Revisiting the Tax Effects of Oil and Gas Property Impairments

Introduction

With the continued softening of oil and gas commodity pricing in 2015, entities owning producing properties[1] (along with their investors, lenders, and independent auditors) are looking at their impairment testing exercises with more scrutiny as to methodology used and interpretation of terms and elements employed in the computation.  This article discusses the treatment of income tax elements of impairment losses for both Full Cost (FC) method entities as well as Successful Efforts (SE) method entities.  When considering the tax effects of these GAAP[2] calculations, FC entities clearly have more tax-related steps to take in performing the calculation, but there are deferred tax consequences to impairments recorded by SE entities as well, as is discussed below.

U.S. Income Tax Law Affecting Oil and Gas Property Impairments

Current Tax Deductibility of Impairment Losses: The purpose of the Internal Revenue Code[3]is to raise revenue to fund the republic[4],whereas U.S. GAAP’s role  is to provide guidance in reporting fair, consistent, but conservative financial results of transactions and the financial position of an entity in such a manner that separate entities’ activities and results are comparable.  With these somewhat differing missions, it is no surprise that an impairment write-down driven by GAAP is not, in and of itself, sufficient evidence to record a similar reduction in taxable income at that time since the GAAP impairment exercise is devoid of an arm’s length exchange with an unrelated third party evidencing such a loss.  See §165[5], and Thor Power Tool Co. v. Commissioner[6]As such, when preparing one’s tax return in the year of an impairment loss, the loss is added back to pre-tax book income in the book-to-tax reconciliation to arrive at current taxable income (which many view as an unexpectedly harsh result).  This is also known as an “unfavorable temporary difference” in the world of Topic 740 Income Taxes.  The tax basis of the property does not change by the book impairment loss (since no related tax loss was claimed in the current year on the tax return), which is an item that has further Topic 740 significance on the deferred tax balances of the entity as discussed below.  Rather, the tax basis is recovered on tax returns through future tax depletion[7] or through the offset of gain (or increase of loss) if the property is disposed of prior to the end of its economic life.

Percentage Depletion and Its’s Effect on the Tax Basis of Properties:   Percentage depletion[8] (also referred to as statutory depletion) is an alternative method to cost depletion allowing certain[9] taxpayers to claim cost recovery deductions on mineral properties.  Percentage depletion deductions are initially the product of the statutory depletion rate (generally 15% for oil and gas production) and the qualifying extraction income for the period. , Percentage depletion is subject to more stringent limitations[10] than cost depletion.  However, similar to GAAP, tax depletion deductions using either method reduce[11] the tax basis of the property giving rise to the production[12].  But, due to the nature of percentage depletion (being based upon gross production revenue), the totality of these deductions over the life of a property may exceed the property’s tax basis.  This does not result in negative property tax basis[13] (a property’s basis will not be reduced to less than zero for future gain or depletion computations), but the excess of percentage depletion claimed over the tax basis of the property is treated as a tax preference item[14], which may require an Alternative Minimum Tax (AMT) calculation.  This depletion is often referred to as “excess depletion” or “preference depletion” in tax circles.

Treatment of the Tax Elements of Impairment of Full Cost Pools

Guidance for the financial accounting and reporting of oil and gas properties using the FC method is found in 17 CFR §201.4-10, with item (D) of Rule 4-10(c)((4)(i) providing that “[T]he income tax effects related to the properties involved should be deducted[15] in computing the full cost ceiling.”  Initially, a year-by-year approach involving estimating and scheduling the expected year of future events is required, with these estimated annual results being discounted to the reporting date.  However, additional guidance related to the ceiling test is found in SAB Topic 12.D.1. which provides a “short cut” method for this calculation, which is commonly employed by upstream entities.  The balance of this section will focus on this Short Cut method[16], noting that similar principles (ignoring scheduling and present values) apply to the prescribed FC method.  Simply stated, under the Short Cut method, a write-down of the FC pool is required when the Net Book Value exceeds Evaluation Value.

Net Book Value: This element is determined by totaling the recorded costs of proved properties being amortized, the cost (or FMV, if lower) of unproved reserves to be amortized, and the cost of properties not being amortized.  Accumulated amortization is subtracted as are the income tax effects of property ownership presently recorded. The term “income tax effects” includes a reduction in the unamortized book basis of the FC pool for the future (undiscounted) deferred tax liability (recorded under Topic 740 presently), and adjusted for other tax items related[17] to the properties being evaluated in the FC pool, including net operating loss (NOL) or other carryforwards like foreign or investment tax credits.  For entities complying with Topic 740, much of this information is likely available from the tax provision workpapers[18] .  Care should be taken to note the difference between pre-tax and tax effected amounts in performing the calculation, as the Book Value definition for this purpose is adjusted for tax-effected amounts.  The tax rate to use (according to SAB Topic 12.D.1.) is the “statutory” rate.  For domestic properties, this rate is typically the top U.S. corporate rate[19] of 35%, but can be increased for applicable state tax effect by adding (to 35%) the appropriate state rate(s) (less the federal benefit at 35%) for onshore producers with income attributed to taxing states.  Generally, entities should avoid simply using the “effective tax rate” or the “cash tax rate” without forethought as these rates often are influenced by factors[20] unrelated to the theory of this exercise.

Evaluation ValueThe Net Book Value is compared to the Evaluation Value, which is the expected present value of the future net revenue stream[21] (including development costs) adjusted for the tax effects of earning that net revenue stream.  In this portion of the calculation (which is pre-tax at this point), the future net revenues are reduced by pre-tax attributes first, such as tax basis in the properties included in the FC pool, NOL carryovers, and “the present value of statutory depletion[22].”  The theory seems to remain aligned with the notion of limiting the present net value of properties recorded on the books to the estimated discounted amount of future after-tax net cash being generated[23].  However, from this author’s experience, the “present value of statutory depletion” element is subject to diverse interpretation.  Some entities interpret this to mean that only statutory depletion carryovers pursuant to §613A(d) (flush language) may be used in determining Evaluation Value, while others include these carryovers but believe that if the theory is to estimate the future net revenues after cash taxes, that statutory depletion in excess of basis[24] should be estimated for the future production and included as another element of the “tax shield” computation.  It seems reasonable to limit this amount to depletion in excess of tax basis only, and not all percentage depletion, because, as stated above, all sustained depletion (percentage or cost) reduces tax basis (to the extent thereof). In the Evaluation Value calculation, if both 100% of the remaining tax basis were to be deducted along with 15% of the future gross revenue (i.e., an estimate of future percentage/statutory depletion), there would seem to be an improper double counting of future deductions as the sum of the two amounts would exceed what would be claimed on the future tax returns.  Estimated AMT inclusion[25] seems consistent with the scheduling approach, but is apparently mooted by the Short Cut approach which ignores the present value of tax payments.  However, similar to the Net Book Value calculation above, the tax effects of future tax attributes usable against net pre-tax revenues should not result in a net positive cash flow[26].

Effect of Existing Valuation AllowancesFrom this author’s experience, the SEC staff and most major accounting firms have insisted that “tax attributes” (especially NOL carryovers) used in these calculations be limited to the net amounts recorded on the financial statements after considering the need for a valuation allowance (VA) as required by Topic 740-10-30.  Thus, if an entity’s NOL carryover is wholly or partly reserved on its books, this treatment must be consistently reflected in the ceiling test by using only the NOL (or other carryforward) not subjected to a VA.

The Tax Gross-UpAt the bottom of the SAB Topic 12.D.1. Short Cut example is an adjustment that is occasionally overlooked: the tax gross-up.  Since deferred taxes reduce the Net Book Value (which is generally the property cost less accumulated DD&A) to arrive at the net of tax investment on the entity’s books, once the impairment is determined using this net of tax amount, this net loss must be unwound or grossed up to separate the property component and the deferred tax component to record.  SAB Topic 12.D.1. uses the statutory rate (and not the “effective tax rate” for the entity); however, in light of the VA step required in applying Topic 740, it is not uncommon for the balance sheet effect of the deferred tax benefit recorded to cause the entity to have a net deferred tax asset after recording the grossed-up impairment.  The author views the current state of practice (especially among SEC registrants) is to look-upon any net deferred tax assets with relative skepticism, and thus causing a robust exercise (and discussion with one’s independent auditors) to take place justifying this position[27].  Recording a VA results in a charge to income from continuing operations[28] in most cases, and results in changes to the effective tax rate for the year.

Current Year Valuation Allowances: An area of concern arises when the tax benefit of the impairment causes an entity to pass into this “net deferred tax asset” situation in the current year.  While it seems clear that the Topic 740-10-30 VA analysis is performed after all of the adjustments to pre-tax income take place for the period, there are some instances where entities have reflected the resulting VA as a part of the tax effect[29] of the impairment.

The author believes that the better view is to record the VA as a separate adjustment to income from continuing operations after consideration of all relevant factors related to the entity’s financial and tax affairs, and not, absent compelling facts to the contrary, apportion the VA wholly or partly to the impairment.  While period net income is the same irrespective of the view taken, there are potential changes in reporting the tax effect of the VA (or not) as it effects the impairment disclosure specificallySupport for this later view is provided by: (i) SAB Topic 12.D.1., itself as the example to record the entry refers to the statutory tax rate, and (ii) Topic 740-10-30-8 which requires that a deferred tax liability or asset is measured “. . . [U]sing the enacted tax rates(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.”  Thus, the rate at which the temporary difference is being removed (arguably “settled” as the delta between book and tax basis is typically reduced by book property impairments) should be the rate at which it was initially recorded (absent changes in tax law) and irrespective of the presence or absence of a VA.  While it is true that tax benefits should not result in a net cash in-flow in the Evaluation Value, having a net deferred tax asset (even if solely related to the properties themselves) did not result in such an increase for the current period’s test.  Any resulting VAs will be properly reflected in the next period’s ceiling test.

Interim Period ReportingShould an impairment appear in an interim period, the exercise described above is largely the same, with the main tax-related issue being: how does one reflect the VA in an interim period?  The general rules are found in Topic 740-270 which first instructs preparers of financial statements to conclude whether they are changing judgment as to the recorded amount of an allowance that was existing at the beginning of the accounting yearIf so, the effect of the change is not apportioned among the interim periods of the current year, but is recognized in the interim period where the change occurs[30]. Conversely, if the VA concern arose during the current fiscal year, the literature requires it to be considered in estimating the annual effective tax rate for the year that is applied and to determine if the benefit can be recognized during the year.  This too can be a complex calculation requiring judgment on several issues[31] as to expected full-year results, and often results in a forecast annual effective tax rate (benefit) that is different from the statutory rate set out in SAB Topic 12.D.1.  In these cases, many entities do not formally record a VA in the interim period, but record a lower benefit during the interim periods with a true-up during the last quarter where the interim period literature of Topic 270 does not apply.  This treatment is often supported with additional disclosure in the tax footnote or elsewhere in the MD&A.

Tax Elements of Successful Efforts Method Impairments

SE literature is found in Topic 932-360, with impairment guidance appearing in Topic 932-360-35-8/9 which cross-references the general rules of Long-Lived Assets in sections -15 and -35 of Topic 360-10[32].  The headlines regarding the tax effects of SE impairments are: deferred tax liabilities related to the properties are not included in the book carrying amount (unlike FC pools), nor are the tax effects of future cash flows used to measure recoverability considered[33].  Thus, there is no balance sheet netting of deferred tax accounts and attributes with book carrying values of SE properties, nor is there a calculated tax effect of the estimated tax burden of future cash flows used to measure impairment values[34].  By excluding tax calculations entirely, only pre-tax cash flows are measured against pre-tax asset carrying values which seems to be a conceptually sound approach.

However, an impairment to SE properties also has income tax accounting consequences when recorded, as the “balance sheet” approach required by Topic 740 reflects this change in relationship between the book and tax carrying values of the properties post-impairment.  As discussed above, in all likelihood, an SE impairment is also an unfavorable temporary difference in the period it is recorded, with no immediate impact on the effective tax rate.  However, since the corresponding tax benefit adjusts the deferred balances, consideration of the need to record a VA is appropriate.  An exception to this “unfavorable temporary difference” conclusion would be where there was a goodwill element associated with an SE cost pool that, due to the form[35] of its acquisition, had no tax basis.  In this case, the impairment of non-tax deductible goodwill is an unfavorable permanent difference, and the tax cost of the lost benefit is recognized either fully in the period of the impairment, or, in other cases (for example, where the entity has a policy or history of impairing such goodwill), the lost benefit is factored into the revised estimate of the annual effective tax rate as previously discussed under Topic 740-270.

Conclusion:  The tax consequences of oil and gas property impairments can be an especially challenging intersection of highly-technical and industry specific guidance that overlaps multiple disciplines of tax and financial reporting.  It is rare that one finds all of the answers in only one source, thus making early and detailed collaboration an essential step in quality financial reporting.

 

Author:  W. Lynn Loden, CPA, is the Managing Director of Transaction Services and Taxation for Opportune LLP, in Houston, Texas.  The author would like to thank his Opportune colleagues Stephen Patton, Calvin Nguyen, and Rachel Patrinely for their helpful comments.


[1] As defined by the appropriate accounting literature.

[2] Generally Accepted Accounting Principles in the U.S., currently codified by the Financial Accounting Standards Board in its Accounting Standards Codification (ASC) effective July 1, 2009, as amended.  References to GAAP citations in this writing are indicated through the use of ASC or Topic prefixes.  Securities and Exchange Commission references are denoted by CFR, Rule, or SAB Topic, as appropriate.

[3] Specifically, the Internal Revenue Code of 1986, as amended (IRC).  Statutory references, unless stated otherwise, are indicated by § as a prefix.

[4] Although this writer strongly believes that Congress cannot resist using the IRC as a tool of social engineering by encouraging or discouraging behavior through economic incentives or disincentives, as one need look no further than the myriad of constantly changing tax credits and special deductions (many of which, known as “extenders,” must be renewed periodically thus keeping multiple political footballs in play), or the Affordable Care Act itself for confirmation.

[5] Treas. Reg. §1.165-1(b), where generally a deduction is allowable for “worthless” property if the loss actually is sustained during the tax year, is evidenced by closed and completed transactions and is fixed by identifiable events. Most state taxing authorities follow these U.S. federal rules.

[6] Thor Power Tool Co. v. Commissioner, (1979, S Ct) 43 AFTR 2d 79-362 (99 S. Ct), 01/16/1979.  Regarding the ability of a taxpayer to follow a GAAP accounting method for tax purposes, the Thor court also noted (at 79-372) [that]:  “This difference in objectives is mirrored in numerous differences of treatment. Where the tax law requires that a deduction be deferred until "all the events" have occurred that will make it fixed and certain, United States v. Anderson, 269 U.S. 422, 441 [ 5 AFTR 5674] (1926), accounting principles typically require that a liability be accrued as soon as it can reasonably be estimated. Conversely, where the tax law requires that income be recognized currently under "claim of right," "ability to pay," and "control" rationales, accounting principles may defer accrual until a later year so that revenues and expenses may be better matched. Financial accounting, in short, is hospitable to estimates, probabilities, and reasonable certainties; the tax law, with its mandate to preserve the revenue, can give no quarter to uncertainty. This is as it should be. Reasonable estimates may be useful, even essential, in giving shareholders and creditors an accurate picture of a firm's overall financial health; but the accountant's conservatism cannot bind the Commissioner in his efforts to collect taxes (emphasis applied). "Only a few reserves voluntarily established as a matter of conservative accounting," Mr. Justice Brandeis wrote for the Court, "are authorized by the Revenue Acts." Brown v. Helvering, 291 U.S., at 201-202. “

[7] Including, for this purpose, tax amortization of IDCs capitalized under §59(e).

[8] Two types of depletion are allowable by the IRC: cost (§611) and percentage (§613 and §613A).  Qualifying taxpayers typically determine both, and use the method (on a per-property basis) that saves the most current tax.

[9] See footnote 22, infra.

[10] §613(a) limits percentage depletion on oil and gas wells to 100% of the taxable income from the property before considering the depletion deduction, and §613A(d)(1)(a) limits total percentage depletion sustainable for a year (for taxpayers other than certain trusts) to 65% of the taxpayer’s taxable income before: (i) the oil and gas percentage depletion deduction itself, (ii) the production activities deduction under §199, (iii) NOL carrybacks to the tax year, and (iv) capital loss carrybacks to the tax year.

[11] Treas. Reg. §1.1016-3(a).

[12] However, this basis reduction only occurs when percentage depletion is “allowed,” which means when the depletion actually offsets taxable income. Thus, an entity with a current or existing NOL carryover will often result in application of the 65% of taxable income limitation of §613A(d)(1), which  both defers the percentage depletion deduction and technically suspends the basis reduction.  This often causes these entities to have percentage depletion carryovers.  As a result, upstream producers often have “reconciling” schedules for properties in this scenario, and make appropriate adjustments when properties are disposed of or the NOL carryforwards begin to be used.  This series of events can also effect the makeup of deferred tax items in an entity’s deferred tax inventory.  The author generally sees suspended percentage depletion (otherwise available for future use) claimed as a tax attribute in the ceiling test calculation with a corresponding reduction in tax basis in properties that is likewise used in this calculation.

[13] Rev. Rul. 75-541, 1975-2 CB 330.

[14] §57(a)(1).

[15] For this purpose, the author is unaware of “net tax effects” related to properties resulting in a net increase in Net Book Value for this purpose.

[16] Clearly different results are possible between these two methods when applied to the same facts, and these differences can be material. However, as a general observation, for FC pools with significant tax basis subject to depletion (such as in the case of recently purchased properties vs. those developed with domestic intangible drilling costs being currently expensed), the Short Cut method often results in a better result for the testing entity.

[17] For entities with both NOL carryforwards engaged in upstream and non-upstream businesses, some reasonable and consistent allocation between the businesses is required as SAB Topic 12.D. only allows use of loss carryforwards in these cases which are “. . . available for tax purposes and which related to (presumably only upstream) oil and gas operations.” See SAB Topic 12.D.1, question 1, after amendment by SAB 113.

[18] Note to exclude from this computation deferred tax assets attributable to Asset Retirement Obligation liabilities to be consistent with SAB Topic 12.D.4.a.’s exclusion of elements related to future cash flows associated with settlement of accrued AROs.

[19] Since FC impairments are typically measured by country, use of the appropriate in-country statutory tax rate is required, and this rate may differ from the US rate of 35%.  However, knowledge of the in-country and consolidated legal structure is required, as many tax planning opportunities and elections exist that can change this rate (such as the “check-the-box” election where, for example, a foreign entity is disregarded as an entity and treated as a branch of a US entity).  In these cases, significant analysis is often required to fully understand the proper future tax rates and credits against the taxes to comply with the literature.

[20] For example, permanent differences relating to share based compensation, non-tax deductible goodwill impairments, or changes in a VA can significantly impact an effective tax rate but are generally not directly related to a property impairment.  “Cash tax rates” are basically a shorthand term describing the relationship between the current tax provision to pre-tax income, as the current tax provision is heavily influenced by temporary differences in addition to permanent differences.  Neither of these rates (in and of themselves) seem appropriate.

[21] Discounted at 10% using the average price during the 12-month period prior to the ending date of the period covered by the report.  Rule 4-10(c)(4).

[22] Under present law, percentage (or “statutory”) depletion is only available to “independent producers” (§613A(c)) on domestic production of up to 1,000 barrels per day. Integrated “refiners” or “marketers” as described in §613A(d)(2) and (4) are excluded from this benefit.

[23] This notion holds together well by claiming an offset for the tax savings from the remaining tax basis in the properties and NOL carryovers in their actual amounts which takes into account prior book-tax basis differences.

[24] Additional support for this position is inferred from the inclusion of “Estimated Preference Tax” in SAB Topic 12.D. in arriving at the net tax effect of the Evaluation Value (e.g., the cost center ceiling).  Preference taxes (now known as the Alternative Minimum Tax, or AMT) would usually only arise in upstream industries in situations where significant IDCs or percentage depletion in excess of basis resulted in a current tax savings.  §§57(a)(1) and (2).

[25] Together with allowable minimum tax credits pursuant to §53.

[26] See also SAB Topic 12.D.1. question 1, after amendment by SAB 113.

[27] A complete discussion of the application of Topic 740-10-30 is beyond the scope of this writing.  Suffice it to say for many upstream entities, the tax bases in the properties is often less than their book carrying value (due to previous IDC expensing), but an NOL carryover (often as a result of the IDC expensing in excess of pre-tax operating income) exists.  Generally speaking, practice seems to allow avoidance of recording a VA to the extent the NOL deferred tax asset does not exceed the property deferred tax liability.  See Topic 740-10-30-18(a), as the property deferred tax liability represents “existing taxable temporary differences,” and where there is no other factor (such as a previous §382 ownership change of the entity) limiting the use of the NOL.  This is a highly factually sensitive area requiring close consultation with one’s independent auditors and tax advisors.

[28] Topic 740-10-45-4 and 45-20.

[29] A sub-element of this VA analysis also arises regarding the status of individual deferred tax line items making up the entity’s deferred tax inventory in that: must one must consider whether the deferred tax liability solely associated with the oil and gas properties being evaluated should be subject to the impairment-related VA analysis, and not the entity’s deferred tax situation as a whole?  This approach is not supported by the current literature as VAs (generally) are not specifically allocated to specific deferred tax assets.  Topic 740-10-45-5.

[30] See Topic 740-270-25-7. This is usually recorded as a “discrete” item in that period.  However, at this writing, there is a proposed change to this literature (mainly defining items constituting a “discrete” item), and hopefully there will be added clarity in the future.  This is another issue requiring early and open discussion with one’s external auditors.

[31] See Topic 740-270-25-8 and the helpful examples from Topic 740-270-55.

[32] It is worthwhile to note that Topic 360-10-15-5 specifically excludes the following items (among others) from its impairment scope: deferred tax assets, unproved oil and gas properties accounted for using the SE method, and oil and gas properties accounted for under the FC method.

[33] This treatment apparently descended from the separation of tax-specific assets and liabilities from their pre-tax financial statement carrying values (e.g., the rejected “net-of-tax” approach) when SFAS No. 96 was adopted in 1987. See SFAS No. 96, Accounting for Income Taxes, Appendix B, paragraphs 188-192, which was carried forward into SFAS No. 109 and ultimately codified by Topic 740.

[34] The author understands that there is additional diversity in practice of the “net of tax” approach to this second step for SE entities as to determining the FMV of the properties from a valuation standpoint, but believes that the better answer is that income taxes should be excluded from this computation as supported by Topic 740’s specific rejection of the “net of tax approach” and the lack of a tax requirement in the impairment language of Topic 360-10-35.

[35] An example would be where the stock of a target entity were purchased and there were no tax basis step-up in the underlying properties agreed to under §338(h)(10) or §336(e) due to transactional reasons or ineligibility to make the election.  Thus, Topic 805-740-30-1 would require a deferred tax liability for the tax effect of acquired book-tax basis differences in properties to be recorded at closing, but for the basis difference attributable to “non-tax deductible goodwill.”

 

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