TAX CONSIDERATIONS FOR MLPS
SCOTT MAGZEN, TODD CRAWFORD, TED MCELROY, AND JASON SPANN, DELOITTE, HOUSTON
THE PLUNGE in commodity prices since 2014 continues to roil the oil and gas industry, with oilfield services and upstream companies taking much of the pain so far. The upstream sector experienced a 50% drop in revenues in less than a year. In the 18 months ending Dec. 31, 2015, 35 US E&Ps, including some long-established companies, filed for bankruptcy protection through liquidation or debt restructuring. Other operators, less distressed but vulnerable, are focusing on reducing capital and operating expenses.
As more E&P companies file for bankruptcy protection, midstream companies, including master limited partnerships (MLPs), could be impacted. In the early months of the price downturn, midstream operators were somewhat insulated from the turmoil in the upstream sector. Now, though, the continuing low-price environment is increasing the number of producers asking to renegotiate contracts, paying to terminate transportation arrangements, or even petitioning the courts to cancel transportation contracts as cost-saving measures. For some midstream MLPs, revenues based on volume commitment could be at risk. Meanwhile, MLPs that have anticipated capacity expansion projects to continue growing their revenue base, and by extension distributions, have seen their infrastructure needs slow significantly.
Midstream companies pioneered the use of MLPs. Rockies Express Pipeline (Kinder Morgan photo).
Are the conditions that are leading upstream companies to cut costs and delay capital projects-or even restructure debt or liquidate-coming to the midstream sector? While it may be too soon to tell, survival is nonetheless a key theme in 2016, with companies trying to conserve cash and hoping for a possible rebound in the 2017-18 timeframe.
As midstream MLPs consider strategies for weathering today's turbulent conditions, a valuable aspect of their deliberation can be exploring the tax implications of various options-some of which, like cancellation of debt situations described below, could come as a surprise to their investors-and other potential tax developments that could come into play. Also, in considering potential avenues, MLPs can employ analytics tools now available to help them gain a clearer view of their tax basis in certain assets.
The MLP outlook
MLP structures have become most prevalent in the US midstream sector. They are designed to be tax efficient for investors, in that free cash flow is distributed and the tax burden is borne by the investor at a lower effective rate than would be the case for a traditional corporate entity.
An MLP's attractiveness to investors depends to a large extent on maintaining and growing cash-flow distributions to shareholders. The distributions are often achieved through the drop-down of assets from the corporate parent or general partner of the MLP who has constructed the system and borne the development risk.
As noted earlier, renegotiation of contracts and termination of transportation arrangements are among ways producers are looking to cut costs. Midstream operators that are concentrated in a certain basin or have significant exposure to distressed producers could face heightened risk of terminations and contract renegotiations.
Pipeline transportation fees are likely to provide cash flows in the midstream sector over the near term, but continuing growth prospects have diminished with the slowdown in the upstream sector, particularly for field gathering and processing services that are directly tied to new drillings. In addition, both long-distance crude and product pipelines will need fewer capacity additions until oil prices recover and supply development takes off again.
Evaluating companies individually rather than with a broad brush is essential as they can differ widely in the make-up of their assets, where they sit geographically, and the nature and counterparties of their contracts. In assessing midstream MLPs prospects, investors are gauging the stability of cash flows and the associated contractual risks. An MLP whose primary counterparty is large and well-capitalized is less likely to be distressed than an independent midstream operator focused on a single basin.
MLP tax implications
Given the continuing stresses in the sector, some midstream MLPs may consider various strategic alternatives for strengthening their balance sheets, which can trigger tax considerations. Those options can include:
- Exchanging existing debt for new debt, buying back existing debt at a discount, or working with lenders to adjust existing debt balances
- Selling assets to service or pay down debt
- Issuing preferred equity or finding another financing source
- Exploring white knight scenarios and other M&A possibilities
- Selling the company outright
Regardless of which avenue an MLP operator may choose, tax implications can arise if debt becomes compromised or the partnership is unable to fully repay lenders. Importantly, the consequences of the chosen workout approach can differ substantially from those facing a corporation in a similar situation, something of which even more sophisticated CFOs may be unaware. This is notably the case with respect to income recognition in cancellation of debt (COD) situations.
Generally speaking, corporations undergoing some form of Title 11 reorganization can avail themselves of certain exclusions to income recognition due to COD, such as reduction of net operating loss carryforwards and basis of assets. However, such options are typically not available to MLPs because despite a Title 11 proceeding at the MLP, the ability to take advantage of these exclusions is determined at the partner, rather than the partnership, level. And, even when debt is not compromised, modifications to it can trigger COD income.
In either case, MLP investors may not anticipate what can happen next-substantial taxable income with no associated cash coming to them. Other strategic alternatives such as asset sales can also trigger income or capital gains that potentially create tax exposure for partners.
Tax considerations related to asset sales or M&A transactions can also be complex, from pre-transaction planning, modeling, and due diligence to post-transaction integration, compliance, and monitoring. For example, will the transaction be taxable vs. tax-free, asset vs. equity shares, or the carve-out of part of the business? Other important focus areas include tax history and attributes, state income taxes, and tax accounting methods.
IRS audit and financial statement reserves developments
The Bipartisan Budget Act of 2015 enacted last November includes significant rule changes for partnership Internal Revenue Service (IRS) audits and adjustments. The new rules are effective for returns filed for partnership taxable years beginning after December 31, 2017.
The act completely establishes a single set of partnership-level audit rules, effectively replacing the current Tax Equity and Fiscal Responsibility Act (TEFRA) procedural rules for partnership audits and adjustments, as well as the simplified electing large partnership (ELP) reporting regime. The new rules apply to all partnerships, subject to an option to elect out for certain partnerships with 100 or fewer partners. Under the new act, the partnership will pay the tax, interest, and penalties on underpayments.
The change has important implications for partnerships. Historically, the IRS has been challenged in its efforts to audit MLPs and large partnerships; any IRS-sought adjustments would have to flow out to potentially tens of thousands of investors and would require amended tax returns by each of those investors. How to do that and whether it was worth the effort was a consideration. The new rules will make it simpler and more viable for the IRS to audit MLPs and large partnerships.
New complexities related to income tax reserves in issuers' financial statements may also arise in today's environment. MLPs deal with requirements to analyze, account for, and disclose income tax risks under financial accounting and reporting standards. In light of the fact that an MLP could be obligated to make certain tax payments related to any IRS audit adjustments, it could be advisable to consider the financial accounting impact of the new rules and developments discussed here.
A vital role for analytics
As MLPs consider transactions they might undertake in today's environment, it can be helpful to carefully examine the tax basis in certain assets. For example, which assets might be the least productive but offer benefit if sold, written off, or abandoned?
Available data analytics tools can help MLP operators analyze the MLP's assets and focus on areas in which the tax basis is less favorable. MLP operators may find data analytics tools helpful in running scenario analyses and their planning around various stages of debt workouts and restructurings, providing insights into the impact of those options for partnerships and their partners. Analytics may also be helpful to identify deductions to offset income come from sources such as COD. In using analytics, it is important to keep in mind that each situation is unique, and the consultations of tax specialists can be highly valuable in the process.
Positioning for tomorrow
While the oil and gas industry has gone through its share of ups and downs through the years, the current environment represents an extreme swing, with prices at their lowest point in nearly a decade and a half. Some midstream MLPs are starting to feel some of the pain that has swept over their upstream counterparts, and recovery will take time. However the future plays out, MLP operators can benefit from considering the tax impacts of the options available to weather the downturn.
ABOUT THE AUTHORS
Scott Magzen is a partner with Deloitte Tax LLP in Houston and specializes in the oil and gas sector. Todd Crawford is the Tax Energy and Resources Industry Leader for Deloitte Tax LLP in Houston, where he works with clients in the power and utilities sector. Ted McElroy is a director and senior oil and gas industry leader with Deloitte Tax LLP in Houston. Jason Spann is a regional marketplace leader of M&A Transaction Services for Deloitte Tax LLP in Houston, specializing in energy transactions.
This article does not constitute tax, legal, or other advice from Deloitte, which assumes no responsibility regarding assessing or advising the reader about tax, legal, or other consequences arising from the reader's particular situation.
