As MLPs Test Limits, Trust Inertia

Just about every MLP investor has probably pondered at one time or another the possibility that some day Congress could revoke the preferential tax treatment MLPs enjoy. After all, something like that did happen in Canada.

A tax ruling in Canada in 1985 opened the door for the income trust structure, and by the early 2000s many corporations in Canada were converting to trusts. Similar to MLPs in the U.S., income trusts in Canada paid little or no corporate tax and distributed the bulk of their earnings to investors, who then paid taxes according to their individual income tax rates. Also similar to MLPs, because of the advantageous tax structure these trusts paid attractive dividends and traded at a premium to publicly traded corporations.  

But the popularity of these trusts became their undoing. The Canadian trusts had traditionally been concentrated in real estate and petroleum companies, but by the early 2000s telecommunications firms, airlines, and banks had all announced plans for trust structures.

In September 2005 the Canadian Department of Finance published a paper that estimated the trust structure had cost the government at least $300 million Canadian in lost revenue from the previous year. Shortly afterward, the agency announced a suspension to advance tax rulings on future trusts.

Then on Oct. 31, 2006, in what became known as the Halloween massacre, Canadian Finance Minister Jim Flaherty announced that trusts would be taxed in the future at the same rate as corporations. The reason cited was that too many big companies were converting to trusts, which was now costing the government an estimated $500 million a year in lost revenue. Overnight the market value of most trusts fell by double digits, and most had to sharply cut dividends.

Canada’s decision to tax these income trusts as corporations is sometimes cited as a potential risk for MLP investors in the U.S. I this this is unlikely, as it would require the law to be changed and many in Congress are strongly supportive of the current MLP structure. However, each time the MLP treatment expands into a new niche, it makes me wonder whether the U.S. government will eventually take action.

The rules for publicly traded partnerships were set forth in 1987 in Internal Revenue Code Section 7704. These rules state that at least 90 percent of an MLP’s income must come from qualified sources, such as real estate or natural resources. (Some financial businesses, notably the leading private equity firms, also qualify.) Section 613 of the tax code requires qualifying energy sources to be depletable resources or their derivatives such as crude oil, petroleum products, natural gas and coal. But over the past few years, case-by-case Internal Revenue Service rulings have expanded the range of activities qualifying for MLP treatment.

Last June Viper Energy Partners (NASDAQ: VNOM) became the first US-listed partnership to rely on oil and gas royalty payments for income. Then, in November, Landmark Infrastructure Partners (NASDAQ: LMRK) went public with a business that acquires, owns and manages real property interests in the wireless communications, outdoor advertising and renewable power generation industries. These property interests include cellular towers, rooftop wireless sites, billboards and wind turbines — another first for MLPs.

In October, Enviva Partners (EVA) filed initial paperwork to raise $100 million for an MLP based on the sale of wood pellets. According to the S-1 filing with the Securities and Exchange Commission (SEC) that was updated earlier this month, the partnership will own five industrial-scale wood pellet plants. These plants have a combined production capacity of approximately 1.7 million metric tons of wood pellets per year, which is equivalent to nearly 19% of European market demand (the key market for wood pellets from the U.S.) in 2014.

Finally, in another first, ethanol maker Green Plains (NASDAQ: GPRE) announced in March that it filed a confidential draft registration with the SEC for an IPO of its downstream ethanol transportation and storage assets.  The S-1 filing proposes to raise $200 million to $250 million, with initial assets consisting of the company’s ethanol transportation and storage assets in 12 states through the Midwest and Southeast.

The company does not operate any ethanol pipelines, but leases a fleet of about 2,200 tank cars to transport ethanol, as well as 900 hopper cars to transport distiller’s grain, a byproduct of ethanol production used for livestock feed. Green Plains also owns eight fuel terminals with a throughput capacity of 822 million gallons per year. I don’t think this will open the floodgates for midstream ethanol MLPs, because quite frankly there isn’t a lot of midstream MLP infrastructure. But ethanol producers could potentially spin off other assets into MLPs.

In addition to these new niches, the MLP structure now covers partnerships involved in amusement parks, cemeteries, timber, and financial services. The proliferation of a similar shelter across industries was one of the reasons Canada ultimately acted, but the real catalyst was that very large companies were converting to trust structures to lower their tax bill. So, while the list of industries covered by an MLP structure continues to grow, unless a huge company like ExxonMobil (NYSE: XOM) opts to convert to an MLP (a remote and expensive option), the government may continue to allow MLPs to expand into new niches.  

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