CHAPTER 10 UNDERSTANDING AND MONETIZING THE SECTION 29 CREDIT

• Jurisdiction: United States

Coalbed Gas Development
(Apr 1992)
CHAPTER 10
UNDERSTANDING AND MONETIZING THE SECTION 29 CREDIT
Dennis J. Grindinger
Thompson & Knight, P.C.
Dallas, Texas
Matthew Shanahan
The Deerpath Group, Inc.
Chicago, Illinois

TABLE OF CONTENTS

SYNOPSIS

I. Introduction

II. Determining the Amount of the Section 29 Credit

A. General Rules

B. Apportionment among Taxpayers

C. Reductions from Government Subsidies, Grants, Tax-exempt Financing, and Other Tax Credits

D. Reduction from Effect of Tentative Tax Limitation

E. Reduction from Phase-out of the Credit

III. Determining the Applicability of the Section 29 Credit

A. Source Requirement

B. Ownership Requirement

C. Drilling Requirement

D. Prior Production Limitation

E. Sale Requirement

IV. Effect of Passive Activity Limitation.

A. Meaning of "Activity"

B. Meaning of "Trade or Business"

C. Meaning of "Material Participation"

V. Planning Techniques

A. Sale of Economic Interest with Retained Production Payment

B. Partnership with Special Allocations

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I. Introduction.

Twelve years ago, Congress passed (and the administration signed into law) an income tax credit which impacts the development of domestic energy reserves.¹ During the period of its existence, the section 29 credit has stimulated increased production of gas from coal seams, Devonian shale and tight formations.² There has not been an equivalent surge in production of oil from tar sands and shale due to the ambiguity caused by the ruling and audit positions of the Internal Revenue Service (the "Service") regarding what type of oil production qualifies for this credit.³

The income tax credit set forth in section 29 of the Code⁴ arises from the sale of certain "qualified fuels" (originally enacted as section 44D of the Code).⁵ This credit was enacted to accomplish two purposes: (i) to protect producers of nonconventional fuels from decreases in the wellhead price (relative to the price of imported oil) which resulted from the decontrol of domestic oil and (ii) to stimulate the domestic production of alternate fuels by lowering the after-tax cost of their extraction.⁶ Since its enactment, Congress has amended section 29 several times to correct perceived technical flaws and to extend its applicability. Currently, the window for drilling wells in order to qualify production for the section 29 credit will end on December 31, 1992, and the period in which the section 29 credit may be taken will expire on December 31, 2002.⁷

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This article will discuss the benefits of receiving and the requirements of taking the income tax credit under section 29 (the "section 29 credit"). Specifically, the article will focus on (a) the amount of section 29 credits earned on the sale of certain qualified fuels, (b) the statutory prerequisites for obtaining the section 29 credit, (c) the effect of the passive activity limitations on the section 29 credit, and (c) planning techniques for monetization of the section 29 credit.

II. Determining the Amount of the Section 29 Credit.

A. General Rules

The amount of the income tax credit under section 29 is determined by the taxpayer on the basis of a statutory formula prescribed by Congress.⁸ Under this formula, the "statutory amount"⁹ is multiplied by the "barrel of oil equivalent" of the qualified fuel sold by the taxpayer during the taxable year. For all qualified fuels other than gas from a tight formation, the statutory amount for the calendar year in which the sale occurs is determined by adjusting the $3.00 amount prescribed in section 29(a)(1) by the applicable inflation factor.¹⁰ The statutory amount is not adjusted for gas produced from a tight formation.¹¹ For oil, the "barrel-of-oil equivalent" is equal to 42 U.S. gallons of oil.¹² For qualified fuels

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other than oil, the "barrel-of-oil equivalent" is calculated on the basis of the energy content of the applicable fuel produced.¹³

An example will most easily demonstrate the four steps for calculating the amount of the credit for a qualified fuel. For purposes of this example, assume a taxpayer, during the calendar year 1991, produces and sells 12,000 Mcf of gas from coal seams which has a Btu content of approximately 1,020 per cubic foot. First, the statutory amount of the credit is determined by multiplying $3.00 by the inflation adjustment factor of 1.7835.¹⁴ Thus, the statutory amount of the credit is $5.35 per barrel-of-oil equivalent. Second, the barrel-of-oil equivalent, measured in Mcf, is determined by dividing 5.8 million by 1,020,000 (the product of 1,020 multiplied by 1,000).¹⁵ In this example, approximately 5.69 Mcf of such gas is equivalent to one barrel of oil. Third, the amount of the credit per Mcf is determined by dividing the statutory amount of $5.35 by the barrel-of-oil equivalent of 5.69 Mcf, resulting in approximately $.94 of credit per Mcf.¹⁶ Finally, the amount of the credit to be claimed by the taxpayer for the year is determined by multiplying $.94 by 12,000 Mcf, which, in this example, results in a aggregate credit of $11,284 for the 1991 calendar year.

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B. Apportionment among Taxpayers

The amount of the section 29 credit available with respect to a qualified fuel must be apportioned on the basis of the amount of production which is attributable to each taxpayer.¹⁷ In defining what is meant by "attributable to a taxpayer," section 29(d)(3) provides generally that production from the property or facility will be allocated among all of the persons owning an interest in such property or facility in proportion to their respective shares in the gross sales from such property or facility.¹⁸ Thus, the credit is apportioned among each of the owners of the property on the basis of their respective shares of the gross revenue from the sale of the qualified fuel.¹⁹

If a partnership owns an interest in a property or facility, the amount of the credit attributable to such interest will be further apportioned among its partners.²⁰ The direct allocation of a tax credit among partners of a partnership, however, cannot qualify for one of the safe harbors regarding allocations under the section 704 regulations, because the allocation of any tax credit cannot have "economic effect."²¹ In the absence of a safe harbor, practitioners turn to the principles underlying the regulations to determine whether the proposed manner of allocating the section 29 credit will be sustained. Under section 704(b) principles, a partner's share of the section 29 credit would be determined on the basis

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of his or her interest in partnership income derived from the sale of the qualified fuel.²² Accordingly, tax credits (including the section 29 credit) must be shared by the partners in accordance with their interests in the partnership as of the time the credit arises.²³ Thus, the section 29 credit should be shared among partners based on their respective shares of gross revenue from the sale of the qualified fuel giving rise to the section 29 credit.²⁴ If there is a change in a partner's interest in the partnership during the taxable year, the amount of the section 29 credit allocated to each partner will be determined on the basis of such partner's interest in the partnership at the time the qualified fuel is sold.²⁵

C. Reductions from Government Subsidies, Grants, Tax-exempt Financing, and Other Tax Credits

In general, the amount of the section 29 credit is reduced if the taxpayer claiming the credit is receiving, with respect to the property or facility, (a) certain subsidies, grants, or tax-exempt financing with respect to the property or project, (b) any other energy credits, or (c) the enhanced oil recovery credit.²⁶ If a taxpayer receives any federal, state or local grants, subsidized energy loans, or tax-exempt financing in connection with the construction or acquisition of the project, the section 29 credit otherwise allowable is reduced proportionally, based on the level of federal, state and local grants, tax-exempt financing, and subsidized energy financing used in connection with a project relative to the aggregate capital expenditures with respect to the project.²⁷ The section 29 credit is also reduced

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dollar-for-dollar in proportion to any energy tax credit allowed in respect of the property or project used to produce the qualified fuel.²⁸ In addition, the section 29 credit will be reduced, on a project by project basis, by the aggregate unrecaptured amount of the new enhanced oil recovery credit taken with respect to such project.²⁹

D. Reduction from Effect of Tentative Tax Limitation

The section 29 credit claimed by a taxpayer in any taxable year cannot exceed the difference between the taxpayer's (a) regular tax for such year (reduced by any possession tax credits or credits for testing certain drugs) and (b) tentative minimum tax for such year.³⁰ Unlike any of the other reductions to the section 29 credit mentioned in this paragraph, however, a taxpayer is permitted to carryforward and offset future regular tax by any credits which are not used solely because of limitation based on the taxpayer's tentative minimum tax.³¹

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E. Reduction from Phase-out of the Credit

The credit under section 29 is also subject to reduction based on the phase-out rules.³² Under these rules, the credit is reduced on the basis of a formula which is driven by the average wellhead price per barrel for all domestic crude oil.³³ As a result, this phase-out could occur at a time when the average price of oil has been driven to phase-out levels as a result of foreign oil markets while the price of gas has not risen proportionally, thereby causing producers of qualified gas to suffer a full or partial loss of the credit without the concomitant benefit of an increase in revenues from the sales of such gas.

III. Determining the Applicability of the Section 29 Credit.

A taxpayer is...