January 2020, Vol. 247, No. 1

Legal Perspectives

Midstream Energy REITs: A New Structure

A recent IRS private ruling allows a real estate investment trust or “REIT” to own and operate traditional midstream infrastructure assets, including storage assets and pipelines, and derive REIT qualifying income from traditional commercial arrangements with customers. If structured correctly, the REIT’s income from these assets and arrangements is treated as “rents from real property,” an important aspect of qualifying for REIT status under the Internal Revenue Code (IRS).

While there are many advantages to structuring a midstream business as a REIT, it is important to note that a midstream energy REIT will be entering new territory, since the IRS private letter ruling is new and is the only ruling addressing the ownership and operation of midstream energy infrastructure assets. Therefore, we recommend that midstream companies request a private ruling from the IRS before creating a REIT structure for their midstream assets.

REIT – Tax Favored Entity

REITs are state law corporations or trusts that, if specific Internal Revenue Code requirements are met, do not pay entity level federal income taxes to the extent their earnings are distributed each year to shareholders. 

Since 1960, when the original federal legislation was enacted, the REIT industry has grown exponentially.

In order to maintain REIT status, a company must meet Internal Revenue Code diversification of ownership and distribution requirements as well as income and asset tests designed to ensure that most of its income and assets are real estate related.  

The benefit to satisfying all of the requirements is that the REIT can avail itself of a deduction for dividends paid and generally not pay any federal income taxes.

In the recent private letter ruling (the “Ruling”), the IRS ruled that use fees paid by customers unrelated to a REIT for storage capacity and pipeline capacity with respect to storage tanks and pipelines owned by the REIT qualify as “rents from real property.” 

The Ruling breaks new ground in concluding that income derived by the REIT from traditional storage tank and pipeline commercial arrangements with customers, including charges for both dedicated capacity and customary services, qualifies as “rent from real property” for purposes of the REIT rules. 

The Ruling was based on the taxpayer’s representation that the storage tank facilities and the pipelines constitute “real property,” and that certain other assets constitute personal property, for purpose of the REIT rules.  

Under the REIT rules, ancillary personal property that is leased with real property is treated as real property as long as its fair market value (FMV) does not exceed 15% of the total FMV of the leased property. 

The Ruling indicates that storage tank and pipeline use agreements must have a number of key features to produce rents from real property for purposes of the REIT rules. 

The REIT itself can only provide services that are customary and consistent with owning the leased real property and making it usable by tenants. Other customary services provided to customers must be provided by a taxable REIT subsidiary or independent contractor.

In the Ruling, the REIT also represented that all of its services met the “customarily provided” standard, and the IRS accepted that representation. As a result, the entire fee received from a customer was treated as qualifying rent from real property for the REIT. 

Tax Advantages for Investors

REITs are generally more attractive from a tax perspective for certain investors than public or private partnerships. REITs do not pay federal income tax on taxable income that is distributed to their shareholders and issue 1099s, not K-1s, to their shareholders.  REIT dividends received by U.S. individuals are subject to an effective 29.6% income tax rate.  

REITs block unrelated business taxable income, or UBTI, for tax exempt investors and effectively connected income, or ECI, for foreign investors. REIT dividends and gain on sales of REIT stock do not generate UBTI (subject to some exceptions). 

While ordinary REIT dividends do not produce ECI for foreign investors, they are subject to U.S. withholding tax that is subject to reduction by tax treaty. Sovereign wealth funds and some foreign pension funds resident in treaty countries are generally exempt from U.S. withholding tax. 

Although FIRPTA tax and withholding potentially can apply to sales of REIT stock by foreign investors or REIT distributions to foreign investors that are attributable to gain from the sale of U.S. real estate by the REIT, there are important exceptions such that as a practical matter FIRPTA tax will not apply to most foreign investors.

REIT Corporate Governance

Corporate governance for a publicly-traded REIT is the same as for a typical public company. To qualify as a REIT under applicable tax rules, an entity must be managed by a board of directors or trustees elected by the entity’s shareholders. Publicly-traded REITs generally are required to have a majority of independent directors or trustees.

Although some REITs have a classified board, most are not classified so that the whole board is subject to annual election by the shareholders. Corporate governance for publicly-traded REITs and MLPs differ significantly: 1) The board of an MLP general partner is appointed by the owner(s) of the general partner, while a public REIT’s board is elected by the shareholders. 2) Like other public companies, publicly-traded REITs are subject to “say on pay” and “say on frequency” (unless exempt as an emerging growth company). The criticism to which MLPs are subjected on the governance front due to the inability to have any say on board composition is not present in public REITs. 

There are a number of ways that an existing midstream MLP or integrated energy company can structure midstream businesses to achieve the associated tax and governance advantages of a midstream energy infrastructure REIT. REITs can be public or private.   

While there are many advantages to structuring a midstream business as a REIT, it is important to note that a midstream energy REIT will be entering new territory. Because the midstream REIT structure remains early in its development at this point, we recommend that midstream companies seek legal expertise and request a private letter ruling from the IRS before implementing any REIT structure for their midstream energy assets.

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