february 27, 2018 upstream oil and gas like-kind … · 2018. 4. 14. · upstream oil and gas...

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

Confidential and Proprietary ©2018 Vinson & Elkins LLP velaw.com 2

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: 214-220-7883

[email protected]

BIOGRAPHY – JULIA PASHIN


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: 214-220-7781

[email protected]

BIOGRAPHY – MEGAN JAMES


• 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.

SCOPE OF PRESENTATIONINTRODUCTION


TOPICSINTRODUCTION

• 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


• 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

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”

INTRODUCTION


INTRODUCTIONBASIC DEFERRED EXCHANGE STRUCTURES: FORWARD

Taxpayer

Relinquished

Property

Third Party

Buyer

Exchange

Proceeds

QI (Qualified

Trust or Escrow)

Step 1 –

Sale of Relinquished Property

Third Party

Seller

Replacement

Property

Step 2 –

Purchase of

Replacement Property

Relinquished

Property Purchase Price

Replacement

Property

Purchase Price


INTRODUCTIONBASIC DEFERRED EXCHANGE STRUCTURES: REVERSE

Taxpayer

Replacement

Property

EAT

Third Party

Seller

Step 1 – Purchase of Replacement Property by EAT

Replacement

Property

Purchase Price

Taxpayer Loans EAT

Replacement

Property Purchase Price

Promissory Note from

EAT to Taxpayer


BASIC DEFERRED EXCHANGE STRUCTURES: REVERSEINTRODUCTION

Taxpayer

Relinquished

Property

Third Party

Buyer

Replacement

Property

EAT

Step 2 – Sale of Relinquished Property and Closing of RLKE

QI (Qualified

Trust or Escrow)

Relinquished

Property

Purchase Price

Replacement

Property

Purchase Price

Repayment of

Promissory Note

Step 2(a)

Ste

p 2

(b)

Exchange

Proceeds


• Tax Cuts and Jobs Act, Public Law 115-97 (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

TAX CUTS AND JOBS ACT OF 2017


• 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 2018. Tax Cuts and Jobs Act,§ 13303(c)(2)(A).

– Rule 2:

• Applies when Replacement Property is “received” on or before December 31,

2017. 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?

TRANSITIONAL RULESTAX CUTS AND JOBS ACT OF 2017


• 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

UPSTREAM OIL AND GAS EXCHANGESTAX CUTS AND JOBS ACT OF 2017


• 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

DOES A LIKE-KIND EXCHANGE MAKE SENSE?


• 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

EXAMPLEDOES A LIKE-KIND EXCHANGE MAKE SENSE?


• 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 1.1254-1(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”)

OVERVIEW SECTION 1254 RECAPTURE


• 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)

TAX TRAP: RECOGNITION OF ORDINARY INCOME SECTION 1254 RECAPTURE


• 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. § 1.1254-1(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

TAX TRAP: EXCHANGING INTO UNDEVELOPED ACREAGE SECTION 1254 RECAPTURE


• 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.

EXAMPLESECTION 1254 RECAPTURE


• 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?

EXAMPLESECTION 1254 RECAPTURE


• 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

IN GENERALWHAT IS REAL PROPERTY?


• 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. 34651 (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. 68-186, 1968-1 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. 68-331, 1968-1 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)

UPSTREAM OIL AND GAS INTERESTSWHAT IS REAL PROPERTY?


• 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 1.636-3 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

TAX TRAP: PRODUCTION PAYMENTSWHAT IS REAL PROPERTY?


• 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. 1154 (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

TAX TRAP: PRODUCTION PAYMENTSWHAT IS REAL PROPERTY?


• 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

DISREGARDED ENTITIES SAME TAXPAYER REQUIREMENT


• 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

TAX TRAPTAX PARTNERSHIPS


• 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

ELECTING OUTTAX PARTNERSHIPS


• 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. 77-337, 1977-2 C.B. 305)

• For a comprehensive discussion of the swap-and-drop and drop-and-

swap 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)

RISKSTAX PARTNERSHIPS


• 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. 69-352,

1969-1 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 1031. 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).

TAX TRAPRETAINING AN OVERRIDING ROYALTY INTEREST


• 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. 86-119, 1986-2 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

POTENTIAL SOLUTIONS?RETAINING AN OVERRIDING ROYALTY INTEREST


• Treasury Regulations Section 1.1031(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

TAX TRAP: UNAMBIGUOUSLY IDENTIFYING OIL AND GAS PROPERTIESIDENTIFYING OIL AND GAS 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.

TAX TRAP: IDENTIFYING MULTIPLE REPLACEMENT PROPERTIESIDENTIFYING OIL AND GAS 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?



• 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



• 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

TAX TRAP: DEVELOPING “PARKED” ACREAGEREVERSE EXCHANGES UNDER REV. PROC. 2000-37


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QUESTIONSJulia Pashin

[email protected]

214-220-7883

Megan James

[email protected]

214-220-7781

february 27, 2018 upstream oil and gas like-kind … · 2018. 4. 14. · upstream oil and gas...

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