U.S. tax law encourages energy companies focused on exploration and production of oil, gas, and minerals to form as master limited partnerships. That raises certain tax issues for investors in troubled debt of troubled energy companies. A group of lawyers from Kaye Scholer discuss related issues at length in a white paper entitled, “The Price of Oil & the Potential for Master Limited Partnership Restructuring and Insolvencies,” which was published on the firm’s website, and which we recommend.
In the 4th quarter of 2014, the price per barrel of crude oil declined by about 40% and has not since meaningfully recovered. Obviously, oil companies that are profitable only at prices toward the 4th quarter highs (as well as other companies dependent upon such oil companies) have been stressed by the price decline. Capital expenditures and head count have been reduced. Some such companies have entered bankruptcy.
This creates an opportunity for distressed investors, whether for purchasing assets on the cheap, or oil company debt on the cheap. Outside the oil patch, distressed investors may purchase company debt in hopes of its conversion to equity (either in or out of bankruptcy) in a downsized or reorganized but financially stronger entity. But ownership of master limited partnership interests presents enhanced taxation risks that should be taken into account, and these are explained in the article.
The enhanced taxation risks are related to the favorable tax aspects of master limited partnerships for energy exploration and production (among other things). The MLP is a pass-through entity, relieving the MLP level from income taxes that would be levied upon a corporation, and which would thus diminish returns to MLP interest holders. Presumably, such tax relief is intended to encourage more exploration and production. (Tangential query: if that’s how investment is encouraged, why not provide such relief to all business entities, and instead tax profits as they enter the hands of owners?)
When the good times cease to roll, however, this pass-through taxation promises complications to new equity owners of a troubled energy company. As explained in the article, a financially stable MLP is able to set off taxable income allocated to owners by using tax deductions for depreciation of acquired assets and interest on debt. These offsets diminish or disappear in a troubled scenario. The debt holder whose interest has been converted to equity may find itself allocated with taxable income while not even receiving any cash! The authors explain this, and more, in outlining potential risks which for which distressed investors in the oil patch should account.
You can read more here.
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