The Tax Cuts and Jobs Act (TCJA) passed in December 2017 was one of the most sweeping tax reforms in decades. It reduced taxes for corporations and individuals.

However, Section 163(j) of the Internal Revenue Code, enacted under the law, imposes an annual limitation on the deductibility of interest. This applies to all borrowers, regardless of whether a borrower is a corporation or a partnership for federal income tax purposes.

Generally, the net interest expense of a corporation or partnership is deductible only to the extent it does not exceed 30% of the borrower’s taxable income for the year (the limitation). The limitation represents a dramatic change to prior limitations on interest deductibility and has far-reaching implications for the way oil and gas ventures may structure their debt and equity capital.

The prior version of Code Section 163(j), commonly known as the earnings-stripping rules, applied only to thinly capitalized U.S. corporations paying interest to foreign affiliates. These rules were intended to prevent multinational corporations from reducing their U.S. taxable income, which was previously subject to tax at a federal rate of up to 35%, by making deductible interest payments to related lenders in low-tax jurisdictions.

Prior to the TCJA, subject to certain limited exceptions, borrowers generally could take a dollar-for-dollar deduction for interest expense paid or accrued to domestic lenders. Accordingly, most debt financing provided a tax benefit relative to equity financing, since dividends or distributions paid or accrued in respect of equity capital are not deductible by corporations or partnerships.

By expanding the limitation on interest deductibility under the TCJA, Congress intended to reduce the tax benefit associated with the payment of interest expense and thereby curtail the implicit preference for debt financing relative to equity financing under federal income tax law.

The limitation

The limitation is determined and applied on an annual basis. For each year, a taxpayer’s limitation is equal to the sum of the taxpayer’s business interest income for such year, plus 30% of the taxpayer’s adjusted taxable income (ATI) for such year. The calculation of ATI is similar to the calculation of EBITDA until the end of 2021.

Beginning in 2022, however, the calculation of ATI will be reduced by deductions for depreciation, amortization and depletion, and therefore will more closely resemble the calculation of EBIT.

Interest expense in excess of a taxpayer’s limitation in any year is not lost, but instead is carried forward to future years without expiration. The limitation does not include a grandfathering rule. As a result, it applies to all interest expense beginning Jan. 1, 2018, regardless of when the related debt was issued. Oil and gas businesses with strong credit ratings that are not highly leveraged, and therefore pay interest at a lower rate, may not be materially affected by the limitation in 2018.

By contrast, businesses with multiple tranches of debt, including subordinated debt bearing a higher rate of interest, are more likely to experience a material increase to their after-tax cost of capital.

Taxpayers with low ATI also are more susceptible to an immediate increase in their federal income tax liability as a result of the limitation. Accordingly, businesses that are highly leveraged and do not yet have robust earnings, particularly those in the growth or development stage, could be the hardest hit by the limitation, which will raise their tax liability and further reduce their available cash flow.

To illustrate the application of the limitation to corporations, assume a U.S. corporation engaged in the upstream oil and gas business borrows $10 million from a bank lender in 2020. The loan bears interest at a rate of 5% per annum and has a 10-year term. The corporation applies $5 million of loan proceeds to acquire depreciable assets for use in its business. The depreciable assets are eligible for bonus depreciation equal to 100% of the purchase price of the assets, or $5 million, in 2020. The corporation uses the balance of the loan proceeds for general business purposes.

The upstream corporation generates $1 million of ATI in 2020. The corporation’s limitation for 2020 therefore is $300,000, or 30% of ATI. Accordingly, the corporation would not be permitted to deduct $200,000 of its interest expense in 2020. The remaining $200,000 of interest expense is carried forward to future taxable years when the corporation’s limitation is greater than its current year interest expense. As a result, the limitation would cause the corporation’s after-tax cost of borrowing in 2020 to be higher than prior to the TCJA, when the entire $5 million of interest expense would have been deductible.

Looking ahead to future years, the corporation must generate $1.667 million of ATI each year to deduct the full $500,000 of annual interest expense on the loan, and an additional $666,667 of ATI to utilize the disallowed interest expense from 2020.

Note, however, had this example occurred in 2022, the corporation’s ATI would have been reduced by the $5-million bonus depreciation deduction with respect to its newly acquired assets, which would have driven the corporation’s ATI down to zero dollars and prevented the corporation from deducting any of its interest expense for such year.

Effect on partnerships and LLCs

The application of the limitation is more complex in the case of partnerships, including MLPs and other entities that are classified as partnerships for federal income tax purposes, such as limited liability companies that do not elect to be taxed as corporations. Partnerships generally are not subject to federal income tax at the entity level but, instead, the partners of the partnership are subject to federal income taxation directly, on a pass-through basis, on their allocable share of the partnership’s taxable income.

Partnerships, like corporations, first calculate the limitation at the partnership level. However, unlike corporations, a partnership’s interest expense in excess of the limitation is allocated among the partners rather than carried forward by the partnership itself.

This disallowed interest expense is suspended in the hands of the partners, and deductible by them in a subsequent year only to the extent they are allocated excess taxable income of the partnership.

Excess taxable income generally is the excess of 30% of the partnership’s ATI for the year, over the partnership’s net interest expense for the year. Until it is utilized, the disallowed interest expense is reflected as a reduction to each partner’s tax basis in its partnership equity. Such tax basis is restored, however, when the partnership interest is sold, even if the disallowed interest expense was not deducted by the partner prior to the sale.

To illustrate the application of the limitation to a partnership, assume a U.S. partnership engaged in the upstream oil and gas business borrows $10 million from a bank lender in 2020. The loan bears interest at a rate of 5% per annum and has a 10-year term. The partnership applies $5 million of loan proceeds to acquire depreciable assets for use in its business. The depreciable assets are eligible for bonus depreciation equal to 100% of the purchase price of the assets, or $5 million, in 2020. The partnership uses the balance of the loan proceeds for general business purposes.

The upstream partnership generates $1 million of ATI in 2020. The partnership’s limitation for 2020 therefore is $300,000, or 30% of ATI. Accordingly, the partnership would be permitted to deduct only $300,000 of its interest expense for the year.

However, unlike a corporate borrower, the remaining $200,000 of interest expense would not be carried forward to future taxable years at the partnership level but, instead, would be allocated to A and B in accordance with their respective interests in the partnership, or $100,000 each. The $100,000 of disallowed interest expense would be suspended in the hands of both A and B until, in a future year, such partners are allocated excess taxable income of the partnership.

Until the disallowed interest expense is utilized at the partner level, or A or B sells its partnership interest, A and B’s basis in their respective partnership interests is reduced by the amount of such disallowed interest expense.

As a result of the limitation, the partners’ after-tax cost of borrowing in 2020 would be higher than prior to the TCJA, when the partnership was permitted to deduct all $500,000 of interest expense, and A and B would have shared the corresponding deduction, $250,000 each, on a pass-through basis. Accordingly, unlike a corporate borrower, the increased cost of capital is borne directly by A and B, since each of A and B is permitted to deduct only $150,000, rather than $250,000, of the partnership’s interest expense against its allocable share of the partnership’s taxable income.

Looking ahead, the partnership must generate $1.667 million of ATI each year to deduct the full $500,000 of annual interest expense on the loan, to be shared by A and B in the amount of $250,000 each, and the partnership must generate an additional $666,667 of excess taxable income to permit A and B to utilize the disallowed interest expense from 2020.

Equity or debt? Looking forward, as oil and gas businesses seek additional capital, the limitation is expected to affect some taxpayers’ decision whether to raise debt or equity financing. We expect some taxpayers to determine that the impact of the limitation will be immaterial, or that the reduction in tax benefits associated with debt financing is not sufficient to cause them to pursue equity as an alternative, since equity investment typically results in ownership dilution and may be more expensive than debt.

These taxpayers may be motivated to pursue shorter-term debt or offer enhanced security to lenders as a means of keeping their interest rate low.

By contrast, businesses that already are highly leveraged, with low ATI and limited cash flow to service their debt, may seek equity financing to avoid the significantly higher after-tax cost of the debt and the corresponding reduction in liquidity.

Finally, taxpayers may be more likely to consider alternative means of financing. For instance, oil and gas businesses operated as partnerships may be drawn to preferred equity financing, which generally results in allocations of taxable income to preferred holders, to the extent of the preferred return, rather than to the common holders. As a result, from the perspective of the common holders, the income allocation to a preferred holder would have an impact similar to an interest deduction, except without the burden of the limitation.

A current area of uncertainty relates to regulated gas businesses, which are not subject to the limitation. The TCJA does not specify how businesses that are partially regulated and partially unregulated should apply the limitation.

For instance, a company group operating both regulated and unregulated businesses in separate subsidiaries, with bank debt at the holding company level, currently has no guidance for allocating the limitation among the various entities, particularly if they have shared assets. These issues are expected to be addressed in future guidance from the IRS and the Treasury Department.

Most practitioners expect that the IRS and Treasury Department will provide a framework to allocate interest expense among regulated and unregulated businesses, either based on relative asset value or relative income production, and may provide taxpayers the flexibility to use either method.

On the other hand, it appears likely that future regulations will not adopt a tracing method, by which a taxpayer’s use of borrowed funds would be traced to regulated or unregulated activities with the interest expense allocated accordingly.

Looking forward

Looking further ahead, businesses in the oil and gas industry with significant depletion deductions or substantial depreciable assets should expect another increase in the after-tax cost of their debt financing after 2021, when ATI is required to be calculated in a manner similar to EBIT rather than EBITDA. At that point, depreciation and depletion deductions will reduce ATI and increase the impact of the limitation for these businesses.

For oil and gas businesses that continue to use debt financing, building or acquiring additional depreciable property will make borrowing more expensive after 2021, which could have a potential chilling effect on expansion.

For this reason, we expect businesses that build or buy depreciable assets to consider electing out of 100% bonus depreciation and, instead, calculate depreciation under the modified accelerated cost recovery system (MACRS). Although MACRS depreciation would provide for a slower depreciation schedule, it would generate a more consistent stream of ATI each year and, as a result, a more predictable limitation.

It has yet to be seen whether the limitation will impact the prices that buyers are willing to pay for oil and gas assets. Although it was initially expected that deal pricing would be impacted by buyers’ increased cost of debt financing, or the relative cost of using alternative financing such as preferred equity, no consistent pricing trends can be attributed yet solely to the limitation. Time will tell, particularly if market interest rates continue to rise as they have throughout 2018.

Elizabeth McGinley is chair of Bracewell’s tax department and advises clients on acquisitions, dispositions, restructurings, joint ventures and debt and equity investments in the upstream and midstream oil and gas and power industries. She represents both public and private energy companies as well as private equity funds. Steven Lorch advises public and private clients on the various U.S. tax aspects of M&A, divestitures and joint-venture transactions in the oil, gas and power industries.

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