Master limited partnerships

Master limited partnerships

March 03, 2006 | By Keith Martin in Washington, DC

Some project developers in the United States have been trying to reorganize recently as “master limited partnerships” in an effort to create more value in their companies. The move also gives them an acquisition vehicle that can afford to outbid other companies for existing assets.

Most income earned by corporations in the United States is taxed twice — once to the corporation and again to the shareholders when they receive the earnings in the form of dividends.

US and Canadian businesses have been searching for ownership structures that would subject their earnings to tax only once.

Many Canadian companies found a way to do this by converting to “income trusts.” Units are traded on the Toronto stock exchange, and such trusts now account for 10% of companies traded on the exchange by market capitalization. The Canadian government became concerned about the loss of tax revenue and put a halt last fall to any further advance tax rulings that such structures work until it could complete a study. However, the government came under pressure to make a decision in the run up to the January election after realizing that as many as 60% to 80% of Canadian retail investors, many of them senior citizens, hold interests in income trusts. In late November, the finance minister made a surprise announcement that the government would resume issuing advance tax rulings, not tax trusts and instead cut dividend taxes as a way to make corporations more competitive. The government lost the January election.

An equivalent structure in the United States is a “master limited partnership,” or “MLP.” MLPs are limited liability companies or partnerships whose interests are traded on a stock exchange or over-the-counter market. The United States usually taxes partnerships in which interests are publicly traded like corporations, but there are exceptions in the US tax code that let many oil, gas and timber companies operate as publicly-traded companies while being taxed like partnerships. A partnership does not pay income taxes; rather, its income is taxed directly to the partners that own it.

Companies that own wind farms, LNG regasification terminals, ethanol plants and hydroelectric projects, among other types of assets, have been asking in recent months whether they can use the same structure. Operating as a publicly-traded partnership not only eliminates one level of taxes, but it also lets the company raise equity at the higher multiples for shares in which there is a liquid market. These two advantages give MLPs higher after-tax returns and a lower cost of equity capital, making them not only good vehicles to own new projects but also good acquisition vehicles for rolling up existing assets.

There were 57 MLPs trading on the two main US stock exchanges and NASDAQ as of February 2006. Most involve energy assets. Estimates are that only 20% of eligible energy assets in the United States are held currently in MLPs. Even in the most advanced sector for current use of MLPs — oil and gas pipelines — MLP coverage extends to only 34% of existing assets. The market capitalization of energy MLPs more than doubled from 2002 through 2005, moving from $28.9 billion to $64.4 billion. Daily trading volume in energy MLP interests went from 88,300 shares to 128,600 during the same period. The two largest MLPs — Kinder Morgan and Enterprise Products Partners — have market capitalizations of more than $10 billion each. Another 20 MLPs have market capitalizations of more than $1 billion.

Eligible Income?

The key to qualifying as an MLP is to make sure that at least 90% of the gross income the MLP earns each year is considered eligible income. The types of eligible income are mostly various forms of passive income.

Examples are interest, dividends, rents from leasing out “real property” (as opposed to equipment), and gains from the sale of capital assets and real property. Congress said that, in general, it wanted MLPs to be used only by passive investors rather than to engage in real operating businesses. However, it made an exception that is at the core of most energy MLPs. The exception treats as eligible income

income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber).

The key is the MLP must do something to a “mineral or natural resource.”

Geothermal energy, fertilizer and timber are considered natural resources, but Congress said that “fishing, farming . . . [and] hydroelectric, solar, wind, or nuclear power production” are not activities that deal in minerals or natural resources. Inexhaustible resources, even if natural resources, do not qualify. Examples of inexhaustible resources are soil, sod, turf, water, air and minerals from sea water.

Thus, wind farms, solar power plants and hydroelectric projects are generally not suitable assets for MLPs. It may be possible for an MLP to own a hydroelectric project, but lease it to someone else and receive earnings from the project in the form of real property rents. Most other power projects are not considered “real property.” Internal Revenue Service officials have left open the possibility that a hydroelectric plant is such property. The rents could be tied to gross receipts from electricity sales, but not to profits. The lessee could not have an ownership interest in the MLP.

Landfill gas projects are not suitable for MLPs because gas from decomposing garbage is not considered a “natural” resource.

The US tax authorities have not addressed whether power plants that convert fossil fuels into electricity are suitable assets. Such plants arguably process coal, gas or oil by converting it into electricity. However, while energy MLPs that process oil and gas clearly qualify, IRS regulations draw a line at downstream processing from the point where the product is no longer recognizable as oil or gas. Thus, refining oil or gas to produce butane, propane or diesel fuel is a suitable MLP activity, but not further processing to make plastics. The IRS has also not addressed whether transmission lines that transport electricity made from burning fossil

fuels are suitable assets. Income from transporting processed products of minerals or natural resources is good income, but not from the last stage of transportation to retail customers. IRS regulations make clear that a utility buying natural gas to fuel its power plants is not considered a retail customer.

Most existing MLPs involve oil and gas pipelines, gas storage facilities, non-producing interests in oil and gas properties, ships for transporting oil and liquefied natural gas, fertilizer factories, timber land, lumber mills and factories that make wood products, interests in coal mines and commercial real estate properties. The assets do not have to be in the United States. MLPs have also been used to roll up lots of small propane distributors. The IRS has issued a series of private letter rulings that shed additional light on what kinds of businesses may be engaged in by MLPs.

An MLP may own an aluminum smelter that buys alumina made from bauxite from other companies and turns it into aluminum.

Fees that blenders earn from mixing ethanol or biodiesel with petroleum fuels and fees earned by pipeline operators are good income. However, fees earned arranging oil or gas hedges for third parties are not from an eligible activity. At least 90% of the gross income the MLP earns each year must be eligible income. Losses are ignored in doing this calculation. The MLP adds up all of its income from all sources during the year and tests whether at least 90% of it is eligible income. Once the MLP fails this 90% test in a year, then it loses its status permanently as an MLP, unless the failure to qualify was inadvertent and the MLP takes steps within a reasonable time after learning of the problem to correct it. The MLP will also have to pay a tax charge to put it in the same position as if it had been taxed like a corporation during the period it failed the 90% test. Congress said the IRS can refuse to accept screw ups as inadvertent if they occur in each of “several successive years, or in several years within a longer period.” A footnote in a Congressional committee report suggests that there should be a three consecutive-year limit on relief. Congress said action within one year after discovery to correct a problem is “within a reasonable time,” unless the IRS says otherwise in regulations.

Practical Considerations

Many MLPs are organized as two-tier businesses. A holding company owns interests in operating companies. The reason for this is archaic statutes in some states where there are operating businesses that require the names and addresses of all the limited partners be filed with state authorities. Trading is limited to interests in the parent holding company.

In most MLPs, the general partner or managing member takes an increasing share of cash distributions as an incentive to try to increase the annual distributions per unit. Thus, for example, a general partner might receive a 2% share of the first dollar in cash distributed per unit, increasing to 15% of the next dollar, 25% of the next dollar, and 50% of annual distributions above $3 a unit. General partners have an incentive to increase cash distributions until the company is operating in the “high splits” tier.

MLPs have not traditionally tried to raise capital from pension plans and other tax-exempt investors or from retail investors investing through mutual funds. The problem mutual funds faced is that MLP income was not among the kinds of “qualifying income” that a mutual fund can earn and retain its tax status. This changed in the JOBS Act in October 2004, with the result that more mutual fund money is expected to flow into MLPs. A mutual fund may still not invest more than 25% of its total assets in MLPs and more than 10% of assets in a single MLP.

The problem pension plans and other tax-exempt investors face is that their income from energy MLPs that are real operating businesses is classified as “unrelated business taxable income” — it is not related to their tax-exempt missions. Such investors can earn passive income without problems, but they must pay income taxes on any active income from operating businesses or else they could compete against private-sector companies and have a competitive advantage because their earnings go untaxed. Active income from an energy MLP retains its character as active income as it passes through the MLP.

Only about 10% of money invested in MLPs is from institutional investors. Another deterrent to such investors is the potential need to file state income tax returns in states where the MLPs are doing business. Two large MLPs — Kinder Morgan and Enbridge Energy — have attempted to deal with this problem by allowing pension funds and other institutional investors to invest through special “i-units.”The holders of the i-units are not allocated any taxable income or loss by the MLP, and distributions to them are in the form of additional units rather than cash. Such investors earn their returns by selling their units.

Since MLPs are transparent for tax purposes, any depreciation, depletion and other tax losses pass through to the investors. MLPs that are growing through acquisitions typically have lots of tax write offs that provide shelter against income taxes. The tax shield in the case of most energy MLPs is on the order of 80 to 90%. In other words, the taxable income reported each year by investors is only 10% to 20% of the cash distributed. The tax shield is “recaptured” at ordinary income tax rates later when the investor sells his or her interest. Gain from the sale of units is recharacterized as ordinary income to the extent of the depreciation and depletion from which the investor benefited earlier. The combination of transparent tax treatment and public trading of units gives MLPs a much lower cost of equity capital than corporations with whom they might compete.

However, the cost advantage erodes somewhat over time as the MLP moves toward the “high splits” on sharing cash with the general partner.

One problem that regulated businesses face when operating as MLPs is the inability to pass through taxes to ratepayers when the taxes are imposed one tier up on the owners rather than on the business directly.

However, the Federal Energy Regulatory Commission directed in 2005 that partnerships that own regulated businesses should be able to pass through taxes that are imposed on the partners. The partnership must calculate the average income tax rate of all the partners. The FERC order has direct application only to businesses whose rates are set by the federal government. Retail utility businesses tend to be subject to state rate regulation. Electric transmission, interstate gas transportation and wholesale electric and gas sales are subject to federal regulation.

Publicly Traded?

The IRS has a fairly technical definition of what it means to be publicly traded. Thus, a company worried about whether at least 90% of its gross income each year will be eligible income might focus instead on ensuring that ownership interests in the company are not considered “publicly traded.” It is possible to allow some trading of the interests without causing the company to be taxed like a corporation. The interests could not be listed on a stock exchange or NASDAQ.

Restricting trading may not be a satisfactory approach since the company will not benefit fully from the higher multiples for publicly-traded shares.

Thus, knowledge of the rules in this area is probably more useful to ensure that a limited liability company or partnership does not become taxed like a corporation inadvertently due to limited trading in its shares.

In general, shares are considered publicly traded if they are listed on a stock exchange or are “readily tradable on a secondary market (or the substantial equivalent thereof).” Congress said shares are not be considered “readily tradable” on a secondary market unless the share prices are regularly quoted by someone who is making a market in the shares.

Also, the time frame to complete a trade must be comparable to trading on an established exchange. Thus, interests are not readily tradable where one can find a quote on a computer system, but the interests cannot be sold within the same time frame as on an over-the-counter market. The LLC or partnership must also facilitate the trading. It must have listed the shares or at least accept investors who buy shares as new partners for the shares to be considered publicly traded.

Share redemption or repurchase plans are potentially a problem. These are arrangements where the partnership stands ready to buy back interests from any partner who wants out.“Closed-end” redemption plans are okay. That is where a partnership may buy back shares but does not issue any new ones after the initial offering. Alternatively, it is okay if the MLP makes partners trying to cash out wait at least 60 days after giving notice. The redemption price must be set at the time of redemption or on no more than four dates during the year, and no more than 10% of partnership profits or capital interests can be transferred during the year.

The fact that LLC or partnership interests are sold in a private placement is not a problem, as long as the company will not have more than 100 partners.