CHAPTER 7 TAX PLANNING FOR JOINT OPERATIONS: KEEPING THE AFTER-TAX ECONOMICS OF THE TRADE INTACT

• Jurisdiction: United States

Oil & Gas Agreements: Joint Operations
(Dec 2007)
CHAPTER 7
TAX PLANNING FOR JOINT OPERATIONS: KEEPING THE AFTER-TAX ECONOMICS OF THE TRADE INTACT
John T. Bradford
Principal, Washington National Tax
KPMG LLP
Washington, D.C.

JOHN T. BRADFORD

John T. Bradford joined KPMG in 2002 as a principal in its Washington National Tax practice. He has extensive experience in the energy industry, having practiced as a tax lawyer for Exxon Corporation (now known as Exxon Mobil Corporation), one of the largest multinational integrated oil and gas companies in the world and having worked in energy finance at JPMorgan, one of the leading U.S. energy investment banking institutions. Mr. Bradford leads KPMG's tax relationships with several of its multinational integrated oil and gas company clients, and focuses professionally on providing solutions for the energy industry's specialized tax and financing issues.

Mr. Bradford received his Bachelor's Degree in Accountancy with Highest Honors from the College of Business at the University of Illinois in 1977. He received his Juris Doctorate magna cum laude from the College of Law at the University of Illinois in 1980. He received his Master of Laws in Taxation from the University of Houston Law School in 1991. He is a member of the American Bar Association and sits on its committees for Energy and Environmental Taxes and Partnership Taxation. He is a frequent speaker on energy taxation matters, having presented to the American Petroleum Institute Federal Tax Forum, the University of Texas Parker Fielder Oil and Gas Tax Conference, the American Bar Association Energy and Environmental Taxes Committee, and the KPMG Global Energy Conference. He is an instructor for oil and gas taxation for KPMG's internal training.

Introduction

Joint operations for oil and gas exploration and development may be undertaken in many different situations. For example, in its simplest case, joint operations may be undertaken to drill a single exploratory well on one oil and gas lease located in a wildcat area. Or, in a more complex case, joint operations may be undertaken to develop an oil and gas lease that already has had a discovery well drilled on the lease by its owner. In each situation, the parties to the trade agree to share the risks and rewards of exploring, developing, and operating the oil and gas property. And, in each situation, the parties to the trade each expect to receive certain tax benefits that flow from the joint operation. These tax benefits are factored in to each party's after-tax economics anticipated for the trade.

This article first identifies the expected federal income tax benefits that are included in the after-tax economics for a typical trade in which one party agrees to drill a well or provide capital to drill the well to earn an interest in an oil and gas lease held by another party.¹ Then, the article identifies those federal income tax rules that impact the determination of the after-tax economics. Because an oil and gas tax partnership can play an essential role in keeping the after-tax economics of the trade intact, the article defines an oil and gas tax partnership and explains those instances when it can be beneficial for the trade. Finally, typical tax partnership allocations are analyzed to show how the expected after-tax economics are kept intact by the tax partnership.

The Expected After-Tax Economics for the Trade

Regardless of how the joint operation is structured, the parties to the trade each will have certain expectations regarding the tax benefits that flow therefrom, and it is the realization of those tax benefits that impact the after-tax economics for the trade. For purposes of illustration, this article will consider a farmout trade in which the party owning the oil and gas lease (the "Farmor") agrees to assign to the party agreeing to incur the costs of drilling and equipping a well (the "Farmee") a working interest in a portion of the lease designated as the drill site acreage and a working interest in the remaining acreage of the lease. In this trade, the Farmor may retain an overriding royalty interest in the drill site

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acreage, and that overriding royalty interest may be convertible at the option of the Farmor into a fractional working interest in that acreage at some point during the joint operation.²

In the trade, the party earning the interest in the oil and gas lease will incur costs to drill and equip an oil and gas well. The intangible drilling and development costs ("IDC") incurred by the owner of a working interest in drilling the well are subject to the option to deduct such costs currently pursuant to section 263(c) of the Internal Revenue Code³ (the "Code") and section 1.612-4(a) of the Treasury regulations (the "Regulations").⁴ The party contributing cash to pay for the cost of drilling and equipping the well will expect to deduct that IDC currently, subject to limitations elsewhere in the Code.⁵

The party also may incur costs for lease and well equipment necessary to produce the oil and gas. Such costs are capitalized pursuant to section 263(a) of the Code and recovered through depreciation pursuant to section 167(a). The rules for the depreciation deduction for such equipment are provided in section 168, and those rules generally provide that the depreciation deduction is determined by using the applicable depreciation method, the applicable recovery period, and the applicable convention.⁶ Oil and gas lease and well

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equipment is seven-year property for purposes of section 168(e), with the applicable depreciation method being the two hundred percent declining balance method with a switch to the straight line method for the first year that the straight line method yields a larger allowance as provided for in section 168(b)(1).⁷ The party contributing cash to pay for the cost of depreciable lease and well equipment will expect to receive the depreciation deduction allowed with respect to such equipment.

The party also may incur costs to operate the oil and gas properties once oil and gas production has begun. Such costs generally are deducted as ordinary and necessary business expenses pursuant to section 162 of the Code. The party contributing cash to pay for operating costs will expect to receive the section 162 deductions allowed for such costs.

A party's working interest in an oil and gas lease may be involved in the trade so that an oil and gas well may be drilled thereon. The party's cost to acquire that working interest in the lease generally is capitalized pursuant to section 263(a) of the Code and is recovered through depletion pursuant to section 611 and section 1.611-1 of the Regulations.⁸ The party's cost to acquire the working interest generally becomes its basis for the property pursuant to section 1011 and it is that basis upon which the cost depletion deduction provided for in section 612 is computed.⁹ The party contributing to the cost of the working interest in the oil and gas lease involved in the trade will expect to receive the depletable tax basis in that lease so that it may compute its deduction for cost depletion. Each party to the trade separately will compute any available percentage depletion deduction.¹⁰

The trade also may involve one or more transfers of leasehold interests among the parties. For example, in the farmout trade described above, the Farmor may assign a working interest in drill site acreage and other acreage covered by the oil and gas lease in exchange for the Farmee bearing the cost of the drilling of an oil and gas well. The party assigning an interest in an oil and gas lease to another party to the trade will expect to transfer

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that interest without incurring federal income tax. Similarly, the party receiving an interest in an oil and gas lease will expect to receive that interest without incurring federal income tax.

The joint operating agreement for the trade typically provides for the parties to take their respective shares of oil and gas production in kind and separately dispose of such production. There may be instances, however, in which the parties delegate limited authority to the operator to sell their respective shares of such production. Each party who holds an interest in an oil and gas property as a result of the trade generally will expect to recognize ordinary depletable income only with respect to the oil and gas production or production proceeds it receives. There may be exceptions, however, in instances in which a party has a net operating loss carryforward that is about to expire or otherwise does not have sufficient taxable income in the year in order to be able to utilize fully certain production tax credits.¹¹

Each party who holds an interest in an oil and gas property or earns an interest in an oil and gas property as a result of the trade also will expect to be entitled to no less than that interest if and when the joint operation terminates. For example, in the farmout trade described above, the Farmee earns a working interest in the drill site acreage and the other acreage covered by the oil and gas lease in exchange for incurring the costs of drilling an oil and gas well. The joint operating agreement covering the farmout trade typically provides for termination in certain instances. The Farmee will expect that if a termination of the joint operation occurs, it will be entitled to both of the working interests earned in the trade.

Finally, each party to the joint operation will expect to minimize the tax complexity and reporting for the trade. Ideally, no tax partnership agreement would be included in the trade so that the complexity of administering a tax partnership and the incremental cost of preparing and filing a Form 1065 - partnership income tax return could be avoided.¹²

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Federal Income Tax Rules Impacting the After-Tax Economics of the Trade

Deducting IDC and...