Dual-capacity worries

Oct. 17, 2011
In its fight against punishing tax hikes, the US oil and gas industry won a round this month. Senate Democrats scuttled at least some industry tax reversals from their proposal for funding a jobs bill.

In its fight against punishing tax hikes, the US oil and gas industry won a round this month. Senate Democrats scuttled at least some industry tax reversals from their proposal for funding a jobs bill. But the reported reason for this outburst of judgment provides reason to think victory isn't complete. The ideological battle, meanwhile, continues.

President Barack Obama included in the funding proposal for his recently unveiled employment program a standard assault on tax measures important to oil and gas companies. In the Senate, members of his political party focused instead on a surcharge on wealthy taxpayers. According to news reports, some of them expressed worry about potential harm to small businesses.

Smallest hit hardest

They should be worried. Many of the targeted tax measures would hit small producers and royalty owners hardest. Only independent producers, for example, can charge all intangible drilling costs to expense in the year they're incurred; integrated producers can expense only 70% of IDCs. Only small independent producers and royalty owners can use percentage depletion, subject to production and income limits.

That these intricacies elude lawmakers became clear last year in a proposal to deny the five biggest oil companies use of, among other things, percentage depletion—which hasn't been available to integrated companies for decades. Given the evident confusion, no one should draw much comfort from one silent spell on a complex subject politicians love to exploit.

Still unclear is the status of a threatened provision important to US companies with production abroad. Because international companies tend not to be small, they probably weren't the intended recipients of the Democrats' unusual dispensation of mercy.

The threatened provision applies to calculation of the foreign tax credit—which keeps income earned abroad from being taxed once in the host country and again in the US—by dual-capacity taxpayers. These are US companies that pay taxes to non-US governments and also make payments in exchange for economic benefits, such as royalties on oil and gas production.

Current law addresses concerns that foreign governments might tilt revenue mechanisms toward income taxation and away from royalties as a favor to US producers. The foreign tax credit lowers US tax liability by the full amount of tax paid abroad; by contrast, royalties are treated as deductions, which only reduce income subject to taxation and thus have less value to taxpayers.

For income from countries in which tax rates on oil and gas producers are higher than corporate tax rates generally, taxpayers have two options. They can take the foreign tax credit up to the amount of tax that would be paid on their income at the lower general rate. Or they can argue that the increment really represents tax and not royalty—and prepare to defend the position in court on the basis of "facts and circumstances."

Administration proposal

The administration proposes to treat as disguised royalty any amount by which taxes paid on oil and gas production exceed what would be paid under lower general tax rates. Yet some governments, including those of the UK and Norway, tax oil and gas companies more heavily than they do others simply because they're large and profitable.

And some governments, seeking economic diversity, tax resource companies more heavily than they do service firms and manufacturers. The higher taxes producers pay in such places are indeed taxes, argue analysts at the Peterson Institute for International Economics in an October policy paper entitled "US Tax Discrimination against Large Corporations Should Be Discarded," which includes a clear summary of this issue.

If implemented, the administration's proposal for dual-capacity taxpayers would hurt the international competitiveness of oil and gas companies based in the US.

It's far from certain that a majority of lawmakers understand this—or that they care. And the industry must assume that the provision, like others in the Obama proposal, still tantalizes the congressional "super committee" hunting ways to cut the federal budget deficit.

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