On December 20, 2017, the United States Congress passed legislation known as the Tax Cuts and Jobs Act (the Tax Act), the first comprehensive reform of the U.S. tax code since 1986. The legislation is expected to be signed by President Trump and enacted into law. The changes will be effective for taxable years beginning after December 31, 2017, unless otherwise noted below.
The following summary analyzes certain aspects of the Tax Act likely to affect the energy industry, particularly publicly traded partnerships or master limited partnerships (MLPs).
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Publicly Traded Partnerships or Master Limited Partnerships
- Partnership Status Preserved. The Tax Act does not eliminate or modify the “qualifying income exception” under Internal Revenue Code § 7704 that allows certain MLPs to be treated as partnerships for federal income tax purposes. Thus, MLPs will retain their tax-advantaged status, and income earned by an MLP will continue to be passed through to its owners without being subject to an entity-level federal income tax.
- Reduced Rate for MLP Income. For taxable years beginning before January 1, 2026, the Tax Act provides for a lower effective tax rate on certain pass-through income. Specifically, non-corporate owners of MLPs may take a deduction equal to 20 percent of the sum of (i) such taxpayer’s allocable share of domestic income from an MLP; plus (ii) gain recognized upon the sale of an interest in an MLP that would otherwise be taxed as ordinary income. The deduction in respect of MLP income is not subject to phase-outs or limitations resulting in a maximum effective income tax rate of 29.6 percent on MLP income.1
- Reduced Corporate Tax Rates. The Tax Act permanently reduces the corporate tax rate to a flat 21 percent (down from a maximum of 35 percent currently). After taking into account the tax on qualified dividends, the effective tax rate on income earned through corporations is approximately 36.8 percent.2 Thus, MLPs continue to be more tax-efficient vehicles than corporations.
The reduced maximum individual tax rate and the deduction for pass-through income are scheduled to expire after 2025. Thus, unless these provisions are extended, after 2025, the effective tax rate on pass-through income will be slightly higher than the effective tax rate on C corporation income. - Tax on Gain on Sale of Partnership Interest. For sales or exchanges occurring on or after November 27, 2017, gain recognized by a foreign person on the sale of an interest in an MLP that is engaged in a U.S. trade or business will be treated as effectively connected income and subject to U.S. federal income tax.
Additionally, effective for sales or exchanges occurring after December 31, 2017, the transferee of such an interest is required to withhold 10 percent of the amount realized by the transferor unless the transferor certifies that it is not a foreign person. In the event the transferee of such partnership interest fails to withhold, the partnership is responsible for the withholding tax. The explanation to the Tax Act indicates that the IRS may provide guidance permitting brokers to withhold where foreign partners sell MLP units through a broker.
The Treasury Department and the IRS issued Notice 2018-08 suspending all withholding obligations on the sale or disposition of publicly traded MLP units pending further guidance. The Notice was issued in response to comments made to Treasury regarding the significant practical problems with the new withholding requirements in the context of MLPs, including (i) the inability of a buyer/transferee of an MLP unit to identify the seller/transferor; (ii) the uncertainty as to whether any portion of the seller’s gain is effectively connected income and subject to withholding; and (iii) complications in determining the amount realized on the sale taking into account the allocation of partnership liabilities. The Notice indicates that forthcoming guidance will be prospective (i.e., no retroactive withholding) and will include transition rules that are intended to allow sufficient time to prepare for implementation of the rules. - Repeal of Technical Terminations. The Tax Act permanently repeals the partnership technical termination rule. MLPs will no longer have to track public trading of units to determine whether a termination has occurred, and will be able to continue without restarting depreciation periods and without allowing or requiring new elections.
- Limitations on Deduction of Interest. The Tax Act limits the deduction for business interest to the sum of (i) business interest income for that year; plus (ii) 30 percent of the taxpayer’s adjusted taxable income for the year. This limitation applies at the entity level and any interest disallowed is carried forward indefinitely, subject to certain restrictions. The limitation generally does not apply to certain regulated utilities businesses, including the transportation of gas by regulated pipeline.
Oil and Gas Industry
- Taxation of Natural Resources. Most provisions specific to the taxation of natural resources remain unchanged, including the deduction for intangible drilling costs, percentage depletion deductions, business credits for enhanced oil recovery under Internal Revenue Code § 43 and credits relating to production from marginal wells under Internal Revenue Code § 45I. The Tax Act does, however, repeal the deduction under Internal Revenue Code § 199 for domestic production activities.
- Repeal of the Corporate Alternative Minimum Tax. The Tax Act repeals the corporate alternative minimum tax (AMT), allows a corporation with AMT credit carryforwards to claim a refund of 50 percent of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning in 2018, 2019 and 2020, and allows a refund of all remaining credits in the tax year beginning in 2021. This is beneficial for the oil industry as the AMT often limits the benefits of the deductions otherwise available to offset taxable income, such as intangible drilling costs.
- Immediate Expensing. The Tax Act allows taxpayers to fully and immediately expense 100 percent of the cost of qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023. Qualified property is new or used property generally subject to the allowance for depreciation. Although costs associated with the acquisition of mineral property are depletable and not depreciable, amounts expended on well equipment and other tangible property could qualify for immediate expensing. Additionally, immediate expensing does not apply to certain regulated utilities businesses, including the transportation of gas by regulated pipeline.
- Like-Kind Exchanges. Although the Tax Act limits tax-deferred like-kind exchanges to real property, mineral interests are typically considered real property and should continue to qualify. Personal depreciable property replaced in a like-kind exchange will generate a taxable event, but some portion of the replacement cost may also qualify for immediate expensing.
1 This does not take into account the 3.8 percent net investment income tax under Internal Revenue Code § 1411.
2 This does not take into account the 3.8 percent net investment income tax under Internal Revenue Code § 1411.
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