CHAPTER 13 MONEY MAGIC: PULLING THE GOLDEN RABBIT FROM THE HAT

• Jurisdiction: United States

Mineral Financing
(Nov 1982)
CHAPTER 13
MONEY MAGIC: PULLING THE GOLDEN RABBIT FROM THE HAT
Ted P. Stockmar
Martha Traudt Collins Holme Roberts & Owen ^*
Denver, Colorado

I. INTRODUCTION

This paper is divided into three parts: first it will review selected industry methods of raising capital, second it will review the production payment and finally it will touch on certain more exotic financing arrangements. This paper does not review the implications of the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, nor will it attempt to explore in any great detail the tax consequences of the various financing methods, although it will identify and briefly discuss the most significant tax consequences of the various financing arrangements discussed.

II. INDUSTRY METHODS OF RAISING CAPITAL

There are numerous common industry methods of raising capital, of which only a few will be discussed below. This portion of the paper will review carried interests (sometimes referred to as "promoted" interests), including "1/3 for 1/4" deals; farmouts; and bottom hole and dry hole agreements. All of these are financing techniques commonly used among industry participants. For simplicity, much of the discussion in this paper assumes that the leasehold estate in question is owned only by one party. The discussion is equally applicable to an owner of less than 100% of the leasehold estate.

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A. CARRIED INTERESTS

A "carried interest" may be generally described as an arrangement whereby one working interest owner (the "carrying party") agrees to bear the costs attributable to all or a part of the interest of another working interest owner (the "carried party") in a property for a specified period.¹ The carrying party is then entitled to receive the production attributable to the carried interest until the carrying party has recouped certain specified costs. The right to receive the production attributable to the carried interest may be in the form of an actual assignment of the working interest, a production payment or merely a contractual right secured by a lien on the carried interest. At such time as the carried interest terminates, the carried party becomes a working interest owner for all purposes and commences paying his proportionate share of future costs attributable to his working interest and receives his proportionate share of the revenues from production. The details of carried interest arrangements vary considerably. The period for which the interest is to be carried is subject to negotiation between the parties and may apply simply to the drilling, testing and completing of an initial test well on a single lease or the interest may be carried through the exploration and initial development of a multiple lease prospect, or otherwise.

1. Use of Carried Interests

The circumstances under which a carried interest arrangement arise also vary. In some instances it is part of the purchase price for a working interest in a leasehold estate. The carried party, as the original owner of the leasehold estate, may not have the capital to adequately and timely develop the lease and thus agrees to sell a working interest in such lease in exchange for cash and in exchange for being carried by the purchaser on the first well or on several wells. A carried interest arrangement may arise as the result of one co-owner desiring to develop a property in which the other co-owner does not desire to participate, either because of his doubts as to its productivity potential or because of his lack of immediately available funds. Thus the co-owners may agree that the co-owner desirous of developing the property shall pay 100% of the costs of such development and shall be entitled to receive all of the revenues from all wells drilled until he has recovered out of the other co-owner's share of production certain specified costs.

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A carried interest arrangement is also commonly used by one party (a "promoter") who assembles an exploration prospect and then offers working interests in the prospect to various parties in return for a carried interest in such properties. An exploration prospect may be offered by a promoter to non-industry participants, but typically such an arrangement would be available to a non-industry participant on less favorable terms than it would be available to an industry participant who may himself find prospects and offer them to the promoter at a later time.

2. Tax Considerations

Although historically the tax treatment of the carried interest varied depending upon its exact structure, most of the historical differences have been eliminated. A carried interest is usually a "sharing arrangement" for tax purposes. A "sharing arrangement is a transaction wherein one party makes a contribution to the acquisition, exploration, or development of a mineral property and receives as consideration an interest in the property to which the contribution is made."² If the carried interest is a pure sharing arrangement the receipt of the interest in the property to which the contribution was made by the carrying party in exchange for his agreement to carry the other party, is a tax-free transaction. The theory underlying this tax-free treatment is the "pool of capital" doctrine.³ According to this doctrine, one who makes a contribution to the acquisition, exploration or development of a property makes a contribution to the "pool of capital." The contributor recognizes no gain because he has merely made an investment; the owner of the property recognizes no immediate gain, the value of his property has simply been enhanced. One key question in reviewing any potential sharing arrangement is determining what is the "property" for tax purposes to which the contribution was made. The definition of "property" for tax purposes is somewhat elusive⁴ and if is later determined that an interest was received in two properties: both the property to which the contribution was made and a separate property, then only the first portion of the transfer would be a tax-free sharing arrangement and the second portion would give rise to taxable income.⁵

As drilling costs are incurred, the carrying party is required to pay the costs attributable to the interest he received, including the carried interest. Assuming that his interest is 100% and thus he pays 100% of the drilling

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costs, he is entitled to deduct only that percentage of the intangible drilling costs ("IDC's") attributable to his smallest working interest in the property at any time during the "complete payout period."⁶ "Payout" for this purpose is defined by several Revenue Rulings⁷ and may be a trap for the unwary. For example, assume that the carrying party owns 100% of the working interest in a property until payout (as defined in the parties' agreement) at which time his interest reverts to a 50% working interest. If the definition of payout in the agreement does not comply with the minimum "payout" definition for tax purposes, the carrying party will be entitled to deduct only 50% of the costs incurred in IDC's rather than being allowed to deduct 100% of the IDC's.⁸ The difference, if any, between what the carrying party pays in IDC's and what he is allowed to deduct, must be capitalized by the carrying party as additional lease hold basis. These adverse tax consequences may be avoided by either including a tax approved "payout" definition in the agreement or by the use of a properly drafted tax partnership agreement.⁹ The tax partnership agreement may allocate the deductions to the party paying the costs which give rise to the deduction without regard to the "payout" concept.

Once production is finally obtained, the revenue from the production attributable to the carried interest is included in the gross income of the party entitled to receive it under the agreement, generally the carrying party.

3. "1/3 for 1/4 Deal"

Although there are many variations of the carried interest, what was thought for a long time to be the standard industry deal was the "1/3 for 1/4." In this arrangement a participant agrees to pay one-third of the development costs of a property for a specified period in order to acquire an undivided one-fourth working interest in the property. Thus, if the promoter had three such participants, his share (1/4) of the costs for a specified period would be paid for by the other three, but the promoter would be entitled to receive one-fourth of the revenues from the outset. Under this arrangement each of the carrying parties would be entitled to deduct only one-fourth of the IDC's incurred even though they were required to pay one-third of such costs and they would be required to capitalize the additional 1/12th paid by each of them attributable to the carried interest of the promoter. This tax result may be

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avoided through the use of a properly structured tax partnership in which the deductions are allocated to the party paying the costs giving rise to such deductions.

B. FARMOUTS

The term "farmout" generally refers to a sharing arrangement in which one party (the "farmee") performs drilling services in order to earn an interest in all or a portion of a lease. Failure to perform results in the farmee not acquiring an interest in the lease. Under a farmout, the farmee typically bears the entire cost of exploration and development of a lease or some portion thereof and in exchange for the performance of the exploration and development activity the farmee receives an interest in all or a portion of such lease. The party who contributes the lease (the "farmor") retains some form of interest in the lease. While the details of each farmout are as unique as the arrangements devised by the parties to exploit their mineral prospects, a farmout is basically (a) an executory contract (b) to assign an interest in a lease insofar as it relates to specified...