Old sayings such as “a picture is worth a thousand words” and “actions speak louder than words” might lead you to believe that words don’t matter. At the very least, they imply that words carry comparatively little value. However, business owners and advisors should carefully consider the words they do and don’t include when documenting a business transaction. Doing so could save millions of dollars in damages and legal fees.
Consider the following scenario: Company A enters into an agreement with Company B in which Company A pays Company B for its services. The contract states that “Company B shall be paid 5% of the profit generated by Company A, in accordance with generally accepted accounting principles (GAAP).” First of all, “profits” is not a defined term in GAAP. Is the contract referring to gross profits? Net profits? Is there a common industry-specific calculation of profits? Without a more precise definition, both companies are exposed to potential lawsuits.
To offer more perspective on situations like these, we examine two real-life examples in which words that were not appropriately defined resulted in lawsuits with millions of dollars on the line.
Alaska enacted its oil and gas property tax, codified in Alaska Statute (AS) 43.56 in 1973, four years before the Prudhoe Bay field, the first development on Alaska’s North Slope, began producing hydrocarbons. Since the statute was put into effect, much has changed in the landscape of the oil and gas industry and the North Slope itself. In just the last 10 years, the advent of hydraulic fracturing (“fracking”) has transformed the industry, spurred the development of oil and gas fields across the United States and Canada, and brought new players, both big and small, to Alaska’s North Slope in hopes of discovering the next major North American reserve. The Alaska Department of Revenue (DOR) is the body that assesses oil and gas developments on the North Slope and determines the taxable value for each taxpayer.
To incentivize drilling activity, the state tax code allows for certain costs to be excluded from the assessment of the full and true value of oil and gas properties. AS 43.56.060(f) describes costs that are not to be included when calculating the actual cost or replacement cost. Specifically, neither cost method is to include capitalized interest or “the value of intangible drilling expenses.” “Intangible drilling expenses” is defined later in the statute and in the Alaska state code by citing the federal income tax code. The IRS code exempts “intangible drilling and development costs.”
Did you catch the difference?
The term “intangible drilling expenses,” as found in the Alaska statute, is not the same as “intangible drilling and development costs,” as found in the IRS code. The Alaska code even explicitly states that intangible drilling expenses do not include “intangible development expenses.”
In summary, the Alaska code defines intangible drilling expenses eligible for tax exemption by referring to the IRS’ federal income tax code. However, the income tax code defines a substantially different term – drilling and development costs – of which the development costs are explicitly excluded in the term used in the Alaska code. Indeed, the State Assessment Review Board (SARB) of Alaska confirmed such an interpretation in its Decision on Taxability of Intangible Development Expenses issued in April 2016. In its decision, the SARB wrote that it “respects the 40 years of consistent interpretation, codified in the Alaska Administrative Code, that intangible development expenses are taxable.”
Where the SARB’s decision answers one question, it raises another: Which expenses are related to drilling and which are related to development?
Although the regulation has been updated since going into effect decades ago, the proliferation of horizontal drilling techniques and fracking as well as environmental factors unique to the North Slope require additional consideration to determine which activities should be classified as drilling or development.
Conventional completion costs are typically a small fraction of the total costs to drill and complete a well, after which the well will begin commercial production of hydrocarbons. After completion, incremental intangible expenses are related to development rather than drilling.
With modern fracked wells, the difference between drilling and completion costs may be drastic compared with that of conventional wells.
For example, well stimulation is an activity that historically has been used to enhance the production of a well. Well-stimulation activities include injecting fluids into the wellbore to clear impediments or, as is the case with fracking, to fracture the reservoir formation itself. In conventionally drilled wells, the fluids and proppants used in well-stimulation activities are an intangible development expense. In a modern fracked well, however, well stimulation may occur as part of the completion process. On the North Slope, well-stimulation expenses can run into the millions of dollars per well and greatly increase the ratio of completion costs to drilling costs. The state code does not specify whether such completion costs qualify as tax-exempt intangible drilling expenses or taxable intangible development expenses.
Numerous stakeholders have litigated over which costs are exempt from taxable value as a result of innovation in drilling and completion processes and inconsistent wording in tax codes. Taxpayers, the DOR, and local taxing authorities have gone before the SARB and administrative courts to determine how the code should be interpreted and applied to the billions of dollars spent drilling oil and gas wells in the last decade in Alaska. So far, such cases have settled before reaching the highest state court.
Business owners and their advisors should be cautious of using words or phrases that are terms of art. While the business owner may use an everyday term with a broad or general meaning, the term may have a very precise or technical definition within a professional context. Terms such as “material,” “public domain,” or even “expense” may have precise definitions within an accounting, legal, or financial context. If these terms are not well-defined within a legal document or business transaction, the business owner may find that it is difficult to interpret and enforce the terms of a contract when the other party does not perform as expected.
The following case is an example of how an accounting term should have been applied to a transaction between midstream oil and gas companies.
The purchaser and the seller entered into an option agreement, which gave the purchaser the option to acquire a material in the form of a gas to be used in its tertiary oil and gas production.
The purchaser intended to use the material to enhance its own oil and gas production as well as to sell the gaseous material to third-party producers when production of its field was complete. According to the option agreement, the seller would retain certain rights, including a small overriding royalty interest and a reversionary working interest once a defined payout was reached. The payout provision basically provided for a marked-up recovery to the purchaser on capital costs and a flat recovery of operating costs, including the gaseous material costs.
The crux of the dispute was the costs that the purchaser claimed as material costs, which it charged back to the seller. According to the option agreement, the material costs were defined as the direct cost of acquiring and delivering the material to the oil and gas field.
The term “direct cost” is a term of art. It has a specific meaning to accountants and financial professionals, particularly those with a background in managerial accounting or cost accounting. Because the term is not further defined anywhere within the option agreement, the appropriate application of the term direct cost should be consistent with normal managerial accounting or cost accounting practices.
One set of professionals reviewed the costs charged by the purchaser and found that costs were overcharged in the payout calculation. For example, the purchaser’s calculation of commodity costs included a 10% “internal operating cost,” which was described as an approximation of costs of certain departments that provided services related to the commodity supply and transportation. This does not fit the cost accounting definition of direct cost. The pioneer of cost accounting, Charles Horngren, stated that direct costs “can be conveniently and economically traced (tracked) to a cost object.” Instead of being traced, indirect costs are “allocated to a cost object in a rational and systematic manner.” The 10% internal operating cost included in the payout calculation was clearly an indirect cost that should not have been included.
Unsurprisingly, the opposing side took the position that the purchaser’s regular accounting practices should be used as the basis for the payout calculation, even though in GAAP accounting there is no definition of a direct cost.
This one term caused both sides to spend hundreds of thousands of dollars to determine which interpretation was correct.
In any business transaction or corporate document, it’s clear that words must be carefully chosen. The examples described above demonstrate that sloppy language can expose businesses to unnecessary liabilities. There are several lessons that can be gleaned from these examples:
Attention to detail is important in any business. When it comes to contracts and transactions, a critical eye can save a business money as well as its relationship with the counterparty.