Private equity funds have raised billions of dollars for investment in U.S. oil and gas ventures. There are many different forms of investment in oil and gas production available, including interests in partnerships owning oil and gas properties, royalty interests, net profits interests and production payments, each with unique tax characteristics relevant to fund investors.
An oil and gas royalty is a perpetual, nonoperating interest in a percentage of the production from a specified property, paid either in actual production or the cash value of such production. Royalty payments are not reduced for costs associated with development, operation or production. Production payments are similar to royalties but terminate when a specified volume of production or dollar amount of sales of production are received by the holder. Net profits interests also are similar to royalties but are determined net of costs of development, operations and production.
Interests in partnerships owning oil and gas properties can be operating interests, and the holder is allocated its share of the profits, as well as losses, generated by the partnership. For federal income tax purposes, partners are treated as if they were directly engaged in the business of the partnership.
Private equity funds considering an investment in U.S. oil and gas must be aware of the tax consequences of the various forms of investment for different types of fund investors. First, funds with tax-exempt investors must consider whether the investment could generate unrelated business taxable income, or UBTI, taxable to otherwise tax-exempt investors. UBTI generally is income from the conduct of a trade or business unrelated to the tax-exempt purpose of an entity. However, passive income, such as dividends, interest, royalties and gains from the sale of property, generally is not treated as UBTI, unless derived from debt-financed investments.
Income from royalties, production payments or net profits interests is not UBTI, and thus tax-exempt investors are not subject to federal income tax on such amounts unless the interests were acquired with the proceeds of debt financing. Income from interests in partnerships operating oil and gas properties, however, generally is UBTI.
Foreign fund investors are subject to U.S. taxation with respect to fund investments that generate income effectively connected with a U.S. trade or business, or ECI. Unless a foreign investor is otherwise engaged in a U.S. trade or business, passive investment income generally is not ECI. Accordingly, periodic income from oil and gas royalties, production payments and net profits interests generally are not treated as income from a U.S. trade or business. In contrast, because the activities of a partnership are attributed to its partners, income from an interest in an operating partnership engaged in oil and gas production is ECI.
However, when a foreign person recognizes gain from the sale of an interest in U.S. real property, such gain is treated as if it were ECI even if the person is not otherwise engaged in a U.S. trade or business. A U.S. real property interest is broadly defined to include interests in a well or other natural deposit, thus gain on the sale of a royalty, net profits interest or production payment allocated to a foreign investor is treated as ECI. Gain from the sale of an interest in a fund or other entity treated as a partnership also will be treated as ECI to the extent it is attributable to U.S. real property interests held by the partnership. There is an exception, however, for sales of interests in publicly traded partnerships, such as master limited partnerships, which are not treated as U.S. real property interests unless the holder has a greater than 5% interest in the partnership.
Understanding the variation in the federal income tax consequences of different forms of U.S. oil and gas investments is critical to evaluating investors' potential after-tax return. However, understanding such consequences is only the first step in the analysis. Once negative tax implications are identified, PE firms can explore opportunities to mitigate some of the negative consequences to investors, including holding the investment through a corporation, using debt financing to generate offsetting interest deductions or employing other tax-planning techniques. Accordingly, PE funds are well advised to undertake a thorough tax analysis before committing to any investment in U.S. oil and gas.
Elizabeth McGinley and Alexander Jones are tax attorneys in the New York office of the law firm of Bracewell & Giuliani LLP.