The Stop Tax-Breaks for Oil Profiteering Act: Proposed Legislation Regarding Investments in Oil and Natural Gas

As discussed in more detail below, new legislation has been proposed that, if enacted, may have material adverse tax consequences to U.S. taxable and tax-exempt investors with investments in certain oil and natural gas positions.  In particular, the proposal in its current form would—

• subject a tax-exempt investor’s income, gain and loss related to certain oil and natural gas positions to current taxation, whether earned directly or by a foreign corporation in which such tax-exempt investor invests
  
  
• treat all capital gain or loss recognized by U.S. persons that relates to certain oil and natural gas positions as short-term capital gain or loss, including gains or losses triggered through a sale of interests in a partnership holding certain positions in oil and natural gas
  
  
• eliminate the favorable capital gain and loss treatment currently afforded to holders of “section 1256” contracts relating to oil and natural gas, which treats any gain or loss recognized with respect to such contracts as 60 percent long-term capital gain or loss and 40 percent short-term gain or loss. 
  
  

Introduction

Legislation introduced on August 6, 2009, by Sen. Ron Wyden, D-Ore., would have a profound effect on investment funds (and their investors) that engage in trading strategies relating to oil and natural gas.  This proposed legislation (The Stop Tax-breaks for Oil Profiteering (STOP) Act of 2009, S.1588) follows a similar proposal by Sen. Wyden and Sen. Chuck Grassley, R-Iowa, in July 2008.  This legislation is intended to eliminate the favorable tax treatment afforded to investors in oil and gas commodities that is believed to be responsible, in part, for what is viewed as “excess speculation” causing a dramatic rise in the price of oil and natural gas.  The legislation would apply to any transactions occurring between August 31, 2009 and January 1, 2014, with respect to the following items (“applicable commodities”)—

1. actively traded oil or natural gas (or any primary product such as gasoline, kerosene and diesel fuel)
2. an index that is based substantially on oil or natural gas as of the date the position in the index is acquired
3. a notional principal contract with respect to oil, natural gas or an index described above
4. any evidence of an interest in, or a derivative instrument in, any such commodity, index or notional principal contract, including an option, forward contract, futures contract, short position and similar instrument.

Tax Treatment of Gains and Losses from the Sale of Commodities by Tax-exempt Entities

A tax-exempt organization’s gross income derived from any trade or business the conduct of which is not substantially related to the organization’s exempt purpose is generally subject to tax as “unrelated business taxable income” (UBTI).  However, gains from the sale or exchange of property (including applicable commodities), other than stock in trade, inventory or property held for sale to customers in the ordinary course of business, are generally not treated as UBTI.  In addition, a tax-exempt organization generally will not recognize UBTI as a result of an investment in a foreign corporation that holds UBTI-producing assets.

The proposed legislation would treat net income, gain or loss with respect to applicable commodities[1] into account as UBTI to tax-exempt investors.  In addition, with respect to stock in foreign corporations held directly or indirectly by tax-exempt organizations, the proposed legislation would require a tax-exempt organization to currently recognize its pro rata share of a foreign corporation’s income, gain or loss with respect to any applicable commodity, unless such income, gain or loss was already subject to U.S. federal income tax (e.g., effectively connected income).  Further, a tax-exempt organization would be required to recognize UBTI on a sale of stock of a foreign corporation that holds applicable commodities to the extent of gain or loss that is attributable to the foreign corporation’s unrecognized gain or loss with respect to applicable commodities.

Taxation of Sales and Exchanges of Commodities by U.S. Persons

Generally, gains and losses from the sale or exchange of commodities are taxed as capital gains or losses.  Under present law, long-term capital gains recognized by individuals are subject to a preferred tax rate.

Under the proposed legislation, any gain or loss from the sale or exchange of any applicable commodity that otherwise would be long-term capital gain or loss is treated as a short-term capital gain or loss, without regard to the taxpayer’s holding period.[2]  In addition, a sale or exchange of a partnership interest holding an applicable commodity would be treated as short-term capital gain or loss with respect to the portion attributable to the unrecognized gain or loss in the applicable commodity, provided the partner otherwise would not be required to treat the gain or loss as ordinary income or loss.

Taxation of Commodities Derivatives

Gain or loss with respect to a commodity derivative that is a section 1256 contract subject to mark-to-market rules is generally characterized as long-term capital gain or loss and short-term capital gain or loss in a ratio of 60 percent and 40 percent, respectively (the “60/40 rule”).  Gain or loss from the termination of a section 1256 contract is also generally subject to the 60/40 rule. 

Under the proposed legislation, any gain or loss of a taxpayer with respect to a section 1256 contract that is an applicable commodity, and that under present law would be subject to the 60/40 rule, is treated as 100 percent short-term capital gain or loss.  In addition, certain taxpayer elections would not be available for mixed straddles if any position forming a part of the straddle is a section 1256 contract that is an applicable commodity.  The proposed legislation also contains certain anti-abuse provisions, as well as provisions related to the carryback of certain losses.

Analysis

This proposed legislation would impose particularly onerous tax consequences to persons trading in applicable commodities, particularly U.S. tax-exempt investors, U.S. individual investors with a long-term holding period investment strategy and U.S. taxable investors trading section 1256 contracts.  The bill raises a number of questions regarding its viability, including issues related to the administration and compliance issues arising from tax-exempt entities’ investment in foreign corporations holding any applicable commodities and a potential chilling effect on tax-exempt entities’ ability to invest in many types of offshore funds. 

Because this legislation was introduced shortly before Congress adjourned for its summer recess, it is difficult to determine the level of support for this bill until Congress returns to session in September.  Congress is currently focused on health care reform, which may further delay consideration of this proposed legislation.  However, in light of Sen. Wyden’s position on the Senate Finance Committee and the government’s need to generate revenue to offset various spending and revenue initiatives, we believe this legislation merits careful attention.  As such, we will continue to monitor any developments relating to this or similar legislation on behalf of our clients.

  [1] For purposes of determining UBTI, “applicable commodities” is expanded to include section 1256 contracts that are required to be marked to market.
[2] The proposed legislation does not affect the ordinary income recognized by (i) a person who treats an applicable commodity as inventory (e.g., a producer of an applicable commodity), (ii) a dealer in commodities, (iii) a trader in commodities that has elected mark-to-market treatment under section 475(f) of the Internal Revenue Code, (iv) a business that sells or exchanges an applicable commodity as part of a hedging transaction, as defined in section 1221(a)(7) of the Internal Revenue Code, or (v) a person who regularly uses or consumes an applicable commodity in the ordinary course of such person’s trade or business.  

IRS Circular 230 Notice Requirement.  This communication is not given in the form of a covered opinion, within the meaning of Circular 230 issued by the United States Secretary of the Treasury.  Thus, we are required to inform you that you cannot rely upon any tax advice contained in this communication for the purpose of avoiding United States federal tax penalties.  In addition, any tax advice contained in this communication may not be used to promote, market or recommend a transaction to another party.