Could an investment vehicle from the ’60s hold the key?
To provide nondiscriminatory access to the nation’s high voltage power grid has been the primary federal regulatory goal of the electric power industry for at least a decade. Buckets of regulatory ink have been devoted to open access transmission tariffs (OATT) and standards of conduct for transmission providers in their dealings with affiliates since the enactment of the Energy Policy Act of 1992. Recent proceedings convened before the Federal Energy Regulatory Commission to re-examine the effectiveness of the OATT and standards, further attesting to the elusiveness of nondiscriminatory access.
Instead of improving tariffs or developing new standards of conduct to prevent transmitting utilities from granting superior access to affiliates, the solution may be found in an investment vehicle from the 1960s: the real estate investment trust, or REIT (rhymes with “treat”).
What a REIT offers
It has long been recognized that one sure way to prevent transmitting utilities from discriminating is to uproot the incentive to discriminate. Place ownership of the grid in the hands of stand-alone companies unaffiliated with transmission users, interested only in maximizing the paying uses of the grid, irrespective of the specific users.
But even if an integrated utility were interested in selling off its transmission system, it would likely be dissuaded from doing so not only by the loss of the opportunity to use the transmission system to maximize affiliate earnings, but also by the high capital gains tax it would have to pay on transmission assets that have been mostly, if not entirely, depreciated under the tax code. That perhaps explains why, notwithstanding the top priority of federal regulators, the ownership of only two high voltage transmission systems-International Transmission Company and Michigan Electric Transmission Company-has been separated from ownership of the vertically integrated utilities that created them.
What if ownership could be separated, capital gains tax avoided, and a favorable tax status achieved? This is precisely what a REIT offers to the electric power industry and its regulators. REIT is a federal tax designation for a corporation, trust or association, publicly or privately held, that invests in real estate and reduces or eliminates corporate income taxes. Congress created REITs in 1960 to provide a structure for investing in real estate that was similar to the way in which mutual funds provide for investments in stocks.
How a REIT would work
A REIT, with a minimum of 100 investor shareholders, could become the vehicle for owning a stand-alone high voltage transmission system. Assume that a vertically integrated electric utility leases its transmission system to a transmission REIT for 30 years or some comparable term. The REIT would fully pre-pay the rent at an agreed-upon discount rate. The transmission REIT, in turn, would then sublease the transmission system to an independent transmission system operator.
Global Signal Inc.,a REIT, recently used a comparable fully pre-paid, long-term lease to acquire from Sprint/Nextel more than 6,500 communications towers in a $1.2 billion deal. Most of the towers were then subleased back to Sprint/Nextel. As there is no sale of capital assets in these transactions, the first lessor would escape paying capital gains. And going forward, the REIT (similar to a master limited partnership) would operate as a pass-through entity that escapes corporate-level taxation; only the REIT shareholders would pay ordinary income tax on the REIT distributions to them.
Bringing an electric transmission REIT to fruition will surely require careful planning and coordination between a selling utility’s tax planners and the Internal Revenue Service. In order to qualify as a pass-through entity, a REIT must satisfy a number of highly technical and complex requirements of the Internal Revenue Code, including permissible types of business organization; type of management; limitations on ownership; 75 percent of investment must be in real estate; and 90 percent of its taxable income must be distributed in dividends to shareholders.
The minimum investment in real estate should be easily achieved since the IRS already has instructed that real property or an interest in real property extends to inherently permanent structures on land, including cellular “transmitting and receiving towers,” “air rights” above real property, and a liquids pipeline system leased to a third party. Further, revenues from sales of transmission could easily be distributed to satisfy the 90 percent requirement. While this might deter growth-oriented investors, it would make a transmission REIT attractive to earnings-oriented investors, similar to an annuity.
To recapitulate, the key to achieving the federal regulatory goal of an independently owned and operated high voltage transmission grid, free of any incentive to discriminate unduly among customers, may lie in a nearly 50-year-old federal tax designation. A transmission REIT, although a work in progress, shows real promise as a vehicle for investing in a business whose assets are primarily real estate-right-of-way real estate and inherently permanent structures of towers, poles and control devices attached to that real estate-and offers a path forward, around capital gains tax exposure, at favorable going-forward tax rates for investors.
Dan Watkiss is a partner with Bracewell & Giuliani in Washington, D.C., representing power companies, exploration and production and mid-market companies, natural gas pipelines, power and liquefied natural gas project developers and lenders, as well as government agencies and regulators. Contact him at Dan.Watkiss@bracewellgiuliani.com.