By Lee A. Sheppard -- firstname.lastname@example.org
What is a hedge fund?
A tax practitioner might think of a hedge fund as a U.S.-managed, Cayman-organized partnership that really ought to be redomesticated so we can stop wasting our time arguing about the application of the effectively connected income rules.
A securities law practitioner might think of a hedge fund as an investment company that really ought to be regulated under the Investment Company Act of 1940 but is merely required to register its existence with the SEC.
A swaps practitioner might think of a hedge fund as a dangerous counterparty whose activity should be regulated because it could cause systemic problems like the Long-Term Capital Management meltdown nearly did in 1998.
But what distinguishes hedge funds as investment vehicles, other than their fees? For all the blather about alternative investments, independent thinking, and piratical names, herd behavior characterizes a lot of what the world's 10,000 hedge funds do with the more than $2 trillion they manage these days. So says the former Office of Management and Budget director under the Reagan administration, David Stockman, in his new book, The Great Deformation: The Corruption of Capitalism in America (PublicAffairs 2013).
"The last thing hedge funds do is hedge," Stockman wrote. Hedge funds have become "a giant moveable trade" that feeds whatever momentum exists in the markets until it crashes and moves on to the next trade. "The great financial deformation has spiked the system with opportunities for huge, misshapen speculations that could never arise on the free market," Stockman wrote.
Hedge funds utterly depend on cheap loans from prime brokers. Cheap loans are made possible by the Fed's financial repression and by endless rehypothecation out of London. Many claimants scrambling to retrieve what they thought were their securities in the Lehman Brothers bankruptcy were hedge funds. The Fed has enabled "trillions of permanent momentum-chasing capital," according to Stockman.
The biggest prime brokers -- Goldman Sachs and JPMorgan -- are also the biggest sponsors of hedge funds. Rather than compete with hedge fund clients, prime brokers share information and join them in momentum trading. Prime brokers also design the structured financial products that enable hedge funds to have exposure without ownership.
So what trade are the hedgies piling into now? Would-be REITs among publicly traded companies. But they're on both sides of the trade. Some believe that any company can be a REIT, while others believe that the opportunity to convert to REIT status is overstated.
Barron's has identified a REIT bubble, noting that the tax benefits of REITs are less than meets the eye. Shares of publicly traded REITs are selling at "stretched" capitalization rates, the investor magazine argued (Barron's, May 4, 2013). About 10 public companies were asking for REIT conversion rulings last year, and another 10 are thought to be contemplating it (Tax Notes, Nov. 12, 2012, p. 707). (Prior analysis: Tax Notes, June 2, 2003, p. 1298.)
The IRS has a working group led by Helen Hubbard, the newly appointed IRS associate chief counsel (financial institutions and products), to rethink letter rulings defining the term real property for purposes of REIT qualification (Tax Notes, June 17, 2013, p. 1364).
As this article shows, IRS REIT conversion rulings over the last few years have been expansionary interpretations of the statute. Three financial institutions and products branches issue these rulings. The IRS has been feeling a bit hard done by lately by a spate of newspaper articles criticizing it for giving rulings to data centers that look like power companies. Hence the IRS told four companies seeking REIT rulings that they were on hold.
The impetus for the ruling pause may also have included taxpayers to which the IRS said no -- renewable energy providers that want to put their solar panels in REITs. The IRS may well have told them that renewable energy facilities constitute equipment.
And there may be internal conflicts about the definition of real property, which is used for both REIT qualification and depreciation. The IRS income tax and accounting group, which is in charge of depreciation, does not rule on the definition of real estate (Rev. Proc. 2013-3, 2013-1 IRB 113, section 3). This article suggests other issues for the IRS to examine.
What is a REIT? Is a REIT just any company that happens to have a large portion of its assets and income tied up in real estate? Used to be that a public company with more than 75 percent of its assets tied up in real estate was not an acronym at all -- it was just stupid for not unloading that property to an owner willing to accept the burden. Periodically, McDonald's Corp. incurs pressure to separate its real estate assets from burger-slinging.
What are REITs for? President Eisenhower reluctantly approved them to get investment capital into real estate. (See A. Overton Durrett, "The Real Estate Investment Trust: A New Medium for Investors," 3 Wm. & Mary L. Rev. 140 (1961), available at http://scholarship.law.wm.edu/wmlr/vol3/iss1/8/.)
The original impetus was to allow the dumb money into commercial real estate investment by creating a tradable, RIC-type passthrough vehicle for passive real estate holdings. Your correspondent might argue that commercial real estate really ought to be left to sophisticated investors, but congressional intent might be construed to confine REIT status to office buildings and shopping malls.
REIT conversions by industrial corporations are so popular that the trend makes real estate types, who jealously guard industry tax goodies, nervous about the perception of do-it-yourself tax cutting (The Wall Street Journal, Oct. 11, 2012). The National Association of Real Estate Investment Trusts (NAREIT) praised the IRS working group in a statement that could be read both ways:
Congress enacted REIT legislation more than 50 years ago to ensure that Americans from all walks of life could access the real estate asset class on a collective basis to secure greater investment diversification with the benefit of professional management. NAREIT believes that the IRS has that objective clearly in mind as it conducts its process.
There is no current impediment to the dumb money investing in would-be REITs because they are already public companies. And retail investors are effectively tax exempt because they mostly invest through retirement accounts.
Should the only barrier to an industrial corporation putting its real estate in a REIT be a willingness to pay itself rent? Legislators generally dislike DIY tax exemptions; they like to be the ones to bestow favors. Has Congress registered the conversion trend? Recent tax reform ideas run along the lines of expanding REIT privileges.
Senate Finance Committee leaders mentioned REITs in a speculative document about tax reform. Their ideas ranged from restricting the activities of REIT subsidiaries to expanding the amount of property REITs (which are passive) may sell. The president's 2014 budget proposed to allow publicly traded REITs to deduct non-pro-rata dividends, which is thought to raise money because some shareholders are taxable.
On to the statute! Under section 856(c), a REIT must meet three asset and income tests at the end of each quarter to qualify:
- at least 75 percent of a REIT's assets must be real estate assets (the asset test);
- at least 75 percent of a REIT's gross income must be from items related to real estate, such as rents from real property (the 75 percent income test); and
- at least 95 percent of a REIT's gross income must be from items related to real estate and certain enumerated passive investments (the 95 percent income test).
Our readers have heard a lot about high-frequency trading. They know that the floors of the old stock exchange buildings are props for television, and the real work of the exchanges takes place in server farms in New Jersey, where high-frequency traders pay huge fees to co-locate their computers right next to the exchange's order-matching computers.
The value of server farms comes from power services and proximity rather than square footage in Weehawken. As much as 70 percent of the cost of a slot at a server farm is attributable to power costs. So as a financial matter, these providers could be considered power and telecom resellers, even though they are not regulated as utilities (The New York Times, May 13, 2013).
Customers of server farms pay variable fees depending on how much interconnectivity they want. Often the contract charges for power made available to the customer, rather than actual usage, so that customers often pay as much as twice the power they consume. Some power is attributable to air conditioning for the facility. Customers want redundancy, and backup generators are available.
A server farm proprietor does not own any servers -- those all belong to customers. It provides the facility and utilities required to run them. Digital Realty Trust, a REIT, owns a lot of real estate that other server farm providers lease for use in their businesses. This company, which has a ruling, charges customers for actual power usage plus a fee for space.
The world's largest data center company is publicly traded Equinix, which wants to convert to a REIT. It runs 97 data centers, most of which are housed in buildings that it leases. Its Secaucus server farm is situated just in between the New York Stock Exchange's Mahwah order-matching facility and Nasdaq's Carteret facility, to which it is connected by fiber-optic cables. High-frequency traders pay Equinix for the physical hookup to the order-matching engines and the exchanges for the right to the data feeds.
Most of Equinix's revenue comes from co-location fees. Interconnection fees for outside telecom services and hookups to other servers -- like the exchanges' order-matching engines -- are the next largest source of revenue. Analysts believe that the profit margin on interconnection is massive. Cross-connections and power are billed separately from the space. Equinix also offers "smart hands" on-site technical assistance like network upgrades.
Equinix's customer contracts are not real property leases by their own terms. Its 2008 master services agreement with LinkedIn expressly states that it is not a lease of real property. It states that the customer has not been granted an interest in real property and has no rights as a tenant under local landlord/tenant laws. Rather, it states that it is a services agreement. Space is "licensed" -- that is the term used -- at a set price. (See Exhibit 10.13 to LinkedIn's Form S-1 filed Jan. 27, 2011.)
Some data centers cannot be fully occupied because of power constraints; a center can eat enough power to run a small town. Equinix cited its inability to increase power provision at some centers as a limitation on its future growth (Equinix Form 10-Q filed July 26, 2013). Equinix doesn't even own most of that real estate anyway. Equinix's leases on the buildings it uses are short-term, renewable operating leases.
The IRS working group is looking at the definition of real property. Real property is defined in reg. section 1.856-3(d) as "land or improvements thereon, such as buildings or other inherently permanent structures."
Like every other tax shelter we can think of, the REIT conversion idea was initiated in the 1970s. Back then, the investment tax credit was available for industrial assets like machinery. Taxpayers constantly angled to get their buildings covered, so the courts developed rules broadly defining real estate to include specialized structures (Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975), acq., 1980-1 C.B. 1).
In Rev. Rul. 75-424, 1975-2 C.B. 269, the IRS ruled that microwave transmission towers were real estate assets under the REIT rules. The ruling quoted verbatim reg. section 1.856-3(d) for the conclusion that the tower was a real estate asset, but the antennas affixed to it were not.
Both the REIT statute and the investment tax credit regulations used the phrase "inherently permanent structure." The investment credit analysis migrated to the REIT area as the definition of real estate, and here we are. Taxpayers used to get the investment tax credit for billboards because they weren't real estate. Now they can put them in REITs because they are real estate. It makes perfect sense.
Billboard companies can be REITs (LTR 201143011, LTR 201204006). Lamar Advertising has told investors that it is seeking REIT status. Lamar's request involves digital screens; some billboards are not substantial. Lamar told investors that its ruling request has been put on hold while the IRS studies the definition of real estate. But it said that it anticipated that it would get a favorable ruling (Lamar's Form 8-K filed June 7, 2013).
Lamar plans to use a section 355 spinoff to move its real estate assets into a REIT. Spinoffs were controversial until the IRS ruled that real estate could be an active business in Rev. Rul. 2001-29, 2001-1 C.B. 1348. (Prior coverage: Tax Notes, Apr. 15, 2013, p. 241.)
Another group of players doesn't want the IRS to use the investment tax credit definition of real estate. That'd be the alternative energy crowd, whose solar panels and windmills would have qualified for the credit on the view that they were not real estate. But now their proprietors want them to be real estate so they can be REITs. The solar crowd is already trying to build its own passthrough entities (Tax Notes, Aug. 12, 2013, p. 701).
Well, gee, what about all those green energy tax credits Congress so enthusiastically passes? Those are too ephemeral to justify sustained investment (e.g., sections 40A, 45, 45K, 54, 54C). The renewables crowd has concluded it is better off with a permanent tax-free vehicle. It has also looked at master limited partnerships. Sen. Christopher A. Coons, D-Del., sponsored S. 795, the Master Limited Partnerships Parity Act of 2013, to enable renewable energy producers to use this form of organization.
Billboards and cell towers are pretty straightforward. It is an open question whether the IRS understands that real estate is the least important income-producing factor in a server farm.
In LTR 200752012, the taxpayer had server farms whose five- to 10-year contracts with tenants called for base rent and reimbursement of all operating costs. The question was whether the extensive systems installed to provide telecommunications, electricity, HVAC, fire protection, and security were part of the real estate or personal property.
The implication of the question was that the payments for the use of these systems would be a large component of the tenants' monthly payments, so that too much of the total payments would be going toward rents from personal property ("assets accessory to the operation of a business"). It was therefore necessary to differentiate these systems from, say, countertops in a store or other things the IRS considers personal property.
"The buildings differ from other office buildings because of the magnitude and quality of the electrical power and air conditioning furnished to tenants and the redundancies built into the electrical and air conditioning systems," the ruling noted, adding that the systems facilitate the technology business of the tenants. The IRS ruled that these systems were part of the real property and not assets accessory to the operation of a business.
The taxpayer in LTR 201034010 converted from an S corporation, which is not required to distribute income, to a REIT, which is, so it could go public. The taxpayer maintained both wholesale (single tenant) and retail (multiple tenants each with their own space) data centers. The ruling's description of the physical plant echoes that of LTR 200752012. The IRS ruled that the various systems serving data center customers were part of the real property.
A data center proprietor converting to a REIT would have to act according to its REIT classification for depreciation purposes. That means that it would have to treat as part of the real estate all of the power, HVAC, and interconnections equipment that it had been separately depreciating as personal property. A section 481 adjustment would be required to recapture previous depreciation on the personal property. It is not kosher to continue depreciating systems as personal property while treating them as real property.
Permanence of the structure is a physical concept. The taxpayer need not own the building to be eligible to be a REIT. A leasehold is considered an interest in real property (reg. section 1.856-3(c)). The regulation does not differentiate long-term leases from short-term leases. The expansive interpretation of leasehold goes way back.
In LTR 8705084, the IRS ruled that a leasehold interest in a thoroughbred racetrack qualified as a real estate asset under section 856(c)(5) and the payments received under subleases for kitchen, dining, bar space, storage, and parking lot space constituted rents from real property under section 856(d).
In LTR 9843020, the IRS ruled that a term special use permit for operation of a ski resort on federally owned land is an interest in real property under section 856(c)(5)(C) and a real estate asset under section 856(c)(4)(A). Local law definitions do not control the determination whether an asset is real property (reg. section 1.856-3(d)). The IRS ruled that permits are analogous to leases, despite being revocable (reg. section 1.856-3(c)).
Financial accounting generally considers a long-term "capital" lease to be a transfer of real property ownership, provided the term is 75 percent of the useful life of the property, and the present value of rent payments is 90 percent of its value. A capital lease is booked as a balance sheet asset and an obligation representing the present value of lease payments. Basically, this is loan treatment (ASC Topic 840).
Any lease that is not a capital lease is an operating lease. A short-term "operating" lease is classified as a lease with payments expensed on the income statement. But to the IRS, a lease is a lease. And a contract may be a lease -- the thinking goes back to the rulings permitting condominiums to be considered interests in real property (Rev. Rul. 76-197, 1976-1 C.B. 187).
Rent and Services
Reg. section 1.856-4(b)(1) defines rents from real property to include payment for services ancillary to the property usage as long as the services are usually and customarily provided in connection with the rental of similar property. What the regulation has in mind is air conditioning of apartments and changing of sheets in hotels.
A customary service can roughly be described as industry practice. If everyone is offering it and tenants expect it, it's customary.
Otherwise, rents from personal property leased in connection with real property is treated as rents from real property provided the amount does not exceed 15 percent of the total rent received under the property lease for the tax year (section 856(d)(1)(C)).
Rents from real property exclude "impermissible tenant service income" defined in section 856(d)(7). So providing maid services in an apartment building is an impermissible tenant service, while heat and light are permissible (Rev. Rul. 98-60, 1998-2 C.B. 749). Impermissible services cannot be valued at less than 150 percent of the direct costs of furnishing the service (section 856(d)(7)(D)).
Section 856(d)(7)(B) limits the total value of impermissible services provided to tenants to 1 percent of the total gross income derived from the property. If the value of impermissible services exceeds 1 percent, all rent received from tenants located at the property is tainted and becomes nonqualifying gross income (section 856(d)(7)(C)(ii) and reg. section 1.512(b)-1(c)(5)).
But a REIT can get around this limitation by providing impermissible services through a section 856(l) taxable REIT subsidiary, even without separate billing (Rev. Rul. 2002-38, 2002-2 C.B. 4, and LTR 200428019). The taxable REIT subsidiary must have an arm's-length contract with the REIT. This is a transfer pricing question. (Prior analysis: Tax Notes, Jan. 7, 2013, p. 127.)
The situation posited in Rev. Rul. 2002-38 was an apartment building, not a data center, and the impermissible service was housekeeping, not connection to the NYSE order-matching engine. The taxable REIT subsidiary pays tax on the impermissible services income. The taxpayer does not need to seek a ruling about services it is unsure about.
The taxpayer in LTR 200752012 used a taxable REIT subsidiary and independent contractors to provide extensive services to data center tenants. The IRS ruled that some services were usual and customary, while some were not, but the rents from real property would not be tainted by the latter because the services would be provided by the subsidiary and the contractors. The taxpayer in LTR 201034010 used a similar corporate structure, representing that no personal service would be performed by the REIT itself, and got the same ruling.
How does preventing the residents from escaping stack up as services income? LTR 201317001 is a ruling given to a prison REIT, believed to be GEO Group. Its competitor Corrections Corp. also has a similar ruling on REIT conversion, which could be LTR 201320007. The taxpayer set up a taxable REIT subsidiary to provide services to the prisons. It asked for a ruling that all fees paid by governments for keeping prisoners would be treated as rents from real property under section 856(d)(1).
The taxpayer owned some facilities, leased some, and had management contracts for others. Sometimes the taxpayer built a prison on government land and contracted to operate it until its ownership reverted to the government. The contracts called for a monthly lump sum per prisoner for housing and services. Services included the obvious, plus food, counseling, medical care, administration, maintenance, and transport of prisoners.
The IRS ruled that these services were, um, "customarily furnished" under section 856(d)(1)(B) and reg. section 1.856-4(b). So none of the income for services was impermissible tenant services income. The IRS ruled that the fees for the services were rents from real property received by the REIT, which then compensated the subsidiary.
It is not possible to run a hospital or a nursing home as a REIT -- but it is somehow possible for a prison that provides medical care. A taxable subsidiary is statutorily prohibited from operating a healthcare facility (section 856(l)(3)(A)). But the taxpayer got around that rule by not being licensed, and the IRS accepted that it provided medical services as a secondary function. In LTR 201320007, the IRS ruled that the prisons were not lodging facilities under section 856(d)(9)(D)(ii) or healthcare facilities under section 856(l)(4)(B).
Data Center Services
Well, gee, aren't server farm clients just buying a whole lot of electricity, HVAC, and telecom services? Aren't those just regular old building services? Does it matter how many services a data center customer buys as long as those services are associated with a postage stamp of real estate?
Lawyers representing data centers have convinced the IRS that the extensive bundle of services they provide to customers is a customary part of the rental package. The reasoning is that interconnections for server customers are just like cable television service in a luxury apartment building. And they have gotten the systems classified as part of the real estate instead of personal property.
Before the data center rulings were issued, the taxpayer in LTR 199935071 contracted with an outside telecom service provider to provide telecommunications services to its office building tenants, while billing the latter in one monthly bill. The taxpayer passed on the telecom service provider's portion of the charges without taking a cut of it.
The IRS ruled that the telecom services were customarily offered to tenants of that type of building (section 856(c)(2) and reg. section 1.856-4(b)(1)). The IRS conceded that the taxpayer had to offer these services to be comparable to other similar office offerings in the same geographic market. So the service fees were considered rents from real property and not impermissible services income (sections 856(d)(1)(B) and 856(d)(7)(C)(ii)).
A data center ruling request will typically list the services in detail and describe which will be performed by the REIT and which will be performed by the taxable REIT subsidiary. Because a taxable REIT subsidiary can be only 25 percent of the value of the entire REIT, there are limits on how much assets and services can be attributed to it (section 856(c)(4)(B)(ii)). For a data center, the value of the impermissible services is usually small.
In publicly disclosed rulings, the IRS typically does not break out which services in that bundle it considers usual and customary. But it did segregate the customary and impermissible services in LTR 201314002 , the recipient of which is believed to be CyrusOne, a data storage business belonging to Cincinnati Bell.
The taxpayer owned or leased buildings for data centers. The taxpayer leased rack space to customers and furnished electrical power, telecommunications, and cooling for their computers. The IRS ruled that the leased properties, associated intangibles, and structural components were real estate assets under section 856(c).
The ruling explicitly states that interconnection services are customary services that are rents from real property. Interconnection services include both outgoing telecom services and internal hookups to other servers. Here is the money shot from the ruling:
Some of these services will include . . . telecommunications infrastructure to allow tenants to connect to telecommunication carriers, and interconnection using wires, cables and other transmission equipment to provide tenants connectivity to carriers, their own servers, and directly with each other.
The REIT also offered remote hands services to customers. A taxable REIT subsidiary, with which the REIT shared employees at cost, offered smart hands services. The ruling implies that smart hands services are impermissible services because they were offered by the subsidiary or independent contractors.
The parent also separately offered its own services to data center customers. The IRS ruled that the services provided by the parent will not be attributed to the REIT.
Another data center, CoreSite Realty Corp., told investors that it has an unreleased letter ruling permitting interconnection services to be treated as customary services, so that fees are rents from real property. CoreSite noted that this revenue was previously recognized by its taxable REIT subsidiary (CoreSite's Form 8-K dated May 22, 2013).
The Newest Ruling Requests
But other data storage companies have had their ruling requests on hold. Iron Mountain told investors that the IRS said it was tentatively adverse to giving it a ruling on its real property question. Lamar told investors it would keep them updated on its ruling request. Another billboard company, CBS Outdoor, told investors it has a pending ruling request (CBS Outdoor Form S-11 filed June 27, 2013).
Equinix also told investors its ruling is on hold because of the working group. Equinix is arguing to the IRS that its server farm systems deserve real property classification, and said that a section 481 adjustment will be required (Equinix Form 10-Q filed July 26, 2013).
Equinix is likely arguing that the separately stated fees it charges for interconnections should be considered customary charges, and therefore rents from real property. Equinix told investors it believes the law is on its side (Equinix's Form 8-K filed June 6, 2013).
The document management company Iron Mountain is asking for a ruling that metal shelving and racks for computers used for data storage be considered a real estate asset. Iron Mountain does not own the buildings in which it provides services. When informing investors, Iron Mountain speculated that its other ruling request questions could be decided in the meantime while the working group proceeds (Iron Mountain's Form 8-K filed June 6, 2013).
Lawyers for would-be REITs are indignant about the delay in getting favorable rulings. That's what they see the working group as -- a delay, a speed bump. At the recent webcast sponsored by the American Law Institute Continuing Legal Education Group and the American College of Real Estate Lawyers, they whinged that the definition of real estate was graven in stone and consistent over time.
Suppose the IRS working group decides that server farm proprietors are utilities and should not be REITs. It is not clear how the IRS would extricate itself from its previous ruling policy, especially when other large data center operators already have rulings. Endless expansion of tax benefits is the American way.
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