Tax reform legislation commonly referred to as the Tax Cuts and Jobs Act (TCJA) will have a significant impact on taxpayers.
Taxpayers in the oil and gas industry are affected because they hold their assets and investments in a variety of entity types, including C corporations, partnerships, S corporations, and directly by individuals.
The TCJA also eliminates or limits many tax breaks, and much of the tax relief is only temporary. The key changes that affect taxpayers in the oil and gas industry are outlined below.
Reduced Corporate Income Tax Rate
The corporate income tax rate was reduced to a flat 21% from 35% starting in 2018.
Oil prices declined sharply from above $100 per barrel in late 2014 to below $30 per barrel in early 2016. Prices have slowly risen since early 2016 and are slightly above $60 per barrel at the beginning of 2018.
With this dip in prices, many exploration and production companies generated net operating losses (NOLs) during the past few years. However, with prices rising, some companies are generating profit again and are also looking to monetize certain oil and gas properties. If companies are in a taxable income position or plan to sell properties at a gain, the corporate rate reduction could be favorable.
New Deduction from Pass-Through Entities
The TCJA provides taxpayers that are operating businesses through pass-through entities such as partnerships and S corporations a special deduction under new Section 199A. This new deduction will impact a large amount of taxpayers in the oil and gas industry because a significant number of businesses are structured through partnerships owned primarily by large private equity groups (PEGs), private investors, and family groups.
The deduction is equal to the lesser of:
- The combined qualified business income amount
- 20% of the excess of the taxpayer’s taxable income determined before the Section 199A deduction over the taxpayer’s adjusted net capital gain
Combined Qualified Business Income
Subject to certain limitations discussed below, the combined qualified business income amount for a taxable year generally equals the aggregate of 20% of the taxpayer’s qualified business income with respect to each qualified trade or business.
Qualified and Specified Service Trade or Business
A qualified trade or business is any trade or business other than:
- A specified service trade or business
- A trade or business involving the performance of services as an employee
A specified service trade or business must meet the following criteria:
- Involves the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such a trade or business is the reputation or skill of one or more employees or owners
- Performs services involving investing and investment management, trading, or dealing in securities, partnership interests, or commodities
- The definition of specified service trade or business specifically excludes engineering and architecture businesses.
Although a taxpayer’s combined qualified business income amount will generally equal 20% of the aggregate amount of qualified business income from each qualified trade or business, the calculation is subject to limitations.
Specifically, the qualified business income for each qualified trade or business is limited to the greater of the following:
- 50% of the W-2 wages with respect to the qualified trade or business
- The sum of 25% of the W-2 wages with respect to such trade or business and 2.5% of the unadjusted basis immediately after acquisition of all qualified property
Full Expensing of Tangible Property
This provision could be a significant benefit because the oil and gas industry is very capital intensive.
Tangible drilling costs, lease and well equipment, pipelines, and all other tangible personal property can be fully deducted when acquired and placed in service after September 27, 2017, and before January 1, 2023. The full deduction is phased down by 20% each year in taxable years beginning on or after January 1, 2023:
The new tax law also permits used property to be eligible for the full expensing provision. This change may impact merger and acquisition transactions by motivating buyers to structure deals as actual or deemed asset acquisitions rather than stock acquisitions. This is accomplished by enabling the buyer to immediately deduct a significant portion of the purchase price and generate NOLs in the year of purchase to offset future taxable income.
Limitation on Deduction of Net Interest Expense
For companies with high leverage, the limitation on deduction of net interest expense could offset some benefit of the lower tax rates.
The new tax law limits the deductibility of net interest expense to 30% of taxable income before interest, the NOL deduction (discussed below), the pass-through deduction, and, for years before 2022, depreciation, amortization, and depletion. Businesses with average annual gross receipts of $25 million or less are exempted from the limit.
Historically, taxpayers could defer US taxation on offshore earnings of affiliated corporations subject to several anti-abuse regimes. The TCJA ushered in a dramatic change by allowing tax-free repatriations received by US corporations that have a 10% or greater stake in specified foreign corporations—and this is in addition to reducing the corporate tax rate to 21% from 35%.
For taxable years of deferred foreign income corporations (DFICs) beginning before January 1, 2018, all US taxpayers are required to calculate a transition tax on their offshore earnings and begin paying it to the Treasury as early as April 15, 2018.
Generally, most taxpayers can elect to pay the transition tax over eight years. And, for individual shareholders who holds his or her interests in DFICs through an S corporation, a potentially indefinite deferral exists until there is a so-called triggering event.
The following is an overview of additional changes that will significantly affect New Mexico’s industries, companies, and their owners.
- Repeal of the domestic production activities deduction for years beginning after 2017
- Reduction in the deductible portion of dividend received from domestic corporations
- Limitation of nonrecognition of gain from like-kind exchanges to exchanges involving real property, effective for exchanges completed after 2017
- Limitation of net operating loss (NOL) deduction to 80% of taxable income, elimination of NOL carrybacks for most taxpayers, and allowing indefinite carryforwards for losses arising in tax years beginning after 2017
- Immediate taxation of previously nonrepatriated foreign earnings at a rate of 15.5% for liquid assets and 8% for illiquid assets, while allowing a 100% dividends-received deduction on qualifying dividends paid by controlled foreign corporations (CFCs) to US corporate shareholders that own at least 10% of the CFC.
The new provisions are complex, and there are still some unanswered questions. The IRS is expected to issue more guidance in the coming weeks and months as companies and tax professionals grapple with these changes in the tax regime. Work closely with your tax professional to understand how these provisions will affect you and your business.
We’re Here to Help
For more information about how tax reform will affect you and your business, please contact your Moss Adams professional, visit our oil & gas industry webpage, or read more on our dedicated tax reform webpage.