On February 15, 2019, the Internal Revenue Service (the “IRS”) released PLR 201907001 (the “Ruling”), a private letter ruling addressing whether certain income related to the leasing of an oil and gas platform, selling of capacity and storage space at storage tank facilities, and shipping oil and gas on pipelines would qualify as “rents from real property” under Section 856(d)(1) of the Internal Revenue Code (the “Code”). In determining that the income from these leases would qualify as rents from real property, the Ruling provides some insight into the range of asset types and contractual arrangements, many of which are common in the oil and gas production, storage, and transportation businesses, that can potentially work within a real estate investment trust (“REIT”) structure.
A REIT must derive at least 75% of its gross income from “rents from real property” and other real-estate-related sources. “Rents from real property” is a term of art that includes charges for both space and “customary” services that are provided in connection with a lease. Customary services are those that are customarily provided by properties of a similar class in the same geographic market. On the other hand, “impermissible tenant service income” (“ITSI”) does not qualify as rent, and receiving more than a de minimis amount of ITSI can taint all the rental income from a property. Generally speaking, any services that are provided for the convenience of a particular tenant must be provided by an independent contractor or a taxable REIT subsidiary (a “TRS”) to avoid creating ITSI.
In the Ruling, a REIT planned to construct an offshore oil and gas platform (the “Platform”) and purchase and operate several storage tank facilities (the “Storage Tanks”) and pipelines (the “Pipelines”). The taxpayer would then lease the Platform, sell storage capacity in the Storage Tanks and sell shipping capacity and transport oil and gas for unrelated customers and provide certain services relating to the Storage Tanks and Pipelines to the tenants/customers through a TRS.
With respect to the Platform, the REIT would simply lease the Platform and associated equipment but provide no additional services. The lessee would be responsible for operating, maintaining, and repairing the Platform and its related equipment. The rents received under the lease would be comprised of both a fixed amount (designed to provide the taxpayer a return of and on its invested capital in the Platform) and a variable amount based on the volume of oil and gas that passed through the Platform (such amount would fluctuate based on changes in oil and gas commodity prices).
The Storage Tanks, which included various related infrastructure including driveways, docks, and rail spurs, was leased as either dedicated space within a specific tank, or as commingled space within the overall system. The fees paid by the Storage Tank lessees would consist of a monthly fixed amount for a prescribed amount of reserved storage capacity, which would be due regardless of whether the lessee actually used that available capacity.
A TRS would perform any services, including loading, unloading, and moving the oil and gas products, as well as blending additives into the products. The REIT would thereafter compensate the TRS for these services at customary rates. The Ruling does not specify whether the charges for these services were separately stated or bundled with the lease charge.
With respect to the Pipeline, the REIT would provide pipeline shippers1 with a certain specified capacity to transport oil and gas. Some shippers would pay a fixed monthly amount for a prescribed amount of capacity, which would be charged on a “take or pay” basis (i.e., the shipper would pay the fixed amount regardless of their actual usage). Other shippers were obligated to pay fees based solely on the volume of the shipper’s product shipped through the Pipelines.
Except for certain supervisory and monitoring activities, all Pipeline services would be provided by a TRS. For these services, the TRS received arm’s length compensation from the REIT. The shipper paid the full shipping charge to the REIT, without any apparent allocation between the REIT and the TRS. Again, the Ruling does not indicate if the REIT separately stated any service charges.
The Ruling
In the ruling, the REIT represented that the services provided to Storage Tank and Pipeline customers were customary for similar facilities in the relevant geographic markets. Based on this representation and the other facts presented by the REIT, the Ruling determines that the income from the Platform, Storage Tanks, and Pipelines would qualify as rents from real property and would not give rise to ITSI for the REIT.
One important point that the Ruling brings out is that, when deciding whether a nontraditional asset may be held by a REIT, the key question may not be whether the asset would satisfy the REIT asset test, but rather whether it is feasible to structure the operation such that the income derived from the assets would qualify as rents from real property. The real property regulations finalized in 2016 provide clear and flexible guidance on what constitutes real property for REIT purposes, and it seems clear that the assets described in the Ruling would so qualify, with the possible exception of any machinery that served an active function (such as pumping oil or gas through a pipeline). The challenge for the taxpayer in this Ruling was likely ensuring that it could enter into leasing, storage and shipping contracts that would comport with the commercial needs of oil and gas customers while still producing “rents from real property” for purposes of the REIT income tests. The regulations relating to the definition of rents from real property have not been modernized and provide much less guidance to taxpayers about what requirements an unconventional commercial arrangement must meet to qualify as a lease for REIT purposes. In this case, the Platform contract was essentially a master lease, so the determination that it gave rise to rents from real property was likely relatively easy. The Storage Tank and Pipeline arrangements are more complicated. For instance, the Storage Tank leases are somewhat atypical of traditional leases, in that the lessees might not have a defined space that they were leasing, but rather a given volume of space that might be spread over a number of tanks and which could require that their product be commingled with that of other lessees. Additionally, although some of the taxpayer’s proposed pricing models are fairly straightforward, as for example the leases of designated storage tanks, others relied on variable rates based on market conditions and capacity used. The Ruling sweeps all of these arrangements under the umbrella of rents from real property.
Another interesting point about the Ruling is that the services provided by the TRS to the tenants were paid to the REIT, rather than to the TRS. There has been some uncertainty as to the circumstances under which those payments for services are considered rents from real property. Section 856(d)(1)(B) provides that customary services, whether or not priced separately from the underlying rental charge, count as rents from real property. The IRS has also ruled that charges for noncustomary services that are “bundled” into a single rental charge qualify as rents. In Rev. Rul. 2002-38, an apartment REIT provided housekeeping services to its residents through a TRS. The charges for those services were not stated separately from the rents the tenants paid to the REIT. Under these facts, the IRS found that the entire rental charge was rents from real property, including the portion implicitly attributable to the maid service. To summarize, these authorities make it clear that charges for customary services are always rents from real property, while charges for noncustomary services should count as rents where they are bundled into the rent payment.2
As described in the Ruling, the TRS would provide all of the services related to the Storage Tanks and Pipelines and the only activities that the REIT planned to undertake would be in relation to the maintenance of the REIT’s property. Under Rev. Rul. 2002-38, this would seem to be acceptable, provided that the service charges were not separately stated. The Ruling, however, does not address this point. Further, in the Ruling the IRS apparently required the taxpayer to stipulate that all of the services provided by the TRS were customary in order to give the ruling that the income would qualify as rents from real property. Based on the IRS’s position in Rev. Rul. 2002-38, this stipulation should not have been needed as long as the charges were bundled. This requirement suggests that the IRS may be hesitant to broadly apply the analysis of Rev. Rul. 2002-38 to nontraditional asset types (where service charges often account for a more substantial portion of the charge to the tenant), at least in the context of granting a ruling where the taxpayer is able to provide an alternative basis for a favorable outcome by representing that the services are customary.
