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REITs: The Next Vehicle for Midstream Assets?

Industry - Midstream Oil and Gas

Recent IRS guidance may provide a new, tax-favored vehicle for investment in midstream assets

Investing in the midstream energy sector is a popular way to participate in the North American energy market. Midstream, which includes gathering, processing, transporting and storing energy products, offers investors comparatively low risk, an attractive yield, and often competitively high barriers to entry. Currently, almost half of U.S. midstream assets are housed in master limited partnership (MLP) structures, which in the last two years have faced challenges in accessing the equity capital markets. MLP securities have not performed well compared to many other equity securities, and some investors have expressed concerns about the structure of MLPs, including more complicated tax reporting (MLP investors receive a K-1, as opposed to the simpler Form 1099 corporate investors receive), and sometimes unique governance arrangements. In addition, a decrease in the corporate tax rate under the Tax Cuts and Jobs Act of 2017, and a ruling by FERC that disallowed certain income tax allowances previously enjoyed by MLPs, have reduced the relative attractiveness of MLP securities.

These developments have made it difficult for midstream MLPs to raise capital to fund growth. Many of these partnerships have dealt with these challenges by simplifying their structure and converting to C corporations via an “Up-C” or other investment structure. Other MLPs have been taken private by their private equity sponsors or other new investors. Antero Midstream, Enlink Midstream, Dominion Energy Midstream, and Valero Energy Partners are notable examples of this trend. For those MLPs converting to C corporations or an Up-C structure, the upside is simpler reporting for investors, while the downside is double taxation via the corporate level tax. While the current 21% federal corporate tax rate has made this choice favorable for some, many observers doubt that the rate will remain at its current 21% level. Additionally, it can be extremely difficult to exit C-corp. solution in a tax-efficient manner once entered.

REIT as an Alternative Structure

Enter the real estate investment trust (REIT). REITs are entities that own or finance income-producing real property in various industry sectors. Traditionally designed for investors who want to make passive investments in real estate, REITs are exempt from corporate-level income tax provided they derive at least 75% of their gross income from rents from real property and certain other real estate-related activities, such as making loans secured by real estate, and at least 95% of their gross income from passive income such as interest, dividends, and items qualifying for the 75% gross income test.1 REITs must also generally distribute at least 90% of their taxable income to investors each year. In general, REITs generate income by financing or leasing real estate and collecting rent or interest. In the past, this meant REITs could not operate real property assets, such as platforms, pipelines or storage tanks.

IRS Guidance on Qualifying Rents in the Midstream Context

Recently, the IRS clarified its position on payments qualifying as “rent” under the REIT rules, opening the door to the possibility of midstream asset operators converting to a REIT structure. A 2019 private letter ruling (PLR)2 finds that service fees collected by a REIT from the end-user for the right to use platforms, pipelines and storage tank facilities may be considered “rents from real property” for purposes of the REIT rules under certain conditions. Previously, it was assumed that REITs could only lease these facilities to third-party operators and collect rent. Now, based on the conclusions reached in the PLR, it appears that with the proper conditions in place, a REIT (or one of its subsidiaries) can operate the midstream assets itself and charge service fees to the end-user, giving rise to qualifying rents from real property. Critically, the PLR concludes that a REIT can charge the customer a single fee, allowing midstream asset owners to utilize the REIT structure without restructuring customer agreements. Additionally, unlike MLPs, the storage or movement through pipelines of products that are not “natural resources” for MLP purposes may nevertheless give rise to qualifying rents from real property under the REIT rules.

REIT Advantages

There are many potential advantages of operating midstream assets within a REIT structure rather than within an MLP or non-REIT C corporation. Utilizing a REIT as operator addresses the challenges of partnership structures, including complicated tax filings, and is more likely to feature traditional corporate governance. In terms of tax reporting, REIT investors receive 1099s (as opposed to K-1s). The governance structure of a REIT tends to be similar to that of a typical public company (e.g., a board of directors elected by the REIT’s shareholders). Further, a flow-through partnership structure exposes tax-exempt investors to tax on unrelated business income (“UBTI”) unless they are blocked, while distributions from REITs are considered passive and do not give rise to UBTI. In addition, foreign investors in a partnership may recognize effectively connected income (“ECI”) and be subject to U.S. withholding tax of 10% upon disposition of their partnership interests. By contrast, REITs block ECI for foreign investors, and foreign investors who satisfy certain exceptions may avoid all U.S. tax on the disposition of REIT shares. Finally, the absence of corporate-level taxation makes the REIT structure attractive to all investors.

The following chart summarizes key differences in taxation and reporting among MLPs, C corporation structures, and REITs.

MLP C Corp or “Up-C” REIT
Entity-level tax  0% (flow-through tax treatment) 21% 0% (if REIT tests are met)
Investor-level tax  29.6%3  20% (dividend rate) 29.6%4
Effective federal tax rate 29.6% 36.8%5 29.6%
Tax Reporting K-1 1099 1099
Is Income Effectively Connected Income? (Foreign investors)  Yes No No
Is Income UBTI? (Tax-exempt investors) Yes No No
Required Payout None None 90%

REIT Challenges in the Midstream Space

While the potential benefits are considerable, there are roadblocks that could prevent broad use of the REIT structure for midstream operators. First, because REITs were designed as passive investment vehicles that collect rents from real property, too much active income could cause failure of the REIT tests. Payment for personalized services provided to the customer or “tenant” would be considered active income instead of rent from real property. Any services provided to the customer beyond basic maintenance and repair of the facilities would give rise to non-REIT income. In the PLR, a taxable REIT subsidiary (TRS) performed all services for customers, including loading and unloading product, adding agents or additives to storage tanks, sampling, and the like.  As noted above, importantly, the REIT was able to charge a unified storage or pipeline fee to the customer, and then remit to the TRS arm’s-length compensation for the services performed by the TRS. Some income tax will be due with respect to services performed by the TRS.

Additionally, the REIT rules provide that rents derived from related party tenants are nonqualifying income. Specifically, the definition of “rents from real property” excludes rents received from a tenant in which the REIT owns, directly or indirectly (through constructive ownership rules), 10% or more of the voting power or value.  Many midstream MLPs have historically provided significant services to related parties, including their sponsors. To successfully implement the REIT structure in the midstream context, nearly all of the REIT’s rental income would need to come from third party customers. There may be opportunities in certain instances to structure around these related-party rent issues with UPREIT structures.

Finally, income related to assets that are not considered real property, such as compressors that push product through pipelines, would not qualify as rents from real property. A midstream operator in a REIT structure would have to parse the portion of fees paid with respect to similar non-real property assets, assigning these to the TRS instead. A REIT structure also would not work for an operator that buys and sells commodities, oversubscribes pipe capacity, or sells based on spot volumes, as each of these activities would disqualify the related income as rent.

Key Takeaways

Overall, the position taken by the IRS in the PLR is promising, potentially opening up the tax benefits associated with REIT investments to investors in midstream energy. Because PLRs are not  precedential, in the absence of binding guidance issued by the IRS we would advise any midstream operators considering converting to a REIT structure to secure their own PLR before committing resources toward a conversion.

Visit our website to learn more about V&E’s REITs and Energy – Midstream Oil & Gas practices. For more information, please contact Vinson & Elkins lawyers Christopher Mangin, Daniel LeBey, David Oelman, or Ryan Carney.

Join V&E lawyers for “REITs: IRS Ruling Opens Door for Midstream Assets” on February 12. To read more or register, click here.

1 A REIT must meet other statutory tests regarding the composition of its assets and its organization that are beyond the scope of this discussion.

2 PLR 201907001.

3 This is the highest individual ordinary dividend rate of 37% reduced by the Section 199A 20% deduction for qualified business income from a domestic business operated through partnership, S corporation, trust, estate, or sole proprietorship.

4 Assumes distribution of after-tax income to shareholders.

5 Assumes distribution of after-tax income to shareholders.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.