Industry tax preferences

Nov. 5, 2012
Favorable tax options available to US oil and gas companies have been under siege throughout the Obama presidency and would remain so if former Massachusetts Gov. Mitt Romney won the general election Nov. 6. Romney stated his position in his second debate with Obama on Oct. 16, when he said he'd make industry preferences part of his broad review of deductions and credits subject to elimination in a program of tax reform.

Favorable tax options available to US oil and gas companies have been under siege throughout the Obama presidency and would remain so if former Massachusetts Gov. Mitt Romney won the general election Nov. 6. Romney stated his position in his second debate with Obama on Oct. 16, when he said he'd make industry preferences part of his broad review of deductions and credits subject to elimination in a program of tax reform. Regardless of the outcome of the election, therefore, the industry will have to defend longstanding tax mechanisms mischaracterized as subsidies.

It won't be easy. The subject is complicated and, except to tax accountants, boring. No one lacking a professional interest in the information wants to learn the intricacies of, say, current-year expensing of intangible drilling costs. It's easier to lump IDCs together with wholly unrelated but dauntingly labeled measures such as the manufacturer's deduction or foreign tax credit for dual-capacity taxpayers and call them all undeserved handouts.

Mostly deferrals

Yet most tax preferences available to oil and gas companies are not subsidies in the strict sense of a wealth transfer from the general public to narrow interests. In most cases, they're deferrals—measures that affect the timing of tax payments but not, ultimately, the amount. The intent of timing preferences is to sustain investment without cutting total tax payments over time. The mechanism can boost tax receipts by the government overall by stimulating work that otherwise wouldn't occur.

A skeptical public still will want to know why so many preferences have been made available to the oil and gas industry. This question has two answers.

One answer is that no oil and gas company qualifies for all available preferences. For example, only small independent producers and royalty owners can use percentage depletion, a leading preference in total dollar value. Integrated companies and large independents can't use it. Company size reduces the benefits of some other industry tax preferences. Yet other measures, such as treatment of foreign tax payments, are important to large companies but obviously not to smaller operators with no work outside the US.

The other reason so many special tax mechanisms have evolved for the oil and gas business is that the industry has unique characteristics to which Congress has seen the need to adapt tax laws. An example is the difficulty of assigning value to the industry's fundamental source of income, oil and gas reserves. Reserves volumes depend greatly on interpretation and change greatly over the lives of associated properties for a range of unpredictable reasons, including commodity prices. They defy dollar valuation consistent enough to serve as the basis for an asset account that can be written down with depletion the way a piece of machinery can be booked at its purchase price and depreciated. The best accounting can do with oil and gas reserves is to accumulate development costs in a capital account to be written down with as production advances.

Yet most costs of an oil and gas well are for perishable materials and services that don't stay in the hole. And the hole itself, unlike a piece of machinery, has no salvage value; when it ceases to produce oil and gas—and, therefore, revenue—it's just a hole. In fact, it's a liability because of costs incurred through plugging and abandonment.

Competing for capital

The oil and gas industry must compete for capital with industries built on salvageable assets more amenable to evaluation and consistent accounting, industries that furthermore face no exploratory risk. In its adaptations of tax law to accounting problems and investment challenges unique to oil and gas, Congress indeed has given companies well-defined, strictly controlled options to account for their business in helpful ways that cost taxpayers in general little or nothing over time. This is why most of the options are better described as preferences rather than subsidies.

The oil and gas industry now must communicate that distinction clearly and often.