MLP taxation – the worst case scenario

What is the worst that could happen? That’s a question I always ask myself when making an investment. I look at the major risks posed to an investment and do a worst case scenario analysis with respect to that risk factor. When it comes to MLPs probably the major risk associated with an investment in the sector is the potential ending of their preferred tax status by the government. Over the years rumors of the ending of the MLP tax preferred status has caused the sector to sell off several times and I’m sure has kept many investors away from the sector despite their strong fundamentals. So, what’s the worst that could happen?

The worst thing that could happen to MLPs is an overnight immediate change to their tax status. Lets say that tomorrow MLPs would have to start paying the statuary corporate tax rate of 35%. If that happened the initial analysis of the impact is relatively straight forward. Distributions would drop by 35% and share prices would probably do the same to adjust to the same yield levels. Pretty scary stuff on the surface. But as with most things the reality is not that straightforward and in this case not as bad is it may seem. There are two major factors to consider; net income and distribution coverage ratio. First and most important, MLP distributions are paid out of cash flow while corporate taxes are paid on net income. Second, an MLP rarely pays out all its available cash flow as distributions. It retains a portion for unforeseen events and other such things. Lets take a look at each factor.

Corporate taxes are paid on net income. For MLPs, net income can be quite a bit lower than cash flow available for distributions. Why? Due to non cash charges, mainly depreciation. MLPs , especially those in growth mode, have significant capital expenditures to fund future growth. These high capital expenditures lead to large depreciation charges which reduce taxable income significantly. For example, in Q1 2011 EPD’s net income was 63% of their total cash flow available for distributions. In the case of EPD then the impact of an overnight 35% tax rate would be a -22% impact on their distribution. Not as bad as 35% but still not a positive development.

The other factor to consider is the distribution coverage ratio. Most MLPs retain a portion of the cash flows to provide a cushion for shareholder distributions. They do this for several reasons such as to mitigate against unforeseen events or reduce their need for external funding. Needless to say an overnight tax change would be an unforeseen event. MLPs that have higher coverage ratios would have more capability to withstand such an event. At the extreme an MLP would need a coverage ratio of 1.54 times to withstand a 35% tax rate without impacting distributions (1/(1-0.35)) if all cash flow was taxable. Using EPD as an example again, in Q1 2011 it had a DCF coverage ratio of 1.4 times. Based in this metric alone it would need to reduce distributions by only -9%. Much better than the initial back of the envelope -35% hit. Now what if we combine the two factors, net income to total DCF ratio and DCF coverage ratio? The table below shows the results.

As the table shows the combination of a lower net income to cash flow ratio and a higher DCF ratio has the potential to mitigate the impact of paying corporate taxes quite a bit. Back to my EPD example, with a coverage ratio of 1.4 and a income to DCF ratio of 63% EPD’s distributions to shareholders would not need to be impacted at all! Now, not all MLPs are in the same position. Looking at an MLP like PAA tells a different story. In Q1 2011 PAA had a DCF coverage ratio of 1.08 and a income to cash flow ratio of 98%. Thus, PAA’s distributions to shareholders would be impacted by -29%. Not all MLPs are created equal. Overall, from my reading of many MLP financials the MLP average for coverage ratios seems to be 1.1 to 1.2 and for income to cash flow ratios around 60-70%. This is by no means an exhaustive analysis but it gives you some idea of the range of potential impacts to the sector as a whole. Overall, the impact would not be nearly as bad as the initial analysis would suggest.

Of course, in reality a massive regulatory change like this would not happen overnight. The implementation of such a change would most likely happen over a period of years. Most likely something like 3-5 years like in Canada. Also, companies are not stagnant entities either, they would start to plan and react to these changes. For example, in Canada companies created large tax pools to defer future taxes. Many of the big former royalty trusts still have not paid corporate taxes after the initial announcement of the tax change in October 2006. US MLPs could take similar actions or others like increase DCF coverage ratios over the years until the tax change goes into effect further mitigating the impact of the change. My main point is that impact to MLPs would not be as bad as most people think. Short term reactions in MLP stock prices would probably be severe but longer term impacts would not be so great.

In summary, an MLP tax status change would not be as bad as most people think. They key metrics to look at to judge the impact on your chosen MLP are DCF coverage ratio and the ratio of net income to DCF. Some MLPs would do better than others. And finally, not all the impact of a tax status change would be negative. Believe it or not there would be many positive impacts of an MLP tax status change. Like what? Well, you’ll have to come back for my next post. Stay tuned…