Inside Fortress Energy’s $18.5 million tax battle
After a 21-month fight, Cam Bailey eyes light oil assets in Brazil
Cam Bailey was at home and thought he was done work for the day when his cell phone rang. It was around dinner time on February 23, 2011. A collection agent from Canada Revenue Agency (CRA) wanted to know how the president and chief executive of Fortress Energy Inc. was going to pay the company’s $18.5 million tax assessment.
Bailey was stunned, but not quite speechless, and he told the collection agent his Calgary-based junior oil and gas company never received a tax assessment. He heard some typing in the background over the phone and then the agent apologized. It turned out the tax assessment had not been mailed – yet.
The call for collection and the amount of the assessment was not completely unexpected. The CRA Aggressive Tax Planning division in Calgary began auditing Fortress in May 2008. The division investigates arrangements that might be legal in a technical sense, but are structured to reduce the tax burden. CRA’s audit of Fortress began shortly after the company sold most of its assets to transition into a gas-weighted producer.
The entire proceeds of the transaction were sheltered by tax credits and the CRA was a little suspicious. “A $100 million transaction goes through and there’s no tax hit? Well, I’m sure the alarm bells are going off all over the place,” Bailey says. “It wasn’t the sort of gradual use of tax pools over a period of time.”
The subsequent 21-month dispute with the CRA cost Fortress $1 million in legal fees and halted the company’s next transition from a natural gas producer in Western Canada to a light oil producer in Brazil. The company had whittled down its assets and didn’t have enough cash to cover the $9 million and change that was due in late-February 2011 to the CRA, let alone the full $18.5 million.
So, rather than pay the requisite 50 per cent to get on with rebuilding Fortress while the company appealed the tax assessment, Bailey prepared for battle.
“From our position it was: we will take it all the way to court and go for as many years as it takes,” he says.
Signalgene Inc.’s prospects were bleak in 2003. The public company had been developing a handful of cancer therapeutic technologies, but they were still a long way from becoming commercial products. The Montreal-based company’s chief executive decided to wind down operations and sell off assets to get some money back for the shareholders.
That decision would lead to the creation of SignalEnergy Inc., which would eventually become Fortress.
Bailey was a partner with Network Management Capital Inc. at the time. The Calgary-based investment firm specialized in taking nearly broke public companies that had accumulated losses and transitioning them into a new business where those losses could be used to reduce taxes paid in the future.
“SignalGene had $5 million in cash, it had a Toronto Stock Exchange listing and it had $55 million in tax deductibles,” Bailey says.
It was a niche investment market, but not a new strategy.
Canadian tax rules were amended in the 1980s to take tax pools away from companies where a so-called acquisition of control had taken place, says Brent Perry, Fortress’ legal counsel and partner in the Calgary office of Felesky Flynn LLP. If no acquisition of control took place, then the companies would be able to retain any tax credits that had been generated.
“The original shareholders might have put in millions of dollars that were expended on activities that might not have produced economic value,” Perry says. “Now they’re given an opportunity to recapitalize, start again and realize those losses. What’s wrong with that?”
To an outsider, and certainly to the CRA, Bailey’s use of tax pools after SignalGene was recapitalized into an oil and gas producer appeared to take advantage of the tax system.
The revenue agency recognizes companies have the right to try and minimize the tax they pay, says Sandra Mah, tax lawyer and partner in the Calgary office of Gowlings LLP, speaking broadly and not about the Fortress case specifically. “What they’re balancing is the other side of this, which is plans that undermine the integrity of the tax laws and the tax base,” she says.
The CRA did not respond to interview requests for this story, but Bailey figures the agency’s aggressive tax planning group wanted to set an example by pursuing the tax assessment against Fortress.
“CRA has started to challenge a number of those transactions, but we have yet to see one challenged to the extent that they did with ours,” Bailey says. “If they won this case, they could win every other tax loss case that’s out there.”
In November 2003, Network Capital paid $0.71 per share, a total of $8.6 million, to acquire 45 per cent of SignalGene’s common shares and 21 million non-voting shares. Bailey became chief executive when the repurposed company launched as SignalEnergy in December 2003.
Network’s investment was less than 49 per cent ownership of SignalGene, but the CRA contested the structure of the deal gave Network “de jure” control. Basically, the CRA thought Network effectively had control of SignalGene before it changed its business from biotechnology to oil and gas.
The agency staked its claim to the fact that Network held an option to convert a number of its preferred shares to voting shares and that four of the five board members of the new company were nominated by Network.
After nearly two years of investigation, the CRA Aggressive Tax Planning division in Calgary sent a letter to Fortress in January 2010 proposing to deny the deduction of roughly $3 million in non-capital losses in 2004 and 2005. The agency also wanted to bar non-capital losses and Scientific Research and Experimental Development (SR&ED) tax credits that were generated by the biotechnology company to make up the $55 million tax pool.
“When we reviewed it, we thought there was no case,” Bailey says. “They had these frail arguments that they were trying to use to string together this view that we had abused the tax act.”
Fortress spent the next two months compiling company documents into three-inch binders and presented a rebuttal. The CRA responded with a letter eight months later, in November 2010, that not only tacked on a $13 million non-capital loss deduction from 2006, but incorporated none of the comments Fortress submitted.
“We were surprised,” Felesky’s Perry says. “I think initially the people who were reviewing it weren’t persuaded. You can only guess as to what their reasons were, but in a complicated area of law people often disagree. I think what happened was the aggressive tax planning group just was not persuaded by, or didn’t understand, or were uncomfortable agreeing with our conclusions.”
Despite the CRA’s reluctance to incorporate any of Fortress’ initial response, Bailey says he didn’t realize the severity of the situation until he received the call from the CRA collection agent. Once the 10-minute phone call ended, he called his lawyer and discussed protecting the company’s equity by filing under the Companies’ Creditors Arrangement Act.
“I thought, OK, these guys are going to be absolutely vigilant,” Bailey recalls. “Once the assessment notice is out, they have the right to garnish or sweep your bank accounts to pay for the taxes, so their powers of collection are beyond the ability of any creditor to collect.”
The move into creditor protection de-listed Fortress from the Toronto Stock Exchange and hindered the company’s next transition. Fortress had accumulated several natural gas properties straddling the British Columbia-Alberta border, but profits from the project began to erode as the price for natural gas plummetted. As prices sank, Bailey looked to transition the company into light oil production.
During 2010, Fortress earned $11.4 million in revenue and had about 30 full-time employees. The company’s stock price closed that year at 12.5 cents per share, as Fortress sold most of its assets to fund the transition. But the dispute with the CRA and the move into creditor protection hung over the company. It held onto roughly 120 barrels of oil equivalent per day and three employees, but wasn’t able to re-invest the $855,000 in revenue that was earned during 2011.
The downtime gave Fortress ample time to research light oil plays around North America and other parts of the world. The company had its eye on property in the Paris Basin before France moved to ban hydraulic fracturing.
Then, on October 27, 2011, a revised tax assessment arrived at the Felesky Flynn office. The CRA had adjusted the balance Fortress owed to zero. The tax dispute was over.
Bailey says he never got an explanation from the CRA on why the tax claim was vacated, but he never doubted that Fortress would win the dispute. “It was a huge relief,” Bailey says. “It was some vindication, but at the end of the day we wasted nine months of the company [in creditor protection].”
PowerPoint presentations, binders, reports, and charts are scattered the length of Bailey’s horseshoe-shaped desk. The titles of many of the documents are in Portuguese. Fortress’ quest for light oil ended in Brazil.
Fortress offered US$37 million for Alvorada Petroleo SA, a private Brazilian oil and gas company, in December 2011. The acquisition is expected to close in October 2012 and will provide Fortress with seven exploration blocks in the Reconcavo Basin and three producing fields in other basins in the South American country with current output of 50 barrels per day of light oil.
Oil was first discovered in the rolling farmland that makes up the Reconcavo Basin in 1939, which kick-started Brazil’s oil industry. Gran Tierra Energy Inc. also holds land in the basin. The Calgary-based company plans to introduce horizontal drilling and hydraulic fracturing into a region that has seen only conventional vertical wells.
Ultimately, Fortress has the same plan for its property, but Brazil’s services sector isn’t yet equipped to handle those unconventional operations. “How it all plays out we don’t yet know because they haven’t actually tested their concept,” says CIBC World Markets analyst Ian Macqueen, who covers Gran Tierra. “Then you have to be concerned about technical issues as well as costs associated with developing reserves.”
Bailey says part of Fortress’ business plan for Brazil includes assisting in infrastructure development and importing completions equipment. In addition to private equity raised to finance the acquisition, Fortress raised $25 million from various investment banks to fund its capital program in Brazil.
Despite recently coming out of creditor protection and following a lengthy tax dispute with the CRA, Bailey says the company had no problem raising the money.
Fortress is contemplating yet another name change to Alvopetro Inc., to represent the new business focus, but Bailey says the company will still have $55 million of available tax pools to utilize – and they won’t be shy about doing so. “It’s going to be even more interesting how we use them,” he says.
Building and Re-building a Fortress
|1986||SignalGene Inc. is listed on the Toronto Stock Exchange|
|2004||SignalEnergy begins coalbed methane development on 35 sections of land just northeast of Calgary in the Twinning field|
|2005||SignalEnergy sells its coalbed methane properties to Trident Resources Corp.|
|2006||SignalEnergy builds up conventional oil and natural gas production to 2,000 barrels per day. SignalEnergy then sells its assets for $100 million|
|2006||SignalEnergy acquires Marauder Resources West Coast Inc. and natural gas properties straddling the British Columbia-Alberta border|
|2007||SignalEnergy changes its name to Fortress Energy Inc.|
|2007||Fortress begins construction of a 40-kilometer pipeline to bring its estimated reserves of 25 billion cubic feet of natural gas to market|
|2010||Fortress sells the majority of its natural gas assets to Terra Energy Corp. for about $32 million|