In PLR 201716044, the IRS addressed how a real estate investment trust (REIT) computes the proportionate part of rent that does not qualify as "rents from real property" under Section 856(d)(4).

Facts

Taxpayer is a corporation that will engage in the following transaction under a bankruptcy plan:

— A subsidiary of Taxpayer (Distributing) will contribute certain assets, including Leased Property, to a newly formed subsidiary (Controlled) in exchange for all of the common and preferred stock of Controlled.

— Distributing will distribute certain assets, including the common and preferred stock of Controlled, to creditors of Distributing in satisfaction of their claims against Distributing.

— Controlled intends to elect to be treated as a REIT.

— Controlled will lease the Leased Property to Distributing under a lease that provides for the payment of fixed rents for the first [ ] years, and thereafter fixed rents and percentage rents (i.e., rents based on a percentage of Distributing's gross revenues subject to certain adjustments).

The prime lease between Controlled and Distributing will be subject to an existing lease to an unrelated third party (Subtenant). Subtenant has subleased the property that it leases from Distributing to various other unrelated third parties that will become sub-subtenants of Distributing after completion of the transaction. One sub-subtenant (Sub-Subtenant) pays rent that is based on the Sub-Subtenant's net income from the property it leases from Subtenant.

Law and analysis

Under Section 856(c)(2), a REIT must derive at least 95% of its annual gross income from dividends, interest, rents from real property, and certain other sources. Under Section 856(c)(3), a REIT must derive at least 75% of its annual gross income from certain real estate sources, including rents from real property.

Except as provided in Section 856(d)(4) and (6), Section 856(d)(2)(A) generally excludes from "rents from real property" "any amount received or accrued, directly or indirectly, with respect to any real or personal property, if the determination of [the] amount depends in whole or in part on the income or profits derived by any person from the property (except that any amount so received or accrued shall not be excluded from the term 'rents from real property' solely by reason of being based on a fixed percentage or percentages of receipts or sales)."

Section 856(d)(4) provides that, "[if] a [REIT] receives or accrues, with respect to real or personal property, any amount that would be excluded from the term "rents from real property" solely because the tenant of the [REIT] receives or accrues, directly or indirectly, from subtenants any amount the determination of which depends in whole or in part on the income or profits derived by any person from such property, only a proportionate part (determined pursuant to regulations prescribed by the Secretary) of the amount received or accrued by the REIT from that tenant will be excluded from the term "rents from real property."

Reg. Section 1.856-4(b)(3) provides in relevant part that, "[except] as provided in [Reg. Section 1.856-4(b)(6)(ii)], no amount received or accrued, directly or indirectly, with respect to any real property (or personal property leased under, or in connection with, real property) qualifies as rents from real property [if] the determination of the amount depends in whole or in part on the income or profits derived by any person from the property. However, any amount so accrued or received shall not be excluded from the term 'rents from real property' solely by reason of being based on a fixed percentage or percentages of receipts or sales (whether or not receipts or sales are adjusted for returned merchandise, or [federal], [state], or local sales taxes).

Reg. Section 1.856-4(b)(6)(i) states that, "[except] as provided in [Reg. Section 1.856-4(b)(6)(ii)], if a [REIT] leases real property to a tenant under terms other than solely on a fixed sum rental (for example, a percentage of the tenant's gross receipts), and the tenant subleases all or a part of such property under an agreement [that] provides for a rental based in whole or in part on the income or profits of the sublessee, the entire amount of the rent received by the trust from the prime tenant with respect to such property is disqualified as 'rents from real property.'"

Reg. Section 1.856-4(b)(6)(ii) states that, "[for] [tax] years beginning after October 4, 1976, [S]ection 856(d)(4) provides an exception to the general rule that amounts received or accrued, directly or indirectly, by a [REIT] do not qualify as rents from real property if the determination of the amount depends in whole or in part on the income or profits derived by any person from the property. This exception applies [when] the [REIT] rents property to a tenant (the prime tenant) for a rental [that] is based, in whole or in part, on a fixed percentage or percentages of the receipts or sales of the prime tenant, and the rent [that] the [REIT] receives or accrues from the prime tenant pursuant to the lease would not qualify as 'rents from real property' solely because the prime tenant receives or accrues from subtenants (including concessionaires) rents or other amounts based on the income or profits derived by a person from the property. Under the exception, only a proportionate part of the rent received or accrued by the [REIT] does not qualify as 'rents from real property.' The proportionate part of the rent received or accrued by the [REIT] [that] is non-qualified is the lesser of the following two amounts:

A) The [portion of the] rent received or accrued by the [REIT] from the prime tenant pursuant to the lease that is based on a fixed percentage or percentages of receipts or sales or

B) The product determined by multiplying the total rent [that] the [REIT] receive[d] or accrue[d] from the prime tenant pursuant to the lease by a fraction, the numerator of which is the rent or other amount received by the prime tenant that is based, in whole or in part, on the income or profits derived by any person from the property, and the denominator of which is the total rent or other amount received by the prime tenant from the property."

The rules provided in Section 856(d)(4) and Reg. Section 1.856-4(b)(6) apply to the prime lease income stream on a lease-by-lease basis.

In PLR 201716044, the IRS noted that Taxpayer represented that: (i) the profit-based sub-sublease is a preexisting arrangement entered for business reasons independent of tax considerations; and (ii) Controlled would not receive a greater amount of income that qualifies as rents from real property under the formula in Reg. Section 1.856-4(b)(6)(ii)(B) than if Distributing directly entered the same lease with Sub-Subtenant.

Based on the facts presented and representations made by Taxpayer, the IRS ruled, for purposes of applying Reg. Section 1.856-4(b)(3), that: (i) only a proportionate amount of the rent received by Controlled from Distributing, which will depend in part on rent from a sub-sublease that is based on income or profits of the Sub-Subtenant, will be treated as other than rents from real property; and (ii) for purposes of computing this proportionate amount under Reg. Section 1.856-4(b)(6)(ii)(B), the numerator of the fraction equals all rent or other amounts received by Subtenant under the Sub-Sublease, and the denominator equals all rent or other amounts received by Distributing under the Sublease.

Implications

PLR 201716044 is the first private letter ruling to address the "proportionate rent disallowance" rule of Section 856(d)(4) and Reg. Section 1.856-4(b)(6)(ii).

Reg. Section 1.856-4(b)(6)(ii) sets forth a relatively straight-forward "formula" to be used in computing the proportionate part of rents received by a REIT that will be treated as nonqualifying rents when the REIT leases property to a tenant for a rental that is based, in whole or in part, on a fixed percentage of the receipts of the prime tenant, and the rent that the REIT receives from the prime tenant would not qualify as "rents from real property" solely because the prime tenant receives from subtenants rents or other amounts based on the profits derived by the subtenant (or other person) from the property. In the situation described in PLR 201716044, however, it appears the REIT will receive percentage rent from the prime tenant that is based, in part, on the net income of a "sub-subtenant" (apparently through a percentage lease that the subtenant has with the sub-subtenant, although this was not explicitly stated in the ruling), which apparently led the taxpayer to seek this ruling.

Although it is advisable that all leases and subleases not be profit-based, this ruling acknowledges that the relationship between a subtenant and its subsubtenant is more attenuated than the relationship between a prime tenant and its subtenant and, therefore, it is appropriate to apply the proportionate disallowance rule as provided previously when rent is based in whole or part on the income or profits of a sub-subtenant.

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