1) Description of Business

KNOT Offshore Partners LP (the “Partnership”) was formed as a limited partnership under the laws of the Republic of the Marshall Islands. The Partnership was formed for the purpose of acquiring 100% ownership interests in four shuttle tankers owned by Knutsen NYK Offshore Tankers AS (“KNOT”) in connection with the Partnership’s initial public offering of its common units (the “IPO”), which was completed on April 15, 2013.

The Partnership was established prior to the closing of the IPO. In connection with the consummation of the IPO, through KNOT Offshore Partners UK LLC (“KNOT UK”), a 100% owned limited liability company formed under the laws of the Marshall Islands, the Partnership acquired a 100% ownership interest in KNOT Shuttle Tankers AS, a wholly owned subsidiary of KNOT, which as of February 27, 2013 directly or indirectly owned (1) 100% of Knutsen Shuttle Tankers XII KS, the owner of the Recife Knutsen and the Fortaleza Knutsen, (2) 100% of Knutsen Shuttle Tankers XII AS, the general partner of Knutsen Shuttle Tankers XII KS, and (3) the Windsor Knutsen and the Bodil Knutsen and all of their related charters, inventory and long-term debt. In establishing the new KNOT Shuttle Tankers AS structure, KNOT formed three new Norwegian subsidiaries, which acquired 90% of Knutsen Shuttle Tankers XII KS, 100% of the Windsor Knutsen and 100% of the Bodil Knutsen, respectively.

In connection with the consummation of the IPO, (1) the Partnership issued to KNOT 8,567,500 subordinated units, representing a 49.0% limited partner interest in the Partnership, and 100% of the incentive distribution rights (“IDRs”); (2) KNOT Offshore Partners GP LLC, a wholly owned subsidiary of KNOT and the general partner of the Partnership (the “General Partner”), continued its 2.0% general partner interest in the Partnership; and (3) the Partnership issued and sold to the public, through the underwriters, 8,567,500 common units (including 1,117,500 common units sold pursuant to the full exercise of the underwriters’ option to purchase additional units), representing a 49.0% limited partner interest in the Partnership. The Partnership received gross proceeds before underwriting discounts, the structuring fee and estimated offering expenses of approximately $179.9 million in connection with the IPO, all as further described in Note 3—Formation Transactions and Initial Public Offering.

For periods prior to April 15, 2013 (the closing of the IPO), the Partnership and its subsidiaries that had interests in the Windsor Knutsen, the Bodil Knutsen, the Recife Knutsen and the Fortaleza Knutsen are collectively referred to as the “Combined Entity.” The transfers and contributions of the subsidiaries holding interests in the Windsor Knutsen, the Bodil Knutsen, the Recife Knutsen and the Fortaleza Knutsen from KNOT to the Partnership in connection with the IPO were deemed to be a reorganization of entities under common control. As a reorganization of entities under common control, the transfer of the subsidiaries and other net assets has been recorded at KNOT’s historical book value.

Pursuant to the Partnership’s First Amended and Restated Agreement of Limited Partnership (the “Partnership Agreement”), the General Partner has irrevocably delegated to the Partnership’s board of directors the power to oversee and direct the operations of, manage and determine the strategies and policies of the Partnership. During the period from the IPO until the time of the Partnership’s first annual meeting of unitholders (“AGM”) on June 25, 2013, the General Partner retained the sole power to appoint, remove and replace all members of the Partnership’s board of directors. At the first AGM, four of the seven board members became electable by the common unitholders and accordingly, from this date, KNOT, as the owner of the General Partner, no longer retained the power to control the Partnership’s board of directors and hence the Partnership. As a result, the Partnership is no longer considered to be under common control with KNOT, and, as a consequence, the Partnership no longer accounts for any vessel acquisitions from KNOT after June 25, 2013 as a transfer of equity interests between entities under common control.

On August 1, 2013, the Partnership’s wholly owned subsidiary, KNOT Shuttle Tanker AS, acquired Knutsen Shuttle Tanker 13 AS, the company that owns the Carmen Knutsen, from KNOT. The acquisition of the Carmen Knutsen was accounted for as an acquisition of a business. Accordingly, the results of the Carmen Knutsen are consolidated into the Partnership’s results from the date of its acquisition. There has been no retroactive restatement of the Partnership’s financial statements to reflect the historical results of the Carmen Knutsen prior to its acquisition.

On June 27, 2014, the Partnership issued and sold 4,600,000 common units in an underwritten public offering (the “June 2014 Offering”). In connection with the June 2014 Offering, the Partnership also granted the underwriters the option to purchase an additional 690,000 common units. In connection with the partial exercises (the “Option Exercises”) by the underwriters of their option to purchase additional common units, on July 14, 2014 and July 24, 2014, the Partnership issued and sold 150,000 common units and 490,000 common units, respectively, and the General Partner made additional capital contributions to the Partnership in order to maintain its 2% general partner interest in the Partnership.

 

The net proceeds from the June 2014 Offering and the Option Exercises (an aggregate of $144.0 million) and related capital contributions by the General Partner (an aggregate of $3.0 million) were used to fund the purchase price of the acquisitions of the companies that own the Hilda Knutsen and the Torill Knutsen from Knutsen NYK Offshore Tankers AS and for general partnership purposes.

On June 30, 2014, the Partnership’s wholly owned subsidiary, KNOT Shuttle Tankers AS, acquired Knutsen Shuttle Tankers 14 AS and Knutsen Shuttle Tankers 15 AS, the companies that own the Hilda Knutsen and the Torill Knutsen, respectively, from KNOT. The acquisitions of the Hilda Knutsen and the Torill Knutsen were accounted for as an acquisition of businesses. Accordingly, the results of operations of the Hilda Knutsen and the Torill Knutsen are consolidated into the Partnership’s results as of the date of their acquisitions.

On December 15, 2014, the Partnership’s wholly owned subsidiary, KNOT Shuttle Tankers AS, acquired KNOT Shuttle Tankers 20 AS, the company that owns the Dan Cisne, from KNOT. The acquisition of the Dan Cisne was accounted for as an acquisition of a business. Accordingly, the results of operations of the Dan Cisne are consolidated into the Partnership’s results as of the date of its acquisition.

Please read Note 22—Business Acquisitions.

Each of the Windsor Knutsen, the Bodil Knutsen, the Recife Knutsen, the Fortaleza Knutsen, the Carmen Knutsen, the Hilda Knutsen, the Torill Knutsen, and the Dan Cisne are referred to as a “Vessel” and, collectively, as the “Vessels.” As of December 31, 2014, the Partnership operated a fleet of eight vessels. The Vessels operate under fixed long-term charter contracts to charterers, except for the Windsor Knutsen. In April 2014, the Partnership was notified that BG Group would not exercise its option to extend the Windsor Knutsen time charter after the expiration of its initial term. In July 2014, the vessel was re-delivered. In June 2014, the Partnership entered into a new two-year time charter contract with BG Group for the Windsor Knutsen that will commence in the fourth quarter of 2015 and has three one-year extension options. Prior to the commencement of its time charter with BG Group, the Windsor Knutsen is being employed under a time charter with KNOT. The time charter for the Bodil Knutsen expires in 2016 and contains customer options for extension through 2019. The Recife Knutsen and the Fortaleza Knutsen are under bareboat charter contracts that expire in 2023. The time charter for the Carmen Knutsen expires in 2018 and contains customer options for extension through 2021. The time charters for the Hilda Knutsen and the Torill Knutsen each expire in 2018 and contain a customer option for extension through 2023. The Dan Cisne is under a bareboat charter contract that expires in 2023.

2) Summary of Significant Accounting Policies

(a) Basis of Preparation

The consolidated and combined carve-out financial statements are prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). All intercompany balances and transactions are eliminated.

The consolidated and combined carve-out financial statements include the financial statements of the entities listed in Note 4—Subsidiaries.

As of April 16, 2013, the financial statements of the Partnership as a separate legal entity are presented on a consolidated basis. Prior to April 16, 2013, the results of operations, cash flows and balance sheet have been carved out of the consolidated financial statements of KNOT and therefore are presented on a combined carve-out basis. As of February 27, 2013, KNOT Shuttle Tankers AS acquired the 100% ownership in KNOT Shuttle Tankers 12 AS, KNOT Shuttle Tankers 17 AS, KNOT Shuttle Tankers 18 AS, and Knutsen Shuttle Tankers XII AS in a reorganization under common control. As of February 27, 2013, KNOT Shuttle Tankers 12 AS and Knutsen Shuttle Tankers XII AS owned a 90% and 10% ownership interest, respectively, in Knutsen Shuttle Tankers XII KS; and KNOT Shuttle Tankers 17 AS owned a 100% interest in the Bodil Knutsen and KNOT Shuttle Tankers 18 AS owned a 100% interest in the Windsor Knutsen. As a reorganization of entities under common control, the transfer of the subsidiaries and other net assets has been recorded at KNOT’s historical book value.

The Bodil Knutsen and the Windsor Knutsen were not operated as discrete units or included in single purpose legal entities. Accordingly, these Vessels have been “carved-out” of KNOT’s assets, liabilities, revenues, expenses and cash flows as they relate to the Combined Entity’s business through the use of the information system of KNOT. Specific information is recorded and coded by vessel for each accounting transaction for certain line items in the combined carve-out financial statements. Therefore, amounts for such Vessels were specifically identified for revenues, vessel expenses, vessel operating expenses, depreciation and amortization, interest expense and related debt issuance cost for long-term debt and realized and unrealized losses on derivative instruments; and related balances for such Vessels were specifically identified for trade accounts receivable, inventories, prepaid expenses, vessels and equipment, intangible assets, trade accounts payable, certain accrued expenses, prepaid charter revenues, long-term debt, derivative liabilities and contract liabilities.

 

Vessels operating expenses includes ship management fees for the provision of technical and commercial management of Vessels and are based on intercompany charges invoiced by KNOT. All long-term debt is specifically related to financing of the individual Vessels. Derivatives are composed of interest rate swap derivatives and foreign exchange forward contracts. The interest rate swaps were entered into in conjunction with the individual Vessel financing to secure fixed interest rates. The interest rate swaps are included in the combined carve-out financial statements to reflect all of the historical cost of doing business even though they will not be transferred to the Partnership. The foreign exchange forward contracts were entered into in conjunction with the construction of certain of the individual Vessels to secure the amounts payable in foreign currencies.

The following items, which are not directly attributable to the Vessels, have been allocated to the combined carve-out financial statements as set forth below:

 

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General and administrative expenses of KNOT were invoiced to its subsidiaries based upon certain transfer pricing principles by type of cost. See to Note 18—Related Party Transactions. The invoiced amounts that cannot be attributed to the Bodil Knutsen and the Windsor Knutsen have been allocated pro rata based on the number of vessels in KNOT’s fleet.

 

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Cash and cash equivalents for general purposes at the legal entity level have not been allocated. The cash and cash equivalents and restricted cash balances are only included in the combined carve-out balance sheets to the extent they are specifically related to the Bodil Knutsen’s and the Windsor Knutsen’s petty cash or provisions of the loan agreements. Interest income cannot be attributed to the specific Vessels and has only been included in the combined carve-out financial statements to the extent it relates to an interesting bearing cash account included in the combined carve-out balance sheets.

 

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Payables to owners and affiliates (“owner balances”) are not tracked on an individual Vessel basis for the Bodil Knutsen and the Windsor Knutsen but at the legal entity level. General allocations of owner balances based on the number of vessels within a legal entity would be inherently arbitrary. Therefore, the Combined Entity has identified specific payments made by owners to shipyards on Vessels under construction or conversion on behalf of the legal entity owning the Vessel and reflected these balances as payable to owners and affiliates, adjusted for subsequent external bank refinancing or settlements of payables at the legal entity level, in the combined carve-out balance sheet. Interest expense has been allocated on the basis of these owner balances and the historical intercompany interest rates charged by the owners to its subsidiaries on owner balances.

 

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Net gain (loss) of foreign currency transactions cannot be attributed directly to the Bodil Knutsen and the Windsor Knutsen and has been allocated based upon specifically identified or allocated balances included on the combined carve-out balance sheets.

 

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Goodwill arose in 2008 when TSSI acquired the remaining 50% interest in the majority of KNOT’s vessels, including the Windsor Knutsen and the three other Vessels of the Combined Entity under construction, in a transaction that was accounted for as a step acquisition. This transaction resulted in goodwill for KNOT. KNOT’s goodwill was allocated to the Combined Entity based upon the Combined Entity percentage of fair value of the Vessel, the Vessels under construction and the favorable or unfavorable charter contract rights acquired at the acquisition date to the total fair value acquired by KNOT for all vessels, vessels under construction and favorable or unfavorable charter contract rights. See Note 2(n)—Summary of Significant Accounting Policies—Goodwill and Intangibles and Note 14—Goodwill, Intangible Assets and Contract Liabilities.

The Partnership’s activities included in the consolidated and combined carve-out financial statements contain Norwegian entities or activities that were organized as non-taxable partnerships or were without tax status. To reflect the historical cost of doing business, the income tax expense and related deferred tax assets and liabilities arising for the Combined Entity activities included in the historical parent entities have been included in the consolidated and combined carve-out financial statements calculated on a separate return basis.

The Vessels of the Partnership were not historically owned by a separate legal entity or operated as a discrete group. Therefore, no separate share capital existed in owner’s equity. Further, certain Vessels had cash accounts shared with other vessels of the KNOT Group that were not allocated to the Combined Entity.

Accordingly, the historical consolidated and combined carve-out financial statements prior to April 16, 2013 reflect allocations of certain expenses, including that of general and administrative expenses, mark-to-market valuations of interest rate swap derivatives, interest expense on related party payables and net gain (loss) on foreign currency transactions. These allocated costs have been accounted for as equity contribution in the consolidated and combined carve-out balance sheets.

 

Included in the Combined Entity’s equity prior to April 16, 2013 are amounts (net liabilities of $27.8 million) relating to certain assets and liabilities that were carved out as they were readily separable and identifiable within the books of KNOT. However, these amounts have been retained by KNOT and have not been transferred to the Partnership and therefore have been eliminated from the Partnership’s opening equity as of April 16, 2013. Details of the net liabilities eliminated are as follows:

 

(U.S. Dollars in thousands)
Balance sheet captions:
Other current assets		$	89
Other non-current assets			—
Other current liabilities (*)			(6,321	)
Other long-term liabilities (*)			(21,560	)
Net liabilities		$	(27,792	)

 

(*)	The majority of the assets and liabilities not transferred to the Partnership are related to interest swap derivatives (Note 10) and insurance proceeds pursuant to the Contribution and Sale Agreement entered into in connection with the closing of the IPO on April 15, 2013 (Note 8).

Management believes that the allocations included in these consolidated and combined carve-out financial statements are reasonable to present the financial position, results of operations and cash flows of the Partnership on a stand-alone basis.. However, the financial position, results of operations and cash flows of the Combined Entity as presented may differ from those that would have been achieved had the Partnership operated autonomously for all years presented as the Partnership would have had additional general and administrative expenses, including legal, accounting, treasury and regulatory compliance and other costs normally incurred by a stand-alone listed publicly traded entity for the periods prior to the IPO. Accordingly, the consolidated and combined carve-out financial statements do not purport to be indicative of the future financial position, results of operations or cash flows of the Partnership.

Business combinations

Reorganization of entities under common control is accounted for similar to the pooling of interests method of accounting. Under this method, the carrying amount of net assets recognized in the balance sheets of each combining entity are carried forward to the balance sheet of the combined entity, and no other assets or liabilities are recognized as a result of the combination. The excess of the proceeds paid, if any, over the historical cost of the combining entity is accounted for as an equity distribution. In addition, re-organization of entities under common control is accounted for as if the transfer occurred from the date that both the combining entity and combined entity were both under common control. Therefore, the Partnership’s financial statements prior to the date the interests in the combining entity were actually acquired are retroactively adjusted to include the results of the combined entity during the periods it was under common control of KNOT.

As discussed in Note 1—Description of Business, under the Partnership’s Partnership Agreement, the General Partner has irrevocably delegated to the Partnership’s board of directors the power to oversee and direct the operations of, manage and determine the strategies and policies of the Partnership. During the period from the IPO in April 2013 until the time of the Partnership’s first AGM on June 25, 2013, the General Partner retained the sole power to appoint, remove and replace all members of the Partnership’s board of directors. From the date of the Partnership’s first annual meeting of common unitholders, four of the seven board members became electable by the common unitholders and accordingly, from this date, KNOT, as the owner of the General Partner, no longer retains the power to control the Partnership’s board of directors and, hence, the Partnership. As a result, the Partnership is no longer considered to be under common control with KNOT and as a consequence, the Partnership has not accounted for any acquisitions from KNOT after June 25, 2013 as a transfer of equity interests between entities under common control.

Business combinations are accounted for under the acquisition method. On acquisition, the identifiable assets, liabilities and contingent liabilities are measured at their fair values at the date of acquisition. Any excess of the cost of acquisition over the fair values of the identifiable net assets acquired is recognized as goodwill. Any deficiency of the cost of acquisition below the fair values of the identifiable net assets acquired (i.e. bargain purchase) is credited to the statement of operations in the period of acquisition. The consideration transferred for an acquisition is measured at fair value of the consideration given. Acquisition related costs are expensed as incurred. The results of operations of the acquired businesses are included in the consolidated results as of the date of the applicable acquisition.

(b) Reporting Currency

The consolidated and combined carve-out financial statements are prepared in the reporting currency of U.S. Dollars. The functional currency of the vessel-owning Partnership subsidiaries is the U.S. Dollar, because the subsidiaries operate in the international shipping market, in which all revenues are U.S. Dollar-denominated and the majority of expenditures are made in U.S. Dollars. Transactions involving other currencies during the year are converted into U.S. Dollars using the exchange rates in effect at the time of the transactions. As of the balance sheet dates, monetary assets and liabilities that are denominated in currencies other than the U.S. Dollar are translated to reflect the year-end exchange rates. Resulting gains or losses are reflected separately in the accompanying consolidated and combined carve-out statements of operations.

 

(c) Use of Estimates

The preparation of consolidated and combined carve-out financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Significant items subject to such estimates and assumptions include the useful lives and impairment of Vessels, drydocking, the valuation of derivatives and income taxes.

(d) Revenues and Operating Expenses

The Partnership recognizes revenues from time charters and bareboat charters as operating leases on a straight-line basis over the term of the charter, net of any commissions. Under time charters, revenue is not recognized during days the Vessel is off-hire. Revenue is recognized from delivery of the Vessel to the charterer, until the end of the contract period. Under time charters, the Partnership is responsible for providing the crewing and other services related to the Vessel’s operations, the cost of which is included in the daily hire rate, except when off-hire. Fees received from customers for customized equipment are deferred and recognized over the contract period. Under bareboat charters, the Partnership provides a specified Vessel for a fixed period of time at a specified day rate. The Partnership recognizes revenues from spot contracts as voyage revenues using the percentage of completion method on a discharge-to-discharge basis.

Voyage expenses are all expenses unique to a particular voyage, including bunker fuel expenses, port fees, cargo loading and unloading expenses, canal tolls and agency fees. Voyage expenses are paid by the customer under time charter and bareboat charters. Voyage expenses are paid by the Partnership for spot contracts and during periods of off-hire and are recognized when incurred.

Vessel operating expenses include crewing, repairs and maintenance, insurance, stores, lube oils and communication expenses. Vessel operating expenses are paid by the Partnership for time charters, spot contracts and during off-hire and are recognized when incurred.

As further discussed in Note 18—Related Party Transactions, related parties have provided the management services for the Vessels and employ the crews that work on the Vessels. The Partnership has no direct employees and, accordingly, is not liable for any pension or post-retirement benefits.

(e) Financial Income (Expense)

Interest expense incurred on the Partnership’s debt incurred during the construction of the Vessels exceeding one year are capitalized during the construction period.

(f) Cash and Cash Equivalents

The Partnership considers all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents.

(g) Restricted Cash

Restricted cash consists of bank deposits, which may only be used to settle principal payments under the Partnership’s Vessel financing agreements.

(h) Trade Accounts Receivable

Accounts receivable are recorded at the invoiced amount and do not bear interest. Under terms of the current time charters and bareboat charters, the customers are committed to pay for the full month’s charter the first day of each month. See Note 2(r)—Summary of Significant Accounting Policies—Prepaid Charter and Deferred Revenue. The allowance for doubtful accounts is the Partnership’s best estimate of the amount of probable credit losses in existing accounts receivable. The Partnership establishes provisions for doubtful accounts on a case-by-case basis when it is unlikely that required payments of specific amounts will occur. In establishing these provisions, the Partnership considers the financial condition of the customer as well as specific circumstances related to the receivable. Receivable amounts determined to be unrecoverable are written-off. There were no allowances for doubtful accounts or amounts written off against the allowance for doubtful accounts as of December 31, 2014 and 2013. The Partnership does not have any off-balance-sheet credit exposure related to its customers.

 

(i) Inventories

Inventories, which are comprised principally of lubricating oils, are stated at the lower of cost or market. For vessels on time charters or bareboat charters, there are no bunkers, as the charterer supplies the bunkers, which principally consist of fuel oil. Cost is determined using the first-in, first-out method for all inventories.

(j) Other Current Assets

Other current assets principally consist of prepaid expenses, the current portion of deferred cost and other receivables.

(k) Vessels and Equipment

Vessels and equipment are stated at the historical acquisition or construction cost, including capitalized interest, supervision and technical and delivery cost, net of accumulated depreciation and impairment loss, if any. Expenditures for subsequent conversions and major improvements are capitalized, provided that such costs increase the earnings capacity or improve the efficiency or safety of the vessels.

Generally, the Partnership drydocks each vessel every 60 months until the vessel is 15 years old and every 30 months thereafter, as required for the renewal of certifications issued by classification societies. For vessels operating on time charters, the Partnership capitalizes the costs directly associated with the classification and regulatory requirements for inspection of the vessels, major repairs and improvements incurred during drydocking. Drydock cost is depreciated on a straight-line basis over the period until the next planned drydocking takes place. The Partnership expenses costs related to routine repairs and maintenance performed during drydocking or as otherwise incurred. For vessels that are newly built or acquired, an element of the cost of the vessel is initially allocated to a drydock component and depreciated on a straight-line basis over the period until the next planned drydocking. When significant drydocking expenditures occur prior to the expiration of this period, the Partnership expenses the remaining balance of the original drydocking cost in the month of the subsequent drydocking. For vessels operating on bareboat charters, the charterparty bears the cost of any drydocking.

Depreciation on vessels and equipment is calculated on a straight-line basis over the asset’s estimated useful life, less an estimated residual value, as follows:

 

		Useful Life
Hull			25 years
Anchor-handling, loading and unloading equipment			25 years
Main/auxiliary engine			25 years
Thruster, dynamic positioning systems, cranes and other equipment			25 years
Drydock costs			2.5–5 years

A Vessel is depreciated to its estimated residual value, which is calculated based on the weight of the ship and estimated steel price. Any cost related to the disposal is deducted from the residual value.

(l) Capitalized Interest

Interest expense incurred on the Partnership’s debt during the construction of the Vessels exceeding one year is capitalized during the construction period.

(m) Impairment of Long-Lived Assets

Vessels and equipment, vessels under construction and intangible assets subject to amortization are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If circumstances require a long-lived asset or asset group to be tested for possible impairment, the Partnership first compares undiscounted cash flows expected to be generated by that asset or asset group to its carrying value. If the carrying value of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, impairment is recognized to the extent that the carrying value exceeds its fair value. Fair value is determined through various valuation techniques including discounted cash flow models, quoted market values and third-party independent appraisals, as considered necessary.

(n) Goodwill and Intangibles

Goodwill is not amortized but is reviewed for impairment on an annual basis or more frequently if impairment indicators are identified.

 

The Partnership tests goodwill for impairment using a two-step analysis, with the option of performing a qualitative assessment before performing the first step of the two-step analysis, whereby the carrying value of the reporting unit is compared to its fair value in the first step. If the carrying value of the reporting unit is greater than its fair value, the second step is performed, where the implied fair value of goodwill is compared to its carrying value. An impairment charge is recognized for the amount by which the carrying amount of goodwill exceeds its fair value. The fair value is estimated using the net present value of discounted cash flows of the reporting unit. The Partnership has only one reporting unit.

Other intangible assets represent contractual rights for charters obtained in connection with a step acquisition that had favorable contractual terms relative to market as of the acquisition date. Contractual rights for charters obtained in connection with a step acquisition that had unfavorable contractual terms are classified as contract liabilities in the consolidated and combined carve-out balance sheets. The favorable and unfavorable contract rights are amortized to revenues over the period of the contract.

(o) Debt Issuance Costs

Debt issuance costs, including fees, commissions and legal expenses, are deferred. Debt issuance costs of term loans are amortized over the term of the relevant loan. Amortization of debt issuance costs is included in interest expense.

(p) Derivative Instruments

All derivative instruments are initially recorded at fair value as either assets or liabilities in the accompanying consolidated and combined carve-out balance sheets and subsequently measured to fair value. The Partnership does not apply hedge accounting to its derivative instruments. Changes in the fair value of the derivative instruments are recognized in earnings. Gains and losses from the interest rate swap contracts of the Partnership related to long-term mortgage debt and foreign exchange forward contracts are recorded in realized and unrealized gain (loss) on derivative instruments in the consolidated and combined carve-out statements of operations. Cash flows related to interest rate swap contracts are presented as cash flows provided by operating activities. Cash flows related to foreign exchange forward contracts entered into to economically hedge operating expenses in currencies other than U.S. Dollars are presented as cash flows provided by operating activities in the consolidated and combined carve-out statements of cash flows, while cash flows related to foreign exchange forward contracts entered into to hedge contractual obligations to pay the shipyard in currencies other than functional currency of U.S. Dollars are presented as cash flows used in investing activities in the consolidated and combined carve-out statements of cash flows.

(q) Income Taxes

Historically, part of the Partnership’s activities were subject to ordinary taxation and taxes were paid on taxable income (including operating income and net financial income and expense), while part of the activities were subject to the Norwegian Tonnage Tax regime (the “tonnage tax regime”). Under the tonnage tax regime, the tax is based on the tonnage of the vessel, and operating income is tax free. The net financial income and expense remains taxable as ordinary income tax for entities subject to the tonnage tax regime. Income taxes arising from the part of activities subject to ordinary taxation are included in income tax expense in the consolidated and combined carve-out statements of operations. For the portion of activities subject to the tonnage tax regime, tonnage taxes are classified as vessel operating expenses while the current and deferred taxes arising on net financial income and expense are reflected as income tax expense in the consolidated and combined carve-out statements of operations. The amounts of tonnage tax included in operating expenses for the years ended December 31, 2014, 2013 and 2012 were $126,000, $100,000 and $66,000, respectively.

The Partnership accounts for deferred income taxes using the liability method. Under the liability method, deferred tax assets and liabilities are recognized for the anticipated future tax effects of temporary differences between the financial statement basis and the tax basis of the Partnership’s assets and liabilities using enacted tax rates expected to apply to taxable income in the years in which these temporary differences are expected to be recovered or settled. A valuation allowance for deferred tax assets is recorded when it is more likely than not that some or all of the benefit from the deferred tax asset will not be realized.

Recognition of uncertain tax positions is dependent upon whether it is more-likely-than-not that a tax position taken or expected to be taken in a tax return will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. If a tax position meets the more-likely-than-not recognition threshold, it is measured to determine the amount of benefit to recognize in the financial statements based on U.S. GAAP guidance. The Partnership recognizes interest and penalties related to uncertain tax positions in income tax expense.

 

(r) Prepaid Charter and Deferred Revenue

Under terms of the time charters and bareboat charters, the customer pays for the month’s charter the first day of each month that is recorded as prepaid charter revenues. Deferred revenues for fees received from customers for customized equipment are classified as prepaid charter and deferred revenue for the current portion and as other long-term liabilities for the non-current portion.

(s) Commitments, Contingencies and Insurance Proceeds

Liabilities for loss contingencies arising from claims, assessments, litigation, fines and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount can be reasonably estimated. Legal costs incurred in connection with loss contingencies are expensed as incurred. See Note 19—Commitments and Contingencies.

Insurance claims for property damage for recoveries up to the amount of loss recognized are recorded when the claims submitted to insurance carriers are probable of recovery. Claims for property damage in excess of the loss recognized and for loss off-hire are considered gain contingencies, which are generally recognized when the proceeds are received.

(t) Fair Value Measurements

The Partnership utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible. The Partnership determines fair value based on assumptions that market participants would use in pricing an asset or liability in the principal or most advantageous market. When considering market participant assumptions in fair value measurements, the following fair value hierarchy distinguishes between observable and unobservable inputs, which are categorized in one of the following levels:

 

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Level 1 Inputs: Unadjusted quoted prices in active markets for identical assets or liabilities accessible to the reporting entity at the measurement date.

 

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Level 2 Inputs: Other than quoted prices included in Level 1 inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability.

 

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Level 3 Inputs: Unobservable inputs for the asset or liability used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date.

(u) Accounting Pronouncement Not Yet Adopted

New Accounting Standards not yet adopted

In May 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued a comprehensive revenue recognition standard that will supersede existing revenue guidance under U.S. GAAP and IFRS, Accounting Standards Update 2014-09, Revenue from Contracts with Customers, (or ASU 2014-09) for U.S. GAAP. ASU 2014-09 will require an entity to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This update creates a five-step model that requires an entity to exercise judgment when considering the terms of the contract(s) which include (i) identifying the contract(s) with the customer, (ii) identifying the separate performance obligations in the contract, (iii) determining the transaction price, (iv) allocating the transaction price to the separate performance obligations, and (v) recognizing revenue when each performance obligation is satisfied. ASU 2014-09 is effective for interim and annual periods beginning after December 15, 2016 and shall be applied retrospectively to each period presented or as a cumulative-effect adjustment as of the date of adoption. Early adoption is not permitted under U.S. GAAP. The Partnership is evaluating the effect of adopting this new accounting guidance.

In August 2014, FASB issued Presentation of Financial Statements – Going Concern (Subtopic 205-40), Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (ASU 2014-15). ASU 2014-15 requires management to evaluate whether there are conditions and events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the financial statements are issued (or available to be issued when applicable) and, if so, disclose that fact. Management will be required to make this evaluation for both annual and interim reporting periods, if applicable. Management also is required to evaluate and disclose whether its plans alleviate that doubt. The standard is effective for annual periods after December 15, 2016 and interim periods within annual periods beginning after December 15, 2016. Early adoption is permitted. The Partnership is evaluating the effect of adopting this new accounting guidance. The Partnership does not expect the adoption of this standard to have a material impact on the consolidated and combined financial statements.

In October 2014, FASB issued Interest – Imputation of Interest (Subtopic 835-30), simplifying the presentation of debt issuance cost. To reduce complexity, the proposed guidance would require that debt issuance costs to be considered a deduction to the corresponding debt for presentation purposes, rather than presented as an asset. The recognition and measurement guidance for debt issuance costs and certain other accounting for debt issuance costs (e.g. as part of the troubled debt restructurings ASC 470-60) would not be affected by the proposal. The proposal would be applied retrospectively. The effective date has not yet been determined.

There are no recent accounting pronouncements issued whose adoption would have a material impact on the Partnership’s combined consolidated and combined carve-out financial statements in the current year or are expected to have a material impact on future years.

3) Formation Transactions and Initial Public Offering

During April 2013, the following transactions occurred in connection with the transfer of the interests in KNOT Shuttle Tankers AS and the subsequent IPO:

Capital Contribution

 

(i)

KNOT contributed to the Partnership’s subsidiary KNOT UK its 100% interest in KNOT Shuttle Tankers AS, which directly or indirectly owned (1) Knutsen Shuttle Tankers XII KS, the owner of the Recife Knutsen and the Fortaleza Knutsen, (2) Knutsen Shuttle Tankers XII AS, the general partner of Knutsen Shuttle Tankers XII KS, and (3) the Windsor Knutsen and the Bodil Knutsen and all of their related charters, inventory and long-term debt. This has been accounted for as a capital contribution by KNOT to the Partnership. However, for the purpose of the historical combined carve-out financial statements, the net assets of the Vessels are included in the carve-out balance sheet as of December 31, 2012.

Recapitalization of the Partnership

 

(ii)

The Partnership issued to KNOT 8,567,500 subordinated units, representing a 49.0% limited partner interest in the Partnership, and 100% of the IDRs, which will entitle KNOT to increasing percentages of the cash the Partnership distributes in excess of $0.43125 per unit per quarter.

 

(iii)

The Partnership issued 349,694 general partner units to the General Partner, KNOT Offshore Partners GP LLC, a wholly owned subsidiary of KNOT, representing a 2.0% general partner interest in the Partnership.

Initial Public Offering

 

(iv)

In connection with the IPO, the Partnership issued and sold to the public, through the underwriters, 8,567,500 common units (including 1,117,500 common units sold pursuant to the full exercise of the underwriters’ option to purchase additional units), representing a 49.0% limited partner interest in the Partnership. The price per common unit in the IPO was $21.00. The Partnership received gross proceeds of approximately $179.9 million in connection with the IPO. Expenses relating to the IPO, including, among other things, incremental costs directly attributable to the IPO, were deferred and charged against the gross proceeds of the IPO, whereas other costs have been expensed as incurred. The net proceeds of the IPO (approximately $160.7 million, after deducting underwriting discounts, commissions and structuring fees and offering expenses payable by the Partnership) have been used by the Partnership to make a cash distribution to KNOT of approximately $21.95 million (which equals net proceeds from the underwriters’ option exercised in full after deducting the underwriting discounts and commissions), to repay approximately $118.9 million of outstanding debt and pre-fund approximately $3.0 million of the Partnership’s one-time entrance tax into the Norwegian tonnage tax regime. The reminder of the net proceeds was made available for general partnership purposes.

Agreements

In connection with the IPO, at or prior to the closing of the IPO, the Partnership entered into several agreements, including:

 

•

An Administrative Services Agreement with KNOT UK, pursuant to which:

 

•

KNOT UK agreed to provide to the Partnership administrative services; and

 

•

KNOT UK is permitted to subcontract certain of the administrative services provided under the administrative services agreement to Knutsen OAS (UK) Ltd. (“KOAS UK”) and Knutsen OAS Shipping AS (“KOAS”), both wholly owned subsidiaries of TS Shipping Invest AS (“TSSI”);

 

•

Amended Technical Management Agreements with KNOT Management AS (“KNOT Management”), a wholly owned subsidiary of KNOT, that govern the crew, technical and commercial management of the vessels in the fleet;

 

•

A Contribution and Sale Agreement with KNOT. See Note 2(a)—Summary of Significant Accounting Policies—Basis of Preparation;

 

•

Amendments to certain of the Partnership’s existing vessel financing agreements to permit the transactions pursuant to which the Partnership acquired its initial fleet in connection with the IPO and to include a $20.0 million revolving credit facility; and

 

•

An Omnibus Agreement with KNOT, the General Partner and the other parties thereto governing, among other things:

 

•

To what extent the Partnership and KNOT may compete with each other;

 

•

The Partnership’s option to purchase the Carmen Knutsen within 24 months after the closing of the IPO, any of the Hilda Knutsen, the Torill Knutsen, the Ingrid Knutsen and the Raquel Knutsen from KNOT within 24 months after KNOT notifies the Partnership’s board of directors of their respective acceptances by their charterers upon reaching an agreement with KNOT regarding the respective purchase prices;

 

•

Certain rights of first offer on shuttle tankers operating under charters of five or more years;

 

•

The provision of certain indemnities to the Partnership by KNOT; and

 

•

KNOT’s guarantee of the payment of the hire rate under the existing Bodil Knutsen and Windsor Knutsen charters for a period of five years following the closing date of the IPO.

4) Subsidiaries

The following table lists the Partnership’s subsidiaries and their purpose as of December 31, 2014.

 

Company Name		Jurisdiction of Formation		Purpose
KNOT Offshore Partners UK LLC		Marshall Islands		Holding company
KNOT Shuttle Tankers AS		Norway		Holding company
KNOT Shuttle Tankers 12 AS		Norway		Majority owner of Knutsen Shuttle Tankers XII KS
KNOT Shuttle Tankers 17 AS		Norway		Owner of the Bodil Knutsen
KNOT Shuttle Tankers 18 AS		Norway		Owner of the Windsor Knutsen
Knutsen Shuttle Tankers 13 AS		Norway		Owner of the Carmen Knutsen
Knutsen Shuttle Tankers XII KS		Norway		Owner of the Fortaleza Knutsen and the Recife Knutsen
Knutsen Shuttle Tankers XII AS		Norway		General partner of Knutsen Shuttle Tanker XII KS
Knutsen Shuttle Tankers 14 AS		Norway		Owner of the Hilda Knutsen
Knutsen Shuttle Tankers 15 AS		Norway		Owner of the Torill Knutsen
KNOT Shuttle Tankers 20 AS		Norway		Owner of the Dan Cisne

5) Significant Risks and Uncertainties Including Business and Credit Concentrations

All but one of the Vessels is employed under long-term fixed rate charters, which mitigates earnings risk. The Partnership’s operational results are dependent on the worldwide market for shuttle tankers and timing of entrance into long-term charters. Market conditions for shipping activities are typically volatile, and, as a consequence, the hire rates may vary from year to year. The market is mainly dependent upon two factors: the supply of vessels and the overall growth in the world economy. The general supply of vessels is impacted by the combination of newbuilds, demolition activity of older vessels and legislation that limits the use of older vessels or new standards for vessels used in specific trades.

As of December 31, 2014, all of the Partnership’s Vessel crews, which are employed through Knutsen OAS Shipping AS, were represented by collective bargaining agreements that are renegotiated annually, or bi-annually.

The Partnership did not incur any loss relating to its customers during the years ended December 31, 2014, 2013 and 2012.

The following table presents revenues and percentage of combined revenues for customers that accounted for more than 10% of the Partnership’s combined revenues during the years ended December 31, 2014, 2013 and 2012.

 

		Year Ended December 31,
(U.S. Dollars in thousands)		2014								2013								2012
Fronape International Company, a subsidiary of Petrobras Transporte S.A.			25,666				23	%			22,860				31	%			24,980				38	%
Eni Trading and Shipping S.pA			23,512				21	%			—				—				—				—
Statoil ASA			22,263				20	%			21,563				29	%			22,193				34	%
Repsol Sinopec Brasil, S.A., a subsidiary of Repsol Sinopec Brasil, B.V.			20,338				18	%			8,417				12	%			—				—
Brazil Shipping I Limited, a subsidiary of BG Group Plc		$	12,124				11	%		$	20,311				28	%		$	14,905				23	%

 

The Partnership has financial assets that expose it to credit risk arising from possible default by a counterparty. The Partnership considers its counterparties to be creditworthy financial institutions and does not expect any significant loss to result from non-performance by such counterparties. The maximum loss due to credit risk that the Partnership would incur if counterparties failed completely to perform would be the carrying value of cash and cash equivalents, restricted cash and trade accounts receivable. The Partnership, in the normal course of business, does not demand collateral from its counterparties.

6) Operating Leases

The time charters and bareboat charters of the Vessels with third parties are accounted for as operating leases. The minimum contractual future revenues to be received from time charters and bareboat charters as of December 31, 2014, were as follows:

 

(U.S. Dollars in thousands)
2015		$	140,929
2016			141,425
2017			136,223
2018			79,566
2019			33,650
2020 and thereafter			117,404
Total		$	649,197

The minimum contractual future revenues should not be construed to reflect total charter hire revenues for any of the years. Minimum contractual future revenues are calculated based on certain assumptions such as operating days per year. In addition, minimum contractual future revenues presented in the table above have not been reduced by estimated off-hire time for periodic maintenance. The amounts may vary given unscheduled future events such as vessel maintenance.

Partnership’s fleet as of December 31, 2014 consisted of:

 

•

the Fortaleza Knutsen, a shuttle tanker built in 2011 that is currently operating under a bareboat charter that expires in March 2023 with Fronape International Company, a subsidiary of Petrobras Transporte S.A. (“Transpetro”);

 

•

the Recife Knutsen, a shuttle tanker built in 2011 that is currently operating under a bareboat charter that expires in August 2023 with Fronape International Company, a subsidiary of Transpetro;

 

•

the Bodil Knutsen, a shuttle tanker built in 2011 that is currently operating under a time charter that expires in May 2016 with Statoil ASA (“Statoil”), with options to extend until May 2019;

 

•

the Windsor Knutsen, a conventional oil tanker built in 2007 and retrofitted to a shuttle tanker in 2011. The vessel operated under a time charter with Brazil Shipping I Limited, a subsidiary of BG Group Plc, until July 28, 2014. Since July 29, 2014 the vessel has been employed under a time charter with KNOT that will expire in the fourth quarter of 2015, when the vessel commences operations under a two year time charter with Brazil Shipping I Limited, a subsidiary of BG Group Plc, with options to extend until 2020;

 

•

the Carmen Knutsen, a shuttle tanker built in 2013 that is currently operating under a time charter that expires in January 2018, with Repsol Sinopec Brasil, S.A, a subsidiary of Repsol Sinopec Brasil, B.V. (“Repsol”), with options to extend until January 2021;

 

•

the Hilda Knutsen, a shuttle tanker built in 2013 that is currently operating under a time charter that expires in August 2018 with Eni Trading and Shipping S.pA. (“ENI”);

 

•

the Torill Knutsen, a shuttle tanker built in 2013 that is currently operating under a time charter that expires in November 2018 with ENI; and

 

•

the Dan Cisne, a shuttle tanker built in 2011 that is currently operating under a bareboat charter that expires in September 2023 with Fronape International Company, a subsidiary of Transpetro.

7) Segment Information

The Partnership has not presented segment information as it considers its operations to occur in one reportable segment, the shuttle tanker market. At December 31, 2014, the Partnership’s fleet operated under five time charters and three bareboat charters. At December 31, 2013, the Partnership’s fleet operated under three time charters and two bareboat charters, and during 2012 the Partnership’s fleet operated under two time charters and two bareboat charters. See Note 5—Significant Risks and Uncertainties Including Business and Credit Concentrations for revenues from customers accounting for over 10 % of the Partnership’s consolidated and combined revenue. In both time charters and bareboat charters, the charterer, not the Partnership, controls the choice of which trading areas the Vessels will serve. Accordingly, the Partnership’s management, including the chief operating decision makers, does not evaluate performance according to geographical region.

8) Insurance Proceeds

In August 2014, the Bodil Knutsen sustained minor damage to its propeller. At December 31, 2014, the Partnership recorded $0.2 million for probable insurance recoveries. See Note 12(b) — Trade Accounts Receivables and Other Current Assets—Other Current Assets.

In March 2012, the Windsor Knutsen damaged its propeller. As a result, the Vessel was off-hire from April 1, 2012 to June 24, 2012 for repairs. Under the Partnership’s loss of hire policies, its insurer will pay the Partnership the hire rate agreed in respect of each vessel for each day, in excess of 14 deductible days, for the time that the Vessel is out of service as a result of damage, for a maximum of 180 days. During the year ended December 31, 2014, 2013 and 2012, the Partnership received payments for loss of hire insurance of $nil million, $0.3 million and $3.6 million, respectively, which were recorded as a component of total revenues since day rates are recovered under terms of the policy.

In addition, as of April 15, 2013 and December 31, 2012, the Partnership recorded $3.5 million and $3.0 million, respectively, for the probable recoveries up to the amount of loss under hull and machinery insurance for the repairs as a result of the propeller damage to the Windsor Knutsen. This is classified under vessel operating expenses along with the cost of the repairs of $4.0 million and $4.1 million during 2013 and 2012, respectively.

In accordance with the Contribution and Sale Agreement entered into as of April 15, 2013, insurance claims were not transferred to the Partnership upon closing. There were no new insurance claims during 2013, and based on this and based on the Contribution and Sale Agreement entered into as of April 15, 2013, there was no claim in the consolidated and combined carve-out balance sheet as of December 31, 2013. See Consolidated and Combined Carve-Out Statements of Changes in Partners’ Capital/Owners’ Capital and Note 2(a)—Summary of Significant Accounting Policies—Basis of Preparation.

9) Finance Income (Expense)

(a) Interest Expense

A reconciliation of total interest cost to interest expense as reported in the consolidated and combined carve-out statements of operations for the years ended December 31, 2014, 2013 and 2012 is as follows:

 

		Year Ended December 31,
(U.S. Dollars in thousands)		2014				2013				2012
Interest cost capitalized		$	—			$	—			$	—
Interest expense			15,271				10,773				13,471
Total interest cost		$	15,271			$	10,773			$	13,471

(b) Other Finance Expense

The following table presents the other finance expense for the years ended December 31, 2014, 2013 and 2012:

 

		Year Ended December 31,
(U.S. Dollars in thousands)		2014				2013				2012
Bank fees, charges and external guarantee costs		$	1,221			$	1,414			$	1,169
Related party guarantee commissions (Note 18)			—				634				2,206
Related party financing service fee (Note 18)			50				—				3
Total other finance expense		$	1,271			$	2,048			$	3,378

10) Derivative Instruments

Interest Rate Risk Management

The consolidated and combined carve-out financial statements include the results of interest rate swap contracts to manage the Partnership’s exposure related to changes in interest rates on its variable rate debt instruments and the results of foreign exchange forward contracts to manage its exposure related to changes in currency exchange rates on its operating expenses, mainly crew expenses, in other currency than USD and on its contract obligations. The Partnership does not apply hedge accounting for derivative instruments. The Partnership does not speculate using derivative instruments.

By using derivative financial instruments to economically hedge exposures to changes in interest rates, the Partnership exposes itself to credit risk and market risk. Derivative instruments that economically hedge exposures are used for risk management purposes, but these instruments are not designated as hedges for accounting purposes. Credit risk is the failure of the counterparty to perform under the terms of the derivative instrument. When the fair value of a derivative instrument is positive, the counterparty owes the Partnership, which creates credit risk for the Partnership. When the fair value of a derivative instrument is negative, the Partnership owes the counterparty, and, therefore, the Partnership is not exposed to the counterparty’s credit risk in those circumstances. The Partnership minimizes counterparty credit risk in derivative instruments by entering into transactions with major banking and financial institutions. The derivative instruments entered into by the Partnership do not contain credit risk-related contingent features. The Partnership has not entered into master netting agreements with the counterparties to its derivative financial instrument contracts.

Market risk is the adverse effect on the value of a derivative instrument that results from a change in interest rates, currency exchange rates or commodity prices. The market risk associated with interest rate contracts is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken.

The Partnership assesses interest rate risk by monitoring changes in interest rate exposures that may adversely impact expected future cash flows and by evaluating economical hedging opportunities.

The Partnership has historically used variable interest rate mortgage debt to finance its vessel construction or conversions. The variable interest rate mortgage debt obligations expose the Partnership to variability in interest payments due to changes in interest rates. The Partnership believes that it is prudent to limit the variability of a portion of its interest payments. To meet this objective, the Partnership entered into London Interbank Offered Rate (“LIBOR”)-based interest rate swap contracts to manage fluctuations in cash flows resulting from changes in the benchmark interest rate of LIBOR. These swaps change the variable rate cash flow exposure on the mortgage debt obligations to fixed cash flows. Under the terms of the interest rate swap contracts, the Partnership receives LIBOR-based variable interest rate payments and makes fixed interest rate payments, thereby creating the equivalent of fixed rate debt for the notional amount of its debt hedged.

All interest rate swap contracts entered into in conjunction with the individual vessel financings prior to the closing date of the IPO have been carved out, as they were readily separable and identifiable within the books of KNOT. Additionally, all these interest rate swap contracts have been retained by KNOT and have not been transferred to the Partnership. Therefore, such interest rate swap contracts have been eliminated from the Partnership’s opening equity position as of April 16, 2013. See Consolidated and Combined Carve-Out Statements of Changes in Partners’ Capital/Owners’ Capital and Note 2(a)—Summary of Significant Accounting Policies—Basis of Preparation.

As of December 31, 2014 and 2013, the total notional amount of the Partnership’s outstanding interest rate swap contracts that were entered into in order to hedge outstanding or forecasted debt obligations were $382.3 million and $200 million, respectively. As of December 31, 2014, the carrying amount of the interest rate swaps contracts were net liabilities of $1.7 million, and as of December 31, 2013, the carrying amount of the interest rate swap contracts were net assets of $0.5 million. See Note 11—Fair Value Measurements.

Changes in the fair value of interest rate swap contracts are reported in realized and unrealized gain (loss) on derivative instruments in the same period in which the related interest affects earnings.

The Partnership and its subsidiaries utilize the U.S. Dollar as their functional and reporting currency, because all of their revenues and the majority of their expenditures, including the majority of their investments in vessels and their financing transactions, are denominated in U.S. Dollars. The Partnership’s predecessor also from time to time contracted vessels with contractual obligations to pay the yards in currencies other than the U.S. Dollar. Payment obligations in currencies other than the U.S. Dollar, and in particular operating expenses in NOK, expose the Partnership to variability in currency exchange rates. The Partnership believes that it is prudent to limit the variability of a portion of its currency exchange exposure. To meet this objective, the Partnership entered into foreign exchange forward contracts to manage fluctuations in cash flows resulting from changes in the exchange rates towards the U.S. Dollar. The agreements change the variable exchange rate to fixed exchange rates at agreed dates.

 

As of December 31, 2014 and 2013, the total contract amount in foreign currency of the Partnership’s outstanding foreign exchange forward contracts that were entered into to economically hedge outstanding future payments in currencies other than the U.S. Dollar were NOK 127.9 million and NOK 124.4 million, respectively. As of December 31, 2014 and 2013, the carrying amount of the Partnership’s foreign exchange forward contracts was a liability of $2.7 million and an asset of $0.2 million, respectively. See Note 11—Fair Value Measurements.

The following table presents the realized and unrealized gains and losses that are recognized in earnings as net gain (loss) on derivative instruments for the years ended December 31, 2014, 2013 and 2012:

 

		Year Ended December 31
(U.S. Dollars in thousands)		2014				2013				2012
Realized gain (loss)
Interest rate swap contracts		$	(2,997	)		$	(1,265	)		$	(5,482	)
Foreign exchange forward contracts			500				—				—
Unrealized gain (loss)
Interest rate swap contracts			(919	)			1,522				(549	)
Foreign exchange forward contracts			(2,991	)			248				—
Total		$	(6,407	)		$	505			$	(6,031	)

11) Fair Value Measurements

(a) Fair Value of Financial Instruments

The following table presents the carrying amounts and estimated fair values of the Partnership’s financial instruments as of December 31, 2014 and 2013. Fair value is defined as the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

 

		December 31, 2014								December 31, 2013
(U.S. Dollars in thousands)		Carrying Amount				Fair Value				Carrying Amount				Fair Value
Financial assets:
Cash and cash equivalents		$	30,726			$	30,726			$	28,836			$	28,836
Restricted cash			—				—				458				458
Current derivative assets:
Foreign exchange forward contract			—				—				248				248
Non-current derivative assets:
Interest rate swap contracts			2,966				2,966				2,617				2,617
Financial liabilities:
Current derivative liabilities:
Interest rate swap contracts			4,708				4,708				2,124				2,124
Foreign exchange forward contract			2,742				2,742				—				—
Non-current derivative liabilities:
Interest rate swap contracts			—				—				—				—
Long-term debt, current and non-current			613,221				613,221				349,977				350,999

The carrying amounts shown in the table above are included in the consolidated and combined carve-out balance sheets under the indicated captions. The carrying value of trade accounts receivable, trade accounts payable and receivables/payables to owners and affiliates approximate their fair value.

The fair values of the financial instruments shown in the above table as of December 31, 2014 and 2013 represent the amounts that would be received to sell those assets or that would be paid to transfer those liabilities in an orderly transaction between market participants at that date. Those fair value measurements maximize the use of observable inputs. However, in situations where there is little, if any, market activity for the asset or liability at the measurement date, the fair value measurement reflects the Partnership’s own judgment about the assumptions that market participants would use in pricing the asset or liability. Those judgments are developed by the Partnership based on the best information available in the circumstances, including expected cash flows, appropriately risk-adjusted discount rates and available observable and unobservable inputs.

 

The following methods and assumptions were used to estimate the fair value of each class of financial instruments:

 

•

Cash and cash equivalents and restricted cash: The fair value of the Partnership’s cash balances approximates the carrying amounts due to the current nature of the amounts.

 

•

Foreign exchange forward contracts: The fair value is calculated using mid-rates (excluding margins) as determined by counterparties based on available market rates as of the balance sheet date. The fair value is discounted from the value at expiration to the current value of the contracts.

 

•

Interest rate swap contracts : The fair value of interest rate swap contracts is determined using an income approach using the following significant inputs: (1) the term of the swap contract (weighted average of 4.5 years and 4.3 years, respectively), (2) the notional amount of the swap contract (ranging from $14,983 to $50,000), discount rates interpolated based on relevant LIBOR swap curves; and (3) the rate on the fixed leg of the swap contract (rates ranging from 1.25% to 2.42% for the contracts as of December 31,2014 and rates ranging from 1.25% to 1.44% for the contracts as of December 31, 2013).

 

•

Long-term debt: With respect to long-term debt measurements, the Partnership uses market interest rates and adjusts that rate for all necessary risks, including its own credit risk. In determining an appropriate spread to reflect its credit standing, the Partnership considered interest rates currently offered to the KNOT Group for similar debt instruments of comparable maturities by KNOT’s and the Partnership’s bankers as well as other banks that regularly compete to provide financing to the Partnership. As all long-term debt has been refinanced in the period from June 2014 to November 2014 the fair value is based on the margin obtained in the refinancing and therefore the fair value equals the carrying value as of December 31, 2014.

(b) Fair Value Hierarchy

The following table presents the placement in the fair value hierarchy of assets and liabilities that are measured at fair value on a recurring basis (including items that are required to be measured at fair value or for which fair value is required to be disclosed) as of December 31, 2014 and 2013:

 

						Fair Value Measurements at Reporting Date Using
(U.S. Dollars in thousands)		December 31, 2014				Quoted Price in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Financial assets:
Cash and cash equivalents		$	30,726			$	30,726			$	—			$	—
Restricted cash			—				—				—				—
Current derivative asset:
Foreign exchange forward contracts			—				—				—				—
Non-current derivative assets:
Interest rate swap contracts			2,966				—				2,966				—
Financial liabilities:
Current derivative liabilities:
Interest rate swap contracts			4,708				—				4,708				—
Foreign exchange forward contracts			2,742				—				2,742				—
Non-current derivative liabilities:
Interest rate swap contracts			—				—				—				—
Long-term debt, current and non-current			613,221				—				613,221				—

 

						Fair Value Measurements at Reporting Date Using
(U.S. Dollars in thousands)		December 31, 2013				Quoted Price in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Financial assets:
Cash and cash equivalents		$	28,836			$	28,836			$	—			$	—
Restricted cash			458				458				—				—
Current derivative asset:
Foreign exchange forward contracts			248				—				248				—
Non-current derivative assets:
Interest rate swap contracts			2,617				—				2,617				—
Financial liabilities:
Current derivative liabilities:
Interest rate swap contracts			2,124				—				2,124				—
Foreign exchange forward contracts			—				—				—				—
Non-current derivative liabilities:
Interest rate swap contracts			—				—				—				—
Long-term debt, current and non-current			350,999				—				350,999				—

The Partnership’s accounting policy is to recognize transfers between levels of the fair value hierarchy on the date of the event or change in circumstances that caused the transfer. There were no transfers into or out of Level 1, Level 2 or Level 3 as of December 31, 2014 and 2013.

12) Trade Accounts Receivables and Other Current Assets

(a) Trade Accounts Receivables

Trade accounts receivable are presented net of provisions for doubtful accounts. As of December 31, 2014 and 2013, there was no provision for doubtful accounts.

(b) Other Current Assets

Other current assets consist of the following:

 

		Year Ended December 31,
(U.S. Dollars in thousands)		2014				2013
Insurance claims for recoveries			189				—
Refund of value added tax			453				312
Prepaid expenses			464				247
Current portion of deferred debt issuance cost			1,149				1,116
Other receivable			1,703				139
Total other current assets		$	3,958			$	1,814

13) Vessels and Equipment

 

(U.S. Dollars in thousands)		Vessel & equipment				Accumulated depreciation				Net vessels
Balance December 31, 2012		$	548,141			$	(51,373	)		$	496,768
Additions			143,231				—				143,231
Drydock costs			1,781				—				1,781
Transfer from vessels under construction			—				—				—
Disposals			(227	)			—				(227	)
Depreciation			—				(23,768	)			(23,768	)
Balance December 31, 2013		$	692,926			$	(75,141	)		$	617,785
Additions			434,232				—				434,232
Drydock costs			4,277				—				4,277
Transfer from vessels under construction			—				—				—
Disposal			(114	)			—				(114	)
Depreciation			—				(34,322	)			(34,322	)
Balance December 31, 2014		$	1,131,321			$	(109,464	)		$	1,021,857

As of December 31, 2014 and 2013, Vessels with a book value of $1,022 million and $618 million, respectively, are pledged as security held as a guarantee for the Partnership’s long-term debt. See Note 16—Long-Term Debt.

Drydocking activity for the years ended December 31, 2014 and 2013 is summarized as follows:

 

		Year Ended December 31,
(U.S. Dollars in thousands)		2014				2013
Balance at the beginning of the year		$	3,369			$	2,472
Costs incurred for drydocking			69				12
Costs allocated to drydocking as part of acquisition of business			4 208				1,769
Drydock depreciation			(1,772	)			(884	)
Balance at the end of the year		$	5,874			$	3,369

14) Goodwill, Intangible Assets and Contract Liabilities

(a) Goodwill

Goodwill arose in 2008 when TSSI acquired the remaining 50% interest in the majority of KNOT’s vessels, including the Windsor Knutsen and the three other Vessels of the Partnership under construction, in a transaction that was accounted for as a step acquisition. The goodwill increased in June 2014, in connection with the acquisition of the Hilda Knutsen and the Torill Knutsen; see Note 22—Business Acquisitions and see Note 2(a)—Summary of Significant Accounting Policies—Basis of Preparation for a discussion on the allocation method.

The carrying amount of goodwill that was allocated to the Partnership was $6,217 and $5,750 as of December 31, 2014 and 2013, respectively. In 2014 and 2013, the Partnership conducted a goodwill impairment review and concluded that no impairment had occurred

 

(b) Intangible Assets and Contract Liabilities

The Partnership’s identified finite-lived intangible assets associated with contractual rights for a charter of a Vessel obtained in connection with a step acquisition in 2008 that had favorable contractual terms relative to market as of the acquisition date. The finite-lived intangible assets of $533 were fully amortized as of December 31, 2010. In addition, as part of that transaction, unfavorable contractual rights for charters of two of the Vessels that had unfavorable contractual terms were identified. The unfavorable contract rights are amortized over the period of the contract to time charter and bareboat revenues as follows:

 

(U.S. Dollars in thousands)		Balance as of December 31, 2012				Amortization for the year ended December 31, 2013				Balance as of December 31, 2013				Amortization for the year ended December 31, 2014				Balance as of December 31, 2014
Contract liabilities:
Unfavorable contract rights		$	(15,829	)		$	1,518			$	(14,311	)		$	1,518			$	(12,793	)
Total amortization income						$	1,518							$	1,518

Accumulated amortization for contract liabilities was $5,422 and $3,904 as of December 31, 2014 and 2013, respectively.

The amortization of contract liabilities that is classified under time charter and bareboat revenues for the next five years is expected to be as follows:

 

(U.S. Dollars in thousands)		2015				2016				2017				2018				2019 and thereafter
Contract liabilities:
Unfavorable contract rights		$	(1,518	)		$	(1,518	)		$	(1,518	)		$	(1,518	)		$	(6,721	)

15) Accrued Expenses

The following table presents accrued expenses as of December 31, 2014 and 2013:

 

		Year Ended December 31,
(U.S. Dollars in thousands)		2014				2013
Operating expenses		$	1,035			$	808
Interest expenses			1,700				1,599
Other finance expenses			—				235
Total accrued expenses		$	2,735			$	2,642

16) Long-Term Debt

Prior to the closing of the IPO, existing vessel financing agreements were amended to permit the transactions pursuant to which the Partnership acquired its initial fleet at the closing of the IPO and to establish a $20.0 million revolving credit facility.

The Partnership used the net proceeds from the IPO to repay either a portion of the amounts outstanding or the full amount outstanding under the existing loan facilities. All amended loan agreements have been assessed for debt extinguishment or debt modifications in accordance with Accounting Standards Codification (ASC) 470, Debt. Debt that has been fully repaid has been accounted for as debt extinguishment, i.e., for all extinguishments of debt, the difference between the reacquisition price (which includes any premium) and the net carrying amount of the debt being extinguished (which includes any deferred debt issuance costs) has been recognized as a gain or loss when the debt was extinguished.

In June 2014, the Partnership entered into two new senior secured credit facilities in order to refinance its existing long term bank debt. The new senior secured credit facilities consist of a $20 million revolving credit facility and two term loans of $220 million and $140 million. The $220 million term loan and the $20 million revolving facility were drawn in June 2014 to repay existing debt under the $120 million loan facility, the $85 million loan facility and the $93 million loan facility secured by the Bodil Knutsen, the Windsor Knutsen and the Carmen Knutsen, respectively, and the seller’s credit from KNOT. The new $140 million term loan was drawn in November 2014 and replaced the $160 million loan facility secured by the Fortaleza Knutsen and the Recife Knutsen. The repayments of the loan facilities in 2014 have been assessed for debt extinguishment or debt modifications in accordance with Accounting Standards Codification (ASC) 470, Debt. These repayments were accounted for as debt extinguishment and $1.8 million has been written off from deferred financing fees and expenses under interest expense for the year ended December 31, 2014.

 

Long-term debt as of December 31, 2014 and 2013, consisted of following:

 

				Year Ended December 31,
(U.S. Dollars in thousands)		Vessel		2014				2013
$220 million loan facility		Windsor Knutsen, Bodil Knutsen, Carmen Knutsen		$	212,142			$	—
$20 million revolving credit facility		Windsor Knutsen, Bodil Knutsen, Carmen Knutsen			20,000				—
$140 million loan facility		Fortaleza Knutsen & Recife Knutsen			135,625				—
$160 million loan facility		Fortaleza Knutsen & Recife Knutsen			—				132,425
$120 million loan facility		Bodil Knutsen			—				67,615
$85 million loan facility		Windsor Knutsen			—				52,400
$93 million loan facility		Carmen Knutsen			—				87,188
$117 million loan facility		Hilda Knutsen			86,724				—
$117 million loan facility		Torill Knutsen			87,960				—
$58.8 million loan facility		Dan Cisne			58,770				—
$12.0 million Seller’s Credit					12,000				—
$10.5 million Seller’s Credit					—				10,349
Total long-term debt					613,221				349,977
Less current installments					38,718				29,269
Less $12 million Seller’s Credit					12,000				—
Less $10.5 million Seller’s Credit					—				10,349
Long-term debt, excluding current installments and seller’s credit				$	562,503			$	310,359

The Partnership’s outstanding debt of $613.2 million as of December 31, 2014 is repayable as follows:

 

Year Ending December 31,		U.S. Dollars in thousands
2015		$	38,718
2016			39,018
2017			39,318
2018			174,887
2019			287,810
2020-2023			33,470
Total		$	613,221

As of December 31, 2014, the interest rates on the Partnership’s loan agreements were the London Interbank Offered Rate (“LIBOR”) plus a fixed margin ranging from 2.125% to 4.5%.

$240 Million Secured Loan Facility

In June 2014, the Partnership’s subsidiaries KNOT Shuttle Tankers 18 AS, KNOT Shuttle Tankers 17 AS and Knutsen Shuttle Tankers 13 AS entered into a senior syndicate secured loan facility in an aggregate amount of $240 million (the “Senior Secured Loan Facility”) to repay existing debt under the $120 million loan facility, the $85 million loan facility, the $93 million loan facility and the $10.5 million seller’s credit from KNOT. The Senior Secured Loan Facility consists of (i) a $220 million term loan (the “Term Loan Facility”) and (ii) a $20 million revolving credit facility (the “Revolving Credit Facility”).

The Revolving Credit Facility terminates in June 2019, and bears interest at LIBOR plus a fixed margin of 2.125%, and has a commitment fee equal to 40% of the margin of the Revolving Credit Facility calculated on the daily undrawn portion of the Revolving Credit Facility. As of December 31, 2014, the Revolving Credit Facility was fully drawn and the outstanding balance was $20.0 million.

 

The Term Loan Facility is repayable in quarterly instalments over five years with a final balloon payment due at maturity at June 2019. The Term Loan Facility bears interest at LIBOR plus a margin of 2.125%.

The Windsor Knutsen, the Bodil Knutsen and the Carmen Knutsen, assignments of earnings, charterparty contracts and insurance proceeds are pledged as collateral for the Senior Secured Loan Facility. The Senior Secured Loan Facility is guaranteed by the Partnership and KNOT Shuttle Tankers AS, and secured by vessel mortgages on the Windsor Knutsen, the Bodil Knutsen and the Carmen Knutsen.

The Senior Secured Loan Facility contains the following financial covenants:

 

•

The aggregate market value of the Windsor Knutsen, Bodil Knutsen and Carmen Knutsen shall not be less than 110% of the outstanding balance under the Senior Secured Loan Facility for the first two years, 120% for the third and fourth years, and 125% thereafter;

 

•

Positive working capital for the borrowers and the Partnership;

 

•

Minimum liquidity of the Partnership of $15 million plus increments of $1 million for each additional vessel acquired by the Partnership above the eighth vessel and $1.5 million for each owned vessel with less than 12 months remaining tenor on its employment contract;

 

•

Minimum book equity ratio for the Partnership of 30%; and

 

•

Minimum EBITDA to interest ratio for the Partnership of 2.50.

The Senior Secured Loan Facility also identifies various events that may trigger mandatory reduction, prepayment and cancellation of the facility, including total loss or sale of a vessel and customary events of default. As of December 31, 2014, the borrowers and the Partnership were in compliance with all covenants under this facility.

$117 Million Hilda Loan Facility

The $117 million secured loan facility (the “Hilda Facility”) is repayable in quarterly installments over five years with a final balloon payment due at maturity in July 2018. The Hilda Facility bears interest at LIBOR plus a fixed margin of 2.5%. The facility is guaranteed by the Partnership and KNOT Shuttle Tankers AS and is secured by a vessel mortgage on the Hilda Knutsen. The Hilda Knutsen, assignments of earnings, charterparty contracts and insurance proceeds are pledged as collateral for the Hilda Facility. The Partnership and KNOT Shuttle Tankers AS are the sole guarantors. The Hilda Facility contains the following primary financial covenants:

 

•

Market value of the Hilda Knutsen shall not be less than 110% of the outstanding balance under the Hilda Facility for the first two years, 120% for the third and fourth year, and 125% thereafter;

 

•

Positive working capital of the borrower and the Partnership;

 

•

Minimum liquidity of the Partnership of $15 million plus increments of $1 million for each additional vessel acquired by the Partnership above the eighth vessel and $1.5 million for each owned vessel with less than 12 months remaining tenor on its employment contract;

 

•

Minimum book equity ratio for the Partnership of 30%; and

 

•

Minimum EBITDA to interest ratio for the Partnership of 2.50.

The Hilda Facility also identifies various events that may trigger mandatory reduction, prepayment and cancellation of the facility, including total loss or sale of a vessel and customary events of default. As of December 31, 2014, the borrowers and the Partnership were in compliance with all covenants under this facility.

$117 Million Torill Loan Facility

The $117 million secured loan facility (the “Torill Facility”) is repayable in quarterly installments over five years with a final balloon payment due at maturity in October 2018. The Torill Facility bears interest at LIBOR plus a fixed margin of 2.5%. The facility is guaranteed by the Partnership and KNOT Shuttle Tankers AS and is secured by a vessel mortgage on the Torill Knutsen. The Torill Knutsen, assignments of earnings, charterparty contracts and insurance proceeds are pledged as collateral for the Torill Facility. The Partnership and KNOT Shuttle Tankers AS are the sole guarantors. The Torill Facility contains the following primary financial covenants:

 

•

Market value of the Torill Knutsen shall not be less than 110% of the outstanding balance under the Torill Facility for the first two years, 120% for the third and fourth year, and 125% thereafter;

 

•

Positive working capital of the borrower and the Partnership;

 

•

Minimum liquidity of the Partnership of $15 million plus increments of $1 million for each additional vessel acquired by the Partnership above the eighth vessel and $1.5 million for each owned vessel with less than 12 months remaining tenor on its employment contract;

 

•

Minimum book equity ratio for the Partnership of 30%; and

 

•

Minimum EBITDA to interest ratio for the Partnership of 2.50.

The Torill Facility also identifies various events that may trigger mandatory reduction, prepayment and cancellation of the facility, including total loss or sale of a vessel and customary events of default. As of December 31, 2014, the borrowers and the Partnership were in compliance with all covenants under this facility.

$140 Million Secured Loan Facility

In June 2014, the Partnership’s subsidiary Knutsen Shuttle Tankers XII KS entered into a senior syndicate secured loan facility in the amount of $140 million (the “New Fortaleza and Recife Facility”). The New Fortaleza and Recife Facility was drawn in November 2014 and replaced the $160 million secured loan facility, described below. The New Fortaleza and Recife Facility is repayable in quarterly installments over five years with a final balloon payment due at maturity at June 2019. The facility bears interest at LIBOR plus a margin of 2.125%. The Fortaleza Knutsen and the Recife Knutsen, assignments of earnings, charterparty contracts and insurance proceeds are pledged as collateral for the New Fortaleza and Recife Facility. The facility is guaranteed by the Partnership and KNOT Shuttle Tankers AS and is secured by vessel mortgages on the Fortaleza Knutsen and the Recife Knutsen.

The New Fortaleza and Recife Facility contains the following financial covenants:

 

•

The aggregate market value of the Fortaleza Knutsen and Recife Knutsen shall not be less than 110% of the outstanding balance under the New Fortaleza and Recife Facility for the first two years, 120% for the third and fourth year, and 125% thereafter;

 

•

Positive working capital of the borrower and the Partnership;

 

•

Minimum liquidity of the Partnership of $15 million plus increments of $1 million for each additional vessel acquired by the Partnership above the eighth vessel and $1.5 million for each owned vessel with less than 12 months remaining tenor on its employment contract;

 

•

Minimum book equity ratio for the Partnership of 30%; and

 

•

Minimum EBITDA to interest ratio for the Partnership of 2.50.

The New Fortaleza and Recife Facility also identifies various events that may trigger mandatory reduction, prepayment and cancellation of the facility, including total loss or sale of a vessel and customary events of default. As of December 31, 2014, the guarantors were in compliance with all covenants under this facility. Due to negative mark-to-market value of foreign exchange forward contracts of $2.7 million as of December 31, 2014, the borrower was not in compliance with the positive working capital covenant, as the working capital included the negative mark-to-market value of foreign exchange forward contracts. As of December 31, 2014, the borrower has received a waiver from the bank syndicate in relation to this breach from December 31, 2014 until March 31, 2015. The breach has since been corrected, and Knutsen Shuttle Tankers XII KS is currently in compliance with this covenant.

$58.8 Million Secured Loan Facility

In April 2014, KNOT’s subsidiaries owning the Dan Cisne and Dan Sabia, as the borrowers, entered into a $172.5 million senior secured loan facility in connection with the purchase of the vessels from J. Lauritzen. In connection with the Partnership’s acquisition of KNOT Shuttle Tankers 20 AS, the company that owns the Dan Cisne, in December 2014, the $172.5 million senior secured loan facility was split into a tranche which is related to the Dan Cisne of $58.8 million (the “Dan Cisne Facility”). The Dan Cisne Facility is guaranteed by the Partnership and secured by a vessel mortgage on the Dan Cisne. The Dan Cisne Facility is repayable in semiannual instalments with a final balloon payment due at maturity at September 2023. The Dan Cisne Facility bears interest at LIBOR plus a margin of 2.4%. The Dan Cisne Facility contains the following financial covenants:

 

•

Market value of the Dan Cisne shall not be less than 100% of the outstanding balance under the Dan Cisne Facility for the first three years, and 125% thereafter;

 

•

Minimum liquidity of the Partnership of $15 million plus increments of $1 million for each additional vessel acquired by the Partnership above the eighth vessel and $1.5 million for each owned vessel with less than 12 months remaining tenor on its employment contract and;

 

•

Minimum book equity ratio for the Partnership of 30%.

 

The facility also identifies various events that may trigger mandatory reduction, prepayment and cancellation of the facility, including total loss or sale of a vessel and customary events of default. As of December 31, 2014, the borrower and the Partnership were in compliance with all covenants under this facility.

$12 Million Seller’s Credit

As part of financing for the purchase of the Dan Cisne, KNOT provided a $12.0 million seller’s credit (the “Dan Cisne Seller’s Credit”). The Dan Cisne Seller’s Credit is non-amortizing, matures in December 2019 or such other date as the parties agree and bears interest at LIBOR plus a fixed margin of 4.5%. Additionally, the Dan Cisne Seller’s Credit is guaranteed by the Partnership, constitutes a senior debt obligation of KNOT Shuttle Tankers AS and has priority over any shareholder loans or equity provided to KNOT Shuttle Tankers AS by its owners. The Dan Cisne Seller’s Credit contains customary provisions in the case of non-payment or bankruptcy proceedings and carries a default interest of LIBOR plus a fixed margin of 8%. Accrued interest on the Dan Cisne Seller’s Credit accumulates at the end of each six-month period and is capitalized.

$160 Million Secured Loan Facility

The $160 million secured loan facility was repaid in full in November 2014 with the proceeds from the $140 million New Fortaleza and Recife Facility noted above.

The $160 million senior secured loan facility was amended in July 2013 to increase borrowing capacity by $25.4 million in connection with the settlement of acquisition of the Carmen Knutsen on August 1, 2013 (such facility, as amended, the “Fortaleza and Recife Facility”).

The Fortaleza and Recife Facility included two tranches. Each tranche was repayable in quarterly installments over five years with final balloon payments due at maturity in March 2016 and August 2016. We used $26.3 million of net proceeds from our IPO to repay borrowings under the Fortaleza and Recife Facility.

The Fortaleza and Recife Facility bore interest at LIBOR plus a fixed margin of 3.0%.

The Fortaleza and Recife Facility was secured by the Fortaleza Knutsen and the Recife Knutsen, and the Partnership and KNOT Shuttle Tankers AS were the sole guarantors. It also contained the following financial covenants:

 

•

Positive working capital for the borrower;

 

•

Minimum liquidity of the Partnership of $15 million plus increments of $1 million for each additional vessel acquired by the Partnership above the eighth vessel and $1.5 million for each owned vessel with less than 12 months remaining tenor on its employment contract;

 

•

Minimum book equity ratio for the Partnership of 30%.

 

•

Minimum EBITDA to interest ratio for the Partnership of 2.50;

 

•

Minimum book equity ratio for the Partnership of 30%; and

 

•

Market value of the Fortaleza Knutsen and the Recife Knutsen to be no less than 100% of the outstanding balance under the Fortaleza and Recife Facility.

$120 Million Secured Loan Facility

The $120 million secured loan facility was repaid in full in June 2014 with the proceeds from the $240 million Secured Loan Facility noted above.

The $120 million secured loan facility included two tranches. One tranche was repayable in semi-annual installments over five years with final balloon payments due at maturity in February 2016. The second tranche was repayable in semi-annual installments over 12 years. The Partnership used approximately $52.1 million of net proceeds from our IPO to repay borrowings under the $120 million secured loan facility and to amend the facility. The amended facility (the “Bodil Facility”) was a $50.0 million term loan facility and a $20.0 million revolving credit facility. The revolving credit facility bore interest at LIBOR plus a fixed margin of 3% and has a commitment fee equal to 40% of the margin of the revolving credit facility calculated on the daily undrawn portion of the revolving credit facility (40% of 3.0%, which was 1.2% of the undrawn facility amount). The revolving credit facility was drawn in connection with the financing of the Carmen Knutsen.

 

The Bodil Facility bore interest at LIBOR plus a margin ranging from 0.6% to 3.0%. In addition to the interest rates, the borrower paid to the agent (for distribution to means the Guarantee Institute for Export Credits (“GIEK”)) a guarantee commission of 1.75% per annum of the outstanding amounts under the GIEK guarantee, payable semi-annually in arrears. GIEK is the Norwegian central governmental agency responsible for furnishing guarantees and insurance of export credits.

The Bodil Knutsen, assignments of earnings, charterparty contracts and insurance proceeds were pledged as collateral for the Bodil Facility. The Partnership and KNOT Shuttle Tankers AS were the sole guarantors. The Bodil Facility contained the following financial covenants:

 

•

Market value of the Bodil Knutsen must be no less than 100% of the outstanding balance under the Bodil Facility for the first four years and 125% for the fifth year;

 

•

Positive working capital for the borrower;

 

•

Minimum liquidity for the Partnership of $15 million plus increments of $1 million for each additional vessel acquired by the Partnership above the eighth vessel and $1.5 million for each owned vessel with less than 12 months remaining tenor on its employment contract;

 

•

Minimum book equity ratio for the Partnership of 30%; and

 

•

Minimum EBITDA to interest ratio for the Partnership of 2.50.

$85 Million Secured Loan Facility

The $85 million secured loan facility was repaid in full in June 2014 with the proceeds from the $240 million Senior Secured Loan Facility noted above.

The $85 million secured loan facility (the “Windsor Purchase Facility”) was repayable in semi-annual installments over eight years with a final balloon payment due at maturity in May 2015. None of the Windsor Purchase Facility was repaid in connection with our IPO. Under the Windsor Purchase Facility, the borrower paid on a monthly basis into a retention account subsequently used for principal installments, which account was considered restricted cash.

The Windsor Purchase Facility bore interest at LIBOR plus a fixed margin of 2.25%. Before the amendment, the interest rate was LIBOR plus a fixed margin of 0.82%.

The Windsor Knutsen, assignments of earnings, charterparty contracts and insurance proceeds were pledged as collateral for the Windsor Purchase Facility. The Windsor Purchase Facility required that the market value of the Windsor Knutsen be no less than 110% of the aggregate outstanding balance of the Windsor Purchase Facility.

$93 Million Secured Loan Facility

The $93 million secured loan facility was repaid in full in June 2014 with the proceeds from the $240 million Senior Secured Loan Facility noted above.

The $93 million secured loan facility (the “Carmen Facility”) was repayable in quarterly installments over five years with a final balloon payment due at maturity in January 2018. The Carmen Facility bore interest at LIBOR plus a fixed margin of 2.5%. The Carmen Knutsen, assignments of earnings, charterparty contracts and insurance proceeds were pledged as collateral for the Carmen Facility. The Partnership and KNOT Shuttle Tankers AS were the sole guarantors. The Carmen Facility contained the following financial covenants:

 

•

Market value of the Carmen Knutsen to be no less than 100% of the outstanding balance under the Carmen Facility for the first four years and 125% for the fifth year;

 

•

Positive working capital for the borrower;

 

•

Minimum liquidity of the Partnership of $15 million plus increments of $1 million for each additional vessel acquired by the Partnership above the eighth vessel and $1.5 million for each owned vessel with less than 12 months remaining tenor on its employment contract;

 

•

Minimum book equity ratio for the Partnership of 30%; and

 

•

Minimum EBITDA to interest ratio for the Partnership of 2.50.

 

$10.5 Million Seller’s Credit

As part of the financing for the purchase of the Carmen Knutsen, KNOT provided a seller’s credit to KNOT Shuttle Tankers AS in the form of a loan for $10.5 million (the “Carmen Seller’s Credit”). The Carmen Seller’s Credit was repaid in full in June 2014 with the proceeds from the $240 million Senior Secured Loan Facility noted above. The Carmen Seller’s Credit was non-amortizing and bore interest at LIBOR plus a fixed margin of 4.5%. Additionally, the Carmen Seller’s Credit was guaranteed by the Partnership, constituted a senior debt obligation of the KNOT Shuttle Tankers AS and had priority over any shareholder loans or equity provided to KNOT Shuttle Tankers AS by its owners. The Carmen Seller’s Credit was reduced by $0.1 million as settlement for the working capital in Knutsen Shuttle Tankers 13 AS.

17) Income Taxes

(a) Components of Current and Deferred Tax Expense

All of the income from continuing operations before income taxes was taxable to Norway for the years ended December 31, 2014, 2013 and 2012 as follows:

 

		Year Ended December 31,
(U.S. Dollars in thousands)		2014				2013				2012
Income before income taxes		$	27,407			$	17,891			$	2,006

The significant components of current and deferred income tax expense attributable to income from continuing operations for the years ended December 31, 2014, 2013 and 2012 are as follows:

 

		Year Ended December 31,
(U.S. Dollars in thousands)		2014				2013				2012
Current tax expense		$	15			$	686			$	—
Deferred tax expense			—				2,141				1,261
Income tax expense		$	15			$	2,827			$	1,261

(b) Tax Rate Reconciliation

Income taxes attributable to income from continuing operations was an income tax expense of $15, $2,827 and $1,261 for the years ended December 31, 2014, 2013 and 2012, respectively, and differed from the amounts computed by applying the Norwegian ordinary income tax rate of 27% in 2014 and 28% in the years before to pretax net income as a result of the following:

 

		Year Ended December 31,
(U.S. Dollars in thousands, except for tax rate)		2014				2013				2012
Income tax expense at Norwegian ordinary tax regime(1)		$	—			$	111			$	562
Income tax expense at Norwegian tonnage tax regime							188				—
Income tax expense within UK			15				—				—
Adjustments for amounts not taxable under tonnage tax regime			—				—				(3,154	)
Adjustments due to permanent differences			—				—				2,228
Translation differences (1)			—				(168	)			(605	)
Entrance tax into the Norwegian tonnage tax regime			—				2,696				—
Reduction in income tax benefit resulting from a change in valuation allowance			—				—				2,230
Income tax expense		$	15			$	2,827			$	1,261
Effective tax rate			0	%			16	%			63	%

 

(1)	These tax elements are related to the carve-out period in 2013, a total tax benefit of $57.

 

(c) Components of Deferred Tax Assets and Liabilities

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2014 and 2013 are presented below.

 

		Year Ended December 31,
(U.S. Dollars in thousands)		2014				2013
Deferred tax assets:
Interest rate swaps		$	—			$	41
Financial loss carry forwards for tonnage tax			9,100				7,718
Total deferred tax asset			9,100				7,759
Less valuation allowance			(9,100	)			(7,759	)
Net deferred tax asset			—				—
Deferred tax liabilities:
Entrance tax			1,402				2,141
Total deferred tax liabilities			1,402				2,141
Net deferred tax liabilities		$	1,402			$	2,141

The net deferred tax liability is classified in the consolidated and combined carve-out balance sheets as follows:

 

		Year Ended December 31,
(U.S. Dollars in thousands)		2014				2013
Current deferred tax asset		$	—			$	—
Non-current deferred tax liabilities			(1,402	)			(2,141	)
Net deferred tax liabilities		$	(1,402	)		$	(2,141	)

Changes in the net deferred tax liabilities at December 31, 2014 and 2013 are presented below:

 

		Year Ended December 31,
(U.S. Dollars in thousands)		2014				2013
Net deferred tax liabilities at January 1		$	2,141			$	2,807
Change in temporary differences			(350	)			111
Translation differences			(389	)			(168	)
Elimination of deferred tax not transferred to the partnership			—				(2,750	)
Changes in temporary differences after the IPO date			—				2,141
Net deferred tax liabilities at December 31		$	1,402			$	2,141

 

A valuation allowance for deferred tax assets is recorded when it is more likely than not that some of or all of the benefit from the deferred tax asset will not be realized. The valuation allowances were $9,100 and $7,759 respectively, as of December 31, 2014 and 2013. The valuation allowances relate to the financial loss carry forwards and other deferred tax assets for tonnage tax that, in the judgment of the Partnership, are more-likely-than not to be realized reflecting the Partnership’s cumulative loss position for tonnage tax. In assessing the realizability of deferred tax assets, the Partnership considers whether it is more-likely-than-not that some portion or all of the deferred tax assets will not be realized taking into account all the positive and negative evidence available. As of December 31, 2014, the Partnership has determined that the deferred tax assets are likely to not be realized, and the booked value was, therefore, zero.

After the reorganization of the Partnership’s predecessor’s activities into the new group structure in February 2013, all profit from continuing operations in Norway is taxable within the tonnage tax regime. The consequence of the reorganization is a one-time entrance tax into the Norwegian tonnage tax regime due to the Partnership’s acquisition of the shares in the subsidiary that owns the Fortaleza Knutsen and the Recife Knutsen. The total amount of the entrance tax was estimated to be approximately $3.0 million, which was recognized in the three months ended March 31, 2013. The entrance tax on this gain is payable over several years and is calculated by multiplying the Norwegian tax rate by the declining balance of the gain, which will decline by 20% each year. The Norwegian corporate tax rate has been reduced from 28% in 2013 to 27% in 2014. At December 31, 2013 the entrance tax had declined to approximately $2.7 million due to translation effects and tax rate changes. At December 31, 2014 the entrance tax had declined to approximately $1.8 million due to paid entrance tax, change in tax rate and translation effects. The taxes payable and the deferred tax liabilities, both mainly related to the entrance tax, are calculated based on a tax rate of 27%. Income tax expense for 2014 was calculated by multiplying the tax basis with the UK tax rate.

In 2013, the total entrance tax was estimated at $2.7 million of which approximately $0.6 million was estimated to be payable during 2014. In addition, ordinary tonnage taxes payable were estimated at $0.1 million. Total income taxes payable were estimated at $0.7 million as of December 31, 2013 and equaled taxes paid in 2014. In 2014, the total income taxes payable are estimated to be $0.4 million and income taxes payable consist of payable entrance tax and ordinary UK income tax.

Approximately $0.6 million of the estimated entrance tax of $2.7 million was paid during 2014 and approximately $0.4 million is estimated to be payable in the fourth quarter of 2015 and is presented as income taxes payable, while $1.4 million is presented as non-current deferred taxes payable.

The tax loss carry forward from ordinary taxation and financial loss carry forwards for tonnage tax have no expiration dates.

The Partnership’s Norwegian income tax returns are subject to examination by Norwegian tax authorities going back ten years from 2014. The Partnership had no unrecognized tax benefits as December 31, 2014 and 2013. During the years ended December 31, 2014 and 2013, the Partnership did not incur any interest or penalties on its tax return.