CHAPTER 8 TAX PLANNING FOR OIL AND GAS JOINT OPERATIONS
| Jurisdiction | United States |
TAX PLANNING FOR OIL AND GAS JOINT OPERATIONS
Of Counsel
Liskow and Lewis
Houston, TX
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JOHN T. BRADFORD is Of Counsel with the energy and natural resource law firm of Liskow & Lewis in Houston, Texas. He earned his B.S. in Accounting at the University of Illinois in 1977; his J.D. in Law at the University of Illinois College of Law in 1980; and his Master of Laws in Taxation at the University of Houston Law Center in 1991. Mr. Bradford practices energy and natural resources taxation, finance and corporate law at the state, federal, and international levels. His practice involves advising clients on the tax and business consequences of their acquisitions, dispositions, joint ventures, financing activities, hedging activities, and day-to-day business operations. He has advised clients regarding structuring complex energy and natural resources joint ventures, asset acquisitions and dispositions, and structured financings. He has represented clients before the Internal Revenue Service on audit, administrative appeal, and for private letter ruling requests. He has extensive experience in the energy and natural resources industry, having practiced for more than 18 years as a tax lawyer for Exxon Corporation (now Exxon Mobil Corporation), having worked in energy and natural resource investment banking at JP Morgan Securities, and having most recently advised clients as a principal in KPMG LLP's Washington National Tax practice. Mr. Bradford is a frequent speaker on energy and natural resource taxation matters, having presented to the American Petroleum Institute Federal Tax Forum, the University of Texas Parker C. Fielder Oil and Gas Tax Conference, the Texas Federal Tax Institute, the Rocky Mountain Mineral Law Foundation, the Tax Executives Institute, the American Bar Association Section of Taxation Energy and Environmental Taxes and Banking and Savings Institutions Committees, the American Bar Association Business Law Section, the Houston Bar Association Tax and Oil and Gas Sections, the Practising Law Institute, the South Texas College of Law Houston's Energy Symposium and Annual Institute for Attorneys and Landmen, KPMG LLP's Global Energy Conference, and the Liskow & Lewis Energy Law Seminar. His articles have been published by The Journal of Taxation, the Rocky Mountain Mineral Law Foundation, the University of Texas Journal of Oil, Gas, and Energy Law, the University of Houston Business and Tax Law Journal, Oil, Gas & Energy Quarterly, Oil and Gas Financial Journal, the University of North Texas Institute of Petroleum Accounting's Petroleum Accounting and Financial Management Journal, and the KPMG Global Energy Institute. Mr. Bradford has been a guest lecturer on oil and gas taxation at Georgetown University School of Law and currently is Adjunct Professor at the University of Illinois College of Law, where he teaches a seminar class on Energy and Natural Resource Transactions.
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TABLE OF CONTENTS
I. Introduction
II. A Description of Joint Operations in Traditional Oil and Gas Farmout Transactions
III. The Expected Tax Results for Joint Operations in Traditional Farmout Transactions
IV. Federal Income Tax Rules Impacting the Tax Results for the Parties to the Traditional Farmout Transaction
A. The Fractional Interest Rule
B. The Impact of the Husky Oil and Marathon Oil Cases on the Fractional Interest Rule and the Complete Payout Period Test
C. The Pool of Capital Doctrine Supports Non-Taxable Assignments of Interests in Oil and Gas Leases
D. Limitations on the Pool of Capital Doctrine in the Farmout Transaction
E. Income Recognition on Gas Sales
F. Other Objectives
G. Using a Tax Partnership to Achieve the Expected Tax Results for the Traditional Farmout Transaction
1. Oil and Gas Tax Partnerships
2. A Historical Perspective on Oil and Gas Tax Partnerships
3. Organizing the Oil and Gas Tax Partnership
4. Using Tax Partnerships for Farmout Transactions Affected by Revenue Ruling 77-176
5. Special Allocations for Oil and Gas Tax Partnerships, including Farmout Transactions Impacted by the Fractional Interest Rule
V. A Description of Joint Operations in the "Cash and Carry" Farmout Transaction
VI. Federal Income Tax Rules Impacting the Tax Results for the Parties to the "Cash and Carry" Farmout Transaction
A. Tax Inefficiencies in the "Cash and Carry" Transaction
B. Using a Tax Partnership to Enhance the Tax Results for the "Cash and Carry" Farmout Transaction
VII. Conclusion
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I. Introduction
Joint operations for oil and gas exploration and development arise when two or more parties join together to share the working interest costs of jointly exploring, developing and producing an oil and gas property. For example, in the simplest case, joint operations may be undertaken by two or more parties 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 by the parties to develop an oil and gas lease that already has had a discovery well drilled on the lease. And finally, joint operations may be undertaken by owners of individual leases whose leases are unitized under state law to maximize the output from the oil and gas reservoir underlying those leases. In each case, the parties to the joint operation agree to share the risks and rewards of exploring, developing and operating the oil and gas property or properties. Those parties each expect to realize certain federal income tax benefits that flow from the joint operation. It is those tax benefits that are factored into each party's after-tax economics anticipated for the joint operation.
This paper identifies the expected federal income tax results for joint operations in two typical farmout transactions.2 The first is a more traditional transaction in which
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the consideration provided by the farmee to the farmor is solely the drilling of a well on farmor's property. The second is a transaction in which the farmee agrees to make an upfront cash payment to farmor, drill one or more wells on farmor's property, and carry farmor for a specified dollar amount of farmor's share of the joint exploration and development costs. This latter transaction re-emerged in application in the 2008 - 2009 timeframe and has come to be known as the "cash and carry" type of farmout transaction.
For each farmout transaction, the paper identifies those federal income tax rules that impact the determination of whether the expected results will be realized by the parties. Because an oil and gas tax partnership can play an essential role in realizing the expected tax results of the farmout transaction, the paper defines an oil and gas tax partnership and explains those instances when it can be beneficial for the transaction. Typical tax partnership allocations are analyzed to show how the parties obtain the tax results expected for the particular farmout transaction.
II. A Description of Joint Operations in Traditional Oil and Gas Farmout Transactions
An oil and gas farmout transaction is a time-honored industry transaction that brings together a party who owns a working interest in an oil and gas property and another party with capital who is interested in drilling a well on that property in order to earn an interest in that property.3 The party owning the oil and gas property is referred to as the "farmor", and it is the farmor who has chosen to engage another party to fund the cost of drilling a well on the farmor's property in exchange typically for a portion of the farmor's working interest in that property. The party with capital to invest in that property is referred to as the "farmee", and it is the farmee who arranges for and pays the cost of the drilling of the well to earn a working interest in farmor's property.
The distinguishing feature of a traditional farmout transaction is that no assignment of a working interest in the subject property is made by the farmor to the farmee unless the farmee drills and pays for a well in accordance with the terms of the farmout letter agreement.4 The farmout transaction is therefore different from an oil and gas leasing transaction in which the party holding the mineral fee interest in the oil and gas property assigns all or a portion of the working interest to another party in consideration of a payment of lease bonus and the retention of a royalty interest in the property. The farmout transaction likewise is different from an oil and gas subleasing transaction in which the party holding the working interest in the oil and gas property
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assigns all or a portion of the working interest to another party in consideration of a cash payment and the retention of an overriding royalty interest in the property. In these latter two transactions, the assignees need not drill a well in order to acquire the assigned interest in the property.
There are a number of reasons why the owner of a working interest in an oil and gas property may not desire to undertake the risk and cost of drilling the well on that property and therefore desires to enter into a farmout transaction with a farmee who may be either an industry or financial party. For example, the farmor may not have readily available risk capital to pay for the well. The farmor may lack an understanding of the geology of the property or may not have access to the proper technology to drill and complete the well. Or, the lease on the oil and gas property may be about to expire and the farmor needs a party with access to risk capital and a drilling rig to step in to drill the well to preserve the lease on the property.
The farmee may be interested in drilling the well on the farmor's property because the farmee has access to available risk capital and a more...
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