In Letter Ruling 201720008, the IRS ruled that, pursuant to its authority under Sec. 856(c)(5)(J), it would consider income recognized by a real estate investment trust (REIT) in connection with the receipt of carbon sequestration credits to be income qualifying the taxpayer to be a REIT under the 95% and 75% income tests under Secs. 856(c)(2) and (c)(3). In addition, the IRS ruled that the REIT would recognize income with respect to the issuance of the credits upon the earliest of when the credits were earned, received, or due.
The taxpayer was a publicly traded REIT that owned commercial forestland throughout the United States. The taxpayer also owned a subsidiary, a foreign corporation that was a qualified REIT subsidiary as defined in Sec. 856(i), which owned forestlands and grasslands in a foreign country.
The taxpayer and subsidiary planned to participate in two carbon sequestration projects on certain portions of the taxpayer's landholdings — one program in the United States and one in the foreign country. Third-party providers would analyze the taxpayer's forestlands, develop forestland management parameters complying with the applicable carbon sequestration standards, and market and sell the credits on behalf of the taxpayer. The taxpayer planned to sell the credits as soon as practicable and would 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 Sec. 856(c)(2) and at least 75% from sources listed in Sec. 856(c)(3).
Sec. 856(c)(5)(J) authorizes the IRS to determine, solely for purposes of the REIT provisions, whether any item of income or gain that does not qualify for the 95% income test under Sec. 856(c)(2) and/or the 75% income test under Sec. 856(c)(3) to nevertheless be considered qualifying gross income for the purposes of those tests.
Subject to certain exceptions, Sec. 61(a) defines gross income as all income from whatever source derived. Under Sec. 61, Congress intended to tax all gains or undeniable accessions to wealth, clearly realized, over which taxpayers have complete dominion (Glenshaw Glass Co., 348 U.S. 426, 477 (1955)).
Regs. Sec. 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, 372 U.S. 128 (1963); see also Rev. Rul. 2003-10).
In this ruling, the IRS noted that the taxpayer would earn the credits by agreeing to certain land-use restrictions, including abstaining from certain uses of its land in both the United States and the foreign country and performing certain actions on it, such as planting trees. The restrictions in the U.S. project could otherwise be recorded as an easement under local law. The restrictions in the foreign project were enforceable, although not recordable as an easement, under the local law of the country.
The taxpayer was agreeing to the restrictions in each project for a period of 100 years and would incur significant penalties if it did not abide by those restrictions. For these reasons, the IRS explained, the credits were 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, treating the credits as qualifying income did not interfere with or impede the objectives of Congress in enacting the REIT income tests. The IRS also explained that the taxpayer would include the fair market value of the credits in its gross income in accordance with Regs. Sec. 1.451-1(a). The taxpayer's basis in a credit would equal its fair market value when accrued as income.
Accordingly, the IRS ruled under its Sec. 856(c)(5)(J) authority that income from the issuance of the credits would be considered qualifying income for purposes of the REIT income tests under Secs. 856(c)(2) and (c)(3). The IRS also ruled that the taxpayer would accrue income with respect to the issuance of the credits and properly recognize such income upon the earliest of when the credits were earned, received, or due.
Letter Ruling 201720008 is the third private letter ruling in which the IRS has ruled under its Sec. 856(c)(5)(J) authority that income attributable to the receipt of carbon emissions credits or units in connection with the ownership of timberlands constituted qualifying income for purposes of the REIT income tests (see Letter Rulings 201123003 and 201123005).
In Letter Rulings 201123003 and 201123005, the IRS also ruled that carbon emission credits or units received by a REIT constituted qualifying REIT assets (and, thus, qualifying assets for purposes of the REIT asset tests), so gain from the subsequent sale of credits or units constituted gain from the sale of real property and, thus, qualifying income for purposes of the 95% and 75% income tests. However, as a result of the issuance of Regs. Sec. 1.856-10 in August 2016 (addressing the definition of real property), it is understood 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 Regs. Sec. 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 (T.D. 9784) 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, Letter Rulings 201123003 and 201123005 concluded that gain from the sale of carbon emission credits or units did not constitute income from a prohibited transaction for purposes of Sec. 857(b)(6). It is understood 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 Regs. Sec. 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 Letter Ruling 201720008 expected 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.
Michael Dell is a partner at Ernst & Young LLP in Washington.
For additional information about these items, contact Mr. Dell at 202-327-8788 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.