On July 29, 2014, Windstream (WIN) announced plans to spin off certain telecommunications network assets, specifically fiber and copper network and other fixed real estate assets, into an independent, publicly traded real estate investment trust (REIT). In connection with the spinoff transaction, WIN plans to enter into long-term, triple net leases with the REIT. The transaction has attracted a lot of attention in the telecom industry, which, with the exception of tower companies and data centers, has not taken advantage of the REIT structure. This memorandum briefly explains the structural issues that have to be addressed in a REIT spinoff transaction. Given the multiple hurdles that must be overcome, a REIT spinoff is not an easy transaction to execute. However, if the stars align, the transaction can produce significant value for shareholders.

Does the REIT hold real property and receive rents from real property?

75% of the REIT’s total assets must be real estate assets, cash, and government securities. In addition, 75% of the REIT’s gross income must be derived from rents from real property and other real estate related income. Thus, the first question is whether WIN’s telecommunications network assets are real property for REIT purposes. The IRS issued proposed regulations in May 2014 providing that inherently permanent structures, including transmission lines, pipelines, telephone poles, and microwave transmission, cell, broadcast, and electrical transmission towers, are real property for REIT purposes. WIN’s telecommunications network assets seem to fit in that category and WIN received a private letter ruling (PLR) from the IRS confirming that treatment. Because wireline telecom, cable, communications backbone, and submarine cable operators also have such assets in their networks, a REIT spinoff could be an option for those companies.

Is the REIT engaged in an active trade or business?

In order for the spinoff to qualify as a tax-free transaction, the REIT has to continue one of WIN’s historically active trades or businesses. Leasing real property on a triple net basis may not rise to the level of an active trade or business, nor was it a business in which WIN historically engaged. However, to meet this requirement, only a small portion of WIN’s business needs to be continued by the REIT. To meet this requirement, WIN transferred its residential CLEC business to the REIT. The income generated by the residential CLEC business may be “bad” income for REIT purposes, but the business can be held in a taxable REIT subsidiary (TRS) of the REIT. The TRS is subject to corporate tax, but the dividends received by the REIT from the TRS generally are “good” income for REIT purposes. The PLR WIN received also addressed the tax-free nature of the spinoff transaction.

Does the REIT have C corp E&P?  

A REIT loses its qualification as a REIT if it has any earnings and profits from a non-REIT year (E&P). In the spinoff transaction, WIN’s E&P will be apportioned between WIN and the REIT. Any E&P apportioned to the REIT must be distributed. WIN is not planning to make a special E&P distribution, which means it must not have any E&P. However, if WIN had a significant amount of E&P that needed to be distributed, the REIT spinoff would have been less attractive.

Will the REIT’s income be related-party rent?

Under the REIT rules, rents from real property do not include any rent received from a tenant in which the REIT owns, by vote or value, a 10% or greater interest. In determining the REIT’s ownership of a tenant, certain constructive ownership rules apply, which treat the REIT as owning any stock that a 10% or greater shareholder of the REIT owns. WIN does not have a 10% or greater shareholder. However, if WIN had a 10% or greater shareholder, that shareholder would have been required to sell a portion of either its WIN stock or its REIT stock in connection with the spinoff so the REIT could avoid a related-party tenant problem.

Is the REIT an attractive investment?

The REIT will be a separate publicly traded company. As such, it must have a management team, assets, and a business plan that make it an attractive investment. WIN’s Chief Financial Officer will become Chief Executive Officer of the REIT. One of WIN’s directors will become Chairman of the REIT’s board. The REIT will focus on expanding and diversifying its assets and tenants through future acquisitions. WIN has certainly put the REIT in a position to achieve its objectives and grow into an attractive investment.

What’s the benefit to WIN’s shareholders?

The REIT spinoff transaction provides two significant benefits to WIN’s shareholders. First, a portion of WIN’s current revenue – the portion attributable to the rental income to be received by the REIT – will no longer be subject to a corporate tax. Second, given the stability of the dividends paid by the REIT and the valuation multiples generally applicable to REITs, the REIT’s shares may be valued at a higher multiple as compared to WIN’s shares currently. Accordingly, the combination of the REIT shares and the WIN shares after the spinoff should be worth more to shareholders than the WIN shares before the spinoff.