Shale oil is tight oil from deposits that were unworkable just a few decades ago. Recent technology introduced new costs to the oil extraction process. Thus, shale oil costs more than conventional oil to extract and is a higher risk investment.
In comparison to conventional wells, shale oil production costs are more front-end loaded. Further, production life is shorter in comparison to conventional wells. Consequently, the shale oil industry is more vulnerable to volatility in prices, operating on a rollercoaster of shut down and ramp up when prices drop or surge. That means there may be challenges for companies with shale oil assets to realize cash flow from idle shale-oil deposits when crude oil prices are hovering around $50 a barrel.
Shale Oil—From a full production life perspective, some shale oil wells may have a break-even point of $40 a barrel. However, the conventional wisdom for a fracked horizontal well may be about $55 a barrel. Higher-cost wells may come in closer to $85 a barrel on the upper end of the range.
Conventional Oil—By way of comparison, the cost-per-barrel of conventional deposits varies, with Saudi Arabia able to produce oil the most cheaply, sometimes under $10 a barrel.
The economic impact of COVID-19 may result in a prolonged period of financial hardship for businesses. Oil prices have visited negative territory. In the face of such difficulty, many debtors may seek to negotiate with lenders to modify the terms of an existing debt instrument. However, while debt modifications may be beneficial for liquidity reasons, they may yield surprising and costly tax results. As businesses weigh their options, it is important for them to consider the tax impact of debt modification prior to finalizing a workout.
A long history in our economy
Borrowing money and surviving downturns have always been part of the U.S. economy. The difference today is the Tax Cuts and Jobs Act (TCJA), the most significant tax change in the United States in 30 years. Modeling based on a company’s specific situation has become critical.
For income tax purposes, a debt modification is a “significant modification” if the legal rights or obligations are altered to a degree determined to be economically significant by the tax law.
Common debt modifications include:
- Extending maturity
- Obtaining payment holidays
- Changing interest rates
- Conversion to pay-in-kind interest
- Changing principal payments from fixed to contingent
- Exercising conversion features
The consequences of a significant modification result in the deemed exchange of the old debt for new debt, which has the potential to trigger cancellation of debt (COD) income, accrual of debt discount and possible interest deduction limitations.
It is key to understand the tax implications of debt reorganizations and modifications. An unanticipated cash payment for taxes could be a very undesirable outcome, which is not uncommon for companies that must recognize phantom income. The tax implications can be further complicated if the debts are publicly traded for tax purposes, or if debts are issued with warrants, conversion rights or other complex features.
The tax law provides a COD income exclusion for companies in bankruptcy or that are insolvent; however, tax attributes like NOLs and basis in property are generally reduced by the COD income excluded from taxable income. Therefore, any tax relief today comes typically at the cost of decreased deductions in the future, which makes planning around these issues very important.
Questions that come out of a debt modification, especially out-of-court debt modifications, may include:
- What is Fair Market Value and is there a gain? This typically isn’t a straight-forward answer. There may be a gain for financial purposes for GAAP reporting, but there may or may not be a gain or COD income for tax purposes. Valuation of debt can help a company understand the amount of gain that may need to be recognized for GAAP purposes. This is often a starting point for determining the tax consequences.
- What is the business worth, and how insolvent is the company? The level of insolvency can impact COD income. For companies not in bankruptcy, the COD income exclusion is generally limited to the amount of insolvency. A valuation of the company can help determine its insolvency level and help support the calculation of excludable COD income for tax purposes.
- Is debt value one size fits all? No. Any debt instruments valuation must first consider what type of debt it is—and the types of debt range broadly. To name a few —straight debt, debt with an equity redemption option, convertible debt, redeemable preferred debt or a kind of debt in default. Features include public versus private debt; secured or unsecured debt; senior, subordinated or fixed- or variable-rate debt; amortizing or non-amortizing debt; interest paid in cash or paid in kind; convertible or nonconvertible; and enhancements or no enhancements.
When we look at key drivers of debt value, we get into company-specific factors, instrument-specific factors and market factors. Company-specific factors might be the credit risk, default risk or nonperformance risk. It might include the risk of loss resulting from a borrower’s inability to fulfill a contractual obligation. There are a number of different credit loss possibilities.
Valuations can also help support Section 382 limitations that companies face after experiencing a change in control. Section 382 places limitations on a company’s tax attributes such as NOLs. A company with a low 382 limitation risks not having attributes available to offset taxable income in future periods. Having a valuation performed may support a higher 382 limitation, which can help a company unlock its tax attributes and create real tax value.
Planning around the complicated tax impacts of debt reorganizations and modifications can leave a company in a much better position financially as they focus on a bright future ahead. Valuations go hand-in-hand with the tax planning that is often required by providing documentation necessary to support tax positions and helping companies arrive at more favorable tax results.
About the authors: Bryan Benoit is a partner in the Houston office of the Grant Thornton LLP and a principal in Grant Thornton Financial Advisors LLC. Tracy Hennesy is a Partner in the Grant Thornton Mergers & Acquisitions Tax Services practice, focusing on transaction-related
tax matters. Calvin Nguyen is a Director in the Grant Thornton Mergers & Acquisitions Tax Services practice.
