Disappointing news with a new tax regime

Disappointing news with a new tax regime

by Pininvest Analysis

MLPs Energy Infrastructure ETNs & ETFs on pininvest.com

  • 20 constituents
  • -42.0% 1y performance
  • 56.2% volatility
Check the investment theme exit_to_app

MLPs are closely linked with a general partner (GP), usually an energy producer who relies on the infrastructure owned by the MLP to distribute extracted oil and gas and who stands to benefit financially the more energy is pumped through the network

Incentives (IDRs)

This is because the GP is entitled to ‘incentive distribution rights’ (IDRs) from the MLP, sharing in the actual cash distribution according to a preset framework: basically, its entitlements to MLP cash distribution rights are tiered and the higher the tier (the larger the distribution), the higher the percentage reverting to the GP

This legal framework meant to align the interests of GP and MLP in growing the business while financing the expansion – and required upgrades – of the energy distribution network and it has been mostly successful

However, it might be observed the alignment holds true as long as significant infrastructure investments are required, limiting actual cash distributions from the MLP to the stakeholders. But, as investment volume tends to drop, and potential cash distributions grow, the incremental share to which the GP is entitled increases very much (at the higher tiers, the GP may receive up to 50% of pay-out)

The indirect effect is to increase significantly the cost of capital for the individual holder of MLP units, which impacts the quoted value to the units: as a result, the alignment between MLP and GP might be lost. This development could explain why the legal framework of MLPs and GPs has been reconsidered in a number of instances since 2016 and IDRs in some cases canceled, either bought by the MLP or annulled by the GP

Interest rates

MLP sensitivity to interest rates remains subdued because the partnerships normally increase payouts over time, which explains their outperformance compared to fixed income instruments in a period of rising rates

Unfortunately, indirect negative impact of rising rates cannot be ignored if the cost of access to financial markets constrains the development of the shale industry, ultimate driver of the MLP business model

Taxation

 The new tax regime, introduced in the US, as of Jan. 1, 2018, maintains a tax advantage for individual MLP unit holders (not applicable to indirect holders of MLP funds) with a sunset clause, scheduling expiration of the tax benefit in 2025 – which may, or may not, be extended by future legislation

The reduce maximum individual tax rate of 37% (from 39.6% before 2018) combines with a deduction to individual MLP unitholders generally equal to 20% of the MLP’s domestic income and 20% of any recapture income of an MLP unitholder on the sale of an MLP unit: actual maximum taxation would be 29.6% (derived from 20%*37%) compared to a maximum of 39.6% before 2018

For more important information on the MLP tax regime, visit the Baker & Botts website