In late July, Windstream Holdings Inc. announced its plan to spin off certain telecommunications network assets (including its fiber and copper transmission facilities) through a newly formed real estate investment trust ("REIT"). This marks at least the fourth tax-free spin-off of a REIT ("REIT Spin-Off") in less than two years, and highlights an intriguing option for U.S. corporations with significant real estate assets.

This alert will first briefly describe the background and history of REIT Spin-Offs, then discuss some technical and practical issues that parties are likely to face in such transactions.

BACKGROUND OF REIT SPIN-OFFS

A REIT generally is not subject to corporate-level tax on income distributed to its shareholders, making it an attractive entity structure in which to own income-producing real estate. Depending on the circumstances, a REIT's tax-advantaged nature, among other things, can allow its stock to trade at a higher earnings multiple than a regular C-corporation. To qualify as a REIT, however, a corporation must meet a series of stringent requirements, including that at least 75 percent of its assets be cash items and "real estate assets" (the "REIT Asset Test"), and that at least 75 percent of its gross income be derived from real estate, such as rental income (the "REIT Income Test").

In the current genre of REIT Spin-Off transactions, generally:

  • An operating corporation that otherwise could not qualify as a REIT (the "OpCo") contributes its real estate assets into a subsidiary (the "PropCo");
  • OpCo then distributes PropCo shares to its shareholders in a tax-free spin-off for U.S. federal income tax purposes; and
  • PropCo then leases the real estate assets back to OpCo under a master lease. Typically, this would be a "triple net lease" under which the tenant (i.e., OpCo) is responsible for all maintenance, insurance, and taxes of the leased properties.

Structured properly, the rent payments made by OpCo under the master lease would be deductible by OpCo, but exempt from corporate-level tax in the hands of PropCo (assuming all REIT taxable income is distributed to its shareholders). For this reason, the possibility of a REIT Spin-Off is an exciting development for companies that have significant real estate assets but could not otherwise qualify as a REIT, since it provides a potential way to unlock value in such assets by taking advantage of the tax-free spin-off rules.

HISTORY OF REIT SPIN-OFFS

REIT Spin-Offs by historical operating companies taxed as C-corporations are a recent phenomenon,1 even though it has been possible – at least theoretically – since 2001, when the IRS announced that a REIT could satisfy the "active business" test for purposes of a tax-free spin-off. 2

It wasn't until 2013 that the first of the modern REIT Spin-Offs took place, when Penn National Gaming, Inc. spun off its casino-related real estate assets through a newly formed REIT. It was also the first time that the Internal Revenue Service ("IRS") issued a ruling formally approving a REIT Spin-Off.3

In the same year, CBS Corp. announced the tax-free spin-off of its outdoor advertising subsidiary, CBS Outdoor. The ruling issued to CBS is generally believed to be Private Letter Ruling 201411002.4 Although the ruling does not discuss the qualification of CBS Outdoor as a REIT following the spin-off, CBS Corp. has stated that it has received a separate IRS ruling approving CBS Outdoor's REIT status.5

Also in 2013, The Ensign Group, Inc., a provider of skilled nursing and rehabilitative care services, announced the tax-free spin-off of its real estate business through a newly formed subsidiary, CareTrust REIT, Inc., which will elect to be treated as a REIT.6

The proposed spin-off by Windstream Holdings Inc. would be at least the fourth REIT Spin-Off by an operating corporation in two years, and at least the fourth IRS ruling approving such transactions in the same period after over a decade of silence.7

POTENTIAL ISSUES OF REIT SPIN-OFFS

Despite the recent successes, parties looking to carry out a REIT Spin-Off generally face many significant challenges. The interaction of the tax-free spin-off rules and the REIT requirements, for example, creates a myriad of thorny issues. These include:

  • Business Purpose: A spin-off generally must have a non-tax related business purpose to qualify for tax-free treatment. Depending on the situation, this might be, for example, the REIT's better access to broader capital sources.
  • Active Business: Following the spin-off, the controlled corporation in a tax-free spin-off generally must conduct an active business that was historically conducted by the OpCo group. In the case of a REIT Spin-Off, the PropCo might not satisfy this requirement as the lessor under a "triple net lease." Thus, OpCo generally must contribute additional operating assets to PropCo as part of the spin-off. These operating assets generally could be held by one or more "taxable REIT subsidiaries" ("TRSs") of PropCo to avoid jeopardizing PropCo's REIT status, although the TRSs would be subject to corporate-level tax on their income.
  • Qualifying REIT Assets: Although recent guidance by the IRS confirms that assets such as outdoor advertising displays and certain components of solar generation facilities could constitute "real estate assets" for purpose of the REIT Asset Test, uncertainties remain as to the qualification of other non-traditional real properties (e.g., those held by companies in the technology sector).
  • Qualifying Rental Income: For purpose of the REIT Income Test, rents received from certain related parties are excluded. Generally this means a single shareholder cannot own (taking into account applicable attribution rules) 10 percent or more of both OpCo and PropCo.
  • E&P "Purging" Distribution: PropCo generally must make an earnings and profits ("E&P") "purging" distribution to its shareholders before it can qualify as a REIT. This "purging" distribution generally is taxable to the shareholders. To the extent a significant amount of E&P is apportioned to PropCo in the spin-off, PropCo shareholders would receive a large taxable "purging" distribution, which reduces the overall tax appeal of the spin-off.8

These issues are compounded by the fact that since August 2013, the IRS no longer provides rulings approving an entire tax-free spin-off transaction. The IRS will still rule on "significant issues" with respect to such transactions, though it is unclear to what extent it considers the above issues (and others) "significant."

A REIT Spin-Off also implicates various non-tax related issues. The terms of the master lease, for example, could be important to OpCos that want to retain a level of control over the real estate assets transferred to PropCo. In addition, the newly formed PropCo might have insufficient liquidity to make the "purging" distribution described above.

Finally, the REIT Spin-Off could be the subject of legislative change. For example, under the tax reform proposals submitted by House Ways and Means Committee Chair Dave Camp (R.-Mich.) earlier this year, many short-lived properties would not qualify as "real estate assets," all transfers of assets into a REIT would be immediately taxable, and spin-offs involving a REIT would not qualify for tax-free treatment. If enacted, these changes could significantly reduce the attractiveness of REIT Spin-Offs.

LOOKING AHEAD

We can expect many large U.S. corporations with substantial real estate to consider whether a REIT Spin-Off, or some variant thereof, is appropriate for their business. Companies, particularly those with significant non-traditional real properties (such as those in the technology, telecommunications, or utility sector), may take a new look at this strategy as the IRS continues to expand the range of "real estate" assets that can be held by a REIT. Moreover, the new focus on REIT Spin-Offs may be part of a larger trend in which corporate taxpayers are trying to carve out from corporate solution a wide variety of assets and businesses that Congress permits to operate in pass-through form, such as REITs and master limited partnerships ("MLPs").9 Although given the many uncertainties (particularly as applied outside of traditional REIT sectors), it remains to be seen whether REIT Spin-Offs will in fact be a viable option for sufficient companies for this apparent trend to continue.

Footnotes

1 The closest iterations were spin-offs in which a company separated its real estate assets, then transferred them to an acquiring corporation in a reverse Morris Trust transaction (e.g., the Georgia-Pacific / Plum Creek Timber transaction in 2001).

2 Revenue Ruling 2001-29, 2001-1 C.B. 1348.

3 The ruling issued to Penn National Gaming is generally believed to be Private Letter Ruling 201337007 (09/13/2013).

4 03/14/2014.

5 The ruling is believed to be Private Letter Ruling 201431020 (08/01/2014).

6 Although Ensign stated that it has received a favorable IRS ruling with respect to the spin-off, it did not receive a ruling with respect to the qualification of CareTrust REIT, Inc. as a REIT, and instead relied on the opinion of its tax counsel.

7 Windstream Holdings Inc. stated that it has received a favorable IRS ruling with respect to the proposed transactions.

8 This could also be structured as a part cash, part stock distribution. See, e.g., Private Letter Ruling 200850022 (12/12/2008).

9 Of course, the recent consolidation of MLPs announced by Kinder Morgan Inc. bucks that trend.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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