INSIGHT: Oil and Gas ‘Capacity’ Lease and REIT Qualification

If properly structured, real estate investment trusts (REITs) owning midstream and infrastructure assets may enter into multiple concurrent capacity-based use agreements for those assets without jeopardizing REIT status.

On March 15, 2019, the Internal Revenue Service released Private Letter Ruling (PLR) 201907001, in which it ruled that amounts received by a real estate investment trust (REIT) from unrelated parties for the use of an offshore oil and gas platform, storage tank facilities, and pipelines (as described in the ruling) would qualify as rents from real property for REIT qualification purposes.

This letter ruling confirms that a capacity-based arrangement, under which a user is committed to pay for a minimum percentage of the overall “capacity” of the real property, may produce rents from real property under the REIT rules notwithstanding that the same property may be concurrently available to other users. Thus, it provides a roadmap on how a REIT may be used to own oil and gas midstream assets as well as certain infrastructure assets that are similarly contracted under capacity-based use agreements (e.g., electricity transmission systems and fiber optic networks). For companies engaged in the midstream space, particularly master limited partnerships (MLPs), restructuring as a REIT could provide companies with unique opportunities to expand its investor base, attract new capital, and fund long-term infrastructure projects.

This article discusses the relevant REIT qualification rules, summarizes the letter ruling (referred to as the “midstream REIT ruling” for purposes of this article), reviews how certain REIT qualification matters are explained by the ruling, and analyzes how midstream MLPs could benefit from restructuring as a REIT.

REIT Qualification Rules

For an entity to qualify and maintain its REIT status, the entity must meet certain requirements concerning its organization and share ownership, asset holdings, sources of income, and distributions to shareholders. With respect to the asset holdings requirement, a REIT must invest 75% of its assets in real estate assets (e.g., real property and mortgage loans), cash and cash items, and U.S. government securities. If the REIT’s other assets are considered securities under the Investment Company Act of 1940 and not otherwise treated as real estate assets, the entity must comply with additional securities diversification requirements. Prior to 2013, many companies with capital-intensive assets explored the possibility of being a REIT, and sought confirmation from the IRS that their assets would be considered real property under the REIT rules. In June 2013, however, the IRS suspended its letter ruling request process on the real property issue and formed a working group to study the standards it was using in defining real property for REIT qualification purposes. During 2016, the Treasury Department and IRS published final regulations defining “real property” for purposes of the REIT rules to mean land, improvements to land (defined as inherently permanent structures and their structural components), and certain intangible assets. Under the framework adopted by the final regulations:

—A REIT applies certain facts-and-circumstances-based factors in determining whether a particular separately identifiable item of property is a distinct asset.

—The REIT then determines whether a distinct asset is land, an inherently permanent structure (i.e., permanently affixed building or other inherently permanent structure), or a structural component of an inherently permanent structure.

—If a distinct asset is one of the examples of buildings or other inherently permanent structures (the “Angel’s List”) (e.g., enclosed transportation stations and terminals, communications and electrical transmission towers, bridges, tunnels, transmission lines, pipelines, offshore drilling platforms, and storage structures, such as silos and oil and gas storage tanks), then the REIT determines whether the distinct asset is permanently affixed to land or to another inherently permanent structure.

• For a distinct asset that is not on the Angel’s List, the REIT must determine whether the distinct asset is an inherently permanent structure by considering whether it serves an active or passive function, and if passive, whether the asset is permanently affixed to land or another inherently permanent structure by considering a list of factors based on the facts and circumstances.

—If a distinct asset is one of the listed examples of structural components (e.g., fire suppression systems, central refrigeration systems, security systems, and humidity control systems), then the REIT determines whether the distinct asset is integrated into an inherently permanent structure and held together with a real property interest in the space of the inherently permanent structure served by that distinct asset.

• Otherwise, if a distinct asset is held together with a real property interest in the space of an inherently permanent structure served by that distinct asset, the REIT applies factors to determine whether the asset is integrated into the inherently permanent structure and serves a passive or utility-like function in order to be a structural component.

The final regulations conclude vis-à-vis examples that certain major structural components of a cold storage warehouse (e.g., freezer walls and central refrigeration systems) and a data center (e.g., central heating and air-conditioning systems, integrated security systems, fire suppression systems, humidity control systems, electrical systems, and telecommunication infrastructure) are considered real property. The final regulations also conclude by example that the majority of a pipeline transmission system (e.g., pipelines, isolation valves and vents, and pressure control and relief valves) is considered real property, but meters and compressors are specifically not real property.

Since the issuance of the final regulations, the IRS has ordinarily looked to taxpayers to apply the framework provided in the final regulations and represent whether the subject property is considered real property in connection with its ruling request. However, in PLR 201740017, the IRS ruled that a dehydrator, which is part of a pipeline transmission system and removes moisture from a product transported through the pipeline to protect the integrity of the pipeline, would be considered a structural component of the pipeline and, therefore, real property under the REIT rules.

Whether an asset is considered real property is also critical because a REIT must also derive at least 75% and 95% of its gross income from real estate and passive sources, including rents from real property. For purposes of the income tests, rents from real property include rents attributable to personal property, which is leased under or in connection with a lease of real property if the value of the personal property does not exceeds 15% of the combined value of the real and personal property for the tax year. Also, rents from real property include charges for services customarily furnished in connection with the rental of real property. For this purpose, “[s]ervices furnished to the tenants of a particular building will be considered as customary if, in the geographic market in which the building is located, tenants in buildings which are of a similar class (such as luxury apartment buildings) are customarily provided with the service.” However, rents from real property do not include: (1) impermissible tenant service income (ITSI); and (2) any amount determined in whole or in part on the income or profits earned by any person from the property, except that an amount is not excluded from rents from real property solely by reason of being based on a fixed percentage or percentages of receipts or sales.

ITSI represents, with respect to any real or personal property, any amounts received or accrued directly or indirectly by a REIT (1) for services furnished or rendered by a REIT to the tenants of the property, or (2) for managing or operating the property. If the amount of ITSI with respect to a property for any tax year exceeds 1% of all amounts received or accrued during the tax year directly or indirectly by the REIT with respect to the property, the ITSI with respect to the property includes all these amounts, i.e., tainting the rents that otherwise qualify as rents from real property. For this purpose, a REIT, through its employees or agents, may conduct usual and customary property management services related to the use of space for occupancy only provided the services are not rendered primarily for the convenience of the tenant (referred to as the “UBTI exception”). Furthermore, services furnished or rendered, or management or operation provided, through an independent contractor (IK) from whom the REIT itself does not derive or receive any income or through a taxable REIT subsidiary (TRS) of the REIT are not treated as furnished, rendered, or provided by the REIT (referred to as the “IK/TRS exception”).

The UBTI exception was added in 1986 to remove the requirement to use an IK for UBTI permitted activities (e.g., furnishing heating and light, the cleaning of public entrances, etc.). However, even before 1986, the income tax regulations have provided that a REIT’s directors are not required to delegate or contract out their fiduciary duty to manage the REIT itself (e.g., establishing rental terms, choosing tenants, entering into and renewing leases, and making capital expenditures with respect to REIT’s property), as distinguished from rendering or furnishing services to the tenants of its property or managing or operating the property. Thus, in many early private letter rulings, the IRS cited both the UBTI exception and fiduciary duty before concluding there was no ITSI. However, it may not always be clear whether an activity (1) constitutes a fiduciary duty that is not considered to be operating or managing the property; or (2) is not considered “rendered to the occupant.” As discussed below, to avoid the ITSI risks, the taxpayer in the midstream REIT ruling agreed to limit its activities to those consistent with its fiduciary duty to manage the REIT itself.

With respect to the prohibition against basing rents on income or profits, certain adjustments to receipts or sales (e.g., returned merchandise, or federal, state, or local sales taxes) do not raise a concern. The income tax regulations also explain rents are not disqualified if:

“[T]he lease provides for differing percentages or receipts or sales from different departments or from separate floors of a retail store so long as each percentage is fixed at the time of entering into the lease and a change in such percentage is not renegotiated during the term of the lease (including any renewal periods of the lease) in a manner which has the effect of basing the rent on income of profits.”

Thus, if a REIT leases a hotel to a tenant, it can receive rents based on the tenant’s room revenue, food and beverage sales, amenity revenue, meeting room revenue, and other revenue at different percentages. Furthermore, the IRS confirmed in the midstream REIT ruling that an exclusion of certain revenue types, which is arguably the equivalent of using a 0% rate, should not cause a concern.

Notwithstanding that rents from real property represent the predominant source of potential qualifying income for an equity REIT, there is surprisingly little guidance under the REIT regulations about what constitutes rents, other than saying that, “rents from real property” means “gross amounts received for the use of, or the right to use, real property.” While this may be sufficient for a traditional real estate and traditional business model (e.g., a lease of an office floor for a term of at least one year), it may not be entirely clear whether any arrangements involving “use” can generate rents. Thus, for clarity, a taxpayer wanting certainty (because the REIT status depends on it) is often advised to submit a ruling request to the IRS.

Prior to the release of the midstream REIT ruling, the IRS expressed its view about multiple and concurrent users in a number of private letter rulings. For example, in PLR 201522002, certain outdoor advertising displays of the taxpayer may allow for multiple advertising agreements or licenses to be in place at one time, and customers share the displays with others because a particular customer’s advertising copy is displayed for only certain intervals of time in a rotation with others. The IRS stated that this arrangement, “does not change the character of the income as rents from real property, because the sharing of the rented space has no bearing on the passive nature of the income from renting the space” of the outdoor advertising displays.

Also, in PLR 201901001, the IRS ruled that payments received by a REIT under certain agreements for allowing others to use its fiber optic cable systems and distributed antenna systems or small cell systems (DAS) would qualify as rents from real property. Under the taxpayer’s agreement with respect to DAS, the tenant had the exclusive right to use either a designated number of individual strands within the fiber optic pathway, or a dedicated wavelength within the fiber optic pathway of a DAS installation. Further, under a capacity lease with respect to taxpayer’s fiber optic cables, the tenant had an exclusive right to use a specified subset of all the wavelengths (or capacity) within a strand located in a fiber optic cable over a specified route for the term of the lease. Finally, under the taxpayer’s backhaul lease concerning the fiber optic cables, the tenant had an exclusive right to use all or a dedicated portion of the capacity of an identifiable fiber optic cable over a specifically identified route from a cell tower to a collection point for the term of the lease. To support its “rent” conclusion, the IRS reasoned that each of these agreements was for a term in excess of C years and required fixed and recurring payments for the contracted usage, regardless of the tenant’s actual usage.

Midstream REIT Ruling

In this letter ruling, a REIT principally investing in energy infrastructure assets proposed to construct an offshore oil and gas platform and acquire storage tank facilities and oil and gas pipelines, each of which is included in the Angel’s List. For purposes of the ruling request, the REIT represented that these properties are real property under tax code Section 856, and that the fair market value of any personal property leased to users in connection with leasing real property was less than 15%.

With respect to the offshore platform, the REIT proposed to enter into a multi-year lease with the platform lessee providing the platform lessee with the exclusive right to use the platform and the equipment. As described, the equipment, which is attached to the platform, will: (1) control the extraction of crude oil and gas produced by the platform lessee from existing or future undersea wells owned by the platform lessee or its partners and located within proximity to the platform; (2) separate oil, gas, and water from the fluid extracted from those wells; and (3) condition the oil and gas for export in undersea oil and gas pipelines. The REIT represented that the equipment is personal property. The platform lessee was solely responsible for operating, maintaining, and repairing the platform, the equipment, and any other property associated with the platform.

The rent paid by the platform lessee was computed based upon a fixed dollar amount per volumetric measure of product flowing through the platform. This fixed dollar amount may change after a specified volume of product flows through the platform and may also change periodically pursuant to a formula set forth in the platform lease to reflect changes in crude oil or gas prices. The REIT also expects that the rent will include a specified minimum amount that would provide for a return of its invested capital associated with the construction of the platform plus a market-based return thereon. The platform lessee may sublease the platform to one or more third parties during the term of the platform lease. In this case, the sublessee would pay to the platform lessee a fixed amount of rent plus additional payments based on volume. The platform lessee would be required to pay a percentage of the gross revenue it received from a sublease to the REIT. According to the letter ruling, the platform lessee would be separately compensated for operating the platform on behalf of the sublessee and would not pay any portion of that amount to the REIT.

With respect to the storage tank facilities, the REIT proposed to enter into agreements with unrelated third-party users for a term generally between b and c years, and in no event for less than d. A storage agreement provides the storage user with a right to a fixed portion of the storage capacity at the respective storage tank facility, but may not specify the specific tank or tanks. The REIT’s activities with respect to the storage tank facilities was limited to those consistent with its fiduciary duty to manage the REIT itself, e.g., inspecting, maintaining, repairing, and constructing storage tanks and other real property assets located at the storage tank facilities. The REIT engaged a TRS to provide all services, including loading, unloading, and moving product and adding agents or additives to product in a storage tank for the benefit of a storage user, etc., which were represented to be customary.

The fee paid by a storage user was a fixed monthly amount for a prescribed amount of reserved storage capacity regardless of whether it uses the capacity reserved for it. In some cases, a storage user had the right to exceed the capacity reserved for it for an additional amount computed based upon a fixed dollar amount set forth in the storage agreement multiplied by the volume of product stored. The storage fee also included amounts paid for the services performed by the TRS.

With respect to oil and gas pipelines, the REIT proposed to enter into agreements with users for a term generally between b and e years, and in no event less than d. The REIT did not oversell capacity in the pipelines and was obligated to ensure that the capacity specified in a pipeline use agreement was reserved for the pipeline user. The REIT represented that it only undertook activities with respect to the pipelines that were consistent with its fiduciary duty to manage the REIT itself, including testing product as it enters the pipelines to verify that it is the product specified in the pipeline use agreement solely to ensure the safety and integrity of the pipeline and the environment. The REIT engaged a TRS to provide all services, including scheduling the use of the pipelines with the pipeline users pursuant to the pipeline use agreements, etc. The TRS also owned, monitored, maintained, and operated all compressors or pumps that may be part of some pipelines. The REIT represented that all services furnished to the pipeline users are customarily provided to tenants of similar properties in the geographic market in which the respective pipeline is located.

The pipeline use fee was a fixed monthly amount for a prescribed amount of reserved pipeline capacity regardless of whether the pipeline user uses the capacity reserved for it. The pipeline use fee included an additional amount for the excess capacity used by the user and computed based upon a fixed dollar amount set forth in the pipeline use agreement multiplied by the volume of product that exits the pipeline. In some cases, the pipeline user agreed to use the pipeline for all the product it extracts from a particular area or field, and the REIT agreed to accept and reserve capacity for that product. In these cases, the pipeline use fee was computed solely based upon a fixed dollar amount set forth in the pipeline use agreement multiplied by the volume of product that exits the pipeline. The pipeline use fee also included amounts paid for the services performed by the TRS.

The IRS reasoned in part:

“The Platform Lease will be a multi-year lease that provides the Platform Lessee with the exclusive right to use the Platform. The Storage Agreements will typically have a term of b to c years, and the Pipeline Use Agreements will typically have a term of b to e years. No Storage Agreement or Pipeline Use Agreement will have a term of less than d. Each of the Storage Agreements and Pipeline Use Agreements will provide the user with the exclusive right to use a fixed portion of the capacity of the Storage Tank Facilities or the Pipelines throughout the term of the lease… The Pipeline Use Fees received by Taxpayer that are solely based upon the volume of product that exits the Pipeline are comparable to amounts received that are based upon a percentage of gross receipts. Accordingly, each of the Platform Rent, Storage Fee, and Pipeline Use Fee are an amount received for the use of, or the right to use, real property of Taxpayer and qualify as rents from interests in real property under section 856(d)(1)(A).”

Lessons Learned

First of all, the conclusion with respect to the capacity arrangements makes sense because while a REIT’s property may be concurrently used by multiple users subject to the property’s overall capacity, the shared-use arrangement should not change the nature of the payments (i.e., in exchange for the use of real property). For example, a REIT may own a five-story office building with total rentable square feet of X and lease each floor to a tenant that has an exclusive right to occupy and use the floor for a period of time. Alternatively, a REIT may own a warehouse totaling the same rentable square feet and construct demising walls to physically divide the warehouse for leasing. These are easier situations because the leased premises are physically separated to establish a tenant’s exclusivity over the demised premises. However, the REIT ultimately is leasing the total capacity of its office or warehouse property (i.e., rentable square footage) to tenants.

In the context of a natural gas pipeline, it similarly has a limited capacity at prescribed operating pressures (i.e., MMBtu per day). This capacity is similarly shared by users, each of which has reserved a specified capacity to transport the same product as other users and is obligated to make payments based on reserved capacity (i.e., regardless of actual usage). The pipeline owner is contractually obligated to ensure that the capacity specified in the use agreement is reserved for the user and does not oversell capacity in the property. Finally, these use agreements are for a long-term period. Thus, the pipeline owner is leasing the total capacity of its pipeline (i.e., MMBtu per day) to a limited number of users similar to the office or warehouse REIT.

Also, as discussed above, rents from real property do not include amounts, the determination of which depends on income or profits of any person from the leased property. However, percentage rents (i.e., rents basing on tenant’s gross revenue) do not cause rents to be considered income or profits-based. As described in the ruling, the rental payment may be computed based on: (1) the unit of measurement of the product transported or stored via the property, multiplied by (2) a fixed amount subject to adjustments, including an agreed upon increase, CPI, or a pre-determined formula to reflect changes in the product price. Notwithstanding the fact that the IRS did not express a view on this matter, the rent so determined should not be considered income or profits-based because it represents a portion of tenant’s gross revenue, which a REIT is permitted to receive. Also, the determination is logical because the amount represents a consideration for a tenant’s usage of REIT property for purposes of transporting or storing its products.

However, if a REIT’s property is leased to a tenant that subleases the same property to others along with the provision of services (similar to the platform lessee in the ruling), the IRS seems to not want the REIT to participate in the prime tenant’s service revenue from subtenants. It is possible that the IRS is concerned with the prime tenant functioning like a conduit and being used to convert otherwise service-intensive operations into qualifying rents. It is worth noting that the fact that the REIT in the ruling takes a percentage of the platform lessee’s rental revenue from subtenants but not the platform lessee’s service revenue from subtenants suggests excluding certain revenue types from the gross receipts in which a percentage rent is based should not cause rents to be considered income or profits-based.

Finally, with respect to the offshore platform, the equipment is represented to be personal property. Presumably, this is due to the fact that the equipment serves an active function but not a utility-like function and, thus, cannot be considered an inherently permanent structure or a structural component of an inherently permanent structure. In the ruling, the REIT did not perform any activities with respect to the offshore platform (including the equipment) and represented the value of personal property (including the equipment) was less than 15%. Thus, there does not seem to be any issue. However, with respect to the pipelines, the ruling described that a TRS owned, monitored, maintained, and operated all compressors or pumps that were part of some pipelines. This is somewhat interesting because while it seems clear that compressors and pumps are considered personal property under the final regulations (i.e., serving active but not utility-like functions), it is not entirely clear why the TRS must own them.

As discussed above, a REIT may avoid realizing impermissible tenant service income by relying on the IK/TRS exception, and the REIT in the letter ruling already represented that all services provided by the TRS are customary. Thus, the TRS should simply need to monitor, maintain, and operate all compressors or pumps but should not be required to own them. It is worth noting that in PLR 201901001 concerning fiber optic cables, all the equipment that receives, amplifies, regenerates, converts, and returns a signal originated by a tenant will similarly be owned by the REIT’s TRS (if not owned and operated by the tenant). Is it possible that the IRS wants the REIT to be absolutely passive (i.e., owning an asset that passively allows a product being transported but not an asset that actively cause a product being transported) when the nature of the business could be viewed as a transporting service?

Opportunities Provided Through Adopting a REIT Structure

The primary benefit of a REIT over a standard C corporation is the REIT can claim a deduction for dividends paid to its shareholders, resulting in quasi-conduit treatment similar to a partnership. Except for the REIT-specific tests and dividends paid deduction, a REIT is generally subject to the same rules applicable to a C corporation (e.g., distributions treated as dividend income, no effectively connected income treatment, etc.).

In comparison, MLP investors realize income on a flow-through basis (i.e., the underlying trade or business of the partnership is attributed to the income received by partners). For non-U.S. and tax exempt investors, this creates effectively connected income and/or unrelated business taxable income. As a result, an MLP may not be an attractive investment opportunity for non-U.S. and tax exempt investors unless an intermediary blocker-corporation is utilized. The blocker-corporation “cleanses” the partnership income received vis-à-vis a corporate-level income tax, and distributes the profits as a dividend. Under either approach, income received by non-U.S. and tax-exempt entities is effectively subjected to a second level of taxation.

REITs offer the best of both worlds: no entity-level income tax while providing distributions that generally are not considered effectively connected with a U.S. trade or business and are not considered unrelated business taxable income. Therefore, non-U.S. investors generally can enjoy an increased yield, and are not required to file U.S. tax returns while tax-exempt investors generally do not receive unrelated business taxable income. Phrased differently, the taxability of income generated by a REIT’s assets depends, in part, on the status of the REIT’s shareholders. Therefore, investors that pay no tax or a lower tax on REIT dividends (e.g., pension plans, university endowments, and state-owned investment funds) may be ideal investors for capital-intensive projects held through a REIT.

In addition to the general benefits inherent in a REIT structure, the federal tax code and regulations provide planning opportunities for the keen observer. For non-U.S. investors, if they invest in a domestically controlled REIT (i.e., more than 50% owned by U.S. persons), then Section 897(h)(2) excludes all interests in the REIT from the definition of a U.S. real property interest. Therefore, proceeds from a subsequent disposition of domestically controlled REIT shares would not be subject to withholding under the Foreign Investment in Real Property Tax Act (FIRPTA) rules and the capital gain realized would not be subject to U.S. tax.

There are still potential traps for the unwary. For example, if a midstream REIT also qualifies as a regulated utility (e.g., tariff rates are approved by FERC on electricity or LNG), then the REIT is automatically exempt from Section 163(j) and ADS depreciation is required to be used for all of its assets. The application of the ADS depreciation rules will result in a slowdown of the tax depreciation deductions being claimed by the REIT and make it ineligible for immediate expensing.

If, however, a midstream REIT is not considered a “regulated utility” it may still qualify as a “real property trade or business” and, therefore, be eligible to elect out of Section 163(j). Once the election is made, the REIT will then be required to apply the ADS depreciation rules. However, in this situation, the ADS depreciation rules would only apply to certain assets (e.g., residential real property, nonresidential real property, and qualified improvement property). As such, infrastructure assets like those described in PLR 201907001 would not meet the definition of “property” required to be depreciated under ADS and, therefore, would be eligible for immediate expensing. This treatment could result in a significant benefit for a midstream REIT as the bulk of its assets would generally consist of these asset types.

Conclusion

Since its creation in 1960, the REIT structure has been popular as both widely held and privately held vehicles for the ownership of eligible assets because a REIT, despite being taxed as a corporation, is not ordinarily taxed on its taxable income distributed to shareholders (i.e., a single level tax if shareholders are in fact subject to tax). For example, according to Nareit, the equity market capitalization of all listed U.S. REITs as of Jan. 31, 2019, was approximately $1.165 trillion. However, of that amount, only $150.5 billion was for REITs owning infrastructure assets, such as communications towers and fiber optic networks. With the release of the recent IRS determinations (e.g., PLR 201907001, PLR 201901001) and the favorable FIRPTA treatment, more infrastructure investors should consider using a REIT structure as it could appeal to a wider investor base as compared with traditional MLPs and other investment vehicles.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Ian Holcomb is a senior associate and Kyle Seipert, is a managing director with KPMG LLP’s Mergers and Acquisitions practice in Houston. David Lee is a member of the REIT Services team and a partner in the Passthroughs group of KPMG LLP’s Washington National Tax practice.

The information in this article is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.