The comprehensive tax reform proposal, the Tax Cuts and Jobs Act (the Chairman's Mark), released by Senate Finance Committee Chairman Orrin Hatch (R-Utah) on November 9, 2017, includes many provisions that would directly and indirectly affect the oil and gas sector. The Chairman's Mark comes a week after the House Ways and Means Committee's initial release of a comprehensive US tax reform bill (the Ways and Means Bill, which was passed by the Committee on November 9, 2017, (for an analysis of the Ways and Means Bill's implications to the energy sector, please see Tax Alert 2017-1858)).

The Chairman's Mark adheres to the same basic tax overhaul framework as the Ways and Means Bill, but includes significant differences in the design of provisions and their timing. Similar to the Ways and Means Bill, the provisions in the Chairman's Mark aim to drive economic growth and continue to foster domestic oil and gas development and production. Although the provisions in the Chairman's Mark ought to be analyzed on a company-by-company basis, the key highlights of the Chairman's Mark are as follows:

Key oil and gas tax provisions

Oil and gas companies, on balance, may react somewhat favorably to the business provisions in the Chairman's Mark. Perhaps most importantly for the oil and gas sector, and similar to the Ways and Means Bill, several of the sector's highest priorities - maintaining the deductibility of intangible drilling and development costs, its eligibility to take percentage depletion, the ability to recover certain geological and geophysical costs, and the designation of certain natural resource-related activities as generating qualifying income under the publicly traded partnership (PTP) rules- were not addressed in the Chairman's Mark.

Reduction in the corporate tax rate

The US corporate tax rate would be reduced to 20%, effective for tax years beginning after December 31, 2018. The effective date under the Chairman's Mark would be delayed a year as compared to the Ways and Means Bill.

Dividends received deduction (DRD)

The amount of deduction allowable against dividends received from a domestic corporation would be reduced to correlate with the reduction in the corporate rate. Specifically, the deduction for dividends received, other than certain small businesses or those treated as "qualifying dividends," would be reduced from 70% to 50%. Dividends from 20%-owned corporations would be reduced from 80% to 65% for the DRD.

Repeal of the corporate AMT

The corporate AMT would be repealed for tax years beginning after 2017. Taxpayers could claim a refund of 50% of any remaining AMT credits (to the extent the credits exceed regular tax for the year) in tax years beginning before 2022. The provision related to AMT credits would similarly apply to tax years beginning after 2017. As noted, in a slight modification of the Ways and Means proposal, the Chairman's Mark provides for a one-year acceleration of AMT credit refunds, with 100% of the credits being refundable by 2021 instead of 2022, as provided in the Ways and Means Bill.

The repeal of the corporate AMT, coupled with the ability to obtain refunds of prior-period AMT credits, is expected to benefit oil and gas companies. Given the nature of drilling programs and capital spending in the sector, many oil and gas companies have been in an AMT position and have carryover AMT credits. Eliminating the economic and administrative burden of the AMT, while allowing prior AMT credits to be potentially refunded, ought to be received positively by taxpayers. The oil and gas sector has historically re-deployed capital into new projects, and the repeal of the AMT and the credit provisions appear to further that purpose and ought to allow new, significant investments to be made.

100% temporary expensing of certain assets

Bonus depreciation would increase from 50% to 100% for "qualified property" placed in service after September 27, 2017 (with certain limited exceptions). The increased allowance would remain until 2022. A transition rule would allow for an election to apply 50% expensing for one year.

As the oil and gas sector is very capital-intensive, and often needs many years to recoup its investments, expanding the 100% expensing provision for five years ought to encourage the deployment of capital and the development of new projects. Similarly, the provision would encourage the oil and gas sector to reinvest in the development of large-scale operations that could spur economic growth and employment. Unlike the Ways and Means Bill, however, the Chairman's Mark would not modify the "original use" rules related to bonus depreciation. Absent relaxation of these rules, oil and gas companies are not likely to view the Chairman's Mark as favorably as the Ways and Means Bill, in this respect. Additionally, and also unlike the Ways and Means Bill, the Chairman's Mark does not appear to have a transitional rule allowing an oil and gas taxpayer to elect out of the temporary 100% expensing provisions and back into the general depreciation regime under Section 168.

Interest limitations

Section 163(j) would be replaced with a provision that would disallow net business interest expense deductions that exceed 30% of adjusted taxable income (ATI) (with certain limited exceptions, including, but not limited to, certain regulated gas pipelines). For partnerships, the limitation would apply at the partnership level. Similar to the Ways and Means Bill, the Chairman's Mark defines the targeted interest — business interest income and expense — as interest paid or accrued on indebtedness, so interest received would need to be properly allocable to a trade or business. The new provision would also compute ATI without regard to any non-trade or business income, gain, deduction or loss, the 17.4% deduction for pass-through income, and any NOL deduction.

Further, a worldwide limitation on interest deductibility would be targeted at US interest deductions that are seen as eroding the US tax base. The limitation would be based on a comparison of the debt that could be incurred if the US group had a debt-equity ratio in proportion to the worldwide group's debt-equity ratio. Under the Chairman's Mark, all US members of the worldwide affiliated group would be treated as one member when determining whether the group has excess domestic indebtedness as a result of a debt-to-equity differential. According to the Chairman's Mark, "[e]xcess domestic indebtedness is the amount by which the total indebtedness of the [US] members exceeds 110[%] of the total indebtedness those members would hold if their total indebtedness to total equity ratio were proportionate to the ratio of total indebtedness to total equity in the worldwide group." The excess domestic indebtedness would be divided by all actual domestic debt and multiplied by the net interest expense. Thus, the more the actual US leverage exceeds the leverage that "should" be in the US group, the more the numerator increases and the allowable percentage of interest deductions decreases.

As with the Ways and Means Bill, when both the Section 163(j) and worldwide interest limitations apply, the one that results in the lower limitation on interest deductions would take precedence. Any disallowed interest would be carried forward indefinitely (as opposed to five years as proposed in the Ways and Means Bill) and subject to both Sections 381 and 382.

The new interest provisions may be detrimental to oil and gas companies. The limitation on the deductibility of interest (which would generally not apply to regulated utilities, regulated gas pipelines and certain other regulated assets) could negatively affect the after-tax cost of capital for investment decisions; however, such an effect ought to be modeled in connection with the 100% expensing, repeal of AMT and other provisions to appropriately determine the true impact. Unlike the Ways and Means Bill, the Chairman's Mark would include depreciation, amortization and depletion for purposes of calculating the available interest expense deduction. Thus, companies that have depreciation, amortization and depletion, as many, if not all, oil and gas companies do, would have a lower interest expense deduction under the Chairman's Mark than under the Ways and Means Bill.

Net operating loss (NOL) rule modifications

For losses arising in tax years beginning after 2017, the NOL deduction would be limited to 90% of taxable income and the carryback provisions would be repealed (except for certain farming losses). The Chairman's Mark would allow an indefinite carryforward, but does not address whether NOL carryforwards would be increased by an interest factor as proposed in the Ways and Means Bill. Potentially unfavorable to oil and gas companies, the Chairman's Mark (similar to the Ways and Means Bill) appears to eliminate the 10-year carryback of specified liability losses, a provision that has benefitted an industry with large NOLs due to prior-year bonus depreciation and other provisions.

Repeal of Section 199

The domestic production deduction under Section 199 would be repealed for tax years after 2018, a year later than under the Ways and Means Bill. The elimination of the Section 199 deduction for certain domestic production activities may negatively affect certain oil and gas companies, particularly those in the downstream space.

Like-kind exchange rule modifications

Like-kind exchanges would be limited to those involving real property only. Transactions involving like-kind exchanges currently underway could complete the like-kind exchange; otherwise, the limitation would be effective for exchanges completed after 2017. As under the Ways and Means Bill, operating and non-operating interests in oil and gas reserves ought to continue to be considered real property for this purpose.

International tax modifications

The Chairman's Mark includes major proposals for the international tax system such as: (a) implementing a territorial tax system; (b) imposing a transition tax on accumulated foreign earnings; and (c) imposing anti-base erosion rules. Highlights include:

— 100% exemption for foreign-source dividends — the Chairman's Mark, similar to the Ways and Means Bill, would exempt 100% of the foreign-source portion of dividends received by a US corporation from a foreign corporation in which the US corporation owns at least a 10% stake. There are a few major differences between the two provisions: (1) the Chairman's Mark would require the foreign corporation's stock to be held more than one year, whereas the Ways and Means Bill would require the stock to be held only six months; (2) the Chairman's Mark would not exempt any dividend received by a US shareholder from a controlled foreign corporation (CFC) if the dividend were deductible by the foreign corporation when computing its taxes; and (3) the Chairman's Mark would apply to the tax year of foreign corporations beginning after December 31, 2017, whereas the Ways and Means Bill would apply to distributions made after December 31, 2017.

— Special rules for the sale of foreign corporations — The Chairman's Mark would apply the dividend exemption to the sale of foreign stock on the gain to the extent of its earnings and profits, among other changes.

— Transition tax on tax-deferred foreign earnings — A one-time transition tax would be imposed on a US 10% shareholder's pro rata share of the foreign corporation's post-1986 tax-deferred earnings, at the rate of either 10% (for accumulated earnings held in cash, cash equivalents or certain other short-term assets) or 5% (for accumulated earnings invested in illiquid assets (e.g., property, plant and equipment)). The Ways and Means Bill would apply rates of 14% and 7%, respectively. A foreign corporation's post-1986 tax-deferred earnings would be the earnings as of November 9, 2017, limited to the earnings accumulated after the shareholder's acquisition of the foreign corporation from a foreign shareholder. Similar to the Ways and Means Bill, the Chairman's Mark would allow an affected US shareholder with a 10%-or-greater stake in a foreign corporation with a post-1986 accumulated deficit to offset the deficit against tax-deferred earnings of other foreign corporations. The US shareholder could elect to pay the transition tax over eight years or less. The Chairman's Mark also has a new anti-inversion provision. The anti-inversion provision requires the US corporation to pay the full 35% rate on the deferred foreign earnings (less the taxes it already paid), if the US corporation inverted within 10 years after enactment. No foreign tax credits would be available to offset the tax in this instance.

— Anti-base erosion rules — Income from the sale of goods and services abroad would be effectively taxed at only 12.5%, whereas those same sales would be taxed at 20% under the Ways and Means Bill. The Chairman's Mark would, however, impose a tax on a US shareholder's aggregate net CFC income at a rate that, presumably, would be similar to the rate on the incentives for US companies (i.e., less than or equal to 12.5%). Net CFC income is gross income in excess of extraordinary returns from tangible assets, excluding ECI, subpart F income, high-taxed income, dividends from related parties, and foreign oil and gas extraction income. Further, under the Chairman's Mark, US companies could repatriate their intangible property tax-free (there was no such provision in the Ways and Means Bill).

— Subpart F modification — comparable to the Ways and Means Bill, the Chairman's Mark would: (a) repeal foreign base company oil related income (FBCORI) as subpart F income; (b) repeal the inclusion based on withdrawal of previously excluded subpart F income from a qualified investment in foreign base company shipping operations; and (c) add an inflation adjustment to the de minimis exception for foreign base company income.

— Modification of stock attribution rules for CFC status — the Chairman's Mark would change the stock attribution rules, similar to the Ways and Means Bill.

— Repeal of the 30-day CFC rules — CFC status would be obtained as soon as the ownership requirements were met and subject to the subpart F base erosion rules.

— Look-through rule for related CFCs made permanent — the Chairman's Mark would make the applicable rules permanent for tax years of foreign corporations beginning after 2019.

— Repeal of tax on investment in US property — the Chairman's Mark would modify the tax treatment of investments made by certain foreign corporations in US property, which current law taxes as dividends.

— Foreign tax credit changes — Similar to the Ways and Means Bill, indirect foreign tax credits would only be available for subpart F income. No credits would be allowed for any dividends associated with exempt dividends. Foreign tax credits would be used on a current-year basis and could not be carried forward or back.

As noted, the Chairman's Mark proposes to repeal the FBCORI rules. This proposal, which was also included in the Ways and Means Bill, would be effective for tax years of foreign corporations beginning after December 31, 2017, and for tax years of US shareholders in which or with which such tax years of foreign subsidiaries end. Unlike the Ways and Means Bill, however, the Chairman's Mark does not appear to address the issue of foreign oil and gas recapture in the context of repatriation.

The other international tax changes contained in the Chairman's Mark appear to apply equally to all companies in all industries, such as the cap on domestic interest expense utilizing a worldwide interest expense cap formula, the mandatory repatriation tax (although the rates in the Chairman's Mark slightly differ from those in the Ways and Means Bill), the new category of subpart F income for global intangible low-taxed income and the tax on base erosion payments, among others.

Unlike the Ways and Means Bill, the Chairman's Mark also does not contain exceptions for actively traded commodities in determining a multi-national oil or gas company's overall income inclusion. Finally, to the dismay of certain non-US investors, the Foreign Investment in Real Property Tax Rules appear to have not been altered under the Chairman's Mark (similar to not being addressed under the Ways and Means Bill).

Pass-through and PTP-related provisions

As many individuals invest in US oil and gas assets through partnerships, it is worth noting that the pass-through rate in the Chairman's Mark may end up being higher than the Ways and Means Bill rate. Similarly, for investors in PTPs and other natural resource partnerships, individuals holding such interests may be subject to tax at a higher rate than they would be under the Ways and Means Bill.

Major proposals in the Chairman's Mark affecting pass-through income, include, but are not limited to, the following:

— 17.4% deduction on certain pass-through income — Unlike the 25% rate for certain pass-through income in the Ways and Means Bill, the Chairman's Mark provides individuals with a 17.4% deduction on certain pass-through income. At the top rate of 38.5% (and assuming that the taxpayer's sole income source is domestic qualified business income (QBI)), the effective tax rate on domestic QBI would be 31.8% under the Chairman's Mark. For more information on the provisions, including information on qualified business income, limitations, special rules for specified service businesses and other pass-through items, please see a forthcoming Tax Alert.

— Sales of partnership interests by foreign partners — The Chairman's Mark would effectively reverse the decision in Grecian Magnesite Mining, Industrial & Shipping Co., SA vs. Comm'r, 149 T.C. No. 3 (Jul. 13, 2017), and re-establish, by statute, a provision similar to the holding in Revenue Ruling 91-32. In Revenue Ruling 91-32, gain or loss from a foreign partner's sale of a partnership interest was treated as effectively connected income (ECI) taxable in the United States if the gain or loss from the sale of the underlying assets held by the partnership would otherwise be treated as assets used in or held for use in the conduct of a US trade or business in which the activities of the trade or business were a material factor. Further, the Chairman's Mark would require the purchaser of a partnership interest to withhold 10% of the amount realized on the sale or exchange of the partnership interest, unless certain conditions were met.

— Basis adjustments and loss limitations — The Chairman's Mark also contains rules on mandatory basis adjustments for sales of partnership interests with built-in losses, rules related to certain partner loss limitations related to foreign taxes, and rules on loss limitations applicable to individuals.

A lower tax rate for individuals investing in pass-through entities operating in the oil and gas sector ought to be a welcome change for many investors. Further, the pass-through rate applicability should be viewed in connection with the other provisions contained in the Chairman's Mark, as applicable.

For oil and gas companies that either operate as PTPs or have PTPs in their structure, the Chairman's Mark may receive mixed reviews, especially relative to the Ways and Means Bill. Similar to the Ways and Means Bill, the Chairman's Mark does not address or change the current PTP regime under Section 7704(c), and does not alter the qualifying income rules under Section 7704(d) and the Treasury Regulations thereunder. Further, the 17.4% deduction for certain pass-through income may result in a lower tax rate for individual PTP investors compared to current law, but other modifications in the Chairman's Mark may result in a higher tax rate for those investors compared to the Ways and Means Bill (assuming the investor would be taxed at the highest individual rate and all of the pass-through income is QBI). Additionally, for many PTPs (and/or sponsors of PTPs), the 100% expensing provisions ought to be carefully analyzed (and ought to be viewed in connection with the use of the remedial method under Section 704(c)), especially since the Chairman's Mark does not currently contain an ability to elect out of the expensing provisions into the general Section 168 provisions.

Finally, and unlike the Ways and Means Bill, the Chairman's Mark does not contain rules that would repeal Section 708(b)(1)(B) related to technical terminations of partnerships. The Ways and Means Bill proposed to delete the technical termination rules, which could affect partnerships, including PTPs, with respect to transfers of interests and the ability to change certain tax elections.

Certain oil and gas credits

The Chairman's Mark does not address a number of provisions that would be repealed under the Ways and Means Bill (i.e., the enhanced oil recovery tax credit (Section 43) and the credit for producing oil and gas from marginal wells (Section 45I)). It is possible, however, that senators may yet be planning to process an energy tax package, either later in the Senate tax reform process, or perhaps in another end-of-the-year tax legislative vehicle altogether.

Subsequent proposed amendments to the Chairman's Mark

On November 12, 2017, a number of proposed amendments were filed with respect to the Chairman's Mark. While many of the proposed amendments would apply to a wide variety of taxpayers, certain amendments would, if enacted, directly or indirectly affect oil and gas companies. Such provisions include, but are not limited to, the following:

— Hatch Amendment #25 to the Chairman's Mark, "12.5% Dividends Paid Deduction for Five Years." The amendment would allow corporations a deduction equal to 12.5% of the amount of dividends that they pay. This provision would be temporary for five years. Although not unique to oil and gas companies, a dividends-paid deduction would need to be further analyzed and modeled to appropriately determine the effect of such a provision.

— Stabenow Amendment #5 to the Chairman's Mark, "To prevent tax increases on farmers and small businesses." The amendment would reinstate Section 199, except it would eliminate the 6% deduction as it relates to oil and gas-related production activities. As an offset, the amendment would propose to delay the implementation of the 20% corporate rate for so long as needed to offset the amendment.

— Stabenow-Brown-Casey-Wyden Amendment #10 to the Chairman's Mark, "To ensure that tax reform does not make it more difficult for our farmers to get their products to market." The amendment would make the Section 45G tax credit permanent. As an offset, the amendment proposes to eliminate the repeal of FBCORI.

— Cantwell Amendment #4 to the Chairman's Mark, "Repealing Foreign Oil Company Handouts." The amendment proposes to strike the provision eliminating FBCORI as a category of foreign base company income from the Chairman's Mark.

— Menendez Amendment #2 to the Chairman's Mark, "Close Big Oil Tax Loopholes." The amendment proposes to repeal tax subsidies for major integrated oil companies and use the savings to provide middle-class families with a refund check to help cover their household energy costs.

— Enzi Amendment #1 to the Chairman's Mark, "Taxation of Energy Companies." The amendment proposes to clarify the tax treatment of certain energy companies.

Similarly, certain amendments were proposed on the taxation and eligibility of PTPs. Such provisions include, but are not limited to, the following:

— Hatch Amendment #1 to the Chairman's Mark, "Master Limited Partnerships Parity Act, S.2005, as introduced by Senator Coons, Senator Moran, and others." The amendment proposes to expand PTP eligibility. Specifically, the proposal would expand the eligibility requirements for master limited partnerships within Section 7704(d)(1) to include a range of new energy resources, such as electric generation from renewable sources, biofuels, energy storage and energy efficiency, among others.

— Cassidy Amendment #7 to the Chairman's Mark, "MLP Improvement Act." The amendment proposes to clarify the definition of "qualifying income" under Section 7704(d).

Conclusion

While similar in many respects to the Ways and Means Bill, the Chairman's Mark also has significant differences, including the international tax regime and the effective dates of certain key provisions. The potential effects of the Tax Cuts and Jobs Act will vary across the domestic oil and gas sector on a company-by-company basis, similar to the Ways and Means Bill. The oil and gas sector is very capital-intensive, and has a history of re-deploying capital and earnings into new projects. The Chairman's Mark appears to support and encourage oil and gas companies to continue to make new and significant investments in the US. That being said, a number of provisions, including those related to interest expense limitations, those affecting inbound oil and gas investments, and those related to the taxation of foreign income and foreign persons, will require further analysis.

Next Steps

The Senate Finance Committee will mark up its plan beginning on Monday, November 13 at 3:00 p.m., and Chairman Hatch said he hopes to report the legislation by the end of that week. A list of filed amendments and a Chairman's Modification may be issued prior to then. Changes are likewise possible during the Committee Process.

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