Only a proportionate share of rent tied to a sub-subtenant's profits was disqualified

Plain-English summary

A company planned to reorganize a subsidiary in bankruptcy and place leased property in a new corporation that would elect REIT status. One remote sub-subtenant paid rent based on its net income, raising the question whether that arrangement would disqualify all rent the REIT received from its prime tenant. The IRS ruled that only the proportionate amount calculated under the regulatory formula would fail to qualify as rents from real property. For that formula, the numerator is the rent or other amount the intermediate subtenant receives from the profit-based sub-subtenant, and the denominator is all rent or other amounts the prime tenant receives under the sublease.

Ruling snapshot

• Question: Does a profit-based sub-sublease disqualify all rent received by the REIT, and how is the proportionate nonqualifying amount calculated?
• Outcome: approved, only the proportionate amount determined under the regulatory formula is nonqualifying rent
• Key authorities: IRC §§ 856(c)(2), 856(c)(3), 856(d)(1), 856(d)(2)(A), 856(d)(4); Treas. Reg. §§ 1.856-4(a), 1.856-4(b)(3), 1.856-4(b)(6)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201716044                                              Third Party Communication: None
Release Date: 4/21/2017                                        Date of Communication: Not Applicable
Index Number: 856.04-00
                                                               Person To Contact:
--------------------                                           ----------------------------
--------------------------                                     ID No. ------------------
-----------------------------------------                      Telephone Number:
-------------------------------------                          ------------------------
----------------------------------                             Refer Reply To:
                                                               CC:FIP:B02
                                                               PLR-138800-16
                                                               Date:
                                                               January 05, 2017


Legend

Taxpayer                            =                 -------------------------------------------------
                                                      ------------------------

Distributing                        =                 ---------------------------------------------------------------
                                    ------------------------------------------------------------------------------
                                             ------------------------------

Bankruptcy Court                    =                 ---------------------------------------------------------- ----
                                                      -----------------------

Date 1                              =                 ----------------------

Date 2                              =                 -----------------------

U                                   =                 ----

V                                   =                 --

W                                   =                 --

X                                   =                 --

Y                                   =                 --

Z                                   =                 ----

State A                             =                 --------------

Leased Property                     =                 --------------------------------------------------------------
PLR-138800-16                                2




Dear -----------------:

       This ruling responds to a letter dated March 19, 2015 and supplemental
submissions submitted on behalf of Taxpayer. Taxpayer requests that for purposes of
applying § 1.856-4(b)(3) of the Income Tax Regulations (the “Regulations”), (i) only a
proportionate amount of the rent received by Controlled (defined below) from
Distributing, which will depend in part on rent from a sub-sublease that is based on
income or profits of Sub-Subtenant (defined below), will be treated as other than "rents
from real property"; and (ii) for purposes of computing this proportionate amount under
§ 1.856-4(b)(6)(ii)(B), the numerator of the fraction equals all rent or other amount
received by Subtenant (defined below) pursuant to the sub-sublease between
Subtenant and Sub-Subtenant, and the denominator equals all rent or other amount
received by Distributing under the Sublease (defined below).

                                         FACTS

        Taxpayer is a State A corporation. Taxpayer represents that, pursuant to a
bankruptcy plan to be approved by the Bankruptcy Court, it will engage in a
reorganization whereby one of its subsidiaries, Distributing, will restructure its business
(the “Proposed Transaction”). As part of the Proposed Transaction, Distributing has
formed a wholly owned subsidiary, a State A limited liability company (“Controlled”).
Distributing (or its subsidiaries that are treated as disregarded entities for federal
income tax purposes) will contribute certain assets, including Leased Property, to
Controlled (the "Contribution"). Controlled will then contribute those assets (including
the Leased Property) to certain subsidiaries that are treated as disregarded entities for
federal income tax purposes. In consideration for the Contribution, Distributing will
receive, inter alia, all common and preferred stock of Controlled. Distributing will then
distribute assets, including the common and preferred stock of Controlled, to creditors of
Distributing (the "Distribution") in satisfaction of their claims against Distributing.

       Controlled intends to elect to be treated as a real estate investment trust (a
“REIT”) under §§ 856-860 of the Internal Revenue Code (the “Code”) effective for either
the taxable year beginning the day after the Distribution and ending on December 31 of
that calendar year or the calendar year following the year in which the Distribution
occurs.

       Controlled, through certain lower-tier entities, will lease Leased Property to
Distributing under a lease with an initial U-year term and V W-year renewal terms (the
“Prime Lease”). Distributing will pay fixed rents for the first X years, and then in
subsequent years will pay rent that is based on a fixed amount and a percentage of
Distributing’s gross revenues subject to certain adjustments.
PLR-138800-16                                 3


       The Prime Lease will be subject to an existing lease to an unrelated third party
("Subtenant") executed on Date 1 (the "Sublease"). The Sublease terminates on Date
2, and vests Subtenant with Y Z-year extension option. Subtenant has subleased the
property it leases from Distributing to various other unrelated third parties that will be
sub-subtenants of Distributing after completion of the Proposed Transaction. One such
sub-subtenant ("Sub-Subtenant") pays rent that is based on Sub-Subtenant’s net
income from the property it leases from Subtenant. Taxpayer represents that this profit-
based sub-sublease is a preexisting arrangement entered into for business reasons
independent of tax considerations. Taxpayer also represents that Controlled would not
receive a greater amount of income that qualifies as rents from real property pursuant to
the formula in § 1.856-4(b)(6)(ii)(B) if Distributing were to have directly entered into the
same lease with Sub-Subtenant.

                                  LAW AND ANALYSIS

       Section 856(c)(2) of the Code provides that at least 95 percent of a REIT’s gross
income must be derived from, among other sources, “rents from real property.” In
addition, § 856(c)(3) provides that at least 75 percent of a REIT’s gross income must be
derived from, among other sources, “rents from real property.”

        Section 856(d)(1) provides that "rents from real property" includes (subject to
exclusions provided in § 856(d)(2)): (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 taxable year does not exceed 15
percent of the total rent for the tax year attributable to both the real and personal
property leased under, or in connection with, the lease.

        Section 856(d)(2)(A) (the "exclusionary rule") generally provides that, except as
provided in §§ 856(d)(4) and (6), rents from real property does not include any amount
received or accrued, directly or indirectly, with respect to any real or personal property,
if the determination of such amount depends in whole or in part on the income or profits
derived by any person from such property (except that any amount so received or
accrued shall not be excluded from the term rents from real property solely by reason of
being based on a fixed percentage or percentages of receipts or sales).

       Section 856(d)(4) provides that if a REIT receives or accrues, with respect to real
or personal property, any amount that would be excluded from the term rents from real
property solely because the tenant of the REIT receives or accrues, directly or indirectly,
from subtenants any amount the determination of which depends in whole or in part on
the income or profits derived by any person from such property, only a proportionate
part (determined pursuant to regulations prescribed by the Secretary) of the amount
PLR-138800-16                                 4

received or accrued by the REIT from that tenant will be excluded from the term rents
from real property (the "proportional exclusion rule").

        Section 1.856-4(a) of the Regulations defines the term rents from real property
generally as the gross amounts received for the use of, or the right to use, real property
of the REIT. Section 1.856-4(b)(3) provides in relevant part that, except as provided in
§ 1.856-4(b)(6)(ii), no amount received or accrued, directly or indirectly, with respect to
any real property (or personal property leased under, or in connection with, real
property) qualifies as rents from real property if the determination of the amount
depends in whole or in part on the income or profits derived by any person from the
property. However, any amount so accrued or received shall not be excluded from the
term rents from real property solely by reason of being based on a fixed percentage or
percentages of receipts or sales (whether or not receipts or sales are adjusted for
returned merchandise, or Federal, State, or local sales taxes). For example, rents from
real property includes rents under a lease that provides for differing percentages of
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 that has the effect of basing the rent on income or
profits. In addition, if in accordance with the terms of an agreement an amount received
or accrued as rent for the taxable year includes both a fixed rental and a percentage of
all or a portion of the lessee's income or profits, neither the fixed rental nor the
additional amount will qualify as rents from real property. In any case, an amount will
not qualify as rents from real property if, considering the lease and all the surrounding
circumstances, the arrangement does not conform with normal business practice but is
in reality used as a means of basing the rent on income or profits.

        Section 1.856-4(b)(6)(i) states that except as provided in § 1.856-4(b)(6)(ii), if a
REIT leases real property to a tenant under terms other than solely on a fixed sum
rental (for example, a percentage of the tenant's gross receipts), and the tenant
subleases all or a part of such property under an agreement that provides for a rental
based in whole or in part on the income or profits of the sublessee, the entire amount of
the rent received by the trust from the prime tenant with respect to such property is
disqualified as rents from real property.

       Section 1.856-4(b)(6)(ii) states that for taxable years beginning after October 4,
1976, the proportional exclusion rule provides an exception to the general rule that
amounts received or accrued, directly or indirectly, by a REIT do not qualify as rents
from real property if the determination of the amount depends in whole or in part on the
income or profits derived by any person from the property. This exception applies when
the REIT rents property to a tenant (the prime tenant) for a rental that is based, in whole
or in part, on a fixed percentage or percentages of the receipts or sales of the prime
tenant, and the rent that the REIT receives or accrues from the prime tenant pursuant to
the lease would not qualify as rents from real property solely because the prime tenant
PLR-138800-16                                 5

receives or accrues from subtenants (including concessionaires) rents or other amounts
based on the income or profits derived by a person from the property. Under the
exception, only a proportionate part of the rent received or accrued by the REIT does
not qualify as rents from real property. The proportionate part of the rent received or
accrued by the REIT that is non-qualified is the lesser of the following two amounts:

       (A) The rent received or accrued by the REIT from the prime tenant pursuant to
       the lease, that is based on a fixed percentage or percentages of receipts or
       sales, or

        (B) The product determined by multiplying the total rent which the REIT receives
       or accrues from the prime tenant pursuant to the lease by a fraction, the
       numerator of which is the rent or other amount received by the prime tenant that
       is based, in whole or in part, on the income or profits derived by any person from
       the property, and the denominator of which is the total rent or other amount
       received by the prime tenant from the property. For example, assume that a real
       estate investment trust owns land underlying a shopping center. The trust rents
       the land to the owner of the shopping center for an annual rent of $10x plus 2
       percent of the gross receipts which the prime tenant receives from subtenants
       who lease space in the shopping center. Assume further that, for the year in
       question, the prime tenant derives total rent from the shopping center of $100x
       and, of that amount, $25x is received from subtenants whose rent is based, in
       whole or in part, on the income or profits derived from the property. Accordingly,
       the trust will receive a total rent of $12x, of which $2x is based on a percentage
       of the gross receipts of the prime tenant. The portion of the rent which is
       disqualified is the lesser of $2x (the rent received by the trust which is based on a
       percentage of gross receipts), or $3x, ($12x multiplied by $25x/$100x).
       Accordingly, $10x of the rent received by the trust qualifies as "rents from real
       property" and $2x does not qualify.

       The legislative history indicates that the proportional exclusion rule is necessary
because full exclusion of rents may be an unduly harsh result to a REIT whose prime
tenant has entered into subleases over which the REIT may not have control. See
JOINT COMM. ON INT. REV. TAX., 94TH CONG., GENERAL EXPLANATION OF THE TAX REFORM
ACT OF 1976, at 456-57 (1976) ("[I]t is often very difficult for a REIT to control the terms
of leases which the prime tenant enters into with its subtenants . . . the Act contains an
amendment under which only a proportionate part of the rent . . . is nonqualifying
income . . . .").

       The equation in § 1.856-4(b)(6)(ii)(B) consists of three components: (1) the total
rents received or accrued from the prime tenant; (2) the rent or other amount received
by the prime tenant that is based in whole or in part on any person's income or profits
from the property (the "numerator"); and (3) the total rent or other amount received by
the prime tenant for the property (the "denominator").
PLR-138800-16                                6


        The exclusionary rule and § 1.856-4(b)(3) generally prohibit the apportionment of
an income stream with respect to any lease for real property into qualifying rents from
real property and disqualified profit-based rents. However, when an income stream
from a prime lease of real property depends in whole or in part on income streams from
the subleasing of the real property, §§ 856(d)(4) and 1.856-4(b)(6)(ii) direct that the
exclusionary rule be applied to the prime lease income stream on a sublease-by-
sublease basis. Congress enacted the exclusionary rule to prevent the total
disqualification of a REIT's income from real property due to subleases, over which the
REIT may have no control, entered into between a prime tenant and a subtenant. The
relationship between a subtenant and a sub-subtenant is more attenuated from the
REIT than the relationship between the prime tenant and a subtenant and, therefore, it
is also appropriate to apply the proportional exclusion rule in situations in which rent is
based in whole or in part on the income or profits of a sub-subtenant.

       Taxpayer has represented that neither Taxpayer, Distributing nor Controlled are
related to either Subtenant or Sub-Subtenant. Taxpayer has also represented that
Controlled would not receive a greater amount of income that qualifies as rents from
real property pursuant to the formula in § 1.856-4(b)(6)(ii)(B), as described above, if
Distributing were to have directly entered into the same lease with Sub-Subtenant.
Accordingly, when Controlled receives or accrues an amount from Distributing that
depends in part on the income or profits of Sub-Subtenant, the numerator of that
formula is the rent or other amount received by Subtenant from Sub-Subtenant. The
denominator of that formula equals any rent or other amount received by Distributing
from the Sublease.

                                     CONCLUSION

        Based on the facts presented and representations made by Taxpayer, we
conclude that for purposes of applying § 1.856-4(b)(3), (i) only a proportionate amount
of the rent received by Controlled from Distributing, which will depend in part on rent
from a sub-sublease that is based on income or profits of the Sub-Subtenant, will be
treated as other than "rents from real property"; and (ii) for purposes of computing this
proportionate amount under § 1.856-4(b)(6)(ii)(B), the numerator of the fraction equals
all rent or other amounts received by Subtenant pursuant to the Sub-Sublease, and the
denominator equals all rent or other amounts received by Distributing under the
Sublease.

        This ruling's application is limited to the facts, representations, Code sections,
and regulations cited herein. Except as expressly provided herein, no opinion is
expressed or implied concerning the tax consequences of any aspect of any transaction
or item discussed or referenced in this letter. In particular, no opinion is expressed
concerning whether Controlled otherwise will qualify as a REIT under subchapter M,
part II of Chapter 1 of the Code. No opinion is expressed on whether the sub-sublease
PLR-138800-16                                  7

arrangement conforms with normal business practices, or is a means of basing rents
from real property on the income or profits of any person from Leased Property.

      This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of
the Code provides that it may not be used or cited as precedent.

         In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to your authorized representatives.

                                       Sincerely,


                                       Julanne Allen
                                       Julanne Allen
                                       Assistant to Branch Chief, Branch 3
                                       (Financial Institutions & Products)