Tax issues can unexpectedly complicate mezzanine financings

Lance W. Behnke, Bracewell & Giuliani LLP, Seattle
Alexander W. Jones, Bracewell & Giuliani LLP, New York

Recent shale plays have caused increased resource exploration and generated significant demand for alternative forms of capital to finance development and production activities. Project developers seeking capital typically do not want to dilute their equity interest in an oil and gas project, but lack established production to attract traditional bank financing. As a result, project developers often seek mezzanine financing to fund a portion of their exploration and development costs.

Mezzanine finance functions as an intermediate source of capital for a project and involves a lender assuming more risk than first or second lien debt. Mezzanine finance can take various forms, but oil and gas mezzanine finance usually involves an "investment unit" comprised of two items: a debt component and an "equity kicker" component. Typically, the debt component will include a fixed or increasing interest rate paid partially in cash and the remainder accrues pursuant to a payment-in kind feature. The equity kicker component could provide a lender with an equity interest in the project company, but often the borrower will grant the lender an overriding royalty interest (ORRI) or net profits interest (NPI) in its mineral properties. An ORRI or NPI generally is a non-operating interest in such mineral properties that entitles the lender to a fixed or variable share of the production from the issuer's financed mineral properties over the life of the property.

Oil and gas mezzanine financings can involve multiple tax complexities that a lender and the issuer of the debt instrument must consider in connection with the transaction's structure. Initially, the tax law will require the parties to apportion the loan proceeds between the debt component and the equity kicker component. The portion allocated to the equity kicker typically equals the fair market value of the property issued as the kicker. This value becomes the lender's tax basis in the equity kicker. The remaining loan proceeds will be allocated to the debt component and will be treated as the "issue price" of the loan. The tax rules will characterize the difference between the stated principal amount of the loan and its issue price as original issue discount (OID). A lender will be required to include such OID in income over the term of the loan without the corresponding receipt of a cash payment and the issuer will have additional interest expense deductions.

If the equity kicker issued to a lender is an ORRI or NPI, the lender will recognize ordinary royalty income from the ORRI or NPI over the life of the interest and may claim depletion deductions equal to the portion of its tax basis in the ORRI or NPI attributable to the production. If the lender holds the ORRI or NPI as a capital asset, its gain from the sale of such interest will be capital gain, subject to the federal income tax code's recapture rules. These recapture rules require the lender to treat a portion of the capital gain as ordinary income up to the amount of certain drilling costs and depletion deductions it previously took into account with respect to the property. A foreign lender or holder of the ORRI or NPI will be subject to US withholding tax upon the disposition of its ORRI or NPI.

In some instances, a lender will receive a "variable" ORRI or NPI. That is, the fixed percentage of production that the lender receives will vary over time, depending on the production generated by the mineral property or pursuant to the agreement among the parties. The portion of the ORRI or NPI that exceeds the minimum fixed percentage of production that the lender will receive over the life of the mineral property is characterized, for tax purposes, as a production payment. The tax rules generally treat a production payment as a separate nonrecourse mortgage loan that generates cash flow comprised of taxable interest payments and the nontaxable return of principal (instead of depletion). Production payments are subject to the contingent payment debt instrument (CPDI) rules contained in the federal tax code. Pursuant to those rules, in order to calculate the lender's interest income and the issuer's interest expense, the parties must compute a complex projected payment schedule based on the yield the issuer would pay on a fixed rate debt instrument that it issued with terms similar to the production payment. A portion of each payment reflected on such schedule related to the production payment will be treated as a repayment of principal and the remaining portion will be ordinary interest income. If the lender disposes of the production payment, the gain derived from the sale may be characterized as ordinary income. A foreign lender could be subject to U.S. withholding tax.

If the issuer grants an ORRI or NPI not treated as a production payment, the issuer will need to determine whether the portion of the loan proceeds allocated to such interest subjects it to taxation. If the issuer does not pledge to use the proceeds allocated to the NPI or ORRI in connection with the development of the burdened oil and gas properties, the issuer will recognize taxable gain equal to the difference between its tax basis in the conveyed mineral interest and the proceeds allocated to the mineral interest. However, in a mezzanine financing the issuer will typically use all of the loan proceeds to fund development and production activities relating to the burdened property. If the loan proceeds allocated to the ORRI or NPI will be used for such activities, the proceeds generally are not taxable to the issuer pursuant to the "pool of capital" doctrine. The pool of capital doctrine generally treats the exchange of cash used to develop a mineral property for an interest in the property as a nontaxable transaction. If the loan proceeds will be used for mineral development or production activities, the issuer should include a statement in the financing documents that the loan proceeds will be used for such purposes to ensure it can qualify for pool of capital treatment.

An issuer must then consider whether it is required to capitalize rather than deduct when paid the interest expense associated with the loan. Loan proceeds used for exploration and development purposes by an issuer may be subject to the capitalization rules contained in the federal income tax code. To the extent the loan proceeds can be traced to the development of an oil and gas property, the issuer will generally be required to capitalize the interest expense associated with the loan. Rather than deducting this interest when it is paid, the issuer will amortize the capitalized interest over the "production period" of the applicable property. The production period applicable to each onshore oil and gas property commences when physical site preparation begins and ends when the property is placed into service or commercial production begins.

An issuer must also review the amount of OID associated with the loan. OID on a mezzanine loan is generated in two ways: (i) OID will accrue based on the difference between the issue price of the loan and its stated principal amount and (ii) from interest that is paid-in-kind. Interest that is paid-in-kind generally is treated for tax purposes as increasing the stated principal of the loan and is taken into account as OID over the remaining term of the loan. In addition, the rules pertaining to applicable high yield discount obligations (AHYDO) may apply if the loan will (i) have a tenor of more than five years, (ii) have a yield to maturity equal to or greater than the applicable federal rate (AFR) at the time of issuance plus 500 basis points, (iii) be issued by an entity classified as a corporation for tax purposes or a partnership that has a corporate partner, and (v) has "significant" OID. The determination of whether debt is subject to AHYDO is made upon issuance and then again upon each accrual period after the fifth anniversary of the issuance of the debt. A loan usually has significant OID for purposes of the AHYDO rules if at the end of any accrual period ending after the fifth anniversary of the issuance of the debt, there is more than one year's worth of accrued but not yet paid interest on the loan. If the loan is subject to AHYDO, the issuer cannot deduct the interest expense on the loan until the interest is paid in cash and the "disqualified portion" of the interest expense associated with the loan is permanently disallowed. The disqualified portion generally will be the portion of the interest on such loan that represents yield in excess of 6 percent plus the AFR in effect for the month the loan is issued.

A mezzanine loan often contains an "excess cash flow sweep" mechanic that obligates the issuer to prepay principal on the loan if it has an agreed amount of cash that is not being used in connection with its operations available during the term of the loan. When the loan is issued with OID and the issuer's financial model projects that it will make regular payments of excess cash flow on the loan, the yield associated with the loan could vary. If such yield variation is not based on LIBOR or a similar benchmark, the loan could be subject to the CPDI rules. Thus, when payments of excess cash flow are expected to be made on the mezzanine loan, the parties must evaluate whether the loan is treated as a fixed rate debt instrument subject to timing contingencies or a CPDI. If the loan is treated as subject to a timing contingency, the issuer will recompute the OID schedule applicable to the loan upon each excess cash flow payment. If the loan is instead characterized as a CPDI, the parties must compute a projected payment schedule, which could alter the timing of the issuer's interest expense deductions and the lender's receipt of interest income.

Oil and gas mezzanine financings can create unexpected tax complexities that affect both the lender and issuer's anticipated economics. Each of the various alternative equity kicker structures generates its own unique tax considerations. Both the lender and the issuer must evaluate the lender's receipt of an ORRI or NPI; the parties are often surprised that a portion of the ORRI or NPI could be treated for tax purposes as additional debt of the issuer subject to complex tax reporting requirements, which could significantly alter the economics of the transaction. The issuer must determine whether it will be required to calculate and provide the lender with an OID schedule and examine its use of the loan proceeds to conclude whether it will be required to capitalize a portion of the interest expense on the loan. If the capitalization of interest expense rules or the AHYDO rules apply to the loan, the issuer's ability to utilize interest expense deductions to offset taxable income derived from production will be deferred or possibly eliminated which may have a significant impact on the issuer's financial model. Thus, in connection with a mezzanine financing, the parties must consider the tax consequences of the financing as they enter into a transaction and confirm that the tax characterization of the transaction is consistent with their expectations of the deal.

About the Authors

Lance W. Behnke is a partner in the Seattle office of Bracewell & Giuliani LLP, and Alexander W. Jones is counsel in Bracewell's New York office. Their practice focuses on federal and state tax issues relevant to both global and U.S. clients, including major public corporations, oil and gas companies, private investment funds, and individuals. They are members of the firm's tax practice.