July 20, 2017 Income from receipt of carbon sequestration credits relating to timberlands is qualifying REIT Income In PLR 201720008, the IRS ruled that, pursuant to its authority under Section 856(c)(5)(J), income recognized by a real estate investment trust (REIT) in connection with the receipt of carbon sequestration credits (Credits) will be considered qualifying income under the 95% and 75% income tests under Section 856(c)(2) and (c)(3). In addition, the IRS ruled that the REIT will recognize income with respect to the issuance of the Credits upon the earliest of the following events to take place: the Credits are earned, the Credits are received or the Credits are due. Facts Taxpayer is a publically traded REIT that owns commercial forestland throughout the United States. Taxpayer also owns Subsidiary, a Foreign Country corporation that is a qualified REIT subsidiary (QRS) as defined in Section 856(i), which owns forestlands and grasslands in Foreign Country. Taxpayer and Subsidiary plan to participate in two carbon sequestration projects on certain portions of Taxpayer's existing landholdings, one program in the US and one in Foreign Country. Third-party providers will analyze Taxpayer's forestlands, develop forestland management parameters complying with the applicable carbon sequestration standards, and market and sell the Credits on behalf of Taxpayer. Taxpayer plans to sell the Credits as soon as practicable and will not hold them for potential appreciation. Law and analysis To qualify as a REIT, an entity must derive at least 95% of its gross income from sources listed in Section 856(c)(2) and at least 75% from sources listed in Section 856(c)(3). Section 856(c)(5)(J) authorizes the IRS to determine, solely for purposes of the REIT provisions of the Code, whether any item of income or gain that does not qualify for the 95% income test under Section 856(c)(2) and/or the 75% income test under Section 856(c)(3) may nevertheless be considered as either: (i) not constituting gross income for purposes of the 95% or 75% income tests, or (ii) qualifying income for purposes of the 95% or 75% income tests. Subject to certain exceptions, Section 61(a) defines gross income as all income from whatever source derived. Under Section 61, Congress intends to tax all gains or undeniable accessions to wealth, clearly realized, over which taxpayers have complete dominion. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 477 (1955). "Regulation Section 1.451-1(a) provides that, under an accrual method of accounting, income is includible in gross income when all the events have occurred [that] fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. Generally, all the events that fix the right to receive income occur upon the earliest of the following events to take place: the payment is received, the payment is due, or the income is earned by performance. See Schlude v. Commissioner, 372 U.S. 128 (1963); See also Revenue Ruling 2003-10, 2003-1 C.B. 288." In this ruling, the IRS explained that Taxpayer will earn the Credits as a result of agreeing to certain restrictions on the use of its land. Specifically, the land-use restrictions require Taxpayer to abstain from certain uses of its land in both the US and Foreign Country. Additionally, the Foreign Country land-use restrictions require Taxpayer to affirmatively perform certain actions, such as planting trees, on its land. The restrictions in the US project are restrictions that could otherwise be recorded as an easement under local law. The restrictions in the Foreign Country project, although not recordable as an easement under the local law of Foreign Country, are enforceable under the local law of Foreign Country. Taxpayer is agreeing to the restrictions in each project for a period of 100 years. Taxpayer will incur significant penalties if it does not abide by the restrictions to which it has agreed. For these reasons, the IRS explained that the Credits are akin to receiving payment for granting an easement for a term of years for the Taxpayer's real property. Under these circumstances, the IRS concluded that treating the Credits as qualifying income does not interfere with or impede the objectives of Congress in enacting the REIT income tests. The IRS also explained that, with respect to the issuance of the Credits, Taxpayer will include the fair market value of the Credits in its gross income in accordance with Regulation Section 1.451-1(a). Taxpayer's basis in a Credit will equal its fair market value when accrued as income. Accordingly, the IRS ruled that, under its Section 856(c)(5)(J) authority, income from the issuance of the Credits will be considered qualifying income for purposes of the REIT income tests under Sections 856(c)(2) and (c)(3). The IRS also ruled that Taxpayer will accrue income with respect to the issuance of the Credits and properly recognize such income upon the earliest of the following events to take place: the Credits are earned, the Credits are received, or the Credits are due. Implications PLR 201720008 is the third private letter ruling in which the IRS has ruled under its Section 856(c)(5)(J) authority that income attributable to the receipt of carbon emissions credits in connection with the ownership of timberlands constitutes qualifying income for purposes of the REIT income tests. See PLRs 201123003 and 201123005 (Tax Alert 2011-1055). In PLRs 201123003 and 201123005, the IRS also ruled that carbon emission credits/units received by a REIT constituted qualifying REIT assets (and thus good assets for purposes of the REIT asset tests) so gain from the subsequent sale of credits/units constituted gain from the sale of real property and, thus, qualifying income for purposes of the 95% and 75% income tests. As a result of the issuance of Regulation Section 1.856-10 in September 2016 (addressing the definition of real property), we understand that the IRS no longer believes that a "transferable" credit constitutes real property for purposes of the REIT asset tests because the credit is not "inseparable" from the underlying real property. See Regulation Section 1.856-10(f) addressing the types of "intangible assets" that may qualify as real property. The IRS also explained in the preamble to the regulations that renewable energy credits received by a REIT are intangible assets and do not qualify as real property because the credits may be sold separately from any real property to which they relate. In addition, PLRs 201123003 and 201123005 concluded that gain from the sale of carbon emission credits/units do not constitute income from a prohibited transaction for purposes of Section 857(b)(6). We understand that the IRS is not inclined to issue additional rulings addressing prohibited transaction considerations in connection with the sale of "credits," which is an inherently factual matter. As such, a REIT that could receive "transferable" credits should consider not only the characterization of the income received for purposes of the REIT income tests, but also the timing of the recognition of that income under Regulation Section 1.451-1(a) (and thus, the amount of the income recognized), which also determines the basis in the credits received and affects the amount of a potential subsequent gain on disposition of the credits. Although the Taxpayer in PLR 201720008 expects to sell the Credits to third parties, the ruling does not discuss the timing of the recognition of gain on the sale of the Credits. ———————————————
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