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In a ruling obtained by professionals at EY, the IRS ruled in PLR 202410005 that a REIT's allocable share of income from tariffs paid by unrelated third parties for the use of regulated oil and gas pipelines qualifies as rents from real property under IRC Section 856(d).

Facts

Taxpayer, a corporation that has elected to be taxed as a real estate investment trust (REIT), invests in energy infrastructure assets and owns an interest in a subsidiary classified as a partnership for US federal income tax purposes (Subsidiary). Through two disregarded entities (Pipeline Companies), Subsidiary owns oil and gas pipelines (Pipelines) that connect certain oil fields to certain refineries. Taxpayer represented that other than a de minimis amount of personal property, such as pumps, compressors and meters, the Pipelines are inherently permanent structures under Treas. Reg. Section 1.856-10 and therefore real estate assets for purposes of IRC Section 856. Taxpayer, Subsidiary and the Pipeline Companies must comply with all the rules, regulations and orders of the Commission that regulates the Pipelines (Commission).

Subsidiary enters into arrangements (Pipeline Use Agreements) for the use of the Pipelines by unrelated third parties (Pipeline Users) pursuant to a monthly nomination process governed by Commission rules and regulations. Subsidiary determines the minimum aggregate monthly amounts of throughput necessary to maintain optimal operations of each Pipeline, and each prospective Pipeline User informs Subsidiary of the type and amount of product the Pipeline User intends to place on a particular Pipeline in the coming month (Nominated Amount). If the total Nominated Amounts for a particular Pipeline meet the minimum aggregate monthly throughput amount, Subsidiary confirms each Nominated Amount (Confirmed Amount) and reserves a portion of the monthly capacity on the Pipeline for each Pipeline User's Confirmed Amount for the coming month (but does not confirm aggregate Nominated Amounts in excess of the total monthly capacity of any Pipeline). Pipeline Users generally utilize the Pipelines on a continuous and consistent basis for extended periods, often years.

Taxpayer made the following representations regarding the Pipeline Use Agreements:

• Subsidiary does not oversell Pipeline capacity and "is obligated at all times to ensure that the capacity confirmed each month for each Pipeline User is available for use by the Pipeline User"
• To Taxpayer's knowledge, "a Pipeline User has never placed [a certain amount of] product on a Pipeline in a month in which they have a nominated and confirmed amount. Taxpayer represents that each Pipeline User who reserves capacity on a Pipeline for a given month uses at least [a certain] percent of such reserved capacity during that month"
• Each Pipeline User "is contractually obligated to deliver product extracted from a particular field or area to a point connected to a Pipeline and is economically compelled to exclusively use the Pipeline to satisfy that legal obligation"
• Each Pipeline User "will exclusively use the Pipeline for the applicable monthly nomination period to deliver such product extracted from a particular field or area to a point connected to the Pipeline"

Pipeline Users pay a tariff for using a Pipeline based on the volume of product placed on the Pipeline by the Pipeline User (Pipeline Use Fee). Pipeline Use Fees are calculated "as the product of the barrels of oil placed on a Pipeline in a given month and the tariff rate approved by Commission for each barrel of oil that is received at a specified origin point on the Pipeline and that exits the Pipeline at a specified destination point." The Pipeline Use Fees do not depend on the income or profits of any party.

Taxpayer represents that Subsidiary will only conduct activities with respect to the Pipelines consistent with its fiduciary duty to manage its assets or that would not result in unrelated business taxable income under IRC Section 512(b)(3) if received by an organization described in IRC Section 511(a)(2). Subsidiary will inspect and monitor the physical condition of the Pipelines; will mark the location of underground Pipelines to minimize the possibility of damage due to digging; and may test product as it enters a Pipeline to verify that the product is specified in the Pipeline Use Agreement (solely to ensure the safety and integrity of the Pipeline and the environment). Subsidiary will also supervise the Pipelines' maintenance, repair and construction by an independent contractor (IK), from whom the taxpayer does not receive any income, in accordance with all regulatory requirements.

All other activities and services will be undertaken by a taxable REIT subsidiary (TRS) or an IK, including scheduling use of the Pipelines and operating, monitoring, maintaining, managing and repairing any pumps, compressors, meters and other personal property associated with the Pipelines. Subsidiary will pay the TRS or IK arm's length compensation for performing these activities and services.

Taxpayer represented that all services furnished to the Pipeline Users are customarily provided to tenants of similar properties in the geographic market in which the relevant Pipeline is located.

Law and analysis

IRC Section 856(c)(2) requires a REIT to derive at least 95% of its gross income from specified sources of passive income, including rents from real property. IRC Section 856(c)(3) requires a REIT to derive at least 75% of its gross income from specified sources of real estate source income, including rents from real property.

Treas. Reg. Section 1.856-4(a) defines the term "rents from real property" generally as the gross amounts received for the use of, or the right to use, the REIT's real property. Under IRC Section 856(d)(1), the term "rents from real property" includes: "(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 [tax] year does not exceed 15[%] of the total rent for the [tax] year attributable to both the real and personal property leased under, or in connection with, such lease." A service furnished to tenants of a particular building will be considered customary if, in the geographic market in which the building is located, the service is customarily provided to tenants in buildings of a similar class (Treas. Reg. Section 1.856-4(b)(1)).

Under IRC Section 856(d)(2)(C), impermissible tenant service income (defined by IRC Section 856(d)(7)(A) as any amount received or accrued by the REIT for services furnished or rendered to tenants or for managing or operating the property) is excluded from the definition of "rents from real property." Impermissible tenant service income does not include (1) payments received for services, management or operations provided through an IK or TRS, and (2) any payment that would be excluded from unrelated business taxable income under IRC Section 512(b)(3) if received by an organization described in IRC Section 511(a)(2) (IRC Section 856(d)(7)(C)).

For purposes of IRC Section 856, Treas. Reg. Section 1.856-3(g) provides that a REIT that is a partner in a partnership is deemed to own its proportionate share of each of the partnership's assets and to be entitled to its proportionate share of the partnership's income. The REIT's share of partnership assets and income is determined in accordance with its capital interest in the partnership.

Based on the facts and Taxpayer's representations, the IRS concluded that the Pipeline Use Fees are received for the use of, or the right to use, real property of Taxpayer and qualify as rents from real property under IRC Section 856(d)(1)(A). In so ruling, the IRS noted that a use fee based on the volume of product put through a Pipeline is comparable to rents based on a percentage of the tenant's gross receipts. Accordingly, the IRS ruled that Taxpayer's allocable share of the Pipeline Use Fees qualifies as rents from real property under IRC Section 856(d) for purposes of the REIT gross income tests under IRC Sections 856(c)(2) and (c)(3). The IRS further concluded that the activities and services performed by Subsidiary and by a TRS or IK do not give rise to impermissible tenant service income.

Implications

The IRS has previously ruled that pipeline use fees will be treated as rents from real property for purposes of the REIT gross income tests (see PLR 202346008 (Tax Alert 2023-1931); PLR 202150014 (Tax Alert 2021-2273); PLR 201907001 (Tax Alert 2019-0721)). In those rulings, with one exception, the pipeline use fees were subject to a minimum volume commitment. Thus, even if a pipeline user did not use a minimum volume of pipeline capacity specified in the pipeline use agreement, the pipeline user was still required to pay for such minimum volume. In PLR 201907001, however, certain pipeline use fees that qualified as rents from real property were not subject to a minimum volume commitment. In such cases, the pipeline user agreed to use the pipeline for all the product it extracted from a particular area or field, and the REIT agreed to accept and reserve capacity for that product.

Similarly, in PLR 202410005, the Pipeline Use Fees are not subject to a minimum volume commitment. Instead, Taxpayer's representations regarding Pipeline Users' contractual obligations and economic compulsion to use the Pipelines and Pipeline Users' actual use of the Pipelines support the IRS's conclusion that the Pipeline Use Fees qualify as rents from real property for purposes of IRC Sections 856(c)(2) and (c)(3).

PLR 202410005 directly addresses the treatment of a tariff paid pursuant to a regulated monthly nomination process. While taxpayers with facts similar to those surrounding the Pipeline Use Fees should consult with their tax advisors, this ruling gives taxpayers some indication of the IRS's current analysis regarding capacity-based payments for the right to use space, particularly where such payments are not subject to a minimum amount and are determined pursuant to a regulated nomination process.