Retail concept finds favor in oil patch

John T. Bradford, Attorney, Houston

Remember the old-fashioned retail cash and carry transaction? It went something like this: When sales at the local lumberyard were slow, the lumberyard advertised a "cash and carry sale." Buyers showed up and purchased discounted goods with cash — no credit cards allowed. In normal circumstances, the lumberyard would have delivered the goods to the buyer's residence, but in a cash and carry sale, the buyer literally carried the goods out the door and transported them home. These sales were winners for all parties involved. The lumberyard accelerated its cash flow and cleared out excess inventory while buyers paid what they considered very attractive prices.

So what does this have to do with oil and gas transactions being undertaken in today's economic environment? Over the past several years, many oil and gas producers acquired significant oil and gas acreage positions in the major onshore shale gas resource plays. This acreage was acquired at significant investment, which may have been based on forward natural gas prices that were well in excess of today's prices. Moreover, the mineral leases under which these acreage positions were acquired may have provided for very short primary terms, significant delay rental payments, and strict continuous drilling clauses.

As natural gas prices fell during 2009 and cash flow was reduced, some of these oil and gas producers realized that they needed additional capital to meet their drilling obligations so that the leasehold acreage could be retained. With borrowing bases being reduced due to lower forward prices and banks pulling back from lending in general, traditional sources of bank capital became scarce.

Oil and gas producers caught in this situation have sought out companies in the industry with stronger balance sheets and cash flows that are looking to establish initial positions or add to existing positions in this highly prospective shale gas acreage. These producers typically intend to raise cash up front to shore up their balance sheets and help with meeting their future drilling obligations on the acreage, and are willing to part with a portion of their acreage positions if these financial and operating objectives can be met.

Buyers, meanwhile, are interested in minimizing upfront payments, and want to use as much of their cash as possible to drill new wells on the acreage. Thus, to make these transactions work, the buyers need to pay some amount of cash up front to the sellers, and agree to carry some or all of the sellers' drilling obligations for a specified dollar amount over a specified period of time. These so-called "cash and carry" transactions currently are in favor in the oil patch, arising in circumstances similar to those in the lumberyard sale described above.

Execution of cash and carry transaction

The cash and carry transaction typically is executed through a Purchase and Sale Agreement (PSA) and a Joint Development Agreement (JDA).

The PSA provides for an amount of cash paid up front as the purchase price for the specified percentage interest in the subject oil and gas acreage to be conveyed to buyer.

The PSA may contain certain limitations on seller's use of the cash received so that buyer can be assured that seller has the funds to meet its obligations under the JDA. For example, the PSA may provide that seller must leave a specified percentage of the purchase price in the operating subsidiary holding the acreage while the balance may be distributed to the parent company for use in paying down debt.

The JDA provides for the development drilling program to be undertaken by the parties on the subject acreage. The JDA also specifies the percentage of seller's share of the cost of drilling that is to be paid by buyer until a specified amount has been spent by buyer on the program. For example, seller may own 100% of the working interests in the subject acreage and agree to convey 50% of its interest to buyer in the PSA for a stated amount. Buyer in the JDA then may agree to pay 80% of seller's 50% share of the cost of drilling provided for in the program until a stated amount has been spent on the program, usually over a stated time period. In this example, buyer has agreed to pay its own 50% working interest share and 80% of seller's 50% working interest share, or in total 90% of the costs of the program until the stated amount has been spent on the drilling program.

Buyers and sellers like these cash and carry transactions because they can be structured with appropriate amounts of "cash" and "carry" necessary to meet their respective financial and operating objectives. Fortunately, these transactions can be structured to meet their tax objectives as well. The remainder of this article identifies those objectives and then focuses on the federal income tax efficiencies available in a cash and carry transaction.

Standard tax results and objectives

For federal income tax purposes, seller in our example transaction generally will recognize gain or loss on the disposition of the interest in the subject acreage and of the interest in any lease and well equipment conveyed to buyer. Gain or loss on the disposition of the interest in the acreage will be measured by the difference of the cash consideration received for the acreage and the acreage's remaining adjusted tax basis.

If certain holding period and other requirements are met, the gain may be considered capital gain, subject however to the ordinary income recapture rules for prior depletion and intangible drilling and development cost deductions on the acreage. Any loss may be considered an ordinary loss, depending on the tax position of the seller.

Similarly, gain or loss on the disposition of the interest in lease and well equipment will be measured by the difference of the cash consideration received for the interest in the equipment and its remaining adjusted tax basis. Again, if certain holding period and other requirement are met, the gain may be considered capital gain, subject to the ordinary income recapture rules for prior depreciation deductions on the equipment. As before, any loss may be considered an ordinary loss, depending on the tax position of the seller.

If seller expects to realize a loss on the acreage and equipment disposed of and that loss can be used on the seller's federal income tax return, seller's federal tax objective will be to structure the acreage transfer as a taxable sale, with recognition of the resulting loss. If, however, seller expects to realize a taxable gain, seller's objective will be to structure the transfer to minimize that gain.

Buyer in the example will allocate its cash purchase price between the interest in the acquired acreage and the interest in the acquired lease and well equipment. Amounts allocated to the acreage will be recovered for tax purposes through depletion (cost or percentage, depending on the circumstances) as oil and gas is produced, while amounts allocated to the lease and well equipment will be recovered for tax purposes through depreciation under rules applicable to seven-year MACRS property.

One of buyer's tax objectives will be to allocate as much of the purchase price as possible to the asset category with the shortest recovery period for tax purposes. Cost depletion is computed under rules similar to those for the units-of-production method for book purposes. Unless the anticipated oil and gas reserves are very short-lived with an expected steep decline curve, the shortest recovery period will be for seven-year MACRS lease and well equipment.

Another of buyer's federal tax objectives will be to deduct as much of the carried intangible drilling and development costs (IDC) and tax depreciation for lease and well equipment that it is obligated to pay for under the JDA. To meet this objective, the structure of the cash and carry transaction for federal income tax purposes will depend upon whether the transaction includes a complete payout provision in favor of buyer (to allow buyer to recover all of its costs of drilling, equipping and producing each of the wells it drills).

With an appropriate complete payout provision, the JDA can elect to be excluded from the federal partnership tax rules and avoid filing partnership tax returns. But many of the cash and carry transactions negotiated and executed today do not contain a complete payout provision. These latter transactions must be structured as partnerships for tax purposes so that the IDC and tax depreciation deductions are considered incurred by the tax partnership and can be allocated between the parties in accordance with their respective contributions to fund the IDC and lease and well equipment costs (90% to buyer in our example above).

In the absence of a tax partnership, buyer generally can deduct only the IDC and depreciation attributable to its acquired working interest, with the remainder of the IDC and lease and well investment capitalized and recovered through cost depletion as oil and gas is produced and sold.

Tax efficiencies in the cash and carry transaction

One of the tax efficiencies in the transaction has to do with the flexibility to size the amount of (1) cash paid to seller and (2) amount of IDC incurred on seller's behalf (the size of the carry). As mentioned above, seller generally will recognize gain or loss with respect to the cash component of the transaction. But when buyer agrees to a carry, the IDC incurred by buyer on seller's behalf is not considered taxable consideration received by seller. Instead, under well-established tax rules, the carry is considered buyer's contribution to the pool of capital required to develop the oil and gas acreage.

Depending on seller's financial and tax objectives, reducing the cash component while increasing the carry component can result in less gain recognized by seller and thus a more tax-efficient transaction to seller. Similarly, as mentioned above, cash consideration paid upfront by buyer to seller generally will be recovered over time either through tax depreciation or tax depletion. But, with proper structuring in the JDA to include a tax partnership with appropriate allocations of IDC and depreciation, buyer's contribution of funds to pay for IDC and lease and well equipment under the carry can be deducted in the year the IDC and tax depreciation is incurred (providing a faster tax recovery than cost depletion). So buyer too has a tax incentive to reduce the upfront cash component and maximize the carry component.

But what if seller needs to receive a significant amount of cash in the transaction? Seller and buyer still have an opportunity to be tax efficient by utilizing a tax partnership structure to minimize seller's reported gain for tax federal purposes. In this situation, the JDA will not elect to be excluded from the partnership tax rules and instead a tax partnership exhibit will be included in the JDA.

The JDA then may provide that the transaction is to be characterized as (1) a contribution by seller of its working interests in the subject leasehold acreage to the tax partnership provided for in the JDA; (2) a contribution by buyer of cash required by the PSA to the tax partnership; (3) a contribution by buyer of cash in the future to the tax partnership to meet the carry commitment provided for in the JDA; and (4) a distribution of the initial cash received by the tax partnership to seller as a reimbursement of seller's expenditures incurred to acquire and develop the working interests in the subject leasehold acreage during the two-year period prior to the contribution of the acreage to the tax partnership.

Seller's contribution of working interests in the subject acreage to the partnership and buyer's current and future contribution of cash to the partnership generally can be made under the federal partnership tax rules without incurring a tax. Seller and buyer can be allocated the IDC and depreciation deductions in accordance with their respective cash contributions to fund the IDC and the depreciable lease and well equipment.

And, finally, the distribution of cash from the tax partnership to the seller can be made without incurring a federal income tax to the extent that the distribution qualifies under the "reimbursement of preformation expenditures" exception to the general rule of a taxable "disguised sale" applicable to a partnership cash distribution like this.

Conclusion

The oil and gas cash and carry transaction provides flexibility to sellers and buyers to adjust the "cash" and "carry" components to meet their tax objectives for the transaction, while still meeting their financial and operating objectives. Most of these transactions will be undertaken through tax partnerships so that the parties can draw on favorable partnership tax rules to improve the tax efficiencies of the transaction.

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