UPSTREAM OIL AND GAS LIKE-KIND EXCHANGE TRANSACTIONS AFTER TAX REFORM

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1 FEBRUARY 27, 2018 UPSTREAM OIL AND GAS LIKE-KIND EXCHANGE TRANSACTIONS AFTER TAX REFORM Tax Executives Institute Houston Chapter Presented by Julia Pashin and Megan James

2 BIOGRAPHY JULIA PASHIN Summary of Practice Julia is a tax attorney at Vinson & Elkins LLP, where she advises clients on the U.S. federal income tax aspects of complex domestic and cross-border transactions, including private equity, mergers and acquisitions, and joint venture transactions. Education and Professional Background Southern Methodist University Dedman School of Law, J.D. magna cum laude, 2012 (Order of the Coif; SMU Law Review) The University of Texas, B.B.A. Business Honors Program & Finance, with high honors, 2009 Contact Info: jpashin@velaw.com Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 2

3 BIOGRAPHY MEGAN JAMES Summary of Practice Megan is a tax attorney at Vinson & Elkins LLP, where she focuses her practice on the federal income tax aspects of complex domestic and cross-border transactions. She advises partnerships, corporations and individuals in a variety of tax matters, including mergers and acquisitions, joint ventures, reorganizations, and private equity. Education and Professional Background Texas Tech University School of Law, J.D. summa cum laude, 2014 (Order of the Coif; Managing Editor, Texas Tech Law Review; Burton Award, 2014 Distinguished Legal Writing Award) Texas A&M University, B.S., Sociology, 2010 Contact Info: meganjames@velaw.com Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 3

4 INTRODUCTION SCOPE OF PRESENTATION This presentation does not offer a comprehensive discussion of the requirements for tax-deferral under Section 1031 of the Code Rather it is intended to provide an overview of the key U.S. federal income tax traps encountered in structuring like-kind exchange transactions involving upstream oil and gas interests, including in the context of the Tax Cuts and Jobs Act. Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 4

5 INTRODUCTION TOPICS Introduction Tax Reform Key Tax Traps in Oil and Gas Like-Kind Exchanges Does a Like-Kind Exchange Make Sense? Recapture What is Real Property? Same Taxpayer Requirement Tax Partnerships Retaining an ORRI Identifying Oil and Gas Properties Developing Parked Acreage in a Reverse Exchange Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 5

6 INTRODUCTION Terms Used in this Presentation Relinquished Property means the real property that the taxpayer intends to dispose of in a Section 1031 transaction Replacement Property means the real property that the taxpayer intends to acquire in exchange for the Relinquished Property in a Section 1031 transaction Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 6

7 INTRODUCTION General Rule Under Section 1031(a)(1) Exception to Section 1001, which requires the recognition of gain upon a sale or exchange of property No gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment if such property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment. Three main elements There must be an exchange The properties must meet the held for requirement Exchanged properties must be of like kind Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 7

8 INTRODUCTION BASIC DEFERRED EXCHANGE STRUCTURES: FORWARD Taxpayer QI (Qualified Trust or Escrow) Relinquished Property Purchase Price Third Party Buyer Exchange Proceeds Relinquished Property Step 1 Sale of Relinquished Property Replacement Property Purchase Price Third Party Seller Step 2 Purchase of Replacement Property Replacement Property Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 8

9 INTRODUCTION BASIC DEFERRED EXCHANGE STRUCTURES: REVERSE Step 1 Purchase of Replacement Property by EAT Taxpayer Taxpayer Loans EAT Replacement Property Purchase Price Promissory Note from EAT to Taxpayer EAT Replacement Property Purchase Price Third Party Seller Replacement Property Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 9

10 Step 2(b) INTRODUCTION BASIC DEFERRED EXCHANGE STRUCTURES: REVERSE Step 2 Sale of Relinquished Property and Closing of RLKE Taxpayer Repayment of Promissory Note EAT Relinquished Property Replacement Property Step 2(a) Third Party Buyer Relinquished Property Purchase Price QI (Qualified Trust or Escrow) Replacement Property Purchase Price Exchange Proceeds Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 10

11 TAX CUTS AND JOBS ACT OF 2017 Tax Cuts and Jobs Act, Public Law (Dec. 22, 2017) Amended Section 1031 Limited Section 1031 to exchanges of real property Like-kind exchanges of personal property no longer qualify for gain deferral Applies to exchanges completed after December 31, 2017 Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 11

12 TAX CUTS AND JOBS ACT OF 2017 TRANSITIONAL RULES Transitional Rules for Personal Property Exchanges Rule 1: Applies to deferred forward exchanges where Relinquished Property is disposed of on or before December 31, 2017, even if the Replacement Property is acquired in Tax Cuts and Jobs Act, 13303(c)(2)(A). Rule 2: Applies when Replacement Property is received on or before December 31, Tax Cuts and Jobs Act, 13303(c)(2)(B). What about reverse exchanges where Replacement Property was parked with exchange accommodation titleholder ( EAT ) in 2017 but exchange was (or will be) completed in 2018? Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 12

13 TAX CUTS AND JOBS ACT OF 2017 UPSTREAM OIL AND GAS EXCHANGES Section 1031 is still relevant for upstream oil and gas exchanges Most oil and gas interests qualify as real property for federal income tax purposes E.g., operating and non-operating working interests and royalty interests Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 13

14 DOES A LIKE-KIND EXCHANGE MAKE SENSE? Before engaging a QI, Qualified Trustee or EAT, consider the following: How much gain can be deferred? Determine the amount of gain that would be realized in a taxable transaction (FMV of the Relinquished Property minus taxpayer s adjusted basis in the property) This represents the maximum amount of gain that could be deferred How much boot is expected to be received in the exchange? Boot is other property or cash received as part of the exchange Under Section 1031(b), built-in gain in the Relinquished Property is recognized to the extent of the boot received Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 14

15 DOES A LIKE-KIND EXCHANGE MAKE SENSE? EXAMPLE Relinquished Property with FMV of $1,000,000 and adjusted tax basis of $750,000 Maximum gain deferred is $250,000 If taxpayer acquires $1,000,000 or more of like-kind real property, all of the gain can be deferred (subject to recapture, discussed later) If the taxpayer only received $500,000 of like-kind replacement property and $500,000 in cash, then all $250,000 of gain would be recognized Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 15

16 SECTION 1254 RECAPTURE OVERVIEW The recapture rules of Section 1254 may cause an otherwise tax-free like-kind exchange to be taxable Applies to dispositions of natural resource recapture property as defined in Treasury Regulations Section (b)(2) ( Section 1254 Property ) Disposition of Section 1254 Property in a taxable transaction results in the recapture of previously deducted IDCs and depletion as ordinary income to the extent of gain realized (the Section 1254 Recapture Amount ) Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 16

17 SECTION 1254 RECAPTURE TAX TRAP: RECOGNITION OF ORDINARY INCOME In a like-kind exchange, Section 1254 Property (e.g., a working interest in a developed oil and gas lease) cannot be exchanged for real property that is not also Section 1254 Property (e.g., a ranch) without triggering recapture of prior deductions Section 1254 Recapture Amount is recognized to the extent of the sum of: (i) the amount of gain recognized under Section 1031 and (ii) the FMV of property acquired that is not Section 1254 Property and that is not taken into account under clause (i) (i.e., the FMV of real property that is not Section 1254 Property) Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 17

18 SECTION 1254 RECAPTURE TAX TRAP: EXCHANGING INTO UNDEVELOPED ACREAGE It is uncertain whether the exchange of developed oil and gas acreage (with respect to which the taxpayer has properly deducted IDCs and depletion) for undeveloped oil and gas acreage can occur without triggering Section 1254 recapture Definition of Section 1254 Property (Treas. Reg (b)(2)) Treasury Regulations define such property by reference to whether expenditures described in Sections 263, 616 or 617 are properly chargeable to such property An expenditure is properly chargeable to property if the property is an operating mineral interest with respect to which the expenditure has been deducted The past tense has been deducted creates a risk that Replacement Property must be developed in order to avoid recapture on the Relinquished Property in a like-kind exchange Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 18

19 SECTION 1254 RECAPTURE EXAMPLE Base Case Taxpayer exchanges a working interest in one oil and gas lease with an adjusted tax basis of $0 and a FMV of $100 for a working interest in another oil and gas lease of the same FMV. Both leases are developed. Taxpayer had taken $80 of IDCs and $20 of depletion on the relinquished lease. No gain is recognized in the exchange, and no amount of IDC or depletion recapture is triggered. The entire 1254 Recapture Amount is carried over to the Replacement Property. Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 19

20 SECTION 1254 RECAPTURE EXAMPLE Base Case with Boot and Non-Section 1254 Property Taxpayer exchanges a working interest in one oil and gas lease with an adjusted tax basis of $0 and a FMV of $100 for a working interest in another oil and gas lease with a FMV of $50, an interest in ranch land held for investment with a FMV of $40 and $10 cash. Both of the oil and gas leases are developed. Taxpayer had taken $80 of IDCs and $20 of depletion on the relinquished lease. Taxpayer recognizes $10 of gain under Section 1031 (to the extent of the boot), and recaptures $50 as ordinary income under Section 1254 notwithstanding that the $40 interest in ranch land is real property that is like-kind to the taxpayer s Relinquished Property What result if, instead of acquiring ranch land, the taxpayer acquired an undeveloped oil and gas lease? Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 20

21 WHAT IS REAL PROPERTY? IN GENERAL Real property is generally considered to be like-kind to other real property despite significant differences in the nature of the properties Exception: Real property located in the United States and real property located outside of the United States are not of like kind. I.R.C. Section 1031(h) State law treatment is not controlling for purposes of determining whether oil and gas interests are real property for purposes of Section 1031 Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 21

22 WHAT IS REAL PROPERTY? UPSTREAM OIL AND GAS INTERESTS Examples of exchanges of like-kind real property involving upstream oil and gas interests: Undivided interest in unimproved real estate for overriding oil and gas royalty interests (G.C.M (Oct. 20, 1971)) Mineral properties for an undivided interest in a hotel (Comm r v. Crichton, 122 F.2d 181 (5th Cir. 1941)) Working interests in two leases (Rev. Rul , C.B. 354) An interest in a producing lease of an oil deposit in place for a fee interest in an improved ranch (Rev. Rul , C.B. 352) All of these examples involve oil and gas interests that are an unlimited economic interest in oil and gas in place Palmer v. Bender, 287 U.S. 551 (1933) Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 22

23 WHAT IS REAL PROPERTY? TAX TRAP: PRODUCTION PAYMENTS Production payments and other limited oil and gas interests are not considered real property for federal income tax purposes; instead, production payments are generally treated as debt obligations. I.R.C. Section 636(a) Treas. Reg. Section defines production payments as: a right to a specified share of the production from the mineral in place (if, as, and when produced), or the proceeds from such production such right must be an economic interest in such mineral in place such right must have an expected economic life (at the time of its creation) of shorter duration than the economic life of the mineral properties burdened thereby Test: Such right is not reasonably expected to extend in substantial amounts over the entire productive life of such mineral property a production payment may be limited by: a dollar amount (e.g., dollar-denominated production payment) a quantum of mineral (e.g., volumetric production payment) a period of time Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 23

24 WHAT IS REAL PROPERTY? TAX TRAP: PRODUCTION PAYMENTS Examples of exchanges of interests that do not qualify as like-kind real property for purposes of Section 1031: Limited oil payment right for an overriding royalty reserved from the same lease (Midfield Oil Co., 39 B.T.A (1954)) Carved-out oil payment rights of limited duration for a fee interest in a ranch (Fleming v. Comm r, 24 T.C. 818 (1955)) Lease for a stated amount of oil to be recovered from other lands or leases of the other parties to the transaction (Bandini Petroleum Co., 10 CCH TCM 999 (1951)) Taxpayers should be cautious in effecting a Section 1031 exchange where the Relinquished Properties or Replacement Properties may include limited interests Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 24

25 SAME TAXPAYER REQUIREMENT DISREGARDED ENTITIES The taxpayer that transfers the Relinquished Property must receive (or be deemed to receive) the Replacement Property Disregarded entities are disregarded from their owner for this purpose; the owner is treated as the taxpayer transferring and receiving the properties This allows a taxpayer to use different disregarded entities to transfer the Relinquished Property and to acquire the Replacement Property To the extent multiple Replacement Properties are received, each Replacement Property can be held in a separate disregarded entity Also applies to qualified Subchapter S subsidiaries Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 25

26 TAX PARTNERSHIPS TAX TRAP Section 1031 does not apply to exchanges of partnership interests. I.R.C. Section 1031(a)(2) By default, jointly owned operating oil and gas interests are treated as held by a tax partnership for federal income tax purposes under Section 761(a) Diligence should be undertaken to confirm that the Relinquished Property is not (and the Replacement Property will not be) treated as held in a tax partnership, prior to effecting a 1031 exchange Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 26

27 TAX PARTNERSHIPS ELECTING OUT A valid election can be made to exclude a joint ownership arrangement from the application of Subchapter K of the Code under Section 761 If a valid election is in place, a co-owner can exchange its jointly held assets in an exchange that qualifies under Section 1031 In order to be eligible to elect out: Parties must own the property as co-owners Each party must have the right to separately take in kind or dispose of its share of any property produced, extracted or used Any delegations of authority to sell a co-owner s share of property produced or extracted must be only for such reasonable periods of time as are consistent with the minimum needs of the industry, but in no event for a period in excess of one year If property will produce natural gas, any imbalances must be resolved using the cumulative gas balancing method Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 27

28 TAX PARTNERSHIPS RISKS The IRS may challenge an election out made immediately prior to a like-kind exchange IRS challenged exchange transactions in which the Relinquished Property was received by the taxpayer as a distribution from an entity prior the exchange on the basis that the Relinquished Property was not held for productive use in a trade or business or for investment at the time of the exchange (Rev. Rul , C.B. 305) For a comprehensive discussion of the swap-and-drop and drop-andswap authorities, see Richard M. Lipton, Samuel P. Grilli & Samuel Pollack, The State of the Art in Like-Kind Exchanges-2015, 124 J. Tax n 5 (2016) and Richard M. Lipton & Leah J. Gruen, The State of the Art in Like-Kind Exchanges, 2012, 116 J. Tax n 246 (2012) Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 28

29 RETAINING AN OVERRIDING ROYALTY INTEREST TAX TRAP Retention of a royalty or ORRI in connection with the sale of a working interest is a common problem Buyer and Taxpayer have negotiated a package of assets with a targeted NRI, but Taxpayer determines it has a greater NRI in certain assets within the package Taxpayer may believe that buyers will not properly value an NRI in excess of the target NRI Taxpayer desires to retain potential upside in the play Retention of an ORRI in connection with the sale of a working interest causes the transaction to be treated as a lease or sublease for federal income tax purposes (rather than a sale or exchange). Rev. Rul , C.B. 34. Upfront proceeds are treated as advanced royalties/lease bonus Ordinary income No basis offset Cannot qualify as an exchange of property for purposes of Section Crooks v. Comm r, 92 T.C. 816 (1989). Sale v. lease is determined on a property by property basis. Cullen v. Comm r, 118 F.2d 651 (5th Cir. 1941). Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 29

30 RETAINING AN OVERRIDING ROYALTY INTEREST POTENTIAL SOLUTIONS? Retain a production payment instead? Production payment is treated as a debt obligation or a loan rather than an economic interest Risk: Must establish that the production payment is not reasonably... expected to extend in substantial amounts over the entire production life of such mineral property. (Rev. Rul , C.B. 81) Carve off an overriding royalty interests and convey it to a separate regarded affiliate of the taxpayer? There is very little authority on this structure IRS may apply a substance over form or step transaction theory to argue that the transaction should still be treated as a leasing transaction Not clear how much time must elapse between ORRI conveyance and disposition of WI Should have a meaningful non-tax business purpose for holding royalty interests or ORRIs in a separate legal entity, but not clear what types of non-tax business purposes are sufficient Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 30

31 IDENTIFYING OIL AND GAS PROPERTIES TAX TRAP: UNAMBIGUOUSLY IDENTIFYING OIL AND GAS PROPERTIES Treasury Regulations Section (k)-1 in the forward exchange context (the Forward Exchange Regs ) require the identification of potential Replacement Properties in a forward exchange to be: Made in a written document Signed by the taxpayer Sent to the QI prior to the end of the 45-day identification period Description must unambiguously describe the property Real property is unambiguously described if a legal description is provided, an address is provided, or it is described by a distinguishable name No specific guidelines for identifying oil and gas assets Oil and gas assets must be described so that they may not be mistaken for other properties or assets Oil and gas assets should be identified using the same level of specificity that the leases and wells exhibits to a standard purchase and sale agreement would provide Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 31

32 IDENTIFYING OIL AND GAS PROPERTIES TAX TRAP: IDENTIFYING MULTIPLE REPLACEMENT PROPERTIES The Forward Exchange Regs provide two key rules for identifying multiple or alternative Replacement Properties in a deferred forward exchange: Three Property Rule: Taxpayer may identify up to three properties of any value as part of the same deferred exchange (regardless of the number of properties relinquished). 200% Rule: Taxpayer may identify any number of properties as long as their aggregate FMV as of the end of the 45-day identification period does not exceed 200% of the aggregate FMV of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer. Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 32

33 IDENTIFYING OIL AND GAS PROPERTIES TAX TRAP: IDENTIFYING MULTIPLE REPLACEMENT PROPERTIES Three Property Rule Oil and gas properties sometimes involve tens or hundreds of leases spanning multiple counties and even multiple states It is not clear what a single property means for purposes of Section 1031 In an acquisition involving multiple leases, is each lease a separate property? In the depletion context, Section 614 defines property as each separate interest owned by the taxpayer in each mineral deposit in each separate tract or parcel of land. Can a taxpayer rely on the Section 614 definition (and the separation and aggregation elections thereunder) for purposes of Section 1031? Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 33

34 IDENTIFYING OIL AND GAS PROPERTIES TAX TRAP: IDENTIFYING MULTIPLE REPLACEMENT PROPERTIES Because of these uncertainties and lack of authority, taxpayers should not rely on the Three Property Rule More prudent approach is to identify Replacement Properties that satisfy the 200% Rule This trap is also present in the reverse exchange context, where the taxpayer may identify multiple potential Relinquished Properties, which may consist of multiple leases Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 34

35 REVERSE EXCHANGES UNDER REV. PROC TAX TRAP: DEVELOPING PARKED ACREAGE A reverse exchange is straight forward if the parked Replacement Property consists of solely non-operating interests Replacement property may be parked with an EAT for up to 180 days What if the Replacement Property consists of operating interests or the taxpayer intends to develop the property during the parking period? Taxpayer is not entitled to deduct IDCs or depletion or take depreciation deductions with respect to the property until after the Replacement Property is acquired by the taxpayer This is a consideration to take into account in determining the potential cost of structuring into a reverse like-kind exchange Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 35

36 QUESTIONS Julia Pashin Megan James Austin T Beijing T Dallas T Dubai T Hong Kong T Houston T London T Moscow T New York T Palo Alto T Richmond T Riyadh T San Francisco T Taipei T Tokyo T Washington T Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com Confidential and Proprietary 2018 Vinson & Elkins LLP velaw.com 36