Windstream Communications was approved by the IRS to transfer its copper and fiber assets into a Real Estate Investment Trust (REIT) and reportedly save about $100 million per year in taxes. This tactic to combat corporate tax rates of 35% (among the highest for industrialized nations) should be of great interest to communications companies that own or plan to deploy such assets.
As defined by investopedia, REITs are “[a] security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.” REITs are free from taxes provided that they pay out 90% of their taxable income in dividends. They are popular because investors who cannot otherwise afford to invest in real estate on their own can do so by owning shares of a REIT. According to the National Association of Real Estate Investment Trusts as reported in The Wall Street Journal, in 1971 there were just 34 REITs with a market value of approximately $1.5 billion; today there are over 200 worth $816 billion.
So how do we get from real estate to copper and fiber? First, the move from traditional real estate holdings began prior to the IRS clearance of Windstream. Iron Mountain, a storage company, and then American Tower, a wireless tower company, were cleared by the IRS to create REITs. That still doesn’t answer the question, but it is not a great leap to see a fit. According to Steven Rosenthal, a senior fellow at the Tax Policy Center, copper and fiber can be considered real estate because they are income-earning assets that are stationary.
The implications of allowing copper and fiber assets to be transferred to a REIT has the potential to be significant for communications companies on a number of levels, including cable companies, wireless carriers and facilities-based telecom carriers. Not only might the formation of a REIT reduce taxes, but it may also permit companies to spread risk and raise capital. Moreover, if the view of the IRS is that copper and fiber assets are stationary, it may be possible that IRUs in those assets could also be deemed stationary and therefore a property right, and not, for instance, a service, which might allow a non-profit company to avoid unrelated business income if it transferred IRUs to a wholly-owned for-profit subsidiary. For rate-of-return telecom carriers, the creation of a REIT and leasing the assets back to the company, as in the case of Windstream, would reduce capital if the lease is considered an operating lease, but increase expenses. As a result, the carrier’s rate-of-return might increase, possibly above its allowable rate-of-return. Moreover, it could be considered a transfer of control or an assignment, either of which would likely require regulatory approval.
So far, the reaction of the investment community has been somewhat mixed. On one hand, Windstream’s stock increased by 12% on the news. In a research note, Timothy Horan at Oppenheimer wrote that “[we] believe this means that every network stock we cover is roughly 20% undervalued at this point, as they should be able to largely avoid paying taxes going forward.” Other analysts, such as CitiBank and Moody’s, however, seem to view the move by Windstream as some type of foreboding and could weaken both Windstream and its REIT by spreading performance too thinly. At least one analyst has recommended selling Windstream because the REIT will cause Windstream to decrease its dividends. Others, somewhat curiously, state that it will not increase Windstream’s value and is nothing more than financial engineering.
And then there always is the potential of political fallout. At a time when some corporations are pushing back against the U.S. corporate tax rate by relocating offshore, which some politicians have characterized as “un-American,” the creation of REITs to reduce taxes possibly could be viewed in the same light. Conversely, although the tactic could have an immediate effect of eroding the corporate tax base, it could, in the long run, increase productivity by freeing up much needed capital in the capital-intensive communications industry.
It is difficult to predict whether the REIT strategy is an isolated act or the beginning of a broader movement. At this point, some have speculated that smaller carriers will pursue REITs as a financing vehicle but that the larger carriers will not do so because the strategy falls outside their comfort zone, would be very complicated given their corporate structures and copper and fiber are not core to their operations.
REITs for copper, fiber, or other stationary communications assets may or may not be the answer, but they are certainly worthy of consideration. Please contact us if you have questions or would like additional information.