Misguided Tax Reform

Repealing the federal tax deduction for IDCs would cost thousands of industry jobs.

David Neal Whitley Penn Fort Worth, Texas

As National budget discussions escalate, we can expect to receive more insight into Congress's framework for business tax reform. An important aspect of this framework is a focus on eliminating tax breaks for specific industries. The American oil and natural gas industry commonly becomes a target in these discussions. However, rarely is any focus given to the positive benefits of existing tax laws.

The United States is one of very few countries with improving energy security. According to the Independent Petroleum Association of America (IPAA), American oil and natural gas productivity will result in the US having the lowest long-term natural resource prices of any industrialized nation. This competitive advantage will have far-reaching and positive implications for various domestic industries including manufacturing, chemical, etc.

Three specific areas of the Internal Revenue Code (IRC) that are frequently targeted for the oil and gas industry, and that require additional insight to properly frame tax reform discussions, are the following:

Intangible Drilling Costs (IDCs) are a section of the tax code frequently scrutinized in tax reform discussions. IDCs represent all of the expenses that are incurred at the wellsite to drill a well, that have no salvage value, and that do not produce a physical asset. Examples of these costs include dirt work performed to prepare the drill site, such as grading and digging mud pits, rig moving and drilling rig transportation costs, and transportation costs for drilling piping and casing. In other words, these are costs that provide no value to the operator if exploration is unsuccessful. These costs are analogous to research and development costs that are fully deductible for other industries.

The IRS standard for deducting IDCs allows independent producers to recover a portion of their costs quickly, permitting them to reinvest these funds in continued drilling operations, ultimately increasing the US oil and gas supply and reducing your price at the pump.

It is important to understand that the standard for deducting IDCs is not applied uniformly across the oil and gas industry. Independent producers are allowed to deduct IDCs as incurred. In contrast, integrated companies (larger companies that engage in exploration, production, refinement, and distribution) must amortize 30% of their IDCs and can only deduct the remaining 70%.

An American Petroleum Institute study found that eliminating the IDC deduction would cost the country 190,000 jobs and reduce domestic oil and gas drilling investment by more than $400 billion in a 10-year period. It has also been estimated that, overall, reducing the IDC deduction would increase the cost of capital by 20% for the industry. As with many other tax provisions, the effect of reducing the IDC deduction would weigh heavily on the small independent producers who drill most of their wells in the US due to their limited access to capital. These independent producers are integral to the US economy.

According to the IPAA, independent producers drill 90% of our nation's wells, support more than 4 million direct, indirect and induced jobs, and paid $67.7 billion dollars in taxes during 2010 alone. Removing the tax provision for IDCs would eliminate capital available to independent producers, reduce industry competitiveness, and concentrate power for larger integrated oil companies.

The percentage depletion deduction is designed to compensate for the decline in oil and gas reserves of a property over time. This deduction enables small independent producers to recoup some of the high costs of maintaining small producing wells. Percentage depletion is not a simple calculation and is subject to a variety of restrictions.

The deduction is calculated by multiplying 15% by the gross revenue from an oil and gas property, and it is then limited to the net income of the individual property, the taxpayer's first 1,000 barrels of production a day, and 65% of the taxpayer's taxable income. As a result of these restrictions, the deduction is limited in use only to small independent producers and royalty owners. Oil and gas production generated by small independent producers is vitally important to the industry as a whole. According to the IPAA, the nation's smallest wells (those producing less than 15 barrels of oil/day and less than 90 cubic feet of gas/day) collectively make up 19% of US oil production and 12% of US gas production.

Eliminating this deduction would increase investment risk for individuals and place further strain on small independent producers to meet the capital requirements necessary to maintain small producing wells.

The working interest exception to passive activity rules is an area of the tax code that allows individuals to treat losses on their investments similar to the treatment available to corporate shareholders. This exception is available to those who participate in oil and gas working interests, but who do not hold their interest in an entity that limits liability.

The Tax Reform Act of 1986 worked to divide investment income into two categories, active and passive. However, these rules apply only to individuals. Passive investments are defined by the IRS as activities in which the investor is not materially involved on a "regular, continuous and substantial basis."

The working interest exception provides some parity between individuals and corporations by allowing individuals to deduct the normal business expenses of their investment in oil and gas working interests, as incurred. Investments in oil and gas working interests are extremely expensive and high-risk.

The passive loss exception works to compensate for some of this risk by allowing investors to recoup a portion of their losses that result from unsuccessful exploration. Ultimately, repeal of the passive loss exception would result in oil and gas investments moving away from individuals and towards corporations, further reducing the competitiveness of independent producers and centralizing power in larger integrated companies.

The IDC deduction was written into the tax code in 1913 and percentage depletion in 1926. These provisions and the working interest exception have an established history and are there for a reason. They work to encourage individual investment in the oil and gas industry and to influence the competitiveness of small independent producers.

Moreover, these provisions support an oil and gas industry that is a significant piece of our national economy. An American Petroleum Institute study found that the oil and gas industry's total employment impact to the national economy in 2011 accounted for 9.8 million jobs or roughly 5.6% of total US employment. These provisions help to stimulate production for small independent producers which directly contributes to US employment, US energy security, and keeping US dollars at home. Congress's business tax reform initiatives threaten these laws, the health of the US oil and gas industry, and the national economy as a whole.

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