Chula PetEcon10 TaxTreatment

1Petroleum EconomicsPetroleum Economics

bybyDr.ThitisakDr.Thitisak BoonpramoteBoonpramote

Department of Mining and Petroleum EngineeringDepartment of Mining and Petroleum EngineeringChulalongkornChulalongkorn UniversityUniversity

Concepts of Tax Treatment for Expenditures Concepts of Tax Treatment for Expenditures under under

the royalty/tax regimethe royalty/tax regime

2AfterAfter--tax Cash Flowtax Cash Flow

The key point is that since taxes are a cash outflow of a project, our economic analyses must reflect the after-tax cash flow of a project in order to achieve a true reflection of the cash flow patterns.

Tax laws are imposed for revenue generation. However, a secondary purpose is that of social legislation. The laws are very complex with many exceptions. However, this section attempts to capture the fundamental concepts.

In a sense, the government shares in every profitable venture through the taxation of a portion of the profits. The contra is also true if the individual or corporation has other profit generating activities to offset the loss in a venture.

CAPEX vs. DD&ACAPEX vs. DD&A

A key point to remember is that capital expenditures (buildings, machinery, etc.) are not deductible as operating expenses, but rather are recovered through DD&A.

A second key point to note is that DD&A when considered as a tax deduction results in less taxes and therefore is a source of cash flow to match the cash outflow when the investment is made.

3The investment in a well of $1,000,000 may be partly depreciated (tangible) and partly amortized (intangible.) The rules (i.e. calculation procedures) for these two types of systematic expensing may be different depending on the standards set by either the financial or the tax model employed. The use of DD&A in a financial model is intended to give a realistic view of the financial viability of a project or firm by accounting for costs that are intended to benefit the future. The use of the both financial model and cash flow modelshould give a better view of financial viability than either model alone.

IssuesIssues

Review of DD&AReview of DD&A

1. Depreciation- the systematic expensing (i.e. treated as an immediate deduction against revenue) of the cost of a tangible asset. A tangible asset is something that has a physical presence such as a flowline, wellhead or tanker.

2. Depletion-the systematic expensing of the cost of a natural resource. For instance, if a company buys oil reserves the cost of these reserves may be expensed in a systematic way, over the years, using depletion methods.

3. Amortization- the systematic expensing of the cost of an intangible asset. An intangible asset is one that has no physical presence. An example might be the labor cost of installing oilfield equipment. The equipment itself is tangible, but the labor has no physical presence after the equipment is installed.

4Operating Cash FlowsOperating Cash Flows

Cash Flows from Operations Recall that:

Operating Cash Flow = EBIT Taxes + DD&A

Net Capital Spending Dont forget salvage value (after tax, of course).

Changes in Net Working Capital Recall that when the project winds down, we enjoy a return of net

working capital.

Tax CalculationTax Calculation

DD&A = % of CAPEX(Depend on Type of Assets & Government Rule)

These deduction allowances are non-cash charges that make cash flow differ from profit or net income in any given year

Taxable Income = Revenue Royalty - OPEX DD&A

Tax = Tax Rate * (Taxable Income)

5Cash Flow vs. ProfitCash Flow vs. Profit

It is important to realize that Net Cash Flow is usually not the same as Net Income in any given year due to DD&A and other tax deductions.

However, total Net Cash Flow equals total Net Income over the life of the project. Checking this equality is an important tool in validating an evaluation model.

Cash Flow vs. ProfitCash Flow vs. Profit

6Cash Flow vs. ProfitCash Flow vs. Profit

Depreciation ConceptsDepreciation Concepts

7DepreciationDepreciation

Depreciation is defined as the loss in service value over time. Thus from a physical standpoint it can be associated with physical

deterioration and obsolescence. In addition, the loss in service value could be based upon remaining useful life in terms of number of units left to be produced.

This technique would recognize that the economic life of an asset is less than the physical life.

We normally think of depreciation from the accounting standpoint which is the systematic allocation of the cost of an asset (less its salvage value) over its useful life.

Depreciation is based upon historical cost accounting or original cost accounting.

DepreciationDepreciation

The key point to remember about depreciation from an economic analysis standpoint is that you must separate book depreciation (accounting depreciation) from tax depreciation.

Our object in economic analysis is to get to the cash flow stream.

Only tax depreciation causes cash flow. If book depreciation is used, deferred tax is needed for

adjustment the cash flow.

8Depreciation, Book Value and SalvageDepreciation, Book Value and Salvage

Book value is the remaining unallocated cost of an asset or:

Book Value = Historical Cost - Accumulated Depreciation

Cost Basis = Historical Cost (includes freight, labor, site preparation)

Depreciation MethodsDepreciation Methods

A. Straight line: use for financial/book accounting

Accelerated depreciation: use for tax accounting such as: B. Sum of years digitsC. Declining balance

D. Unit of production

9A. Straight Line DepreciationA. Straight Line Depreciation

Most often used in book depreciation where the object is to minimize depreciation expense in order to maximize net income.

Tax depreciation is normally not based upon straight line depreciation since other methods will generally maximize tax depreciation expense which tends to minimize taxes payable.

Straight line depreciation results in a constant depreciation expense each year

Historical Cost - Salvage ValueUseful LifeAnnual Depreciation =

An example for the straight line method An example for the straight line method

Original basis = $100,000 Assumed life of asset = 5 years Year Basis at start of year Systematic expense Basis at end of year

1 $100,000 $20,000 $80,0002 $80,000 $20,000 $60,0003 $60,000 $20,000 $40,0004 $40,000 $20,000 $20,0005 $20,000 $20,000 $0

Each year a constant factor, f, was multiplied by the original basis to determine the systematic expense for the yearly period.

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In the case of the straight line method this factor was:

f = 1/Assumed life of asset. f was constant at 0.2 in this example.

Note that all of the basis was expensed at the end of five years. If the asset life is terminated earlier than assumed the usual procedure is to expense the remaining basis immediately. For instance, if the assets life was terminated during the third year, then the remaining basis of $60,000 may be expensed. If the asset is then sold, proceeds from the sale will likely be treated as revenue. Financial profit will be the difference between the revenue and the remaining basis.

The timing of revenue and expensing of the basis may , in practice, vary somewhat from firm to firm according to the rules adopted by the firm and in accordance with generally accepted accounting practices.

An example for the straight line methodAn example for the straight line method

Straight Line Method for 500 million with 5 yearsStraight Line Method for 500 million with 5 years

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B. Sum Of The Years Depreciation (SOYD)B. Sum Of The Years Depreciation (SOYD)

This is a form of accelerated depreciation which results in higher depreciation expense in early years and lower depreciation expense in later years, based upon the sum of the useful years digits:

Sum = Useful Life2

x (Useful Life + 1)

Sum = 52

(5+1) = 15 or 5+4+3+2+1 = 15

Example: Useful Life 5 Years

Sum of the Year Digit for 500 million with 5 yearsSum of the Year Digit for 500 million with 5 years

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Declining Balance MethodDeclining Balance Method

Declining Balance This method is computational slightly more complex than the straight line method. It involves expensing a constant fraction, f, of the remaining basis each period.

Two variations of this method are: single declining balance and double declining balance.

The single (100%)declining balance uses the factor f = 1/Assumed life of asset and the double (200%) declining balance uses the factorf = 2/Assumed life of asset Note again that these factors are applied to the remaining basis, not the

original basis as was the case in the straight line method.

An example for the single declining balance methodAn example for the single declining balance method

Original basis = $100,000 Assumed life of asset = 5 years Year Basis at start of year Systematic expense Basis at end of year

1 $100,000 $20,000 $80,0002 $80,000 $16,000 $64,0003 $64,000 $12,800 $51,2004 $51,200 $10,240 $40,9605 $40,960 $40,960 $0

Note that the systematic expense for the final (fifth) year should have been $8,192. If the formula, Basis at end of year =f*Basis at start of year were to continue without interruption then the basis would never be completely expensed (i.e. reach the value of zero.). However the final years systematic expense is an exception and all the remaining basis is expensed during the final year in the assets life.

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C.C. Double Declining Balance Depreciation (DDB)Double Declining Balance Depreciation (DDB)

2Useful Life

This is one of the few methods which does not take the salvage value directly into account. It also is an accelerated method.Most property except certain used property and real estate has been accorded the treatment of double declining balance which may be stated as:

A constraint is that the accumulated depreciation cannot exceed the historical cost less salvage value.

DDB = x Historical Cost - AccumulatedDepreciation[ ]

An example for the double declining balance method

Original basis = $100,000 Assumed life of asset = 5 years

Year Basis at start of year Systematic expense Basis at end of year

1 $100,000 $40,000 $60,000 2 $60,000 $24,000 $36,000 3 $36,000 $14,400 $21,600 4 $21,600 $8,640 $12,960 5 $12,960 $12,960 $0

This is a more rapid expensing of an asset than the single declining balance method.

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this method allows for the systematic expensing of the cost of oil and gas reserves. Thus it is primarily a depletion method. It differs considerably from the above systematic expensing methods in the way the factor, f, is computed.

In this case f = (production during the year)/(reserves at the start of the year)

D.D. Unit of ProductionUnit of Production

UOPUOPUsed in situations where the loss in service value is more closely related to use or number of units produced rather than time. Most commonly associated with machinery and equipment involved in producing natural resources where the physical life of the equipment exceeds the economic or production life of the natural resources.

Example: The total reserves of a gas field are 10 billion cubic feet. If 30% of the gas is produced the first year the depreciation expense would be equal to 30% times the historical cost less the salvage value. Similarly in future years. Results in a matching of depreciation expense to actual production.

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UOP example

Original basis = $100,000 Assumed life of asset (in this case, the natural resource)= 5 years Reserves at the start of the first year= 10,000 STB Production = amounts given in the table below Year Basis at Systematic Basis at Reserves at Year's Reserves at start of year expense end of year start of year production end of year

1 $100,000 $20,000 $80,000 10000 2000 8000 2 $80,000 $30,000 $50,000 8000 3000 5000 3 $50,000 $25,000 $25,000 5000 2500 2500 4 $25,000 $10,000 $15,000 2500 1000 1500 5 $15,000 $15,000 $0 1500 1500 0

Reserves reReserves re--evaluationevaluation

The last example assumed that reserves were not adjusted from year to year. If reserves had been adjusted then the systematic expense schedule will change. Nevertheless, the factor, f, will still be calculated in the same way. To show how adjustment of reserves influences systematic expenses well use the following scenario:

Scenario

An oil companys engineering department has adjusted reserves at the end of the second year to reflect the results of a new engineering study that showed reserves had increased by an additional 2,000 STB. To simplify the example, well assume that production rates remain the same. This increases the reserve life beyond five years and will leave an unexpensedbasis at the end of that time

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Here is the resulting table. The numbers in bold type have changed from the previous table. Year Basis at Systematic Basis at Reserves at Year's Reserves at start of year expense end of year start of year production end of year

1 $100,000 $20,000 $80,000 10000 2000 8000 2 $80,000 $30,000 $50,000 8000 3000 7000 3 $50,000 $17,857 $32,143 7000 2500 4500 4 $32,143 $7,143 $25,000 4500 1000 3500 5 $25,000 $10,714 $14,286 3500 1500 2000

Note that the first change in systematic expense took place in year three. In the first example the year three value of f was 2500/5000 = 0.5. In the second example the year three value of f changed to 2500/7000 = 0.35714.

Reserves reReserves re--evaluation exampleevaluation example

Comparing of 3 methodsComparing of 3 methods

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Depreciation For Tax Purpose (Thailand I)Depreciation For Tax Purpose (Thailand I)

All pre-production expenditure, except tangible assets, is capitalized at the beginning of first production and amortized at a rate of 10% p.a.

All tangible assets acquired in the pre-production period are capitalized effective start of production and are depreciated at 20% p.a.

As from the beginning of the first production,- all operating expenditures, geological and geophysical survey and study costs and all intangible drilling costs are fully expensed in the year incurred.- all tangible assets (excl. land and buildings) and tangible drilling costs (e.g. wellhead equipment and tubing) are capitalized and depreciated at 20% p.a.- permanent buildings are depreciated at 5% p.a.- no depreciation is allowed on land.- concession payments are amortized at 10% p.a.

Depreciation For Tax Purpose (Thailand III)Depreciation For Tax Purpose (Thailand III)

Fiscal Income: Fiscal Income equals Gross Income minus Allowables.

Allowables: Allowables for PITA purposes include concession payments, production bonuses, exploration costs, production drilling costs, other capital cost items, operating costs, Royalty, Special Remuneration Benefit (SRB) and losses carried forward.

All pre-production expenditures, except tangible assets are capitalized at the beginning of first production and amortized at a rate of 10% per annum.

All tangible assets acquired in the pre-production period (capital expenditure) are capitalized at the effective start of production and are depreciated at 20% per annum.

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Depreciation For Tax Purpose (Thailand III) cont.Depreciation For Tax Purpose (Thailand III) cont.

(l) Exploration CostsIt is assumed that 95% of the exploration costs incurred in the fiscal year relates to intangible assets. Cost incurred after first production can be directly written off for PITA purposes. The remaining 5% - tangible cost - is amortized at 20% per annum after first production.

(2) Production Drilling CostsIt is assumed that 80% of the production drilling costs incurred in the fiscal year relates to intangible assets. Cost incurred after first production can be directly written off for PITA purposes. The remaining 20% - tangible cost - is amortized at 20% per annum after first production.

PITA Liability: PITA liability is 50% of the Fiscal Income. If PITA liability is negative then losses may be rolled forward for a maximum of ten years. Losses may not be carried backward.

Deferred Tax ConceptsDeferred Tax Concepts

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Tax Accounting vs. Book Accounting ConceptsTax Accounting vs. Book Accounting Concepts

The appropriate accounting rules are standardized within a country for determining the corporate profit for purposes of reporting the financial condition of the company to its shareholders includes the calculation of income tax liabilityshown on the income statement.

That value is not the actual amount of income tax paid, but following the matching principle it is the amount of tax due on the profit earned that year.

Tax Accounting vs. Book Accounting ConceptsTax Accounting vs. Book Accounting Concepts

Tax laws rarely coincide with accounting procedures, so the actual amount of income tax paid is frequently less than is shown on the income statement with the difference carried to the balance sheet as a future liability (deferred income tax).

When the rules differ between tax and financial accounting it becomes necessary to maintain more than one set of accounting records. Thus, profit for paying income tax may notbe the same as the profit reported to the shareholders.

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Book (Financial) AccountingBook (Financial) Accounting

Net Income - earnings after recognition of revenues less operating expenses,book depreciation, and the book tax provision.

Revenues - value of product sales or services rendered.

Operating Expenses - salaries, product materials, rent, etc. (Remind that capital expenditures and dividends are not operating expenses.

Book Depreciation - systematic allocation of original cost over the useful life of the asset.

Book Tax Provision - tax rate times income before taxes.

Relationships in Book AccountingRelationships in Book Accounting

Revenues- Operating Expenses- Depreciation (Book)= Income Before Taxes- Book Tax Provision= Net Income (NIAT)

Key Comment: NIAT does not equate to cash flow from operations.

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Tax AccountingTax Accounting

Revenues - generally similar to book revenues. We assume no difference.Operating Expenses - generally similar to book definition. We assume no

difference.(Book Depreciation - no such term in tax accounting.)Tax Depreciation capital expenditure allocation of tax basis.Tax Basis - historical cost of asset less any accumulated tax depreciation.(Net Income - no such term in tax accounting.)Taxable Income - revenues less operating expenses less tax depreciation.Current Taxes Payable - taxable income times tax rate.

Relationships in Tax AccountingRelationships in Tax Accounting

Revenues- Operating Expenses- Tax Depreciation= Taxable Incomex Tax Rate= Current Taxes Payable

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Deferred TaxesDeferred Taxes

Deferred income taxes is a concept associated only with the book or financial accounting. It is not a tax accounting concept.

Tax accounting computes an income tax payable. It is payable for and within the current year.

Book accounting computes a provision for income taxes as a reduction of net income. Thus, the book provision for income taxes is based upon book depreciation and will differ from current taxes payable if book and tax depreciation are not equal.

The difference between current taxes payable and the book tax provision is known as deferred taxes and thus is importantin tracking cash.

Tax BookRevenues 10,000 10,000Operating Expenses 2,000 2,000

8,000 8,000Depreciation 4,000 2,000Taxable Income 4,000 -Income Before Taxes 6,000Current Taxes Payable (50%) 2,000Book Provision (50%) 3,000Net Income 3,000

NOTE:

Tax rate of 50% assumed.

Example I : Deferred TaxExample I : Deferred Tax

Thus, our book provision for income taxes is 3,000 while our current taxes are 2,000. The difference of 1,000 is known as a deferred tax. The meaning of a deferred tax is that it represents a tax on current book year earnings that will be paid in a future year. The deferred tax could alternatively be computed as the difference in tax and book depreciation (4,000-2,000) times the tax rate (50%).

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Assume the following depreciation schedules for book and tax purposes for a $10,000 asset:

Tax Book Tax Deferred AccumulatedYear Depreciation Depreciation Difference Rate Tax Deferred Tax

1 800 1,000 (200) 46% (92) (92)2 1,400 1,000 400 46% 184 923 1,200 1,000 200 46% 92 1844 1,000 1,000 - 46% - 1845 1,000 1,000 - 46% - 1846 1,000 1,000 - 46% - 1847 900 1,000 (100) 46% (46) 1388 900 1,000 (100) 46% (46) 929 900 1,000 (100) 46% (46) 4610 900 1,000 (100) 46% (46) -0-

10,000 10,000 -0- -0-

Example II:Example II: Deferred TaxDeferred Tax

Comments on Deferred ExampleComments on Deferred Example

1. The deferred tax in the first year is negative meaning that the current taxes payable to the government are higher than the book income tax provision.

2. Over time the exact same amount will be taken for tax depreciation as taken for book depreciation.

3. Since the statement in 2. is correct, it follows that over time the accumulated deferred tax will become zero.

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Example: Example: Cash Flow Calculation with 2 approachesCash Flow Calculation with 2 approaches

Assume $10,000 Investment,

5-year straight line book depreciation ($2,000 each year)

Tax Depreciation: $1,500; $2,200; $2,100;$2,100; $2,100

Revenues: $5,000/year

Operating Costs: $1,000/year

Tax Rate: 46%

1) Tax Accounting Approach: use tax depreciation 1) Tax Accounting Approach: use tax depreciation

= - Investment = -10,000

Taxes (IRS) = [Rev - Op Costs - Tax Depr] x Tax RateYear 1 [5000 - 1000 - 1500] x 46% = 1150Year 2 [5000 - 1000 - 2200] x 46% = 828Year 3 [5000 - 1000 - 2100] x 46% = 874Year 4 [5000 - 1000 - 2100] x 46% = 874Year 5 [5000 - 1000 - 2100] x 46% = 874

Time0

CashFlow

}

Cash Flow = Revenues - Op Costs - Taxes (IRS)Year 1 5000 - 1000 - 1150 = 2850Year 2 5000 - 1000 - 828 = 3172Year 3 5000 - 1000 - 874 = 3126Year 4 5000 - 1000 - 874 = 3126Year 5 5000 - 1000 - 874 = 3126

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2) Book Accounting Approach: use book depreciation 2) Book Accounting Approach: use book depreciation and deferred tax adjustmentand deferred tax adjustment

Time 0 Cash Flow = - Investment = -10,000

Net Income = Rev - Op Costs - Book Depreciation - Taxes (Book)Taxes (Book) = [Rev - Op Costs - Book Depreciation] x Tax Rate

Taxes (Book)Year 1 [5000 - 1000 - 2000] x 46% = 920Year 2 [5000 - 1000 - 2000] x 46% = 920Year 3 [5000 - 1000 - 2000] x 46% = 920Year 4 [5000 - 1000 - 2000] x 46% = 920Year 5 [5000 - 1000 - 2000] x 46% = 920

Net IncomeYear 1 5000 - 1000 - 2000 - 920 = 1080Year 2 5000 - 1000 - 2000 - 920 = 1080Year 3 5000 - 1000 - 2000 - 920 = 1080Year 4 5000 - 1000 - 2000 - 920 = 1080Year 5 5000 - 1000 - 2000 - 920 = 1080

Deferred Taxes = (Tax Depr - Book Depr) x Tax RateYear1 (1500 2000) x 46% = (230)Year2 (2200 2000) x 46% = 92Year3 (2100 2000) x 46% = 46Year4 (2100 2000) x 46% = 46Year5 (2100 2000) x 46% = 46

-0- (always sums to zero!)

2) Continue with deferred tax calculation2) Continue with deferred tax calculation

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Cash Flow = Net Income + (Book Depreciation + Deferred Taxes)

Year1 1080 + 2000 + (230) = 2850Year2 1080 + 2000 + 92 = 3172Year3 1080 + 2000 + 46 = 3126Year4 1080 + 2000 + 46 = 3126Year5 1080 + 2000 + 46 = 3126

Note that the cash flows are identical in each period regardless of approach! Must be true in all cases.

2) Continue with deferred tax adjustment2) Continue with deferred tax adjustment