As the Alaska Legislature completes its annual task of setting next year’s budget, conversations about oil tax credits have once again taken center stage. I thought I would take a moment to explain what these credits are, what they are not, and the decision that is now being debated. First I’ll start with a brief overview to separate the fact from fiction regarding this credits. Then I’ll use a metaphor to explain what it is we are debating and how I came to my opinion about how we should move forward.
Oil Tax Credits
First, we need to get one thing straight. A tax credit is a reduction to a tax liability. The amount of taxes that are due is derived by a formula and reduced by a credit. A credit is not a payment to an oil company, it is a part of the calculation that determines how much taxes they owe.
In exactly the same way a coupon reduces what you owe at the register, a credit reduces what you owe to the government. Never would you think about a trip to the grocery store in terms like this:
“I paid them $100 and then the store invested $10 into my meals by giving me a discount”.
Rather, you would say “my groceries cost $90. I bought them because I was expecting to pay that much”.
These types of credit are sometimes called “indirect expenditures”. That is, they change the revenue the state collects rather than hitting the budget directly.
Just like the coupons reduce the cost of something in order to encourage to you make a purchase, these credits are part of the calculation that goes into an oil company’s decision to invest in Alaska.
This suite of credits is mostly found in Alaska tax code under AS 43.55.024.
Some of the tax credits that Alaska offered for a time were a little different. With these credits you had to meet some requirement, and then you become eligible for a rebate.
These are just like when you buy that new lawnmower that has a rebate card inside. It tells you to log in to a website and enter a code to get $50 back. Then, a few weeks later you get a check in the mail. I’m sure we have all seen these at some point in our lives.
The key difference with these types of deals is that you don’t get a discount at the register. You have to make a purchase and then wait for a check to come later.
These schemes also have a different impact on the accounting books. In this case you actually book revenue and then later book a deduction. In the former case, you simply book a smaller revenue stream and don’t book the deduction at all (or in a line on your P&L called DD&A).
These “refundable” credits are the topic of discussion right now, but are occasionally confused with the “discounts” I referenced before. This suite of credits was found in Alaska tax code under AS 43.55.023 and AS 43.55.025 until last year.
A Story to Illustrate the Issue
Let’s say you were looking to open a small business in Alaska. It’s a simple business; you would buy Alaska souvenirs from a wholesaler for $1 and then sell them to tourists for $2.
The market for these souvenirs isn’t very good right now, so this wholesaler wants to encourage you to open up a shop. To attract you, they offer a discount of 10% for your first 7 years in business and also offer a $0.50 refund on each unit while you get up and running. They tell you that after you make an order, the store will give you a certificate worth one half the purchase amount that can be used against your next purchase.
This seems like a good deal, so you start looking at getting into the business. The margins were small without the discount and refund, but now this endeavor pencils out.
After a while, your personal circumstances change. You decide you’re not going to make anymore purchases. Now the refund certificate’s value changes in your mind.
See, the certificate only has value to you if you keep buying souvenirs. While you’re not going to buy any more, it has real cash value to other people who are planning to keep purchasing. So, you approach one of your competitors and ask them if they would like to purchase your refund certificates.
Say you have a $100 certificate. Well, that is worth $100 to your competitor, and worth nothing to you. So, you strike a deal somewhere in the middle and you’re both better off.
But what about the wholesaler? They are still feeling the same $100 reduction in revenues, but they don’t get the benefit of growing their customer base. They even feel a little cheated that one of the large companies that don’t require any incentives are getting the benefit you provided to get other businesses started.
So, they start a buyback program. Now if you get one of these refund certificates, you can take it to the customer service desk and exchange it for the cash value of that piece of paper.
Say I am also considering going into business in Alaska, but I am skeptical about this whole situation. So I watched you as it all played out. After awhile, I see you getting the benefits you were promised and I decide maybe this is a good deal. The problem is, I don’t have enough money to get started.
I figure that I need a beginning inventory of 100,000 units to make it worth the costs of renting space and hiring employees. However, I only have $50,000 in the bank.
But then I get a bright idea. Given the situation with the cash refund, I can do this:
First, I go spend my $50,000 to buy a little over 55,000 units at the discount price. Then, I take the $25,000 refund check directly to the customer service desk. I get in line, and once I get my cash I go straight back into the store and buy another nearly 28,000 units. Now I have 83,000 units and I can keep doing this until I get enough to start my business.
When I tell this ingenious idea to a friend of mine, she’s intrigued. “What if I just loan you the $40,000 you need. Then, when you cash your $45,000 refund check, just give me $42,000 of it” she says.
That sounds like a win-win to me, so I sign up.
How would you feel if after you committed to one of these schemes (reinvestment or bridge loan), the wholesaler pulled the rug out from under you? They tell you that they are having cash flow problems and they can’t afford to buy your rebate certificates. When you tell them that you relied upon their program when you decided to invest, they tell you that you should have read the fine print, but that they may give you the cash next year if their revenues recover.
All of the sudden, you are stuck in between a rock and a hard spot. You don’t have the money to move forward with your business plan, your life savings are tied up in inventory, and the money that you were counting on isn’t there.
If you took a loan with a promise to pay them back with the cash rebate, you are now in default. Since borrowing more money to finish the business plan is not possible while you are in default, you really only have two options. Either declare bankruptcy or hold out and hope that the wholesaler really does come through next year.
And what if you’re the lender? You’re in a similar boat. Your choices are either to foreclose on the loan or wait and see. At this point you realize that the value of the collateral (the inventory) isn’t worth nearly as much as it was when these cash rebates were in place. So, foreclosure doesn’t look like a great option. You wait.
And from the wholesaler’s perspective? Well, current cash flow is the immediate concern, but there was a reason they wanted to attract these new players to participate. If they get a more businesses running, they represent a future cash flow. That means they need to balance current cash flow needs against future cash flow potential. Forcing these new players into bankruptcy solves the former at the expense of the latter.
This is basically the situation in Alaska with the oil tax credits. There are at least four known projects that are stalled due to the financial constraints of the companies involved. They invested in these marginal oil fields because they made sense under the program that was in place. Now, they are sitting on our oil resources; unable to develop them themselves and preventing others from doing so.
So long as Alaska is giving them reason to hope for the cash they were counting on, the resources sit idle. The companies won’t declare bankruptcy and the banks won’t foreclose as they hold out for the cash. Meanwhile, the oil leases can’t move forward with development.
My advice on this issue is “don’t take a half-measure”. A trickle of payments is the worst outcome for the State. It leads to the resources remaining undeveloped and likely still results in future bankruptcy for the companies.
Either commit to purchasing these certificates now, or tell them point-blank that we will not be buying them. In the former case, we would get movement toward development, in the latter we could start the process of moving the resources to someone that can develop them.
Full disclosure – until this year I would have suggested the latter based on some return on investment calculations.
After this last legislative session, I think there is too much evidence on the record from the administration and the appropriating body that relying on these purchases was a rational thing to do. And when a party relies on the promises of another, we get into some tricky legal waters to navigate.
While I still believe that the State never had a statutory obligation to purchase these credit certificates, I do think there are grounds to demand performance based on things like estoppel.
Just that threat of litigation undermines the reason that canceling the program would have been a good idea. The process of bankruptcy and court proceedings would keep these resources from being developed for years to come.
And even if the State were to win the court case, the tax reductions themselves will never be discharged. We end up winning the battle and losing the war. Our reputation is damaged as the resources go up for sale following a bankruptcy that the markets believe the State created. And the winner of those bids end up claiming the credits anyway once the oil starts flowing.
So we are really only talking about timing issues, mostly relating to resource management. From the perspective of resource management, we need to get these fields into production as fast as possible.
For these reasons, I’ve come around to support paying off these “obligations” as soon as possible in order to get the oil flowing.
Where things get tricky is the cash. The State doesn’t have enough cash flow to make these purchases. So, the only option would be to draw a billion dollars out of savings. A slower payment on these purchases makes more financial sense (and the slower the better). But, that is at odds with resource development goals.
A slow payment schedule doesn’t give the companies the capital they need to move forward. In fact, too slow a payment probably only pays the interest on their loans (which has the effect of delaying foreclosure, but never getting them to development).
Enter HB 331
House Bill 331 is a way to achieve both goals. It gets the capital into the hands of the developers to move forward, but has the cash flow effect of a longer payment schedule for the State. As I showed in a previous post, this could result in a win-win for the State as we get both the development of the resources and the benefit of interest by leaving more cash in the interest bearing account.
Since I published that article, a few people have pointed out an unspoken assumption about that conclusion. Basically, this idea only works if the future legislatures exhibit financial restraint. If they take the money they are saving and go on a shopping spree for new sports arenas and engineering buildings, the whole thing falls apart. In that case, I recommend just paying for the credit certificates now.
This topic, regarding the use of these savings, will be my next topic of discussion. Stay tuned.