Pass-through Corporations and Publicly Traded Partnerships

Transcription

1 Pass-through Corporations and Publicly Traded Partnerships Practising Law Institute October 18-20, 2016 New York, NY November 2-4, 2016 Chicago, IL December 7-9, 2016 Los Angeles, CA Dean S. Shulman, P.C. Partner Kirkland & Ellis LLP Ryan K. Carney Partner Vinson & Elkins Richard M. Nugent Partner Cadwalader, Wickersham & Taft LLP R. David Wheat Principal KPMG LLP

2 Agenda 1. Up-C Structure 2. Publicly Traded Partnerships 3. Tax Issues for Distress MLPs and Other Oil & Gas Partnerships 4. Real Estate Investment Trust & Recent Developments 2

3 Up-C Structure Dean S. Shulman, P.C. Kirkland & Ellis LLP 3

4 Up-C Structure An Up-C structure allows existing partners (the Historic Partners) of a partnership or other pass-through entity (Partnership) to take their business public through the creation of a new public company (Pubco) that owns interests in Partnership while retaining many of the tax benefits of a pass-through structure. Up-C transactions include: Shake Shack GoDaddy Moelis Duff & Phelps Graham Packaging Company barnesandnoble.com National Cinemedia Historic Partners Class B Common Stock (Voting, Non-Economic) Class B Units (Non-Voting, Economic) Public Shareholders Pubco Partnership Operating Subsidiaries Class A Common Stock (Voting, Economic) Class A Units (Voting, Economic) 4

5 Up-C Structure: Original Structure An Up-C structure can be used for a company that is currently operating as a pass-through, such as a partnership or limited liability company, and is also possible for a business operated as a sole proprietorship. A pass-through structure is advantageous to the Historic Partners because it does not require payment of entity-level taxes. An Up-C structure cannot be used for a company that has already converted to a corporation. An Up-C structure allows a company to engage in an IPO while retaining single-level taxation for the ownership interests of the Historic Partners and allows tax losses, if any, to pass through to such Historic Partners. Historic Partners Partnership Operating Subsidiaries 5

6 Up-C Structure: IPO Steps Pubco, a newly formed Delaware corporation, has two outstanding classes of common stock: Class A and Class B. Pubco sells its Class A common stock to the public for cash in an IPO. Pubco uses this cash to invest in Partnership and purchase newly issued voting common units of Partnership (Class A Units). Pubco will serve as the managing member of Partnership. Partnership uses all or a portion of the cash received from Pubco to redeem partnership interests from the Historic Partners, which is treated as a direct purchase of partnership interests by Pubco from the Historic Partners. The Historic Partners units are recapitalized into limited partnership interests (non-voting common units) (Class B Units) that are exchangeable into Class A common stock (or the cash equivalent thereof). Each such holder also receives Class B common stock in Pubco, which are high vote stock with no economic interest. Historic Partners Class B Units (Non-Voting, Economic) Class B Common Stock (Voting, Non-Economic) Cash Cash Cash Public Shareholders Pubco Partnership Operating Subsidiaries Class A Common Stock (Voting, Economic) Managing Member Class A Units (Voting, Economic) 6

7 Up-C Structure: Tax Receivables Agreement In connection with the IPO, Pubco and the Historic Partners will typically enter into a Tax Receivables Agreement (TRA) that permits the Historic Partners to share in the value of any tax attributes related to the Up-C transaction. For example, when Pubco acquires partnership interests from the Historic Partners for Pubco shares or cash, it receives a stepped-up basis in its share of Partnership s assets under Section 743 of the Code through an election under Section 754 of the Code. The stepped-up basis will increase Pubco s depreciation and amortization deductions. In many cases, the majority of this step-up is attributable to intangible assets, and thus the basis increase is amortizable over 15 years under Section 197 of the Code. TRAs typically also require circular payment for the value of any tax benefits attributable to payments made under the TRA, which results in an additional tax basis step-up. Some TRAs compensate the Historic Partners for tax attributes that exist at the time of the IPO that could be used to reduce Pubco s future tax liabilities (e.g. NOLs in corporate subsidiaries). Historic Partners Cash Tax Receivables Agreement Pubco Partnership 7

8 Up-C Structure: Tax Receivables Agreement TRAs capture the value of the step-up related to the IPO and Pubco s original acquisition of partnership interests by requiring Pubco to pay cash as the related tax attributes are used by Pubco and reduce Pubco s tax liabilities. TRAs commonly require Pubco to pay the Historic Partners 85% of the realized tax benefits on an annual basis until all tax benefits have been realized. Some TRAs provide for a flat payment of a certain amount over a set term of years. Payments under the TRA are treated as additional consideration for the partnership interests. TRAs are typically accelerated in connection with a Pubco change of control transaction. Historic Partners Cash Tax Receivables Agreement Pubco Partnership 8

9 Up-C Structure: Revised Operating Agreement Following the IPO, Partnership s partners (the Historic Partners and Pubco) will amend Partnership s operating agreement to provide for: Exchange Rights The Historic Partners receive exchange rights, under which they may exchange all or any portion of their partnership units for Pubco shares. The typical exchange ratio is one partnership unit (and one share of Class B common stock) to one share of Class A common stock. This option to convert partnership interests into publicly traded Pubco common stock gives the Historic Partners the effective equivalent of liquid public stock. Some agreements provide that, at Pubco s option or under certain circumstances, the partnership units may be exchanged for cash equal to the value of Class A common stock. Tax Distributions Partnership s operating agreement must provide tax distributions that ensure its partners will receive enough cash to pay any tax liabilities on Partnership operating income. The Partnership must ensure that these provisions are compatible with any restricted payment covenants in existing or new debt documents. 9

10 Up-C Structure: Pros and Cons Pros Preserves flow-through (single-level) taxation for the Historic Partners. The Historic Partners get paid for the use of future tax benefits created by the taxable exchange of partnership units for Pubco stock, at the time of the IPO and in the future, through a negotiated Tax Receivables Agreement. The Historic Partners retain control of the business through their high-vote Pubco stock. The Historic Partners effectively own a liquid public security because their partnership units can be freely exchanged for publicly traded Pubco common stock. Cons Partnership s operating agreement must be revised to provide for cash distributions from Partnership to cover the partners tax liabilities and other expenses. The Historic Partners must determine the feasibility of such a structure under any existing agreements. Historic Partners Class B Units (Non-Voting, Economic) Class B Common Stock (Voting, Non- Economic) Public Shareholders Pubco Partnership Operating Subsidiaries Class A Common Stock (Voting, Economic) Managing Member Class A Units (Voting, Economic) 10

11 Up-C Structure: Items for Additional Consideration Availability and liquidity of Pubco shares increases Partnership s ability to attract and award management (e.g., through options and profits interests) Consolidation of Partnership and Pubco for financial statement purposes Anti-Churning rules under Section 197 of the Code Requirements under Investment Company Act of

12 Questions? Dean S. Shulman, P.C. Partner Kirkland & Ellis LLP New York

13 Publicly Traded Partnerships Ryan K. Carney Vinson & Elkins LLP 13

14 History of MLPs First MLP First Underwritten Tax Reform Act of Section 7704/ MLP 1986 Qualifying Income IDRs Developed Enron Liquids Pipeline, L.P. becomes Kinder Morgan Energy Partners, L.P. First GP MLP First Foreign Shipping MLP Period of Rollups and Liquidations ServiceMaster Limited Partnership 14

15 History of MLPs Return to E&P MLPs First Variable MLP First Frac Sand MLP First Coke MLP First Water Handling MLP Timber MLPs Wholesale/ Retail MLPS First Trona-Mine MLP First Ethylene MLP First Hybrid GP Holding Company/Up-C MLP First YieldCo with MLP Capitalization 15

16 MLP Initial Public Offerings ( ) Key: Industry/Type at IPO VLP Exploration and Production Refining Fertilizer Coal * In Registration Corporate IPO TOO CQH ARCX MEP RMP LMRK Midstream and Other Services Wholesale Distribution Shipping/Maritime Frac Sand Other Propane Timber General Partner/Holding Co. Royalty Interests NSH AHD AHGP MGG PVG HPGP BGH OSP NMM CPLP QELP NRGM MEMP MCEP RRMS LNCO WGP ALDW DKL DLNG SRLP PAGP WNRL OCIP OCIR WPT NAP AM SHLX DM USDP JPEP CNNX NBLX TUG LPG CCP VLP SPH ETP MMP XTEX MMLP NRP XTXI USS CPNO EPE ETE EPB SSW NRGP DPM BWP WPZ GLP CEP ATN EROC EXLP BBEP EVEP VNR ENP CMLP BKEP SEP CQP TRGP QRE RNO OXF RNF LRE OILT KMI AMID GSJK NGL SXE MPLX LGP SDLP SMLP SUSP HCLP QEPM FISH PSXP TEP EMES KNOP NSLP HMLP VTTI RIGP WLKP VNOM FELP GLOP CNCX CNXC GPP PTXP EQGP TEGP BRLP ORRI GPMP SSLP X ORLP HESM FFP MRP EPR EOT NPL NS PPX STON TLP RGP NGLS WES NKA TLLP NTI SXCP PBFX BSM TUSK WGP SFL KPP PRF EEP UAN GTM FGP APU GEL EPD TCP NRGY MWE HEP TGP CLMT DEP PSE CHKM GMLP EQM CVRR ENBL EVA XMLP BCU HWY PCL TPP TNH KMP OKS CRO SGU CNO TIMBZ PAA ARLP APL PVR SXL KSP HLND LINE LGCY WMZ PNG UAN PDH USAC CELP CPPL PESL Years *

17 Typical Organizational Structure Sponsor 100% GP LP/IDRs Public GP LP MLP GP LP IDR = Ownership = General Partner = Limited Partner = Incentive Distribution Rights Operating Subs Assets 17

18 Qualifying Income Requirement: Partnership Treatment Treatment as a partnership for U.S. federal income tax purposes is a fundamental aspect of PTP MLPs PTP MLPs do not pay U.S. federal income tax Unitholders receive cash distributions and pay tax on their share of the MLP s taxable income Pre-1987 any business could qualify Post-1987 most publicly traded partnerships are treated as corporations Marketing efforts/underwriters require certainty will level opinions 18

19 Qualifying Income Requirement: Statutory Requirement for Partnership Treatment Qualifying Income Test: 90% or More of Gross Income Services (e.g., pipeline transportation): Gross revenue No reduction for cost of services Products (e.g., E&P): Gross margin Gross revenue less costs of goods sold Measured each tax year Failure results in corporate tax treatment for that tax year and all tax years going forward Mechanisms to handle Non-Qualifying Income Keep below 5% of gross income Put operations in a corporate subsidiary 19

20 Qualifying Income Types: Natural Resource Qualifying Income Qualifying Products: Natural Resources and Green Fuels Naturally occurring deposits (gas, oil, depletable minerals) Oil and gas products (refinery tailgate or gas processing tailgate) includes gasoline, kerosene, number 2 fuel oil, refined lubricating oils and diesel fuel Fertilizer Geothermal energy Timber Industrial source CO2 Biodiesel/ethanol (transport and storage only) 20

21 Qualifying Income Types: Natural Resource Qualifying Income Qualifying Activities: Natural Resources Exploration Development Mining Production Processing Refining Transportation Storage Marketing 21

22 Qualifying Income Types: Other Qualifying Income Real property income Rents from real property (excluding (i) rents for personal property in excess of 15% associated real property and (ii) related party rents) Income from sale of real property (including inventory) Gain from sale of assets generating qualifying income Interest (not from financial/insurance business) Dividends (from qualifying or non-qualifying activities) Gain from sale of stock Gain from commodities, futures, forwards and options with respect to commodities 22

23 Foreign Activities Qualifying income knows no geographic bounds. A number of MLPs own significant assets outside the United States. 23

24 MLP IPOS v. PLRs: (124 PLRs Since 1987) = PLRs = IPOs

25 Background: Guidance Prior to 2014 Prior to 2015, no comprehensive regulations had been issued by the Treasury department and the IRS with respect to the activities and products that generate qualifying income In the absence of IRS guidance, MLPs relied on will level qualifying income opinions of counsel in order to effect initial public offerings and subsequent equity offerings Opinions are based on the plain language of the statute and the legislative history If counsel could not reach a will level opinion with respect to a particular activity, taxpayers could request a private letter ruling from the IRS 25

26 IRS Pause Turns Into Proposed Regulations February February 28 March 28 Normal IRS interaction regarding potential Qualifying Income PLRs IRS attorneys begin notifying taxpayers of a pause in considering qualifying income PLRs Cliff Warren publicly acknowledges the pause and indicates that it applies to all qualifying income 2015 March 5 May 5 August 4 October 7 October 27 The Pause ends IRS and Treasury release proposed regulations, requesting all comments thereto by August 4, 2015 All comments to proposed regulations due, with apprx. 140 comments submitted to the IRS Outline of topics to be discussed at public hearing on final regulations due Public hearing on final regulations to be held at IRS All comments to the proposed regulations are available at ~95 from investors ~45 from MLPs, operating companies and other organizations 26

27 The Proposed Regulations: Oral Testimony On October 27, 2015, the IRS held a hearing in Washington, D.C. Panel composed of U.S. Treasury and IRS personnel heard testimony from representatives of 10 different organizations, including several MLPs, the NAPTP, and law firms Several themes arose in the testimony Potential problems that arise with the concept of an exclusive list The narrowing of the definition of what constitutes a mineral or natural resource for qualifying income purposes The narrowing of the activities that constitute processing and refining The discrepancies between the treatment of natural gas processing and refining compared to that of crude oil 27

28 Questions? Ryan Carney Partner Vinson & Elkins LLP Houston

29 Tax Issues for Distressed MLPs and Other Oil & Gas Partnerships R. David Wheat KPMG LLP 29

30 Partnership CODI In the context of C corp restructurings, cancellation of debt income ( CODI ) is generally excluded from the corporate debtor s taxable income under Section 108(a)(1)(A) or (B). (a)(1)(a), the bankruptcy exception, applies if the debtor is in bankruptcy. (a)(1)(b) applies so long as the debtor is insolvent for tax purposes (measured on a fair market value/balance sheet basis), but solely to the extent of the debtor s insolvency. In the context of partnerships, Section 108(a)(1) applies at the partner level, not at the partnership level. In other words, the bankruptcy or insolvency of the partnership is irrelevant; the exclusion applies only if the partner is bankrupt or insolvent. Under Revenue Rulings, including 92-53, 92-97, 99-43, and , partners can rely on some or all of their share of excess nonrecourse liabilities allocated to the partners under Section 752 to establish insolvency, even if such partner is not actually liable for such debt under state law. This makes sense because partners will be liable for any adverse tax consequences with respect to such allocated debt. 30

31 Partnership CODI (cont d) Partners in an oil & gas partnership frequently will be solvent even if the partnership is insolvent and, therefore, such partners will be unable to exclude CODI allocated to them. The result: partners of oil and gas partnerships can be allocated significant CODI in a restructuring, with no corresponding cash to pay the resulting tax liability. While this issue applies to all partnerships, MLPs often have numerous mom and pop unitholders that may be unprepared for the significant cash tax liability. Management partners likely have used any allocated operating losses to offset ordinary income (because such losses are not passive losses under Section 469). As a result, management is unlikely to have suspended losses under the passive loss rules that could be used to offset any allocated CODI. The problem is exacerbated by a character whipsaw: CODI is ordinary income, while losses that are available to partners with respect to their partnership interests (e.g., basis in the partnership units, to the extent the units are cancelled in the restructuring) are generally capital in nature. This character whipsaw can be mitigated by asset sales as discussed below. 31

32 Incorporate the Partnership One potential solution to address CODI is to convert the partnership to a corporation in order to trap any CODI within a corporate entity. But this approach raises several issues. For partners: Section 357(c) gain to the extent liabilities exceed asset basis, potentially including IDC/depletion recapture and related issues. For creditors: Realizing the CODI within the corporation, with no other attributes (such as NOLs), is likely to result in tax basis being reduced to fair market value (due to the attribute reduction rules under Sections 108 and 1017). This reduction may be a significant stepdown in basis, to the disadvantage of creditors who will become shareholders of the restructured corporation. Importantly, the conversion also would subject the future profits to corporate tax. 32

33 Incorporate the Partnership (cont d) The conversion could be taxable despite an attempted Section 351 transaction. Under the proposed net value regulations, Prop. Reg (a)(1)(iii), a putative tax-free conversion of an insolvent partnership to a corporation would be a taxable transfer of assets in exchange for stock of a new corporation. This would trigger any recapture and any other gain or loss with respect to the partnership s assets. Whether the conversion is taxable or tax-free, if the conversion occurs when an overall restructuring is essentially agreed to, the IRS could attempt to reorder the conversion as occurring after CODI is triggered (resulting in CODI being allocated to the unitholders). Query whether intentionally failing the qualified income test under Section 7704 reduces the risk that the IRS could reorder the conversion. 33

34 Partial Incorporation Transfer of P Ship Interests Alternatively, some but not all of the partners may be able to exchange their partnership interests for shares in a corporation, either in a Section 351 transaction or in a taxable transaction. The partnership will remain a partnership, but the majority of the interests are now held by the corporation. This transfer could be implemented via an SEC tender offer or an Up- C structure. If the transfer is taxable, the transfer triggers IDC/depletion recapture and other potential tax liabilities from the relief of the partner s allocated share of liabilities, but the exchanging partners will be shielded from CODI thereafter. 34

35 Partial Incorporation Transfer of P Ship Interests (cont d) The corporate transferee also could be an NOL company that agrees to acquire partnership interests, absorb CODI, and contribute capital to the PTP, obtaining an increased equity interest in the partnership. In this structure, the parties should ensure that Section 382 does not prevent the NOLs from sheltering the CODI (perhaps by delaying an ownership change with respect to the NOL corporation until after the CODI has been triggered). There also could be assignment of income concerns with regard to CODI depending on the facts and timing. 35

36 Partial Incorporation The Linn Exchange Example of Partial Incorporation Strategy: Linn Energy and LinnCo. Linn Energy is the largest oil and gas partnership restructuring case to date. Linn Energy is an MLP. Historically, approximately 36% of its partnership units were held by LinnCo, an LLC taxed as a corporation whose sole purpose is to hold Linn Energy shares in C-corporation solution. The units in Linn Energy are currently subject to an open exchange offer with LinnCo. Units are exchangable on a 1:1 basis for LinnCo shares. This exchange offer was launched before Linn Energy and LinnCo filed for bankruptcy. Linn Energy and LinnCo sought bankruptcy court approval to continue the exchange offer. The motion to approve the exchange offer referenced both the desire to protect Linn Energy s unitholders from CODI and the possibility of preserving tax basis in Linn Energy s assets (discussed below). The bankruptcy court approved this approach. Since the exchange offer was announced, over 100 million Linn Energy units have been exchanged for LinnCo stock. 36

37 Partial Incorporation The Linn Exchange (cont d) Before: LinnCo Shares Current: LinnCo Public LinnCo Public Linn Units ~36% ~64% ~65.5% ~33.5% LINN LINN 37

38 Partial Incorporation Preservation of Basis A potential benefit to a structure involving a transfer of partnership units to a separate corporation is that, to the extent liabilities and tax basis both exceed fair market value, the exchange offer may preserve higher tax basis in the partnership assets despite attribute reduction under Section 108. When CODI is ultimately allocated to the transferee corporation under Section 108, the corporation s outside tax basis in the partnership interest, but not inside basis in the partnership s assets, should be reduced (unless an election is made to reduce tax basis in depreciable property first). This benefit requires that creditors exchange their debt claims against the partnership for stock in the corporate transferee, rather than partnership interests. If creditors receive partnership interests, reverse allocations under Section 704(c) will limit such creditors effective inside basis to fair market value. 38

39 Preservation of Basis Structure Original Shareholders (if any) and Exchanging Unitholders Transferee Corp P Ship Debt Newly Issued Shares P ship Creditors Non-Exchanging Unitholders (if any) Transferee Corp Sub (if necessary) P ship 39

40 Preservation of Basis Structure (cont d) Original Shareholders (if any), Exchanging P ship Creditors, and Exchanging Unitholders Transferee Corp Non-Exchanging P ship Creditors (if any) Non-Exchanging Unitholders (if any) Transferee Corp Sub (if necessary) New P ship Units P ship Debt P ship 40

41 Preservation of Basis Structure (cont d) Original Shareholders (if any), Exchanging P ship Creditors, and Exchanging Unitholders Transferee Corp Non-Exchanging P ship Creditors (if any) Non-Exchanging Unitholders (if any) CODI Transferee Corp Sub (if necessary) CODI CODI P ship 41

42 Preservation of Basis Structure (cont d) Original Shareholders (if any), Exchanging P ship Creditors, and Exchanging Unitholders Transferee Corp Transferee Corp Sub (if necessary) 754 Inside Basis Preserved Outside Basis Reduced Non-Exchanging P ship Creditors (if any) 704(c) Limited to FMV Basis Non-Exchanging Unitholders (if any) (if not cancelled) P ship 42

43 Asset Sales to Offset CODI As noted earlier, one of the key problems for unitholders in partnership restructurings is that the loss inherent in the partnership interest is likely to be capital in nature, while CODI is ordinary income. To help mitigate this character whipsaw, if the partnership s assets have built-in losses, the partnership can sell such assets which generally will result in ordinary losses under Section These ordinary losses would then be available to unitholders to offset CODI and reduce any capital loss on the cancellation of the units. However, as with the incorporation approach, asset sales will cause creditors to receive assets with basis equal to fair market value. Also, it may not be possible to fully offset CODI through sales of loss assets. 43

44 Oil & Gas Recapture Provisions Oil and gas partnerships frequently incur large amounts of intangible drilling and development expenditures ( IDCs ) that are deducted under Section 263(c). These deductions, along with deductions for depletion, are subject to recapture under Section 1254 upon the disposition of partnership property. Although gain or loss from the sale or exchange of a partnership interest is generally treated as capital gain or loss, a unitholder may recognize ordinary gain or loss to the extent the partnership has hot assets under Section 751. Hot assets include, but are not limited to, inventory, real and depreciable personal property held for less than one year, and the amount of any potential recapture (e.g., depreciation under Section 1245, depletion under Section 1254, and IDC deductions). Because deductions related to oil and gas properties held by a partnership are generally determined by the partners individually (e.g., depletion, IDC deductions), potential recapture under Section 1254 is calculated by each partner individually (as opposed to the partnership). The fair market value of a partnership s hot assets is determined at the time of any sale or exchange of an interest in the partnership. Any gain or loss that a transferor would have been allocated if the partnership had sold its hot assets prior to the transfer is considered ordinary gain or loss to the transferor on the sale or exchange of the partnership interest. The allocation of nonrecourse liabilities among the partnership s assets could impact the amount of hot asset gain at the partnership level under Tufts principles. The difference between (i) the amount of capital gain or loss that a transferor would realize in the absence of Section 751, and (ii) the amount of ordinary gain or loss attributable to hot assets is treated as capital gain or loss on the sale of its partnership interest. Thus, it is possible for the transferor of a partnership interest to realize both ordinary gain and capital loss in the same transaction. 44

45 Real Estate Investment Trusts & Recent Developments Richard M. Nugent Cadwalader, Wickersham & Taft LLP *As of August 5,

46 REIT General Information Real estate investment trusts (REITs) are a special class of entity that can avoid entity-level taxation. Congress created REITs in 1960 to facilitate investment in real estate. A REIT must make an election to be taxed under the REIT provisions in sections 856 through 860 of the Internal Revenue Code (IRC). A REIT must satisfy a number of strict requirements to obtain and maintain REIT status, including restrictions on how much and what kinds of assets it holds, restrictions on how it earns income, and restrictions on how it is organized. 46

47 REIT General Information Most of the REIT requirements generally fall into 3 categories. Organizational Requirements: Generally tested at formation and continually thereafter. Asset Requirements: Generally tested quarterly. Income Requirements: Generally tested annually. 47

48 REIT Benefits Tax Benefits REITs receive a deduction for dividends paid to their shareholders. This generally allows REITs to avoid the U.S. corporate tax, one of the highest in the world. Unlike partnerships, REITs can still serve as blockers for foreign and exempt investors. Non-Tax Benefits REITs are popular on Wall Street and among investors due to generally high dividend yields, which can be attractive in the current low interest-rate environment. Real property held by REITs may be valued higher than real property trapped inside a C corporation, especially one that is not in the real estate business. REITs can pass through to investors certain beneficial classes of income, such as capital gains. REITs receive coverage from a base of REIT-specific analysts and are listed on separate indices by the National Association of Real Estate Investments Trusts. 48

49 What is Real Property for REIT Purposes? The IRC does not define real property for REIT purposes. Regulations issued in 1962 provide the current definition. Treas. Reg (d). The term real property means land or improvements thereon, such as buildings or other inherently permanent structures thereon (including items which are structural components of such buildings or structures). In addition, the term real property includes interests in real property. The general rule is that an asset must be affixed to land or other real property to qualify as real property itself. This definition is broad and has been interpreted by the IRS to cover a wide range of assets. e.g., telecommunications cabling and cell towers. This broad definition allows many assets beyond land/buildings to qualify as real property, thus giving rise to nontraditional REITs. 49

50 What is Real Property for REIT Purposes? The IRS and Treasury issued proposed regulations in Real property would still encompass land, inherently permanent structures, structural components and interests in real property. Comprehensive examples in the proposed regulations include many categories of assets specifically defined as real property in the existing regulations and in private letter rulings. The proposed regulations are much more detailed than the existing regulations: Active assets are more specifically excluded from real property than under the existing definition. The proposed regulations include a detailed test for determining if an item will be judged as real property on its own or in connection with other items around it, i.e., as a system. The IRS has previously considered individually removable components part of a system that, as a whole, qualify as real property. The detailed test in the proposed regulations suggests that assets will be examined more closely. 50

51 What is Rent for REIT Purposes? A REIT must earn at least 75% of its income each year from rents from real property and certain other sources related to real property. Rents from real property is defined by statute, and Congress has expanded the definition many times. In addition to traditional rents, amounts received for certain services customarily furnished in connection with rents will qualify as rents from real property. IRC 856(d)(7)(C)(ii). Generally, a REIT may only directly perform services that are customary for a particular geographic area. Private letter rulings have featured a wide range of customary REIT services: e.g., basic data center services rebooting servers, etc. PLR As with the broad definition of real property, the broad definition of rents from real property allows many different kinds of businesses to qualify as REITs. 51

52 Risk of Policy Change? Despite a long history of new types of businesses adopting the REIT form and IRS and Congressional approval of broad definitions of real property and rent, some have criticized allowing newer, nontraditional REITs to so qualify. Sen. Ron Wyden (D-OR) introduced legislation in July 2016 that generally would bar prison REITs from using taxable REIT subsidiaries ( TRSs ) to provide management and other services for their facilities. Sen. Bernie Sanders (I-VT) wrote a letter to President Obama in March 2015 arguing that prisons, billboard companies, casinos and other nontraditional REITs should not be able to classify their income as rent. Tax reform proposals from Rep. Dave Camp (R-MI), former chair of House Ways & Means, would have excluded assets with a class life of less than 27.5 years (including many of the assets held by nontraditional REITs) from the definition of real property. This proposal was not adopted. 52

53 REIT Conversions & Spinoffs 53

54 Types of REIT Transactions The conversion of an existing non-reit company into a REIT can take several different forms. Some existing businesses have adopted REIT status as part of an IPO. e.g., MGM Growth Properties (casinos/hotels), CyrusOne (data centers). In other cases, an existing publicly traded C corporation has adopted REIT status. e.g., Lamar Advertising (outdoor advertising). Some operating companies previously spun off a subsidiary holding real estate assets, which later elected REIT status. e.g., Darden Restaurants (restaurants). Recent changes in law now generally preclude tax-free C-to-REIT spinoffs. 54

55 C Corporation Conversion into a REIT A C corporation that seeks to convert into a REIT usually considers a number of issues. To comply with the requirement that a REIT not retain any E&P from pre-reit years, the converting corporation must issue a purging distribution to eliminate its existing E&P. To reduce E&P, the distribution must be a taxable distribution with respect to the REIT s stock. IRC 312. Distributions may be made primarily in stock. IRC 305(b)(1); Treas. Reg The IRS will rule on the effectiveness of a purging distribution in reducing E&P if at least 20% of the distribution is cash. e.g., PLR (cash available in purging distribution not to be less than 20% of aggregate value of distribution). 55

56 C Corporation Conversion into a REIT A C corporation that seeks to convert into a REIT usually considers a number of issues. The converting corporation will often amend its charter to avoid issues with related party rent and closely held status. Payments received from entities in which the REIT holds at least a 10% interest, by vote or value, taking into account section 318 attribution rules, generally do not qualify as good rents from real property. IRC 856(d)(2)(B). In addition, a REIT cannot be closely held as defined in IRC 856(h) and 542(a)(2), after an initial 1-year grace period. Those sections generally apply if, at any time during the last half of a taxable year, more than 50% of the value in a REIT s outstanding stock is owned, directly or indirectly, by 5 or fewer individuals. 56

57 C Corporation Conversion into a REIT A C corporation that seeks to convert into a REIT usually considers a number of issues. For 10 years after conversion, REITs may be required to pay entity-level tax on built-in gain from pre-reit periods. Treas. Reg (d)-7T(b)(2)(iii); see IRC

58 PATH Act The Protecting Americans from Tax Hikes (PATH) Act of 2015 was signed into law on December 18, The legislation made numerous changes to the laws affecting REITs, including generally barring tax-free REIT spinoffs by companies that are not already REITs. Several of the PATH Act s REIT provisions have delayed start dates and are not yet in effect. 58

59 PATH Act FIRPTA The FIRPTA withholding rate generally increased to 15%. The Act added or amended several FIRPTA exclusions: New exclusion from FIRPTA for qualified foreign pension funds. Expanded exclusions from FIRPTA for certain REIT stock. Exclusion of REITs and regulated investment companies ( RICs ) from the cleansing rule. 59

60 PATH Act Basic REIT Rules A new prohibited transaction safe harbor was added, based in part on average volume of sales over the prior three tax years. The preferential dividend rule was repealed for publicly offered REITs. Several additional classes of property were added to the definition of real estate assets, or can count as real estate assets under specific circumstances: Certain debt instruments issued by publicly offered REITs. Certain personal property leased alongside real property. Interests in mortgages secured by real property and some personal property. The PATH Act also made certain changes to the REIT income rules: Additional hedging transactions excluded from gross income. Fix to E&P calculation in instances of different treatment of a tax item for taxable income and E&P purposes. 60

61 PATH Act Taxable REIT Subsidiary Rules REITs will no longer be able to hold more than 20% of their total assets in securities of Taxable REIT Subsidiaries ( TRSs ). Addition of penalty tax on redetermined TRS service income. TRSs are allowed to perform certain additional services for a REIT. 61

62 PATH Act REIT Spinoffs Under new IRC 355(h), REIT spinoffs generally cannot qualify as tax-free. Exclusions: REIT-REIT spinoffs Certain REIT-TRS spinoffs Companies with pending PLR requests as of December 7, 2015 (e.g., Hilton s spinoff of upmarket lodging properties in new REIT Park Hotels & Resorts). C corporations involved in a spinoff generally cannot elect REIT status for 10 years thereafter. IRC 856(c)(8). 62

63 Section 337(d) Regulations On June 7, 2016, the IRS released proposed and temporary regulations under IRC 337(d). The rules generally lengthen the recognition period for assets transferred by a C corporation to a REIT or RIC from 5 years to 10 years. The rules broaden the categories of property that are subject to the built-in gain recognition rules. The rules also further restrict transfers of property to REITs in proximity to a tax-free spinoff under IRC

64 Section 337(d) Regulations - Spinoffs A tax-free acquisition of property by a REIT from a C corporation generally will trigger recognition of built-in gain if: The acquisition occurs in the 10-year period preceding or following an IRC 355 distribution; and The REIT or the C corporation is either the distributing or controlled corporation in the IRC 355 distribution, or a member of the separate affiliated group of the distributing or controlled corporation. 64

65 Questions? Richard M. Nugent Partner Cadwalader, Wickersham & Taft LLP New York

66 About This Presentation This presentation contains general information only and the respective speakers and their firms are not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. The respective speakers and their firms shall not be responsible for any loss sustained by any person who relies on this presentation. 66