EDITOR’S NOTE: This is the second in a two—part series on master limited partnerships (MLPs) and how they can use real estate investment trusts (REITs) in enabling private equity investment in energy projects and infrastructure. In part one in the February issue, Timothy Michael Toy and Dan Watkiss of Bracewell & Giuliani discussed the role of publicly—traded REITs, which have emerged as significant managers of private equity. Part two focuses on private REIT structures. Views expressed are solely those of the authors.

The Tax Code imposes on both publicly—traded real estate investment trusts (REITs) and private REITs a minimum distribution requirement and additional requirements concerning REIT common shareholders. To qualify, a REIT generally is required to distribute to its shareholders an amount at least equal to 90% of its taxable income (other than net capital gains). And whatever amount up to 10% is retained becomes subject to tax on the retained amount at regular ordinary and capital gain corporate tax rates. In contrast, no minimum level of cash distributions is required in order to maintain an MLP’s favorable partnership tax status. Further, a REIT cannot pass tax losses through to its shareholders whereas a partnership can pass tax losses through to partners (subject, in the case of partners who are individuals, to passive loss limitations).

A private REIT would need to have at least 100 unrelated holders. Furthermore, pursuant to a so—called “5/50 rule” not more than 50% of the ownership of a REIT may be held by five or fewer individuals (as defined in the Tax Code to include certain tax—exempt entities). With a private REIT, the 100—holder requirement is typically satisfied by issuing a class of preferred stock to 125 stockholders. Preferred stock is offered solely to employees or to accredited investors in reliance on the exemptions provided by Regulation D under the federal securities laws. Each share of preferred stock has a stated liquidation preference (usually $1,000 to $5,000) and entitles the holder to a specified annual dividend. The preferred stock usually allows the holder to put the stock back to the REIT if dividends are not paid in two consecutive years.

Before turning to the structural implications of the 5/50 rule, it warrants noting that a private REIT with tax—exempt investors would need to be structured to avoid being a “pension—held” REIT. A REIT structure may not completely eliminate UBIT in the case of REITs with a significant pension fund ownership. If at any time during a taxable year a private pension fund holds more than 10% of a pension—held REIT, any UBIT that would have been eliminated by investment through a REIT will constitute UBIT to the private pension fund holding that 10% or greater interest.

A REIT is a pension—held REIT if it would not have qualified as a REIT but for the provision of the Tax Code providing that stock owned by qualified trusts will be treated, for purposes of the “not closely held” requirement, as owned by the beneficiaries of the trust (rather than by the trust itself), and either (a) at least one qualified trust holds more than 25% by value of the interests in the REIT or (b) one or more qualified trusts, each of which owns more than 10% by value of the interests in the REIT, hold in the aggregate more than 50% by value of the interests in the REIT.

The qualified trust look—though rule is a Tax Code provision that treats REIT stock held by a qualified employee pension or profit sharing trust as being held by the beneficiaries of the trust in proportion to their respective actuarial interests in the trust. This can be used to develop a range of private REIT structures. For purposes of the 5/50 rule an “individual” includes, among others, private foundations. “Individuals” for purposes of the 5/50 rule do not include state pension funds.

To illustrate, assume that a large private foundation wants to establish a private REIT to hold leased energy infrastructure assets. A REIT that was 49% owned by the private foundation, 49% owned by a state pension fund and 2% owned by a qualified pension fund with in excess of 125 beneficiaries would meet the 5/50 rule – one individual may own 49% but the next 2% is held by a large number of individuals – and still not be a pension—held REIT because the state pension fund is not caught by the pension—held REIT rule (a state pension fund is not a qualified trust). Alternatively, the state pension plan could own the 51% interest not owned by the private foundation and the 5/50 rule would still be satisfied in that there would be but one individual and it owns less that 50%. An alternative structure would have the state pension plan own 2%, two unrelated qualified plans each own 24.5%, and the private foundation own the remaining 49%.

These examples illustrate the means by which private foundations, state pension plans and qualified pension funds might jointly use the private REIT structure to enable the cleansing of the UBIT that would otherwise arise from energy infrastructure rents. Structuring becomes easier if the private REIT also includes investments from taxable holders.

What is REITable?

In June 2007, the Internal Revenue Service released a private letter ruling (PLR) that confirmed the real property status of a broad range of energy and other tangible non—building, non—machinery infrastructure assets for REIT purposes. The subject of the PLR was “a system of physically connected and functionally interdependent assets that serve as a conduit to allow [a commodity] created by a generation source to flow through the system to end—users” — read “an electric transmission and distribution system.” PLR 200725015 The Service therefore characterized that the system at issue was a permanent structure and not an accessory to the operation of a business. Applicable REIT regulations define real property to include “land or improvements thereon, such as buildings and other inherently permanent structures thereon,” and exclude (i) “assets accessory to a business, such as machinery, printing press and transportation equipment” and (ii) mineral, oil or gas royalty interests.

The Service concluded that the system comprises real estate assets for REIT purposes much like the properties of a railroad (excluding rolling stock) that the IRS had concluded were real property for REIT purposes in a 1969 revenue ruling. To date, there is only one publicly—traded railroad REIT: Pittsburgh & West Virginia Railway.

Infrastructure assets typically owned by energy MLPs can be categorized, at least in a preliminary manner and absent specific Service guidance, as “REITable” and “non—REITable.” (See Table.) In some cases, categorization is uncertain absent additional facts concerning the assets in question.

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Importantly, the conduit system PLR confirmed the REITability of electric transmission and distribution systems thereby offering a new source of qualifying income to MLPs. At least one MLP, Spectra Energy Partners (NYSE: SEP), is understood to be considering expanding its energy transportation platform to include renting electric transmission lines.

In describing the sources of “good” qualifying income, the Tax Code defines “rents from real property” with reference to the Tax Code’s REIT definitions. Electric generating facilities remain off limits to both REITs and MLPs.

Passive income requirement

A central requirement imposed by the Tax Code is that the preponderance of a REIT’s income be passive. In the context of tangible assets such as buildings and other inherently permanent structures and improvements, this requirement means that the REIT assets be leased to a lessee that is not affiliated (as defined for REIT purposes) with the REIT. A “good” REIT lease must meet a number of requirements:

The lease must be a true lease for federal tax purposes and not the functional equivalent of a financing;
The REIT cannot furnish or render services to the lessee in connection with the lease;
Rents attributable to personal property leased with the real property cannot exceed 15% of total rents; and
Rents will not be based in whole or in part upon the lessee’s net income or profit.

Beyond these requirements, there is substantial flexibility on lease terms and other lease provisions. For example, there is no minimum term (among the largest public REITs are public storage companies such as Public Storage). Under the Tax Code, rents can include a percentage element based on the lessee’s gross receipts or sales (but not for example, gross income or another measure of receipts less cost—of—goods sold). Rent can also include a percentage component adjusted to reflect REIT—funded capital improvements.

A range of transaction structures for private REITs can be envisioned. Among the structures is a sale and leaseback, whether involving an entire facility or an undivided interest. Where a facility (such as a pipeline) is fully contracted, the sponsor lessor could have its recourse limited to shipper payments. Co—investment by the MLP would entail an operating partnership or limited liability company that would own the REIT facility; the sponsor would own up to 20% of the partnership and the private REIT would own the remaining 80%—plus.

Virtually all public REITs and many private REITs are structured so that a subsidiary partnership (called an “umbrella partnership REIT” or UPREIT) actually owns the property. UPREIT structures can provide advantages where there are to be sponsor drop—downs of depreciated properties due to the fact that the UPREIT is a partnership and not a REIT. Ownership by the 20% partner of 100% of the lessee is consistent with the Tax Code’s attribution rules as modified in the context of REITs. In recent years, pipeline capacity leases have become increasingly common; it may be that the REIT could enter into a portfolio of pipeline capacity leases directly or through an UPREIT operating partnership.

A recent PLR, 200740010 (Oct. 5, 2007) obtained by an MLP has confirmed the status as qualifying income of management fees under pipeline operating agreements. This PLR provides useful guidance to an MLP considering a private equity management platform.

To recapitulate, while the requirement for a lessee that is not related to the REIT may be a structuring rigidity, there is significant flexibility when it comes to rent design and lease structuring. That flexibility will enable leases that embody varying allocations of risks and rewards among the MLP sponsor, the MLP and private equity. In the case of pipelines and comparable facilities the structuring options are heightened by the fact that most common versions of industry contracts for firm/reserved transportation and storage — under which a fixed monthly reservation or demand charge is due regardless of the actual pipeline and storage capacity used by a customer — are already very close (in a commercial sense) to being REITable leases.

Inward bound foreign private equity

A private REIT could facilitate inward bound foreign private equity investment. Where a REIT is “domestically controlled” (generally, less than 50% in value of its shares are held by non—US holders), foreign holders are shielded from certain taxes (for example, taxes on gains from sale of stock of corporations that are US real property holding corporations) that would otherwise be imposed on the foreign investor. For foreign investors, a private REIT structure could be key to tax efficient investments in United States energy infrastructure. In comparison, both MLP and private partnership structures cannot deliver similar protections when it comes to the myriad taxes that are targeted at non—US investors.

Conclusion: a way forward

Private equity management seems to be a natural extension for energy MLPs and their sponsors. Private REIT structures can play a significant role in attracting private equity from tax—exempt, UBIT—sensitive private investors. While the rules surrounding REITs can be complex, the potential benefit could be great. In particular, if inbound foreign private equity investment can be facilitated, then a private REIT structure may provide the best vehicle through which an MLP or its sponsor manages private equity.

A number of Australian listed property trusts (LPTs) – Downunder’s equivalent of a REIT – have been assembled where the principal investment is one or more private US REITs. LPTs have a number of benefits vis—à—vis US REITs that arise under a 2003 protocol to the US—Australian Double Tax Treaty. Generally, the withholding rate on dividends from US REITs is 15% and on interest (via LPT loans to US REITs) 10%. The benefits available under the protocol would be available to a private US REIT with energy infrastructure assets. A private REIT could thus serve as a means by which MLPs can access Australian public capital. An example of an LPT that invests solely in United States properties via a private REIT structure is Tishman Speyer Office Fund.

After the initial investment in a REIT, transitioning from a private REIT format to a public REIT format via an IPO may be an ideal way for private equity to exit from a particular set of energy infrastructure investments. Digital Realty Trust is a case in point. The October 2004 IPO for DLR was the means by which the California Public Employees’ Retirement System (CalPERS) exited from a portion of a $500 million private equity investment that it had made in technology—related real estate.

Public REITs, if exchange—traded, are by and large fully independent (unlike the typical MLP). Public REITs are frequently not exchange—traded and remain under external management in a structure with numerous parallels to the traditional MLP. One of the more widely known sponsor/managers of externally—managed public REITs that are not exchanged traded is W.P. Carey & Co. LLC, one of a few publicly—traded MLPs that are not energy—related. WPC manages a real estate investment portfolio of more than $10 billion for itself and its consolidated Corporate Property Associates (CPA) series of income—generating non—traded REITs.

About the authors

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Timothy Michael Toy is a partner in the New York City office of Bracewell & Giuliani LLP. He has written and spoken extensively on the topic of real estate investment trust (REIT) alternatives for energy and other infrastructure, including electric and natural gas transmission and distribution facilities, railroads, water systems, and toll roads.

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Dan Watkiss is a partner in the Washington, DC, office of Bracewell & Giuliani LLP. He has written and spoken extensively on the topic of the federal regulatory implications of employing REIT structures for FERC—regulated energy infrastructure.

Using REITs structure to enable private equity investment in energy

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