Proposed Legislation regarding Master Limited Partnerships
Recently, Senator Chris Coons (Dem. Del.) and Senator Jerry Moran (Rep. Kan.) introduced a bill (the “MLP Parity Act”) to expand the use of Master Limited Partnerships (“MLPs”) to finance renewable energy projects (http://www.coons.senate.gov/issues/masterlimited-partnerships-parity-act). By expanding the use of MLPs to renewable energy projects, the MLP Parity Act is intended to level the playing field by providing owners of renewable energy project assets the same access to public equity financing that has been available for owners of oil and gas assets for many years.
The MLP Parity Act is introduced at a time when costs of developing renewable energy projects are expected to increase as a result of federal support for such projects set to expire in the coming years (e.g., the production tax credit that is available for wind projects is set to expire at the end of 2012).
The change effected by the MLP Parity Act would be to expand the definition of income from “qualified” resources to include income from clean energy resources and infrastructure projects, such that an MLP may own such assets. (The MLP Parity Act would not relax the limitations on the ability of non-corporate investors to use the underlying tax benefits from owning such renewable assets.)
The availability of the MLP financing structure to renewable energy projects could possibly attract additional capital from a significantly broader and deeper pool of investors from the public sector seeking a liquid investment in wind, solar, and other renewable energy projects.
The balance of this briefing explores the extent to which the benefits of the MLP financing structure and a similar financing structure, Real Estate Investment Trusts (“REITs”), are already available to investments in renewable energy.
Current Use of Real Estate Investment Trusts and Master Limited Partnerships
Under current law, in order for a partnership to qualify as a MLP, at least ninety percent (90%) of its gross income must consist of income from “qualifying sources,” such as real estate (e.g., land or improvements, such as buildings and other inherently permanent structures), or natural resources such as crude oil, natural gas, petroleum products, coal, timber, and other minerals. I.R.C. § 7704.
Under current law, in order for a corporation to qualify as a REIT: (i) at least seventy-five percent (75%) of the value of the entity’s total assets must be represented by real estate assets (e.g., land or improvements, such as buildings and other inherently permanent structures), and (ii) at least ninety-five percent (95%) of the entity’s gross income must be derived from rents from real property (e.g., charges for services customarily furnished or rendered in connection with the rental of real property). I.R.C. §§ 856(c)(4)(A), 856(c)(2), and 856(d)(1); Treas. Reg. § 1.856-3(b). (Income from real estate is another category of income that may qualify as income from a “qualifying source” for MLP purposes, so a MLP can be used as an investment vehicle for anything in which a REIT may invest.)
In 2007, the Internal Revenue Service (the “IRS”) released Private Letter Ruling 200725015 (Mar. 13, 2007) which confirmed the real property status of a broad range of energy assets for REIT purposes (http://www.irs.gov/pub/irs-wd/0725015.pdf). Specifically, the IRS analyzed whether an electric transmission and distribution system that was physically connected to existing real estate and served as a conduit to allow energy created to flow through to users qualified as real estate under the Internal Revenue Code (the “Code”). According to the IRS, because the electric transmission and distribution system was an “inherently permanent structure”, the electric transmission and distribution system qualified as real estate. (However, renewable generation assets themselves typically have been thought not to be such “inherently permanent structures,” but instead are “machinery and equipment.”)
Furthermore, in 2008, the IRS released Private Letter Ruling 200828025 (Apr. 8, 2008) which determined that the generation of electricity that was physically connected to existing real estate would qualify as a “customary service” for purposes of determining whether at least ninety-five percent (95%) of the REIT’s gross income was derived from rents from real property (http://www.irs.gov/pub/irs-wd/0828025.pdf). Consequently, the IRS held that the income from the sale of electricity to tenants qualified as rents from real property.
Based on the foregoing, even under current law, the REIT and MLP financing structures may be utilized to own and hold land, buildings, and transmission assets associated with renewable energy projects (including gathering lines and interconnect facilities). Furthermore, under existing law, the REIT and MLP financing structures may be used to install renewable energy equipment (e.g., solar photovoltaic cells) on existing buildings and sell the power production to their existing tenants if the provision of power would qualify as a “customary service” in the local area.
Differences between Real Estate Investment Trusts and Master Limited Partnerships
Both REITs and MLPs provide for a single layer of taxation, but the mechanics by which REITs and MLPs achieve that result are fundamentally different. A REIT computes its taxable income as a corporation, except that a REIT is provided an extra deduction for distributions, and, after computing its taxable income, in order to remain a REIT, it is required by law to distribute ninety percent (90%) of its taxable income. Conversely, as a partnership, a MLP passes-through its items of income, deductions, and credits to its unit holders. Therefore, the benefits of accelerated depreciation and tax credits are trapped within a REIT and reduce its required distributions while a MLP can pass-through these benefits to its unit holders although the passive loss and at risk rules generally restrict the ability of any non-corporate partner to use such tax benefits to reduce its taxes.
The distributions to the REIT shareholders are treated as dividends that are taxed to the recipient at its full marginal tax rate while any distributions from a MLP reduce the unit holder’s adjusted basis in its units, therefore, deferring any tax on distributions until such units are sold.1 Consequently, for transactions offering significant tax benefits (e.g., losses, credits, deductions) and for investors seeking to defer tax until such investment is sold, a MLP provides a more efficient financing structure than a REIT.
However, investors also consider the tax reporting obligations of a REIT and MLP. Any investor is able to own interest in a REIT without significant tax complexity because a REIT’s shareholders simply receive an IRS Form 1099 identifying any dividends received and report such dividends on IRS Schedule A. Conversely, for an investment in a MLP, an individual retirement account or pension fund will be subject to unrelated business income tax, a foreign investor will be considered to have a U.S. trade or business and will be subject to additional tax compliance obligations, an individual investor will receive a IRS Schedule K-1 and be required to file an IRS Schedule E, and investors will be subject to additional state tax reporting and compliance obligations. Therefore, a REIT is a more broadly accepted investment structure.