by Dan Watkiss
The Internal Revenue Service issued a private letter ruling in June (PLR 200725015) stating that electric transmission and distribution systems are real estate assets that can be transferred into a real estate investment trust (REIT), a public corporation or trust that pools capital to acquire, develop or finance real estate and is subject to only one level of taxation. In late May, a U.S. Appeals Court upheld a policy of the Federal Energy Regulatory Commission allowing in public utility rates an income tax allowance for oil pipelines held in master limited partnerships that, like REITs, do not pay taxes in their own right but rather are taxed only on distributions to their partners.
These two events join to evoke opera divas, San Antonio sports broadcaster Dan Cook (paraphrasing Yogi Berra) and a piece I wrote for this magazine last autumn, “Open Grid Still Elusive,” to announce that a Fat Lady somewhere is exercising her vocal chords: The long wait for an independent and modern electric transmission (and even distribution) system may soon be over.
Before flinging myself into the cliff-hanger territory of tax policy and utility finance, let me reprise the central thesis of my earlier article. The capital gains tax on proceeds from the sale of very valuable, but largely depreciated, transmission systems loomed as the most formidable obstacle to achieving the near decade-old regulatory goal of a transmission grid that is independent of its users, both power suppliers and consumers. Leasing for a long term, as opposed to selling, those facilities into a tax pass-through entity such as a master limited partnership (MLP) or a REIT could navigate around the capital gains obstacle and, in fact, make the REIT a magnet for earnings-oriented investors, such as pension funds, insurance companies, mutual fund companies, banks and individual investors. The virtue of this structure is that, if successful, it could hasten the long sought-after independent grid. It could also make new sources of capital available for investment in transmission and distribution systems at a point in time when last century’s grid cries out for modernization into an expanded “smart grid.” When I penned my column last autumn, however, the success of a transmission REIT (not to mention a distribution REIT) was anything but assured.
But that was then. The IRS’s PLR and the Court’s approval of an income tax allowance for MLPs eliminates many of the what-ifs that caused me to caution in my earlier column that bringing a transmission REIT “to fruition will surely require careful planning and coordination between a selling utility’s tax planners and the Internal Revenue Service.” That coordination appears to be a fait accompli. The IRS has now ruled that not only transmission systems but significantly, also distribution systems serving end-use customers, are real estate assets that can be held in a REIT. (For certain categorical tax reasons, neither transmission nor distribution facilities are eligible currently for an MLP, so a REIT seems the ideal vehicle, at least for now.)
The IRS’s PLR also confirms that rents that the REIT earns from leasing transmission and distribution systems to an operator qualify as rents from real property that will be subject to only one level of taxation. And that one level of taxation on distributions that the REIT makes to shareholders-the REIT is required to distribute 90 percent of its taxable income-is assured recovery through FERC’s income tax allowance policy upheld in the recent U.S. Appeals Court decision.
Notwithstanding the avoidance of capital gains tax and the potential for favorable tax and rate treatment of earnings going forward, what utility owner of a transmission or distribution system (or both) would want to lease long-term these systems to a REIT? Who might be the first to take the plunge? You might also ask whether the utility’s local regulator would approve of this disposition, knowing that it would, at least in the case of the transmission system, transfer all regulatory jurisdiction to the FERC. (FERC currently does not exercise its jurisdiction to regulate transmission service that is bundled with retail sales service.)
While these are questions that must be addressed in the coming months, they must be addressed in the context of the investments that the industry needs to make in the near future. Cambridge Energy Research Associates recently projected that in the next decade and a half the industry will need to invest $150 billion in transmission systems and $300 billion in distribution systems. Outside of the transmission REIT and distribution REIT, it is questionable whether traditional sources of utility capital can cover this massive need.
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 Dan at Dan.Watkiss@bgllp.com.