
   harvesting activity.

  Only after Organization A reviews and approves an application for Org A Credit

issuance, will it issue Org A Credits, either in a single year or over a period of years,
based on the net amount of GHGs removed from the atmosphere each year above a
predetermined baseline established for the project.

   Organization A reviewed DE 2’s completed application, including reports from the

third party that conducted the validation and verification and additional documentation
submitted by DE 2 directly. Organization A approved DE 2’s application, and the
Organization A Program issued Org A Credits, as a single issuance, to DE 2 in Year 3.
PLR-103656-18 7

Taxpayer represents that DE 2 expects to be issued additional Org A Credits by the
Organization A Program in years after Year 5. Irrespective of whether Organization A
Program were to issue the Org A Credits in a single year or over a period of years, a
specified percentage of those Org A Credits will be held in a buffer account.

   After Org A Credits have been issued, the Category A Projects must continue to

be periodically validated and verified in the manner described above. If, at any time
during the Crediting Period, the Category A Projects fail to reduce atmospheric GHG
emissions in accordance with the predetermined standard, Organization A may cancel
some or all of the Org A Credits held in the buffer account. DE 2 has the option to
extend the Crediting Period beyond Date 1, so long as it continues to meet the Category
A and Organization A Program requirements and restrictions, including refraining from
converting the Property to a Non-Eligible Use. Land-use restrictions to which DE 2
agreed to abide by under the Organization A Program are restrictions that could be
recorded as easements under local law, although Subsidiary is presently not
contemplating doing so.

  Credit Sales

  Taxpayer represents that DE 1 and DE 2 expect 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, Subsidary, Partnership, DE 1, nor
DE 2 intends 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
PLR-103656-18 8

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.

    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).
PLR-103656-18 9

  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
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 DE 1 or DE 2’s basis, as applicable, in each 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 either the State B Program or the
Organization A Program, constitutes gross income that is not listed as qualifying income
under sections 856(c)(2) or (c)(3).

    Subsidary or Partnership will indirectly earn Credits by agreeing to certain

restrictions on the use of its land for a specified term of years. Both the State B
Program and the Organization A Program impose land-use restrictions by requiring
Partnership and Subsidary 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 both the State B Program and
the Organization A Program, Partnership and Subsidiary 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
PLR-103656-18 10

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

   (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 qualifies 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 5.
Additionally, no opinion is expressed regarding whether Taxpayer or Subsidiary 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.
PLR-103656-18 11

     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: