The following article, authored by Keane Associate General Counsel & Project Manager Will King, originally appeared in the Petroleum Accounting and Financial Management Journal. It is published below with the permission of the University of North Texas Institute of Petroleum Accounting.
As domestic energy production has boomed over the last several years, an affiliated risk item has been growing on the books and records of oil and gas firms. Specifically, the unpaid amounts associated with suspended and/or unknown owners creates “unclaimed property” for a company, which must be reported to various states after statutorily defined periods of time have elapsed. As states have taken in more and more unclaimed property in recent years—at least partially to mitigate widening budget shortfalls— enforcement of state unclaimed property laws through audits also has increased, creating large and costly headaches for companies.
All states, several territories, and a handful of Canadian provinces have unclaimed property laws. Broadly speaking, these laws require “holders” (the term for an entity having an unclaimed property reporting obligation) to annually report property/funds that are unclaimed or uncashed by an owner. First, it is important to note that state unclaimed property laws apply to holders across many industries and extend to property types that go beyond mineral interest proceeds (such as payroll checks, stock, benefits items, accounts payable disbursements, and customer credits). Therefore, while mineral interest proceeds may be the most significant source of liability for an oil and gas firm, there may be other liabilities in other departments or areas of the company that also require attention.
Second, unclaimed property compliance obligations vary among states. Determining which state law applies to a given obligation is driven by the last known address of the owner of those funds. The bright line test to determine which state unclaimed property law applies was articulated by the Supreme Court in Texas v. New Jersey (379 U.S.674, 1965). In this case, the Court indicated that property is first reportable to the state of last known address of the owner on the books and records of the holder, and, if that is unknown, to the state of incorporation of the holder. Thus, determining which dormancy period applies (the amount of time an obligation is outstanding prior to being reportable), the state for which a report must be filed, the amount of due diligence that must be performed prior to reporting that obligation, and the type and time that records must be maintained, all hinges on an owner’s last known address, not any nexus the company may have with a given state. While unclaimed property feels (and often resembles) a tax, this is one of the greatest differentiations from the traditional tax arena.
Within each state law, challenges and complexities make unclaimed property reporting extremely burdensome for holders. Aside from the aforementioned variances among state laws, mineral interests specifically have a host of additional nuances.
For example in Ohio, mineral interest properties have a one year dormancy period. In Kentucky, reporting of unclaimed mineral proceeds is exempt entirely. Holders and their advisors must interpret state unclaimed property laws to determine which suspense codes rise to a legal level of being escheatable suspense. In some states with “current to pay” reporting requirements, holders must not only remit the unpaid funds that have been outstanding for the “dormancy period” (typically between three and five years), but also “current” funds that have not yet fully aged. In Texas, those funds must be reported with a special attached code. In Oklahoma, funds unpaid and accumulated as a result of a forced pooling order are reported to the Oklahoma Corporations Commission rather than the Treasurer’s office. Within preparation of the reports themselves, some states require property and well-specific information or special supplemental reports giving greater details of the property than is necessary in a standard unclaimed property report. Lastly, a growing number of escrow or trust schemes that attempt to force remittance of unpaid funds to a geographic region tied to production potentially conflict with the Supreme Court’s dictated last known address jurisdictional scheme.
With all of the above nuances, it’s easy to see how compliance costs and resource dedication can be high for firms with growing suspense account ledgers. However, these outlays can pale in comparison to the costs faced by a holder undergoing an unclaimed property audit on behalf of a state.
It is most important to note that unclaimed property audits, on behalf of multiple states at the same time, are often conducted by private, third-party firms who are paid a portion of the assessment they make against a holder. Because these firms are paid on a contingency basis, we often find aggressive and novel interpretations of state law being made by a private enterprise with a pecuniary interest in the resolution of open issues.
Exams conducted by private firms on behalf of Delaware, in particular, have notoriously taken several years to complete. Further, with a Delaware lookback period as far back as 1981, holders are put in the position of potentially defending estimated unclaimed property liabilities that extend far beyond the years for which they may retain records. With some exams having as many as 30 to 40 participating states (all being coordinated through one or two private firms), it is easy to see how evaluating compliance can be more resource and cost intensive than effecting compliance in the first place.
In the oil and gas space, in particular, currently there is a “cycle” of unclaimed property exams. Further, states such as Texas appear more apt than ever before to participate in third party exams of oil and gas holders. For many auditors, the nuances of mineral interest and revenue accounting are foreign, so the holder must explain suspense codes, ledgers, joint or working interest arrangements, and the like, which is a time consuming and exacerbating process. With no statute of limitations in many states, the penalties and interest associated with past due suspense amounts can often times exceed the principal liability.
One major concern for companies is the use of estimation and extrapolation to calculate liabilities for the years that a holder may not have adequate records to prove the disposition of an item (i.e., paid to an owner, escheated, etc.). In those instances, a mathematical formula creates an error ratio that is, at least in part, based on amounts owed to various states and amounts already appropriately reported. Those numbers are multiplied against revenues for the prior look-back period audit years to create an unclaimed property liability. With no underlying owners associated with this calculated liability, the entire sum is reportable to the holder’s state of incorporation. This is the reason why Delaware claims such a disproportionate amount of unclaimed property; it is the state’s third-largest source of revenue and accounts for nearly 15% of its operating budget.
Mergers and Acquisitions Considerations
In the oil and gas space, one of the greatest sources of unclaimed property liability is acquired suspense. With prices at current levels, many analysts expect merger, acquisition, and divestiture activity to increase throughout 2015. There are important unclaimed property implications with these transactions.
The important thing to remember with such corporate actions is that the dormancy period of an item does not restart upon acquisition. Thus, if a firm acquires old and past due suspense in a property or well acquisition, it also is acquiring the potential penalties and interest associated with that past due suspense. It is important to make unclaimed property a part of the deal’s due diligence process by asking pointed questions about compliance and audit history.
Mitigating Unclaimed Property Risks
Despite all of these challenges, there are steps holders can undertake to mitigate unclaimed property risk. Among them:
- Documenting robust policies and procedures or working with unclaimed property experts to build a comprehensive compliance program;
- Considering Voluntary Disclosure Agreements or other voluntary compliance programs for first-time filers (note: each state’s program is different so it is best to speak to an advisor prior to enrolling) to mitigate penalty and interest assessments;
- Utilizing owner location resources to locate better addresses or next of kin to reduce the amount of property that may be considered unclaimed;
- Understanding and articulating your rights under exam to reduce burdens and costs.
The current frontier of unclaimed property compliance and enforcement is one of the most arduous that holders and practitioners have ever seen. The key for an oil and gas company to weather the current and future environments hinges upon understanding state laws and monitoring trends, legislative updates, and litigation to stay abreast of developments and accordingly adjusting policies to adapt.
For more information on Keane’s unclaimed property compliance services to the oil & gas industry, contact us at [email protected].