On June 6, 2014, the Internal Revenue Service (IRS) released Private Letter Ruling 201423011 (the PLR), confirming that income from certain data center services can constitute “rents from real property” for purposes of the real estate investment trust (REIT) rules. Although the PLR is binding only between the IRS and the requesting taxpayer, and cannot be cited as precedent by any other taxpayer, the PLR indicates how the IRS might treat similar transactions and can generally be viewed as favorable development for data center REITs. In sum, the most significant holdings of the PLR are as follows:
- Cross-connect and certain remote hands services furnished by the taxpayer-REIT to its data center tenants will not cause amounts received by the taxpayer-REIT under data center leases to be treated as other than “rents from real property” for purposes of the REIT rules; and
- Payments made to the taxpayer-REIT under “master service agreements,” which grant customers the same rights they would have under a traditional lease, will be treated as “rents from real property” for purposes of the REIT rules, notwithstanding the form of agreement (i.e., as a “service” agreement).
REITs are tax-favored vehicles which allow for the securitization of real estate and assets related to real estate. For income tax purposes, a REIT that meets the statutory requirements is entitled to a dividends paid deduction. REITs are generally required to distribute to their shareholders at least 90% of their REIT taxable income (other than capital gains), but most REITs distribute an amount sufficient to claim a dividends paid deduction that completely eliminates the REIT’s taxable income each year.
Among numerous other requirements, REITs are subject to a quarterly asset test and an annual gross income test. Very generally, the asset test requires that at least 75% of a REIT’s assets consist of real property, cash, and certain securities. The income test requires that (i) at least 95% of a REIT’s gross income be from passive sources (e.g., dividends, interest, rents from real property, and real property gains) and (ii) at least 75% of a REIT’s gross income be from passive sources specifically related to real property (e.g., rents from real property and real property gains).
For purposes of the income test, “rents from real property” are deemed to include income received for services customarily furnished in connection with the rental of real property. For this purpose, services 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 data centers) are customarily provided with the service. Determining what services are customary is often the challenge, especially for newer classes of buildings.
Treatment of Cross-Connect and Certain Remote Hands Services
The PLR addresses the treatment of certain data center services, including cross-connect and certain remote hands services. The PLR holds that such services will not cause amounts received by the taxpayer-REIT under a data center lease to be treated as other than “rents from real property” for purposes of the REIT rules, provided that the services are customarily offered in the relevant geographic market and are rendered in connection with the operation and maintenance of the data center. The specific services addressed in the PLR include:
- Cross-Connect Services
- Internet access bandwidth purchased by the taxpayer-REIT and resold to a tenant;
- Interconnection to connect tenants to carriers within the data center;
- Interconnection to connect tenants with other tenants within the data center;
- Interconnection between multiple data centers and properties owned by third parties; and
- Installation of the cross-connection cables for the purpose of offering the cross-connections listed above.
- Remote Hands Services
- Supervision of the tenant’s contractors while working on the tenant’s equipment;
- Re-seating, relabeling, or replacing external cables;
- rebooting servers; and
- Changing backup tapes.
Importantly, the PLR did not extend to any service that would require logical access to a tenant’s equipment (i.e., logging into the tenant’s servers with tenant provided access information). The PLR indicates that the taxpayer-REIT would conduct any such services through third-party providers that qualify as independent contractors or through a taxable REIT subsidiary (or, TRS) of the taxpayer-REIT.
Characterization of Amounts Received Under Master Service Agreements
The PLR also addresses whether certain payments received by the taxpayer-REIT in respect of its data centers fail to qualify as “rents from real property” because such payments are received under a “master service agreement,” rather than a traditional lease. In general, the master service agreements at issue in the PLR (i) identify the data center, (ii) grant the customer a license to use specific space, such as space in caged areas, a cabinet, a rack, or specified rooms or floors of the data center, for the purpose of installing, operating, maintaining, altering, and repairing the customer’s communications, computing and electronic data storage equipment in such space, and (iii) require the taxpayer-REIT to provide cross-connect services and remote hands services in order to support the customer’s use of the space and establishes standards for the provision of such services.
The PLR concludes that payments received by the taxpayer-REIT under the master service agreements are considered rents from real property, regardless of the form of the agreement. The PLR explains that the relevant test is whether the payments under such an agreement are “received for the use of, or right to use, real property.” Because the master service agreements provide customers the same rights they would have under a traditional lease, the PLR concludes that payments received by the taxpayer-REIT under such agreements will be treated as “rents from real property” for purposes of the REIT rules.