An M&A lifeline in the North Sea
Assets that cut tax bills could be a blessing for UKCS operators looking for a bargain
Deferred tax assets (DTAs)—assets on the balance sheet that can be used to reduce taxable profits—can be a valuable prize for a prospective buyer of an oil and gas company on the UK Continental Shelf (UKCS).
Oil and gas companies operating in the UKCS typically accrue substantial DTAs in their exploration, development and early producing years. This is because significant capital expenditure is normally needed for exploration and development, which can result in capital allowances—the UK tax equivalent of depreciation. This spending is generally funded, at least in part, through debt. Interest on that debt may be deductible in calculating UK taxable profits.
DTAs can be valuable to a buyer of such a company—but the way in which debt used to fund that spending is handled as part of an acquisition can significantly impact the deal's value, for both the seller and buyer. This can lead to difficulties—and opportunities—when structuring a deal, especially where debt funding is from within a target oil company's group.
Retaining shareholder debt in the target oil and gas company in some form has several advantages. One benefit is the opportunity for cash repatriation. Oil and gas companies typically have negative distributable reserves in their early years, which can prevent them from paying dividends—"dividend blocks".
Shareholder debt can be used to side-step these blocks, acting as a "cash repatriation" or "debt service" route. Tax relief can also prove helpful. Interest on commercially motivated debt is typically deductible (as it accrues) in calculating taxable profits, whereas dividends are not. Shareholder debt can also help to lower stamp duty costs. UK stamp duty, a levy on a transaction, is generally charged at 0.5% on the consideration for shares in a UK company. Shareholder debt effectively suppresses a target's share value, which would also generally reduce the stamp duty charge.
The structure of a UK oil company sale can have major financial impacts
If the buyer wishes to retain the shareholder debt, it can either acquire the debt or make a loan to the target company to fund repayment through a refinancing mechanism. These methods have different consequences, with impacts varying depending on the circumstances of the seller, the buyer and the target.
Those consequences need to be assessed in the context of each deal and some important factors should be considered when deciding which method to use. One is tax relief for interest, particularly as technical rules specific to oil and gas companies can restrict tax relief on a refinancing (but not a transfer). Another consideration is stamp duty. Unless the debt has interest at or below a reasonable commercial return, a transfer can trigger extra stamp duty costs. Withholding tax can, depending on the lender's position, be triggered on a refinancing, but not a transfer. In cases involving non-resident sellers, there is a technical risk that the seller will incur UK tax on a disposal of shareholder debt (for which the target can be secondarily liable) under special UKCS rules. But there may be defences or structural solutions here. There can also be a transfer pricing advantage to a transfer over a refinancing.
Striking a balance
Where the amount of outstanding shareholder debt exceeds the target's enterprise value (the market value of equity and debt in the target), the shareholder debt may need to be reduced before the acquisition takes place. This is to avoid a tax charge for the target. Reducing shareholder debt should be relatively straightforward, despite the tax and company law issues to navigate.
But there is a delicate balance to be struck in assessing the extent to which the debt should be reduced. The problem is that the buyer and seller may not be aligned on this. A larger shareholder debt, and consequently a small reduction in it, is a better option in terms of cash repatriation after the acquisition. This also potentially maximises tax relief for interest after the acquisition has taken place and reduces stamp duty on the consideration for the shares.
Still, if most of the enterprise value is made up of shareholder debt, the company's shares won't command a high price. The downside of a low share price is that warranty/indemnity payments exceeding the share price can result in tax leakage.
Given the sums potentially at stake, DTAs need to be carefully modelled by a buyer to ensure the amount paid for them reflects the time they take to unwind to cash savings.
Buyers should also bear in mind that the use of DTAs can be restricted by several UK tax rules. Buyers (and their financiers) will therefore need to analyse the quality of DTAs in the context of the transaction (in particular, any reorganisation or amalgamation of businesses) before modelling them.
In short, how an acquisition or disposal of an oil and gas company is structured has major financial consequences for both buyers and sellers. The factors involved will vary depending on the circumstances of the parties involved, so prospective buyers and sellers should consider structuring issues early in the process to maximise a deal's value.
Extract from the Oil and Gas Map of the North Sea 2017 Source: Petroleum Economist
Tom Jarvis is a tax partner and John Conlin is an energy and infrastructure partner at Watson Farley & Williams, a law firm