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3rd QUARTER
OIL & GAS UPDATE
Breakfast SeminarOctober 6, 2005
2© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
Agenda
• Introduction
• Trust Financial Reporting Issues—Murray Suey
• Current Developments—Michael McKerracher
• New Auditing Standards—John Gordon
• Proposal on Accounting for Taxes—Chris Post
• Future of Income Trusts—Chris Post
• Scientific Research and Experimental Development—Gregory Brennan
• Transfer Pricing—Michael Hoffman
3© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
New Partners
• Audit:
– Jason Brown, Partner
• Tax:
– Curtis Lester, Partner
– Jodi Roworth, Associate Partner
5© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
Trust Financial Reporting Issues
• Desire for more meaningful information about financial results
• Disclosure of terms of royalty and trust agreements and obligations (CICA 1540.55)
• Clarification of distributable income and distributable cash
• Distributions as return of capital vs income
• Presentation of cumulative distributions as separate component of equity
6© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
Trust Financial Reporting Issues
• Disclosure of terms of all classes of equity
• Accounting for options with decreasing exercise prices
• Update on accounting for exchangeable shares
– Draft changes to EIC 151 posted on CICA website
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Comprehensive Income, Equity, Financial Instruments and Hedges
• Harmonize Canadian GAAP with US standards
• Comprehensive Income
– Separate financial statement
– Includes items that are recognized in comprehensive income but excluded from net income
• Equity
– Incorporates amendments to be consistent with the other new sections
– Replaces Surplus
9© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
Comprehensive Income, Equity, Financial Instruments and Hedges
• Financial Instruments
– All financial instruments are included on the balance sheet at fair value
– All financial instruments classified into five categories which determine measurement
• Hedges
– Specify when hedge accounting is permissible
– Inadequate documentation = no hedge accounting
– Ineffective portion of hedge is recognized in net income
• Effective—Fiscal years beginning after October 1, 2006.
• Early adoption—must adopt all four standards
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Accounting For Stock Based Compensation (FASB 123R)
• US standard on Stock Based Compensation
– Equity awards are measured at the grant date fair value
– Liability awards are measured at the grant date fair value and then re-measured at each balance sheet date
• No preference between Black-Scholes-Merton or Lattice model
• Must consider forfeitures in fair value calculation
• Should be rare in practice that a fair value of an award cannot be determined
• There are differences between Canadian and US GAAP which will cause reconciling items
• Effective: Annual periods beginning after June 15, 2005
11© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
Accounting for Conditional Asset Retirement Obligations (EIC D54)
• Based on US standard—FIN 47
• Clarifies “conditional asset retirement obligation”
– Refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity
– The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement
• Effective—US fiscal years after December 15, 2005; Canada—fiscal years ending after March 31, 2006, retroactively
12© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
Accounting For Business Combinations (ED)
• Definition of a Business—expanded
• All Business Combinations measured at 100% with a minority interest—even if less that 100% is bought
• Equity Instruments—measured at closing rather than date of announcement
• Acquisition costs—expensed as incurred
• Comment Period ends October 28, 2005
• Effective—January 1, 2007
14© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
New Auditing Standards
• Quality Control Standards (CICA 5030)
• Audit Risk Standards (CICA 5095, 5141, 5143, 5300))
• Planning and Documentation Standards (several)
More time will be required by all parties involved
15© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
Quality Control Standards
Our quality control standards
• Firm level standards
– Leadership, Human Resources, client acceptance, monitoring
• Engagement level standards
– Expand responsibilities of the engagement partner and others for matters such as compliance with quality control and independence standards
16© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
Audit Risk Standards
To enhance how auditors assesses and respond to risks of error and fraud
• Obtain and document an expanded understanding of:
– Entity and its environment and business risks
– Governance processes
– Information systems
– Significant risks, and associated controls
– Design and implementation of certain internal controls, even when a substantive approach is anticipated
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Planning and Documentation Standards
Planning
• Engagement acceptance, planning and communication with management and the audit committee
Documentation
• Guidance on documentation of significant issues and findings
• Documentation of matters inconsistent or contradictory with final conclusions
• Documentation required on “report release date”
• Explicit documentation on items tested
19© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
Proposal on Accounting For Tax Uncertainties
• Required to assume that an uncertain position will be subject to review, and that the position is probable of being sustained
– Probable is higher than more likely than not
• Evidence that may support a conclusion
– Unambiguous tax law
– Unqualified should opinion
– Similar positions clearly presented in prior returns that have been accepted or not challenged
– Similar positions taken by other taxpayers that were favorably resolved
• Amount to be recognized is best estimate of the amount that would be sustained (single best estimate—not probability weighted)
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Proposal on Accounting For Tax Uncertainties
De-recognition
• A previously recognized amount would continue to be recognized unless it fell below a more likely than not level
• De-recognition is different than a valuation allowance, which only related to realizability
Potential impact of the proposed rules
• Eliminates diverse practice
• Less flexibility around use of “cushion” to reflect uncertainty
• Earnings may be more volatile
22© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
The Future of Income Trusts
• Department of Finance launches consultations on tax and other issues related to business income trusts—September 8, 2005
• Minister of National Revenue postpones providing advance tax rulings respecting income trusts—September 19, 2005
• Reaction to these events
• Possible outcome
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Finance’s Consultation Paper
• Follow-up on previous budget promise
• Purpose is to promote discussion and third party input
• Submissions received up to December 31, 2005
• Canadian Tax Foundation to host symposiums
• Issues for consideration:
– Impact of tax treatment on how businesses are organized
– Impact on federal tax revenues
– Potential role of tax-exempt investors
– Impact of tax treatment on the Canadian economy
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Advance Tax Rulings Postponed
• Canadian Minster of Finance says while consultations are underway it would be “inappropriate” to issue advance tax rulings (September 19)
• Press Release indicates “Finance is closely monitoring the developments in the FTE (trust) market” and the government will “consider what, if any, transitional measures would be appropriate”
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Reactions
• Minor reaction to consultation exercise
• Significant reaction to halting advance tax rulings
• Market reaction 1
– CDN$9 billion loss in value
– 5% to 10% decrease in trading price of conversion candidates
• Created an environment of uncertainty and instability
1 National Post, September 28, 2005
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Possible Outcome
• Status quo
• Reduce tax on dividends from corporations
• Impose tax on trusts
• Eliminate duplication of corporate and personal taxes (i.e. achieve better integration)
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Headlines in the Technical Oil & Gas Journals
• Improved Reservoir Economics
• Incremental Hydrocarbon Recoveries
• More Profitable—Greater Efficiencies—Lower Cost Per Foot
• Environmental and Safety Issues
• Sustainable Development of Alberta’s Resource
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Scientific Research & Experimental Development—“SR&ED”
• SR&ED is a Defined Term in the Income Tax Act
• Qualifying expenditures carried out on SR&ED projects in Canada earn the SR&ED Tax Credit
• 20% credit against Federal taxes payable—cash / equivalent
• Enhanced Deductions—SR&ED capital costs can be pooled and effectively written off 100%
30© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
What Qualifies for SR&ED?
• Conventional Oil & Gas Exploration
• Unconventional Gas Recovery
• IOR & EOR Applications
• In-Situ Recovery & Upgrading
• CO2 Sequestration & Storage
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Obtaining SR&ED Tax Credits
• SR&ED application with Federal Income Tax return
• 18 month deadline
• Technical project description
• Separate SR&ED accounting—project
• Canada Revenue Agency review / audit
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Enhanced SR&ED Capabilities within KPMG
• Merger with Al Logan, Ph.D.—International Technology Ventures (ITV)
– Technical resources enhanced—additional to existing strong SR&ED team
– Additional capabilities to KPMG clients
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Impact of Transfer Pricing Adjustments
• Consider the initial impact of a $5 million transfer pricing adjustment.
Amount
% of Adjustment
Corporate income tax (suppose 37%) $1,850,000 37%
Interest on tax (4 years at 9%) $750,000 15%
Withholding tax on deemed dividend $1,250,000 25%
Interest on withholding tax (4 years at 9%) $500,000 10%
Transfer pricing penalty (if applied) $500,000 10%
Advisor fees and internal costs to taxpayer Varies
Total initial impact of adjustment > $4,850,000 > 97%
All amounts are in Canadian funds.
35© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
Transfer Pricing Audit Environment
• Increased audit activity
– CRA has been hiring more staff and providing more training
• Vast majority of audit adjustments are due to transfer pricing
• Important to have strong contemporaneous transfer pricing documentation in place
– Auditors ask for this documentation at start of audit
– Foreign-prepared documentation may not be sufficient for Canadian purposes
– CRA is applying transfer pricing penalties when taxpayers have not met reasonable efforts standard for documentation
36© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
Oil & Gas Transfer Pricing Issues
• Canada often has unique transfer pricing issues
• Functions and risks are inconsistent with transfer pricing policies
• Leasing charges and the treatment of repairs and maintenance and lost-in-hole assets
• Unintended and complex intangible property ownership
• Energy trading and the use of capital
• Arm’s length interest rates
• Management fees—what are you getting for these charges?
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QUESTIONS?
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.
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© 2005 KPMG LLP, the Canadian member firm of KPMG International, a Swiss cooperative. All rights reserved.
