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Summary

  • Seadrill has been disputing a retroactive capital gains tax imposed on it by the Norwegian authorities for the past few years.
  • This dispute was resolved earlier this month in a secret deal.
  • The company estimated its maximum exposure at $263 million, $63 million of which would be paid by North Atlantic Drilling.
  • This deal could have either a one-time negative impact on both companies' results or a recurring one, depending on the terms.
  • As this deal was resolved in secret, we do not know any details about the consequences.

Shortly after my last article on Seadrill (NYSE:SDRL), I received an email from YCantIRetire, which pointed out an article in the Norwegian media stating that Seadrill has finally resolved a long running tax dispute with the Norwegian authorities. Unfortunately, the full details of this resolution are not publicly available at this time but I do want to share the information that we do have, as this is something that could prove to have a very material effect on the company and its earnings.

Cause of the Tax Dispute

This tax dispute had its roots back in December 2007 when Seadrill established an office in the Norwegian territory of Svalbard and simultaneously transferred the ownership of five rigs to Svalbard from mainland Norway. This made sense for the company because the Svalbard Treaty of 1920, which established Norwegian sovereignty over the archipelago, limits Norway's right to levy taxes on the citizens of the archipelago to only that level that is necessary to finance services on Svalbard itself. Because of this, Svalbard has a substantially lower income tax than mainland Norway and no value-added tax. By transferring ownership of these rigs to Svalbard, Seadrill was seemingly trying to take advantage of this tax-advantaged regime.

At the time that Seadrill performed this transfer, there were no taxes imposed on such a transaction. However, this changed in December 2008 when the Norwegian authorities imposed a retroactive capital gains tax on such a transaction. Seadrill first discussed this situation in its third quarter 2011 earnings report in which it calculated its total exposure to this tax to be $190 million. In this report, Seadrill stated that it discussed the situation in greater depth in its Form 20-F for 2010 but I cannot find any mention of a tax dispute in this document and the only mention of Svalbard is a statement that some of the company's rigs are owned by entities located in Svalbard. Regardless, at the end of 2010, the company believed its maximum exposure due to this retroactive tax change to be $190 million per its third quarter 2011 report.

That changed in October 2011 when North Atlantic Drilling (NYSE:NADL), which owned the rigs that triggered this tax dispute following its formation in the middle of 2011, received a letter from the Norwegian tax authorities. This letter, which was primarily related to the issue surrounding the transfer of ownership of several rigs to Svalbard, stated that the company's maximum exposure has increased to $263 million. As should be immediately apparent, this means that the company owes much more money to the Norwegian government than it originally thought.

Dispute and Resolution

Naturally, Seadrill has been appealing this position of the tax authorities, partly because retroactive laws are explicitly banned under the Norwegian constitution. The company's position was that it should not have to pay any tax on its transfer of the rigs' ownership to Svalbard because there was no tax on such a transaction at the time that the company performed this transfer. Admittedly, this is the sort of thing that we should like to see as shareholders since it shows that the company is making a concerted effort to minimize its tax burden and in so doing, increasing the amount of money that it has available for other purposes such as paying dividends. Of course, appealing a case in the courts as the company was doing also costs money but it is much less money than what would be paid in taxes should the company not appeal the ruling.

Seadrill and North Atlantic Drilling have been fighting this ruling since that time. However, up until very recently there had been no resolution to the company's appeal. That appears to have changed in the last few weeks though with the announcement that the company reached the aforementioned agreement with the Norwegian tax authorities regarding the taxes that the company will end up paying.

Unfortunately, there is no information on the specifics of this agreement at this time. Therefore, we do not know how much Seadrill or North Atlantic Drilling will end up paying or even which company will end up paying the taxes that are owed. It may end up being both companies that are paying off the taxes owed under this agreement. However, we can predict that both companies will end up paying something due to an earlier agreement that Seadrill made with North Atlantic Drilling regarding this ongoing tax dispute. In short, the two companies agreed that regardless of whatever the final deal with the regulators ends up being, North Atlantic Drilling will not have to pay any more than $63 million. Presumably, North Atlantic Drilling will pay the first $63 million to the authorities and Seadrill will pay whatever is left over. This deal is necessary because North Atlantic Drilling currently owns the rigs whose domicile transfer created this tax liability. However, North Atlantic Drilling did not exist at the time this liability was created and so therefore obtained these rigs with this outstanding tax liability still attached to them. Therefore, it likely seems only fair from the perspective of North Atlantic Drilling that Seadrill provides some sort of guarantee against large tax penalties that may accrue against the smaller subsidiary that North Atlantic Drilling had no hand in creating.

As a result of the deal with Seadrill, North Atlantic Drilling added $63 million in deferred taxes as a liability on its balance sheet in 2011. However, this amount has since been reduced to $35.7 million as of the end of 2013 without so much as a mention about this dispute with the Norwegian tax authorities. Therefore, we are forced to assume that either North Atlantic Drilling assumed that its overall exposure as a result of this dispute is lower than the $63 million that it previously assumed, that it paid off some of this potential liability before a final deal was reached with the authorities, that a new deal was reached with Seadrill that lowered the maximum amount that North Atlantic Drilling could be responsible for, or some combination of the three. If, however, the company is forced to increase its deferred tax liability due to this secret deal (for example, it still owes $63 million and has not prepaid any of it) then it will likely have to decrease its shareholders' equity to compensate for the higher liabilities since assets must equal liabilities plus shareholders' equity.

The payment of whatever amount of money this secret deal specifies will likely have a negative impact on earnings for either Seadrill, North Atlantic Drilling, or both. Unfortunately, we do now know at this time whether the taxes owed by the companies will be paid off as a one-time payment or as recurring installments. If it is the latter then the payment of this tax settlement could be a drag on earnings for the next several quarters. Unfortunately, there is no way to be at all certain about what the impact will actually be until more information about the secret deal is released.

The one thing that we can be relatively certain of is that the deal that was reached will likely have a total cost of less than $263 million. That is because that was the number that the tax authorities provided in the October 2011 letter to North Atlantic Drilling, which Seadrill was unwilling to accept. Therefore, it seems somewhat unlikely that the company's management would just accept it now. Unfortunately, investors may just have to wait until the two companies release their respective first quarter reports later this month before we can find out for sure.

Source: Seadrill Resolves Tax Dispute With Norwegian Authorities, Here's What We Know

Additional disclosure: My long position in NADL consists of the Norwegian OTC shares, not the ones traded on the NYSE.