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2 Master Limited Partnerships (MLPs): What Are They Anyway And Will They Replace REITs or Vice-Versa? September 24, 2014 Presented By: Barbara S. de Marigny David L. Ronn McGuireWoods LLP 600 Travis Street, Suite 7500 Houston, Texas 77002

3 Master Limited Partnerships (MLPs): What Are They Anyway and Will They Replace REITs or Vice-Versa? Click to edit Master title style Barbara S. de Marigny David L. Ronn McGuireWoods LLP 600 Travis Street, Suite 7500 Houston, Texas Webcast Presented to the Association of Corporate Counsel Real Estate Committee September 24, 2014

4 Topics What is an MLP? Evolution of MLPs Qualifying Income Why Use MLP Form? Why Not Be An MLP? Common MLP Structure Distributions Tax Shield Asset Selection Criteria REIT vs. MLP Comparison A Real Property MLP? Will REITs Replace MLPs or Vice-Versa? 4

5 What is an MLP? MLP = Master Limited Partnership Not a technical term Defined in IRC 7704 as Publicly Traded Partnership or PTP Entity (could be LP or LLC) Publicly-traded Not taxed as a corporation for federal income tax purposes because it meets qualifying income (QI) test of IRC

6 Evolu&on of MLPs 1981 First public trading in partnership units 1980 s Many copycats, including Boston Celtics 1987 Congress sees loss of corporate tax, enacts IRC 7704 If publicly traded then must pay corporate tax, unless 90% qualifying income 1990s Little growth, around 16 MLPs 2000s Resurgence in use primarily for midstream oil and gas (pipelines) 2005 GPs of MLPs started to go public 6

7 Evolu&on of MLPs (cont d) Now have: - Exploration & Production MLPs - Financial MLPs (PTPs) - International MLPs - Fracking and SWD MLPs - Non-energy MLPs Today, approximately 150 MLPs, around 120 energy-related 7

8 Ques&on for the A9endees Have you either represented an MLP in a transaction or encountered an MLP across the table from you in a transaction? Yes No 8

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11 Qualifying Income 90% or more Gross income Services gross revenue before costs Products sales minus COGs Worldwide Categories of qualifying income ( 7704(d)): Dividends, Interest Real property rents and gains from sale; 856(c) (2) REIT income Capital Gain from assets used in qualifying activity Income from natural resource activity 11

12 Qualifying Income (cont d) Qualifying Natural Resources include: Oil, gas, petroleum Propane Coal and other minerals Timber (and timber products, MDF) Depletable resources (IRC 613) Industrial source carbon dioxide Ethanol, biodiesel, LNG, liquefied petroleum gas, fuels transportation and storage only Fertilizer 12

13 Qualifying Income (cont d) Qualifying Activity: Exploration, development, mining or production, processing, refining, transportation (including pipelines), or the marketing of any mineral or natural gas. Private Letter Ruling (PLR) Practice Specific to taxpayer Why needed? How much? How long? IRS pause 13

14 Why Use MLP Form? Potentially lower cost of new capital because: Investor clamor for Growth + Yield Tax-efficient structure Lower cost of capital means improved competitiveness for acquisitions Possibility of monetizing assets tax-deferred Broader investor base than private offering Bigger group can raise more money Sponsor can retain effective control Significant revenue from non-real estate sources 14

15 Why Not Be an MLP? Insufficient Qualifying Income Administrative Burden / Expense (K-1s, web hosting, call center services) Limited investor pool (disfavored by foreigners, taxexempts) Insufficient Cash flow High level of distributions expected Need Predictable Operating Income and Cash Flow Long-lived, income-producing properties or services Predictable maintenance expense and capital expenditures Assets that need minimal further development 15

16 Common MLP Legal Entity Structure 100% Sponsor LP (Common Units and Subordinated Units) Public LP (Common Units) General Partner GP Interest and IDRs MLP (Publicly Traded Partnership) LP or LLC (Operating Subs) Lenders Assets 16

17 Distributions In the prospectus, the MLP makes a statement as to its intention to distribute a specified minimum level of available cash on a quarterly basis. This amount is referred to as the minimum quarterly distribution (MQD) or initial quarterly distribution (IQD). Available Cash Agreement to distribute, per the partnership agreement Not a tax requirement (unlike a REIT) Market driven GP will usually have incentive distribution rights (IDRs) Meeting distribution targets results in increasing % share to GP 17

18 Tax Shield Tax Shield Is measured as one minus the ratio the partner s taxable income bears to such partner s cash distribution. For example, a partner who receives a $100 distribution and $30 of taxable income is 70 percent shielded. Is primarily driven by the amount of depreciation, depletion, and amortization (DD&A) the MLP can generate. Outside Tax Basis A Section 754 election/743(b) adjustment is made allowing the purchaser of a unit to receive tax basis based on the purchase price of the unit. Reductions to outside tax basis for the cash distributions not taxed (until excess of basis) Recapture of depreciation on exit 18

19 Asset Selection Criteria $150m cash Sponsor Corp $500m assets, $350m contribution 70% 30% PTP Public $150m cash Asset Selection Issues Must generate QI Must generate sufficient cash flow Need cash flow modeling Must have sufficient tax basis to generate tax shield Need tax shield modeling Sale of properties to MLP may create tax basis Under certain rules, Sponsor may take cash out by levering up property or by reimbursement for capex 19

20 REIT vs MLP Comparison REIT Characteristics n n n REIT A REIT is a corporation that owns real property and, generally, leases it to others. To qualify for REIT status, the corporation must earn primarily rental income. REITs are not subject to U.S. federal, and in most cases state, income taxes, provided they distribute their taxable income annually as dividends to their shareholders. REIT shares can be listed on a stock exchange and publicly traded. REIT investors consist of individuals, taxexempt institutions, U.S. and foreign funds, and others looking for predictable cash distributions or yield. MLP Characteristics n n n n MLP An MLP is a limited partnership or limited liability company that is publicly traded and receives passthrough tax treatment. An MLP is treated as a corporation unless it meets certain eligibility requirements to be treated as a partnership: To qualify for partnership status, the corporation must earn primarily qualifying income. Code Sec. 7704(d) defines qualifying income as including income from certain natural resource activities and passive-type income. MLP shares can be listed on a stock exchange and publicly traded. MLP investors generally consist of retail investors, i.e., individuals and others looking for tax-deferred cash distributions but may have adverse tax consequences for foreign and tax-exempt investors. 20

21 REIT vs MLP Comparison REIT Investors REIT REITs are able to attract a broader base of investors. Although all parties are free to invest in both structures, tax exempt and foreign investors prefer REITs: Foreign investors are not liable for U.S. taxes, or are taxed at a 5%, 10% or 15% rate, on dividends received from a REIT if covered by an income tax treaty. REIT Qualifications At least 75% of the REIT s income must be derived from rents and interest on real estate mortgages. A key restriction on the use of REITs in the oil and gas industry is the requirement that the rental income not be from a related party. Careful structuring can address this concern. MLP Investors MLP U.S. tax liabilities on their share of the MLP income; UBTI to tax-exempt institutions; Foreign investors deemed engaged in business in the United States, triggering filing requirement; Additional branch profit tax on foreign corporate investors; and, U.S. filing obligations both federal and multiple states. MLP Qualifications An MLP is treated as a corporation unless: 90% or more of its gross income consists of qualifying income. 21

22 REIT vs MLP Comparison REIT REIT Qualifications (cont d) MLP MLP Qualifications (cont d) At least 75% of the REIT s assets are real property. At least 90% of its annual taxable income is paid out as dividends to its shareholders. It must have at least 100 shareholders; a service can provide shareholders for a fee if public trading is undesirable. Not more than 50% of the REIT shares can be held by five or fewer individuals. Qualifying Income includes: Passive earnings (rent from unrelated parties, interest, dividends, and capital gains); Natural Resources activities involving certain specified resources (production, extraction, mining, transporting, storing, processing and refining of natural gas, crude oil, LPG, petroleum products, coal, timber, ethanol, bio-diesel, and other hard minerals). The pass-through status of an MLP is not dependent on a minimum distribution percentage or character of assets 22

23 REIT vs MLP Comparison REIT MLP Sponsor monetizes investment in infrastructure without immediate tax hit Same Liquidity through exchange-trading Same Possible to have significant institutional investment Sponsor may retain control through via longterm master lease Rental income from real property exclusively Less tax administrative costs. Form 1099 s instead of K-1s Larger investor pool (favorable to foreigners and tax exempts) Permissible but adverse tax consequences for institutions No lease; MLP provides service; Sponsor controls MLP Business of any nature as long as it generates qualified income (natural resources, real property; interest; dividends) Tax administrative expense (K-1s) Limited investor pool (unfavorable to foreigners and tax exempts) 23

24 REIT vs MLP Comparison REIT Put bad income in taxable REIT subsidiary (TRS) State income tax: handled by the REIT (filing, no withholding) MLP Same: use taxable corporate subsidiary Non-resident state filings, state withholding on distributions Alternative energy assets? Not clear. Certain parts of installations may be REIT-able but many open issues Alternative energy assets? No, electric power production is not qualifying income. Coons Bill MLP Parity Act would change law to permit. 24

25 A Real Estate MLP? Qualifying income definition in IRC section 7704(d)(1)(C) includes: Amounts which would qualify as rent from real property under section 856(d) and section 856(c)(2) REIT income Income from customary services can be from performance of services by its own employees (no third party contractor requirement) For purposes of prohibited related party rent, 5% ownership of MLP rather than 10% IRC 7701(e) can cause service fees to be recharacterized as a rent; can be a problem for pipelines when recipient of services is related and assets may be considered personal property (equipment), not real property Examples of pure real estate MLPs are rare: New England Realty Associates LP, America First Multifamily Investors, LP, Brookfield Property Partners, L.P. 25

26 Will REITs Replace MLPs or Vice-Versa? Hypotheses: If the business is pure real estate, a REIT will be a more efficient way to access capital markets If the business is diversified but natural-resources related, a REIT will be too restrictive and an MLP is preferable If the business is diversified and neither naturalresources focused nor real estate focused, the only option may be a C-corporation IPO 26

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