Tax Planning in a Low Oil Price Environment

Transcription

1 Tax Planning in a Low Oil Price Environment 2016 TEI TAX SCHOOL John T. Bradford Liskow & Lewis James Chenoweth Baker Botts February 17, 2016

2 Partner Baker Bo s Houston James Chenoweth James Chenoweth counsels clients regarding tax efficient structuring of MLP energy transactions, including transactions involving MLPs, particularly IPOs and follow on offerings, as well as acquisitions and dispositions, taxable sales and the formation of joint ventures, particularly in the oil and gas upstream and midstream sectors. EDUCATION/HONORS JD, New York University School of Law 2004 LLM, New York University School of Law 2005 BA, University of Texas at Austin 2001 James represents clients regarding the funding, formation, transfer and acquisition of upstream drilling joint ventures in cash and carry transactions and similar arrangements forming tax partnerships in various shale plays, including the Eagle Ford, Utica, Three Forks, Marcellus and Niobrara. James has also represented taxpayers before the IRS (at Exam and in Appeals) and in litigation. His controversy experience extends to taxable sales and issues specific to the energy industry (including the tax treatment of drilling partnerships and tax issues specific to regulated utilities). BAKER BOTTS

3 John T. Bradford

4 Tax Planning in a Low Oil Price Environment Traditional tax planning Taxpayers plan to defer recognition of income and accelerate recognition of deductions Tax planning in a low oil price environment is traditional tax planning turned upside down Plan to accelerate income and defer deductions to avoid or minimize near term net operating losses Avoid domestic source loss but foreign source income for foreign tax credit purposes Copyright 2016 by John Bradford. All rights reserved. 4

5 Accelerating Recognition of Income Installment sales with election out of installment method treatment Transfer property in busted section 351 and 721 transactions that generate gain and refresh tax basis for the transferee for later years Sale of property to a related (but not tax consolidated) entity that generates gain and refreshes tax basis for the related entity for later years Prepaid forward transactions without Regulations section deferral Draw down on low cost LIFO layers Copyright 2016 by John Bradford. All rights reserved. 5

6 Deferring Recognition of Deductions Capitalize IDC to leasehold and claim cost depletion deductions Entity election Capitalize IDC pursuant to section 59(e) and amortize over 60 months Annual election Elect slower recovery method (e.g., straight line method or unitsof production method in Regulations section ) for new capital investment Entity election Do not elect section 179 expensing for new qualifying capital investment Annual election Capitalize and amortize research and experimental expenditures Entity election Copyright 2016 by John Bradford. All rights reserved. 6

7 Changing the Structure of Traditional Transactions In a low oil price environment, buyers typically have difficulty borrowing the required amounts for oil and gas property purchase and sale transactions Solution: Structure the transaction to include seller arranged limited recourse financing In a low oil price environment, sellers are reluctant to sell and want the opportunity to benefit from any future increases in oil and gas prices Solution: Structure the transaction to include a retained volumetric production payment that triggers at certain oil and gas price levels Consider the basis allocation rules for contingent payment sales OilCos shy away from production payment financing in low oil price environments for fear of near term oil and gas price increases Solution: Add structure to the production payment financing to retain upside for increases in oil and gas prices Copyright 2016 by John Bradford. All rights reserved. 7

8 Financing with Private Equity Traditional 1 OilCo Private Equity $100 Oil & Gas Properties 1 Common Units LLC $100 Cash 1 Preferred Units Oil & Gas Properties $100 Cash Cash Services or Property Vendors Traditional financing in a non taxable transaction with carryover basis to the LLC Contribution of property and cash in exchange for common and preferred units in LLC Common and preferred capital evenly split Structure of private equity s preferred units Preference on current cash distributions and on assets in liquidation Copyright 2016 by John Bradford. All rights reserved. 8

9 Financing with Private Equity Traditional 2 OilCo Private Equity $300 Oil & Gas Properties 1 Common Units and $150 Cash LLC $150 Cash 1 Preferred Units Oil & Gas Properties Vendors Traditional financing through a cash and carry partially taxable section 707 disguised sale Private equity contributes cash and is obligated to fund future development to a stated amount Cash from private equity is distributed to OilCo Partial gain recognition to OilCo but stepped up oil and gas property basis allocated to private equity Structure of Private Equity s preferred units Preference on current cash distributions and on assets in liquidation Cash 2 Services or Property Copyright 2016 by John Bradford. All rights reserved. 9

10 Financing with Private Equity Low Oil Price Environment Step 1 OilCo Private Equity $200 Cash $200 Cash Common Units LLC Preferred Units $400 Cash Step one the monetization vehicle is funded with cash in a nontaxable transaction Structure of Private Equity s preferred units Preference on current cash distributions and on assets in liquidation Private equity obligated to fund future development to stated amount Copyright 2016 by John Bradford. All rights reserved. 10

11 Financing with Private Equity Low Oil Price Environment Step 2 OilCo Private Equity OilCo Oil & Gas Properties $400 Cash LLC Oil & Gas Properties OilCo sells low basis oil and gas properties to the LLC in a fully taxable transaction OilCo maximizes amount of gain recognition to soak up NOLS Consider section 1239 limitations in certain ownership situations LLC takes full cost basis in oil and gas properties OilCo preserves its tax basis in the properties for future years while Private Equity is tax neutral Copyright 2016 by John Bradford. All rights reserved. 11

12 Selling Oil and Gas Properties Traditional Cash Cash Seller 2 Buyer 1 Lender Oil & Gas Properties Note & Mortgage Seller sells oil and gas properties to Buyer for cash Seller recognizes full section 1231 gain on the sale, subject to the section 1245 and section 1254 recapture rules Buyer arranges its own financing with its lenders Buyer takes a full cost basis in the acquired properties Copyright 2016 by John Bradford. All rights reserved. 12

13 Selling Oil and Gas Properties Low Oil Price Environment 1 Financial Institution VPP 1 Cash Seller Cash 2 Oil & Gas Properties Subject to VPP Buyer Seller carves out a volumetric production payment from its working interest and sells the VPP to a financial institution Sale of VPP for cash treated as a mortgage loan, with no taxable event to Seller VPP is a contingent payment debt instrument under section 1275, but has an issue price equal to the amount of cash received Seller then sells the working interest burdened by the VPP to Buyer Per Regulations section (d), Seller s amount realized includes the issue price of the VPP burdening the oil and gas properties and the cash received from Buyer Per Regulations section (d), Buyer takes full cost basis in the oil and gas properties equal to sum of the issue price of the VPP burdening the oil and gas properties and the cash paid to Seller Key to the structure of this transaction is that Seller has arranged financing on behalf of Buyer Copyright 2016 by John Bradford. All rights reserved. 13

14 Selling Oil and Gas Properties Low Oil Price Environment 2 Seller Retained Production Payment Cash Oil & Gas Properties Subject to Retained Production Payment Buyer Seller cuts down the deal size for Buyer by retaining a volumetric production payment payable from the oil and gas properties Seller has retained upside in the selling price with respect to the production attributable to the VPP should the price of oil and gas increase Seller can recognize all gain in year of sale by not electing installment sale treatment Amount realized equals the amount of cash received and the fair market value of the retained VPP Seller can recognize most but not all gain when electing installment sale treatment due to basis allocation rules for contingent payment sales Buyer obtains immediate tax basis for amount of cash paid and increases basis for the principal amount of each production payment made Buyer preserves tax basis for later years Copyright 2016 by John Bradford. All rights reserved. 14

15 Volumetric Production Payment Financing Traditional OilCo Cash Volumetric Production Payment Financial Institution VPP OilCo carves out a volumetric production payment from specified oil and gas properties and sells the VPP to a financial institution for cash Sale of VPP for cash treated as a mortgage loan, with no taxable event to Seller VPP is a contingent payment debt instrument under section 1275, but has an issue price equal to the amount of cash received OilCo recognizes depletable production income and interest expense as production payments are made to financial institution By selling the VPP for a fixed price, OilCo has given up the upside in the oil and gas production used to satisfy the VPP OilCo would have to enter into a fixed/floating swap arrangement to regain the upside Copyright 2016 by John Bradford. All rights reserved. 15

16 Volumetric Production Payment Financing Low Oil Price Environment OilCo VPP 2 Cash OilCo Property Cash Common 1 1 LLC VPP Property Financial Institution Preferred OilCo typically doesn t want to sell a volumetric production payment in a low oil price environment for fear the price of oil and gas used to satisfy the VPP will rise shortly after such a sale To retain the upside in future oil and gas productions used to satisfy the VPP, OilCo and Financial Institution first capitalize a new LLC OilCo contributes cash or property in exchange for the common units Financial Institution contributes cash in exchange for the preferred units Financial Institution s cash capital contribution is used to purchase the VPP Financial Institution is paid its preferred return on its preferred units Value of upside price realization on VPP volumes is retained by OilCo as owner of common units Copyright 2016 by John Bradford. All rights reserved. 16

17 Capital Structure Options In a low commodity price environment, OilCos are pressured to improve balance sheets and restructure debt Common techniques include Debt repurchase Debt for debt exchanges Debt for equity exchanges Issuances of preferred equity 17

18 Debt Repurchase $100 Note Tender OilCo Bondholders $60 Cash OilCo s debt starts to trade at a discount to reflect the increased risk that OilCo will default on its loan obligations as commodity prices fall. OilCo repurchases its debt at a discount. Cancellation of indebtedness income is recognized by OilCo to the extent the amount of the indebtedness ($100) exceeds the fair market value of the repurchase ($60). This cancellation of indebtedness income may be offset by NOLs or IDC deductions in the year of the exchange. 18

19 Debt for Debt Exchange $100 Note Tender OilCo Bondholders $100 Note with value of $60 New Notes OilCo s debt starts to trade at a discount to reflect the increased risk that OilCo will default on its loan obligations as commodity prices fall. OilCo issues New Notes in exchange for its old notes. Cancellation of indebtedness income is recognized by OilCo to the extent the amount of the indebtedness exceeds the fair market value of the New Notes ($60) if the New Notes are traded on an established market, or if untraded, the issue price of the New Notes, so long as the New Notes have adequate stated interest. Recent examples include Chesapeake (December 2015) and LINN (November 2015) 19

20 Debt for Equity Exchange Investors Debtholders Notes Common Preferred LLC Assets To clear up LLC s balance sheet, LLC issues preferred units to Debtholders. Cancellation of indebtedness income is recognized by LLC to the extent the amount of the indebtedness exceeds the fair market value of the equity interest. In a partnership, the liquidation value of the preferred can be used if certain other safe harbor requirements are met. Gain can be recognized to any investor whose allocable share of the reduced debt exceeds such investor s tax basis in LLC. 20

21 Preferred Stock and Unit Issuances Preferred equity issuances are another viable alternative to access capital in the low commodity environment In the MLP space, see Breitburn (May 2014), Vanguard (September 2014), and Targa (October 2015) Preferred distributions paid before common unit distributions as guaranteed payments Generally maintain a $25 capital account to ensure preference upon liquidation Kinder Morgan also issued 9.75% Series A Mandatory Preferred Stock (October 2015) 21

22 Contacts John T. Bradford Liskow & Lewis (713) James Chenoweth Baker Botts (713)

23 About This Presentation This presentation contains general information only and the authors/presenters are not, by means of this presentation, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This presentation is not a substitute for such professional advice or services, not should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. The authors/presenters shall not be responsible for any loss sustained by any person who relies on this presentation. Copyright 2016 by John Bradford. All rights reserved. 23