Click Here for PDF
Private letter ruling 201907001 (the “PLR”), recently issued by the Internal Revenue Service (“IRS”), indicates that a midstream energy company may be able to organize as a real estate investment trust (“REIT”) under Section 856(a) of the Internal Revenue Code of 1986, as amended (the “Code”), without departing significantly from standard operational norms in the midstream industry, assuming other REIT requirements are met. Although private letter rulings cannot be relied upon by taxpayers other than the requesting taxpayer, the authority suggests the REIT structure may be a practical option for various midstream companies searching for a midstream asset investment vehicle more appealing under current market conditions to certain investors than the more traditional master limited partnership (“MLP”) structure.
Midstream Energy Companies and MLPs
MLPs have historically been the preferred investment vehicle for midstream energy companies. However, MLPs involve significant tax compliance costs and complicated tax reporting for investors, who are each issued a separate Form K-1 with respect to their investments rather than a simpler Form 1099 for stock dividends. Additionally, certain institutional investors do not invest in MLPs due to concerns over unrelated business taxable income (“UBTI”) and effectively connected income (“ECI”). Equity investment in midstream MLPs has diminished due to various factors, including a decrease in the corporate tax rate making investment through a corporation relatively more appealing. While some midstream MLPs have decided to reorganize as corporations (e.g., through an “Up-C” transaction), there are various limitations associated with organization as a corporation, including the risk of corporate income tax rates increasing in the future.
REITs as a Potential Investment Vehicle for Midstream Energy Companies
Real estate investment trusts are generally passive investment vehicles for real estate, collecting rents from real property and only providing limited services with respect to the real property assets other than through a taxable REIT subsidiary (a “TRS”). A TRS is a subsidiary of a REIT that has elected to be taxed as a corporation for federal income tax purposes and does not receive the benefits of REIT taxation. REITs are not subject to corporate-level taxes (other than their TRSs) but are generally required to distribute at least 90% of their REIT taxable income each year. Because a REIT is generally not a flow-through entity for federal income tax purposes, many of the complexities associated with MLPs such as ECI for foreign investors, UBTI for tax-exempt investors and tax reporting on Forms K-1 (REIT shareholders receive Forms 1099), are not applicable and therefore REITs are more appealing for certain investors.
REITs are subject to various operational requirements, including the “asset tests” and the “income tests.” The income tests generally require that a REIT derive at least 95% of its gross income from dividends, interest, rents from real property, gain from the sale of certain stock, securities and real property, and similar passive sources of income and 75% of its gross income from rents from real property, interest on obligations from real property, gain from the sale or other disposition of real property, and similar real estate related passive income. The asset tests are focused on the assets of a REIT generally constituting real estate or real estate-related assets. For that reason, it can be difficult for certain companies to meet the operational requirements for a REIT.
The REIT structure is theoretically available to a midstream company based on public guidance (i.e., the Code, the Treasury regulations promulgated thereunder and certain IRS administrative rulings, but not private letter rulings) notwithstanding the PLR but the limitations on a REIT’s activity with respect to its property would potentially require a significant departure from standard industry norms in the midstream energy sector and would potentially reduce profitability as well (given that many income-producing activities would need to be conducted through a TRS, which is taxable as a corporation for federal income tax purposes, because such activities would not generate rents from real property for REIT tax purposes). For example, a midstream REIT may be limited to collecting rents under a master lease of storage tanks or pipelines to a single tenant responsible for operating, maintaining and repairing the storage tanks or pipelines. Even though a TRS could technically provide various services to a tenant, the use of a TRS diminishes the advantages of a REIT structure and, more importantly, potentially requires separate contracts, fees and billing by the REIT and the TRS.
Private Letter Ruling 201907001
In the PLR, a corporation taxed as a REIT for federal income tax purposes (the “REIT Taxpayer”) sought and was granted a private letter ruling that amounts received from certain unrelated third parties in connection with an offshore oil and gas platform, storage tank facilities and pipelines would qualify as rents from real property for REIT tax purposes. The REIT Taxpayer represented with respect to each of the rental properties that (i) it was real property for federal income tax purposes, (ii) any personal property leased with the property would be for less than 15% of the total fair market value of the real and personal property leased under the relevant lease, (iii) each of the leases would be for a minimum period of time (i.e., a long-term lease), and (iv) the rent would generally be based on a fixed fee subject to adjustment (e.g., to reflect changes in crude oil and gas prices or the consumer price index) but not dependent in whole or in part on the net income or profits of any person.
Most importantly, the PLR ruling held that lease income of a midstream company taxed as a REIT for federal income tax purposes will not fail to qualify as rents from real property for REIT tax purposes where the REIT is:
(i) performing certain basic activities relating to some of the property, such as maintenance and repairs, and testing product to ensure the safety and integrity of the property, such activities being consistent with the REIT’s fiduciary duty to manage its assets,
(ii) contracting with multiple users under leases to use a set capacity of a particular property, i.e., a capacity lease wherein the user is charged for a certain capacity of the storage tank or pipeline, and
(iii) charging a single uniform fee to the customer, with a TRS then being paid an arms’ length fee for its services by the REIT, as opposed to the REIT and the TRS each contracting with and receiving payment from the customer directly.
As noted above, a midstream energy company could theoretically operate as a REIT based on public authority but limitations on the activities of a REIT, in particular, complicate utilization of this structure in light of norms in the midstream energy industry. However, the PLR indicates that organization as a REIT may be more practicable given that (i) the REIT may perform certain activities with respect to the property directly (as opposed to through a TRS), (ii) the fact that a lease is only with respect to a certain capacity does not prevent income under the lease from qualifying as rents from real property for REIT tax purposes and (iii) a single unified storage or pipeline fee may be charged to the customer (including for services provided by the REIT) with the TRS being charged arm’s-length compensation for the services performed by the TRS.
Implications of the PLR
The PLR, although it cannot be relied upon by taxpayers other than the taxpayer who received it, indicates that there may be fewer barriers to a midstream energy company operating as a REIT than previously thought based on the REIT operational requirements and applicable published authority. Midstream energy companies interested in utilizing a REIT structure should contact their REIT tax counsel to address their particular situation, as many other factors may be relevant to the decision to organize as a REIT.