INSIGHT: State and Local Incentive Arrangements From a REIT’s Perspective

Nearly three years after taxpayers’ requests for rulings, the IRS issued on April 20, 2018, three identical private letter rulings (PLRs) concerning tax treatment under the real estate investment trust (REIT) rules for incentive payments from a municipality involving tax increment financing (TIF). Specifically, the IRS addressed whether the right to receive payments out of new tax revenue collected by a municipality as the result of a real estate development is a qualifying REIT asset and whether these payments are qualifying REIT income. This article summarizes and contextualizes the three recent PLRs and relevant tax rules, and attempts to explain why there was a delay in issuing the rulings.

BACKGROUND ON REIT RULES

REITs are generally tax-efficient vehicles for investments in real estate assets because REITs are taxable corporations (and therefore owners are not attributed the business activity associated with managing real estate) and are eligible for dividends paid deductions (and therefore REITs are generally taxed only on undistributed taxable income). To qualify as a REIT, an entity must satisfy certain complex requirements in respect of share ownership, asset holding, income source, and distributions. Even though these requirements may not be well defined by public guidance, compliance with the rules is absolutely strict.

Asset Tests

A REIT must satisfy a 75 percent asset test (i.e., 75 percent of its gross assets must be “real estate assets,” cash and cash items, or U.S. government securities) and other asset and securities diversification tests on a quarterly basis. Other than securities of a taxable REIT subsidiary (TRS) or those qualified for the 75 percent asset test, securities held by the REIT (1) must not represent more than five percent of the value of the REIT’s total assets; and (2) must not represent more than 10 percent of the total voting power or value of the outstanding securities of the issuer.

For purposes of a REIT’s qualifying asset tests, security is broadly defined by the Investment Company Act of 1940, but does not include “interests in real property” or “real estate assets.” Certain receivables that arise in the ordinary course of the REIT’s operation (and are not purchased from another person), are treated as cash and cash items for purposes of the 75 percent asset test and, therefore are not subject to five and 10 percent asset tests described above. Receivables for accrued but unpaid rents from tenants are examples of ordinary receivables that are treated as cash and cash items.

Income Tests

Although legislative history to the 1960 legislation enacting the REIT regime limited the “conduit” treatment for “what is clearly passive income from real estate investments, as contrasted to income from the active operation of businesses involving real estate,” over time REITs have conducted increasingly active businesses. The 75 percent income test (which requires that at least 75 percent of a REIT’s gross income be from the certain “passive” sources, including rents from real property and abatements and refunds of taxes on real property) is a remaining guardrail to ensure a REIT is passive.

In addition to the 75 percent test, a REIT must derive annually at least 95 percent of its gross income (other than gross income from prohibited transactions and certain hedging and foreign currency transactions) from 75 percent income test qualifying items, interest, dividends, and gains from the sale or other disposition of non-dealer securities.

Gross Income Authorities

For purposes of both the numerator and denominator of the REIT qualifying income tests described above, the term “gross income” means all income from whatever source derived by a REIT under tax code Section 61 unless excluded by law. The Secretary of Treasury has authority pursuant to Section 856(c)(5)(J) to exclude items of income not otherwise qualifying from consideration under each REIT qualifying income test (i.e., both the numerator and denominator) or treat these items as qualifying (c5J authority), but presumably may only exercise this authority in respect of what are, to begin with, items of gross income. Indeed, an IRS official commented at a March 21 conference sponsored by the National Association of Real Estate Investment Trusts in Hollywood, Fla., that taxpayers seeking a ruling on the REIT qualifying income tests should address whether the item at issue is income under Section 61.

The concept of gross income is to be broadly construed, and therefore all funds received by a taxpayer, including a REIT, are presumed to be gross income unless there is no accession to wealth or the accession fits into one of the narrowly construed exclusions specifically provided by law. Situations in which there is no accession to wealth include, for example, the receipt of loan principal by a debtor, and, as discussed further below, purchase price adjustments or rebates (including, in most circumstances, tax abatements). Specific statutory exclusions from gross income include, for example, nonshareholder contributions to the capital of a corporation under Section 118 (discussed further below in Section 118), cancellation of indebtedness income under Section 108, and improvements by a lessee on a lessor’s property under Section 109.

No Accession to Wealth: Purchase Price Adjustments and Rebates

If a payment is properly characterized as a “purchase price adjustment,” it is not an accession to wealth, but instead reduces the taxpayer’s cost basis in the property. The IRS has applied this theory in multiple revenue rulings and the courts have applied this theory in numerous cases. Although in Uniquest Delaware LLC v. United States, 294 F. Supp. 3d 107 (W.D.N.Y. 2018), the district court recently appears to have pulled back from a variant theory, historically, courts also have applied a doctrine of “inducement” to circumstances in which the recipient of a payment has no accession to wealth, but the payor is not the seller of the property to which the payment relates and therefore the purchase price adjustment theory fits less neatly. The same basic principles apply in the context of tax abatements or non-refundable tax credits (i.e., making a reduced net tax payment).

For example, in Revenue Ruling 76-96, Rev. Rul. 84-41, Brown v. Commissioner, 10 B.T.A. 1036 (1928), and Freedom Newspapers, Inc. v. Commissioner, T.C. Memo. 1977-429, payments from car manufacturers to customers after delivery of cars, payments from a majority stockholder in a company to a purchaser of the company’s preferred stock to facilitate the purchase, and payments from the seller to a purchaser of a newspaper business in a subsequent year after the purchaser was unable to sell an unwanted component of the newspaper business have not resulted in gross income. On the other hand, in TAM 8924002, payments from an electric cooperative to customers to install special systems that were not based upon the customers’ cost to install the systems have resulted in gross income.

Future tax reductions agreed to on the basis of the cost of the taxpayer’s capital improvements and nonrefundable state tax credits are unlikely to give rise to gross income based on Rev. Rul. 79-315, Snyder v. Commissioner, 894 F.2d 1337 (6th Cir. 1990), and Maines v. Commissioner, 144 T.C. 123 (2015). However, tax abatements and exemptions granted on the basis of services provided by a taxpayer could result in gross income to these taxpayers according to ILM 200227003. Because tax refunds inherently relate to taxes that have already been paid and deducted in an earlier tax year, refunds are likely income in the year received based on the tax benefit rule (fortunately, however, the 75 percent income test specifically provides that, in the case of property taxes, tax refunds are REIT qualifying income).

This January the Court of Federal Claims, in Sunoco, Inc. v. United States, 129 Fed. Cl. 322 (2018), held that Sunoco must reduce its federal excise tax liability by the alcohol fuel mixture credit for purposes of computing its cost of goods sold, stating that “[t]he Mixture Credit is like a manufacturer’s rebate in that it reduces the amount of money the taxpayer actually is required to pay out of its own pocket,” and citing prior purchase price adjustment authorities.

Section 118

If a payment is gross income, it may nonetheless be excluded from gross income under various statutory provisions. One such provision is Section 118, enacted during 1954 after the U.S. Supreme Court held that subsidy payments from noncustomers (e.g., a municipality in the case of land grants to complete a railroad, or payments of cash and property in exchange for locating manufacturing facilities in particular locations) were excludable from the recipient’s income. The provision has been controversial, particularly in respect of its historic application to partnerships.

As part of tax reform signed into law on Dec. 22, 2017, Section 118 was further limited, and no longer includes “any contribution by any government entity or civic group (other than a contribution made by a shareholder as such).” However, to the extent the incentive payment is in the form of a tax abatement, the legislative history confirms that Section 118 is not relevant (presumably because there is no gross income).

TAX INCREMENT FINANCING IN GENERAL

TIF includes, broadly, any form of financing in which future taxes attributable to the increase in value of real property after a public improvement or development (project) is completed are relied upon to secure or repay some or all of the costs incurred in completing the project.

In general, a state passes enabling legislation, a TIF district is created to undertake public improvements, public bonds are issued, and under this framework the relevant taxing authority agrees that property tax revenues in excess of a baseline (generally based on pre-project property values, but possibly including property taxes related to adjacent properties and/or tax revenue other than property taxes (i.e., the district’s “revenues”) will be security for or otherwise a source of repayment of the financing (i.e., the district’s “financing”). In recent years, however, TIF arrangements have evolved; the tax increment may include non-property taxes (such as business-related taxes), a special district may or may not be created, and the source of financing may be the municipality’s annual budget or the developer (i.e., an incentive payment may be agreed to upfront and then paid to reimburse the developer out of the municipality’s incremental taxes from the project).

For example, in CCA 201537022, the IRS determined that incentive payments to a developer were a reduction in the developer’s cost basis in the project (rather than repayment of a loan and interest that the taxpayer had inappropriately treated as tax-exempt). In that case, the municipality obtained financing for capital improvements from the developer, to be repaid out of a bond issuance. The CCA described that the entire risk of development would rest with the taxpayer until such time as the financing district developed sufficient assessed valuation to support the debt service requirements of the bonds issued. The IRS reasoned “developers have been permitted to treat amounts that in form are cast as advances or loans, and made in exchange for bonds or other debt instruments, as in substance expenditures for common improvements and thus included in the bases of lots sold.”

To the extent the amount of an incentive payment is determined based on the project costs, there is a threshold question as to whether the incentive payment is gross income (i.e., could it be a purchase price adjustment, inducement payment, tax refund, or other). The gross income issue is particularly relevant when the taxpayer is subject to the REIT qualifying income tests discussed above.

DESCRIPTION OF THE THREE RECENT TIF RULINGS

PLRs 201816001, 201816002, and 201816003 are based on a similar fact pattern: A REIT owns an interest in a partnership developing a mixed-use shopping center. As an incentive to the partnership, a municipality agrees to provide a fixed dollar amount to the partnership to partially offset the project cost (total payment). Because the municipality’s policy limits to a certain percentage the amount of site-specific net new tax revenues (including property and sale and use taxes directly attributable to the project) that could be paid by the municipality to offset project costs, the framework for making the total payment to the partnership is as follows:

• Up to the permitted percentage of site-specific new tax revenues generated by the project will be contributed to a special fund, then that amount will remitted to the partnership annually from the fund,
• The municipality’s share of property taxes paid by the partnership will be remitted to the partnership (annual rebate amount) and to the extent the permitted percentage of net new tax revenues is in excess of the annual rebate amount, an additional amount will be remitted to the partnership (annual refund amount), and
• These annual payments will continue to be made for the later of 25 years or when the total payment is made.

The partnership planned to record unpaid claims for the total annual payment as a receivable for U.S. generally accepted accounting principles (GAAP) purposes, presumably because the amount could be reasonably estimated by the partnership, and there was a delay in payment. Each REIT represented that substantially all the income from the project (other than the payments under the arrangement with the municipality) would be REIT qualifying income.

Because “total assets” for purposes of the REIT qualifying asset tests means the gross assets of the REIT determined in accordance with GAAP, any receivable arising under GAAP related to the TIF must be analyzed (i.e., whether an asset qualifying under the 75 percent asset test and, thus, not subject to the securities diversification limits). The IRS concluded that the GAAP receivable (i.e, the right to receive state and local incentive payments) not from tenants would arise in the ordinary course of the partnership’s operations as owner or lessor of real property, and therefore be treated as cash for purposes of the 75 percent asset test (and, accordingly, not a security subject to the five percent and 10 percent asset tests). Although as discussed below this is not the first PLR to reach this conclusion, the conclusion is meaningful because—even though a security issued by a state or its political subdivision is excluded from the 10 percent value limit—whether a particular municipality is properly treated as a political subdivision for purposes of the 10 percent value limit may not always be clear. In any event, a “security” would remain subject to the five percent value limit, even if issued by a state or its political subdivision. There may, however, be other reasons to treat a REIT’s rights to receive state and local incentive payments as other than securities (even if structured as notes) under the right set of facts.

It is worth noting that the gross income issue is not specifically addressed in these rulings. However, the fact that the IRS ruled on the REIT income test qualification of the payments to the partnership implies that, at least in the IRS’s view, the payments are gross income (i.e., this is an implicit gross income ruling). By contrast, in PLR 200403023, the IRS specifically concluded that incentive payments under a TIF arrangement involving only site-specific property taxes were both gross income and qualifying REIT income from tax refunds or abatements: “[b]ecause the funds are designed to supplement Developer’s operating income, the payments are fully includible in gross income. Texas & Pacific RY. Co. v. United States, 286 U.S. 285 (1932)… Thus, the funds should be considered income described in Section 856(c)(2).”

Per Section 6.11 of Revenue Procedure 2018-1 (the annual IRS revenue procedure setting out general procedures for obtaining PLRs) the IRS is not permitted to provide “comfort” letter rulings on issues that are “clearly and adequately addressed by statute, regulations, decisions of a court, or [other published guidance].” Rev. Proc. 2018-3 (the annual IRS revenue procedure setting out a nonexclusive list of “no rule” areas) includes various specific issues arising under the Section 61 gross income definition as issues on which rulings either “will not” or “will not ordinarily” be issued.

If these payments were not gross income, the IRS could nonetheless have ruled that the receivable was an ordinary receivable (treated as cash and cash items) and, thus, a qualifying asset. Specifically, the IRS ruled that the portion of the annual payment that related to property taxes paid by the partnership was gross income derived from a refund of taxes on real property under Sections 856(c)(2)(E) and (3)(E), and that because “the rental income generated by the [p]roject will be qualifying income under Section 856(c)(2) and (3),” the other portion of the total annual payment was qualifying income for purposes of the 75 percent and 95 percent income tests, invoking c5J authority.

The IRS did not, in the three recent TIF rulings, address the extent to which gain from the sale of the partnership interests attributable to these receivables would be qualifying income if the receivables were capable of being separated from the projects or whether this type of sale would be a prohibited transaction.

IRS C5J AUTHORITY

Although in the three recent TIF rulings the IRS concluded that the portion of the payments from the municipality to the taxpayer that were made out of taxpayer’s property taxes were tax refunds qualifying under Section 856(c)(2)(E) and (3)(E), the IRS invoked the c5J authority in respect of the remainder of the payments.

A report from the Joint Committee on Taxation explained that the 2008 legislation enacting Section 856(c)(5)(J) authorized the “Treasury Department to issue guidance that would allow other items of income to be excluded [for REIT qualifying income test purposes] or to be included [as qualifying income for a REIT]….” The report cites as reasons for enacting Section 856(c)(5)(J) PLRs 200039027 and 200127024 in which the IRS had concluded, respectively, that a settlement payment received by a REIT with respect to construction of a mall and a payment received as a “break-up” fee in a proposed merger, should be excluded from the REIT qualifying income tests. Although no guidance of general application has been promulgated by Treasury, the IRS has invoked c5J authority when issuing the PLRs discussed below (c5J PLRs) that address other state and local incentive payments, as well as other examples (e.g., treating subpart F and PFIC inclusions as qualifying income to the extent they were attributable to passive items, such as interest, dividends, gains from the sale or other disposition of non-dealer stock, securities, or real property, etc.).

• In PLR 201742008, the IRS determined that an incentive payment from a utility company for installing solar photovoltaic system on the roof of REIT’s retail center to produce electricity to serve the retail center was qualifying income to the extent it did not represent a payment in exchange for transferring renewable energy credits (RECs) to the utility. As described in the letter ruling, customers installing solar photovoltaic systems generally received incentive payments from the utility at one of two rates: a lower rate if the customer retained its RECs (base incentive rate), and a higher rate if it transferred its RECs to the utility (REC incentive rate). The REIT intended to transfer any RECs in connection with the solar photovoltaic system and, thus, would qualify for the REC incentive rate. The REIT treated the portion of its incentive payment attributable to the excess of the REC incentive rate over the base incentive rate as non-qualifying income. Invoking c5J authority, the IRS ruled the portion of the incentive payment calculated based on the base incentive rate would be qualifying income for purposes of the REIT income tests. This is somewhat similar to the safe harbor provided in the preamble to the 2016 final real property regulations concerning net metering except that pursuant to the safe harbor, any income resulting from the transfer of excess electricity will not be treated as gross income for the income tests and not be subject to the prohibited transaction tax of Section 857(b)(6).
• In PLR 201716043 (also a TIF ruling), the IRS ruled that an incentive payment to a REIT developing a transit-oriented, mixed-use property was qualifying income by exercise of c5J authority, notwithstanding that the payment was out of incremental “eligible taxes” from the development that included corporate taxes, a tax imposed on marine insurance companies, a hotel and motel occupancy fee, etc.
• In PLR 201518010, the IRS determined that REIT income from refundable tax credits awarded on the basis of its costs incurred for (1) site preparation, (2) qualified tangible property, and (3) on-site groundwater remediation was qualifying income by exercise of c5J authority.
• In PLR 201428002, the IRS ruled that income attributable to refundable tax credits is qualifying income from refunds of real property taxes (to the extent financed through increment property taxes from the development giving rise to a lien on the real property in the period during which the real property is a qualified site), and otherwise qualifying income by exercise of c5J authority. The refundable tax credit income that was qualified by exercise of c5J authority was paid to the developer based on its costs incurred for (1) site preparation, (2) qualified tangible property, and (3) on-site groundwater remediation.

In each of the c5J PLRs, and the three recent TIF rulings, the IRS determinations were, in part, based on the representations from REITs that their income otherwise qualified for purposes of the 75 percent and 95 percent income tests. We understand this as an indication of the IRS’s general willingness to rule favorably on the treatment of state and local incentive payments if a REIT otherwise satisfies the REIT income and asset tests.

Although PLRs may not be relied upon by taxpayers other than those that receive them, and may be revoked by subsequent published guidance or otherwise, because the IRS generally issues these rulings (including c5J PLRs) in accordance with its view of the law, taxpayers understand those rulings, as a practical matter, to be equivalent to published guidance. The c5J PLRs are by their nature discretionary; because the IRS nonetheless obtains representations from REITs and presents policy-type arguments in the rulings it appears that they should be no less persuasive to taxpayers to which they are not specifically directed. To the extent the c5J PLRs are, however, “extra-legal” (i.e., the IRS did not have another basis on which to rule), the topics they cover may, unlike the topics covered by other PLRs, be difficult for tax advisors to opine on.

For most of these c5J PLRs, the IRS was able to issue the letter rulings within the normal time frame (i.e., up to six months). In the case of PLR 201716043, described above, and the three recent TIF PLRs, the IRS took significantly longer to rule. This unusual delay suggests the relevant Associate Office of Chief Counsel had some difficulty reaching its legal conclusion, or determining whether it should rule at all. As noted above, although there is no analysis on the gross income question in the three recent TIF rulings (nor is there in PLR 201716043) there is an implicit ruling in this regard; coordination of this question with the relevant Associate Office of Chief Counsel to conclude on Section 61 (the gross income Code section) may have taken some time. Additionally, we note that the IRS has an open guidance project on the 75 percent and 95 percent income tests and in the case of a pending published guidance project the IRS will ordinarily not rule on PLR requests unless the answer is “clear or reasonably certain” (but not entirely free from doubt) or “in the best interest of tax administration.”

CONCLUSION

We look forward to the IRS’s published guidance on the 75 percent and 95 percent income tests, and anticipate that, in the interest of sound tax administration, the IRS will address the many outstanding questions in relation to the treatment of TIF and other state and local incentive payments. These questions not only include the various issues previously addressed by the IRS in PLRs, whether invoking c5J authority or otherwise, but also extend to new questions raised by the implicit gross income ruling in the three recent TIF rulings. That is—to the extent the IRS has implicitly ruled that the incentive payments in the three TIF rulings were, contrary to Chief Counsel Advice 201537022, gross income to the REITs—REITs may need to consider seeking qualifying income rulings in circumstances in which they would previously have relied on purchase price adjustment authorities to treat payments as other than gross income in the first instance (e.g., REITs receiving post-closing payments in buy/sale transactions for commercial reasons).

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. Orla O’Connor is a principal in the Real Estate Tax group in San Francisco. The authors wish to thank Gary Williams and Mitchell Wong, also based in the San Francisco office, for their assistance with this article. 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.