CHAPTER 7 TAX CONSIDERATIONS IN SELECTING A MINERAL FINANCING VEHICLE
| Jurisdiction | United States |
(Nov 1982)
TAX CONSIDERATIONS IN SELECTING A MINERAL FINANCING VEHICLE
Pendleton & Sabian, P.C.
Denver, Colorado
INDEX
OVERVIEW—FINANCING
TAX ASPECTS OF MINERAL EXPLOITATION
COMMON CONCEPTS
Mineral Interest
Property Unit
Separate Interests
Aggregation Rules
Depletion Concept
Depreciation and ACRS
Investment Tax Credit
Abandonment Losses
Recapture
"At Risk" Rules
Capital Gain
Tax Preference Items and the Minimum Add-On Tax
CONCEPTS-OIL AND GAS OPERATIONS
GENERAL
Election
Disproportionate IDC Allocations
Prepaid IDC
Recapture of IDC
Geological and Geophysical Costs
Windfall Profits Tax
CONCEPTS—HARD MINERAL OPERATIONS
Exploration Expenditures
Development Expenditures
Production Stage
Receding-Face Doctrine
Coal and Iron Ore: Special Treatment
IMPORTANCE OF VEHICLE FORM
GENERAL
SOURCE OF FUNDS
Foreign Investment
Tax-Exempt Organization Investment
Government Sources
Service Contributions
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TRADITIONAL EQUITY FINANCING VEHICLES—GENERAL
CORPORATION
Subchapter S Corporation
Current Law
Reform Act
Incorporation—Contributions
Debt—Equity Rules
PARTNERSHIP
Centralization of Management
Continuity of Life
Free Transferability of Interests
Limited Liability
Tax Partnership
Election Out
Contributions
RADITIONAL DEVICES—MINERAL INDUSTRY
TAX SHELTER PARTNERSHIPS
Expense Allocations
Danger Signals
OTHER INDUSTRY ARRANGEMENTS
Cost Company
Producer—Consumer Arrangement
Production Payment
THE EXOTICS--AN OVERVIEW
TAX-FREE ROLLUP
ROYALTY TRUST
PARTICIPATING FINANCING ARRANGEMENTS
CONCLUSION 102
FOOTNOTES 104
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The following items are provided as supplementary material to the paper:
Intangible Drilling Costs — Election. Add to material at footnote 67:
Under TEFRA, new rules cover IDC's deductible by individuals and the 15% reduction in the deductible amount of such costs available to corporations. The Code now allows individuals to elect to recover IDC's over a 10-year period to avoid such costs being treated as items of tax preference. IRC §§ 58(i)(1) and (2)(C). Individuals, other than limited partners, may claim the investment tax credit and avoid tax preference treatment by electing to recover such costs under the ACRS 5-year property rules. IRC § 58(i)(4). These rules are extremely complex, but amortization of IDC must be considered when a taxpayer's net operating losses and tax credits may expire. In the case of corporations, the 15% reduction in deductible IDC's available to integrated oil companies will be capitalized (with no investment tax credit available) and amortized over 36 months. IRC § 291(b)(2)(A).
Windfall Profits Tax. Add to discussion on page 32:
The WPT has been recently declared illegal based on constitutional grounds by a federal district court judge in Wyoming. His determination was based on the determination that the tax was not permissible, but it was not uniformly applied to all states as required by Article I, § 8, Clause I of the United States Constitution. Certain Alaska crude oil is exempt from the tax. See, Ptasynski, et al. v. U.S., No. C82-050 (D.C. Wyo.) decided on November 4, 1982. The decision will almost certainly be appealed and Congress could repeal the Alaska exemption to eliminate the constitutional issue.
Exploration and Development Expenditures. Add to material at footnote 106:
Under TEFRA, new rules cover mining exploration and development costs deductible by individuals and the 15% reduction in the deductible amount of such costs available to corporations. The Code now allows individuals to elect to recover exploration and development expenditures over a 10-year period to avoid treatment as items of tax preference. IRC §§ 58(i)(1) and 2(D) and (E). The amortization election may be advisable if net operating losses and tax credits are about to expire. Amortization may also result in a greater percentage depletion allowance since the deduction of such costs reduces taxable income for the purpose of the 50% limitation. Corporations will capitalize the 15% reduction amount and amortize it over a 5-year period. The investment tax credit will apply to the capitalized amount. IRC § 291(b)(2)(B).
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OVERVIEW—FINANCING
The focus of this monograph is the tax aspects of structuring a financing vehicle for mineral projects. However, it is perhaps important to reflect for a moment on what is meant by "financing." From such a basis for mutual understanding, it can be readily seen that the techniques for financing a project encompass a broad range of choices.
Starting with a dictionary definition for the purpose of determining common usage, the preferred definition of "finance" is "[t]he science of the management of money and other assets,"1 but in its verb form, the preferred definition introduces the concept of supplying funds or capital for someone to manage.2 Thus, for purposes of common usage, the concept of financing encompasses the provision of capital and the maintenance and use of another's funds. For our purposes, one must also understand that financing for a venture often entails something more than the trip to a friendly banker.
Does the financier look at project financing in the same manner as does the banker? Sometimes one wonders what a banker does look at when he reviews possible financing arrangements for a project. Does he look at the management of the borrower? Perhaps he does, but more likely than not he looks primarily at the source of repayment, which may include to some extent the "bankability" of the managerial or operational talents of the borrower. Experience demonstrates that the banker really looks "...to see if there is going to be sufficient cash flow generated from the asset to service and repay [the] loan over a bankable period of time."3
While a banker may look at the condition and marketability of the assets that will serve as security, the review serves only to determine whether the bank might be interested in discussing the financing for the project. However, approval of a bank loan will almost always be viewed from the perspective of whether the loan can be repaid from the cash flows generated by the borrower or the project. Thus, the more common focus of the banker in financing mineral operations is all too often the ability of the borrower to produce mineral reserves and their discounted cash flow based on assumed production flows. Often accompanying the banker's focus on cash flow is the failure to take into account the tax bite that Uncle Sam may exact. In contrast, the investor-financier is more likely to be concerned with after-tax consequences.
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It is likely that many bankers would challenge the previous statements, and assert that:
"In today's environment, where price controls and taxes are subject to frequent change, a bank must be reasonably prudent in deciding on the future realizable prices of oil and gas. So [a bank must first ascertain] what current governmental regulations, controls and taxes are and how strong a chance there is that they may be altered dramatically...."4
Nonetheless, experience serves as a basis for the assertion that there is at least some amount of truth to the proposition that bankers reflect more often on pre-tax cash flows, because this is what the mineral reserve valuation reports generally present. It is the mineral reserve report that gives the banker his level of comfort about the repayment potential. Thus, the banker is more concerned with the payment of interest [the cash flow the banker generates while managing his capital resources] and the repayment of principal than the single largest partner a participant in a mineral exploitation venture may have—Uncle Sam.
From a historical perspective bank financing is all too often a fairly cut and dried exercise unless participation financing arrangements are attempted, but such arrangements are generally not the vehicle of choice for the conservative banker. From bank loans, we move to transactions involving investors and equity financing, and the first question the uninitiated should ask is: What is meant by "equity financing?"
Back to the dictionary. For purposes of the discussion in this monograph, "equity" is best defined as "[t]he residual value of a business or property beyond any mortgage thereon or liability therein."5 Simply stated, equity is the residual value attributable to the ownership interest. Thus, equity financing can be viewed as the provision of risk capital. That is, it is the "piece of the action" that subjects the holder to all of the risks and rewards of ownership.
No financing device should be utilized solely to obtain tax objectives exclusive of all other business considerations. Each financing technique is unique in structure and results, providing both participants and advisors with many opportunities to consider and resolve many business and tax issues. Often the optimum tax result will not necessarily parallel the intended legal effect of a particular vehicle or structure. This is due to the diversity of legal principles under local law, and the tendency of the tax laws and interpretations to disregard such legal niceties. Funds providers, advisors and fund users alike must keep in mind that
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the primary objective is the proper financing of the project. Within the limits of the primary objective, the participants should attempt to utilize that financing device (mechanism, technique or vehicle) which achieves the primary financing objective and then, and only then, consider what achieves the best available tax consequences (tax benefits or minimization of tax detriments). That is, the selection process should achieve the desired business objectives while concurrently reaping some tax benefits, but the converse may not necessarily hold true.
Potential sources of financing will generally fall within two often intertwined...
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