MLP Index Changes In Pipeline, Taxes Ahead

August 12, 2014

MLP indexes could be in for a big shake-up with Kinder Morgan reorganization.

Sunday’s announcement that Kinder Morgan Energy (KMI) will be buying the Kinder spin-offs Kinder Morgan Energy Partners (KMP) and Kinder Morgan Management (KMR), plus El Paso Pipeline Partners (EPB) could be the beginning of the end for MLP-focused indexes. The consolidated Kinder company will be a C-corporation, abandoning the master limited partnership structure that Richard Kinder helped pioneer.

MLP indexes hold MLPs, not C-corps. The biggest indexer in the MLP space, Alerian, requires all its constituents to be publically traded partnerships or limited liability corporations, as do Solactive, S&P and Miller/Howard. Not so Cushing, which allows “common units of a limited liability company or C-corporation.” The Credit Suisse Cushing 30 MLP ETN (MLPN) won’t need to do a thing with the 10 percent of its constituents in the Kindersphere.

The rest of the indexes, and the funds that track them, are most likely in for some reshuffling. This can bring tax consequences, and change the makeup of MLP indexes.

Kinder Morgan and the three target funds are in nearly every MLP index, sometimes comprising north of 13 percent of the fund. If MLP indexers like Alerian don’t change their rules, they’ll be either reweighting their remaining constituents, or admitting new ones as they adapt to the loss of the Kinder suite.

Alerian MLP (AMLP), the $8.86 billion MLP ETF, with 12.3 percent in the Kinder and EL Paso MLPs, stands to see more than $1 billion in portfolio turnover upon shareholder approval of the merger. In any rebalancing, turnover can produce capital gains, but MLPs will be hit especially hard, because of their tax structure.

The majority of MLP distributions are not taxed as ordinary income or even qualified dividends. They’re considered return of capital. Shareholders owe zero taxes on these. But here’s the catch: Returns of capital lower the security’s cost basis.

If AMLP must liquidate its positions in KMP and EPB, shareholders could face substantial capital gains taxes. The situation could be even worse in the actively managed First Trust North American Energy Infrastructure (EMLP), which currently has 13.15 percent of its portfolio in the Kinder quartet, and Global X MLP & Energy Infrastructure (MLPX), with 13.21 percent in the four securities as of Friday, Aug. 8.


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