Windstream Holdings, Inc. recently announced plans to spin off its copper, fiber and other fixed real estate assets into an independent publicly traded real estate investment trust (REIT). Windstream received a private letter ruling from the IRS confirming the tax-free nature of the spin-off and the qualification of the network assets as real property for REIT purposes. The transaction will reportedly save about $100 million per year in income taxes and allow Windstream to decrease its debt significantly. This strategy of increasing available cash flow by reducing U.S. federal corporate income taxes (at 35%, among the highest tax rates for industrialized nations) and reducing leverage should be of great interest to communications companies that own or plan to deploy such assets.
REITs are tax-favored entities that were created by Congress to allow mutual fund-type investment in income producing real estate. REITs are generally not taxable on income they pay out as dividends. They are popular because investors who cannot otherwise afford to invest in real estate on their own can do so by owning shares of a REIT. According to the National Association of Real Estate Investment Trusts as reported in The Wall Street Journal, in 1971, there were just 34 REITs with a market value of approximately $1.5 billion; today there are over 200 worth $816 billion.
So how do we get from real estate to copper and fiber? The move from traditional real estate holdings for REITs began prior to the IRS clearance of Windstream’s spin-off. Iron Mountain, a storage company, and American Tower, a wireless tower company, received rulings from the IRS on the qualifying nature of their assets as real estate—steel racking structures and broadcast towers—which allowed them to convert to REITs. According to Steven Rosenthal, a senior fellow at the Tax Policy Center, copper and fiber can be considered real estate because they are income-earning assets that are stationary.
The implications of allowing copper and fiber network assets to be transferred to a REIT has the potential to be significant for communications companies on a number of levels, including cable companies, wireless carriers and facilities-based telecom carriers. Not only could the formation of a REIT reduce income taxes, but it may also permit companies to spread risk and raise capital. Moreover, although Windstream has announced that it will not transfer its IRUs into the REIT, it is not clear whether that issue was addressed in the private letter ruling. If IRUs were to be considered real property or interests in real property for REIT purposes, it is possible that could support the treatment of IRUs as property, rather than a service, for other purposes. If so, it could prevent IRUs from being viewed as executory agreements, which can be rejected in a bankruptcy.
For rate-of-return telecom carriers, the creation of a REIT and leasing the assets back to the company, as in the case of Windstream, would reduce capital if the lease is considered an operating lease, but increase expenses. As a result, the carrier’s actual rate-of-return could increase above its allowable rate-of-return. Moreover, it could be considered a transfer of control or an assignment, either of which would likely require regulatory approval.
So far, the reaction of the investment community has been somewhat mixed. On one hand, Windstream’s stock increased by 12% on the news. In a research note, Timothy Horan at Oppenheimer wrote that "[we] believe this means that every network stock we cover is roughly 20% undervalued at this point, as they should be able to largely avoid paying taxes going forward." Other analysts, such as CitiBank and Moody’s, however, seem to view the move by Windstream as some type of foreboding and could weaken both Windstream and its REIT by spreading performance too thinly. At least one analyst has recommended selling Windstream because the REIT will cause Windstream to decrease its dividends. Others, somewhat curiously, state that it will not increase Windstream’s value and is nothing more than financial engineering.
And then there always is the potential of political fallout. At a time when some corporations are pushing back against the U.S. corporate income tax rate by relocating offshore, which some politicians have characterized as “un-American,” the creation of REITs to reduce taxes possibly could be viewed in the same light. Conversely, although the tactic could have an immediate effect of eroding the corporate tax base, it could, in the long run, increase productivity by freeing up much needed capital in the capital-intensive communications industry.
It is difficult to predict whether the REIT strategy is an isolated act or the beginning of a broader movement. At this point, some have speculated that smaller carriers will pursue REITs as a financing vehicle but that the larger carriers will not do so because the strategy falls outside their comfort zone, would be very complicated given their corporate structures and copper and fiber are not core to their operations.
REITs for copper, fiber, or other stationary communications assets may or may not be the answer, but they certainly are worthy of consideration.