Tax Provisions for Oil and Gas Get Hard Looks

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By Alan Kovski

July 14 — When someone points out how heavily the developers of wind farms and solar farms rely upon tax subsidies, a common response is: What about the tax breaks for oil and natural gas producers?

Oil and gas producers benefit from some tax provisions specifically designed to provide incentives for investments in oil and gas exploration and production. The producers benefit even more from tax provisions helping the bottom lines of a broad array of industries, not just oil and gas.

Whether the tax provisions are justified is another matter. Professors specialized in tax law and energy economics offered Bloomberg BNA a mix of observations, in some cases very sharply critical of tax preferences for the oil and gas sector but usually not agreeing on all of the criticisms.

In the White House and Congress, the subject is not ignored. President Barack Obama in February used his budget request for fiscal year 2017 to advocate repeal of 13 tax provisions insofar as they benefit fossil fuel producers, and to that he added a proposed excise tax on petroleum products of $10.25 per barrel of crude oil equivalent. In the same budget plan he advocated making some tax subsidies for wind and solar energy permanent.

Rep. Earl Blumenauer (D-Ore.) and Sen. Ed Markey (D-Mass.) are among the members of Congress who have called for ending what they call subsidies for the oil and gas industry. Some environmental groups have issued similar calls.

House Republicans, under the leadership of Speaker Paul Ryan (R-Wis.), in June released a set of ideas for a tax policy overhaul that would sharply lower the corporate tax rate while eliminating some tax breaks in the process, including some of those used by oil and gas companies and the developers of wind and solar energy.

Tax Provisions President Obama Has Proposed for Repeal

The president's budget proposals for fiscal year 2017 included repeal of 13 tax provisions to the extent that they apply to fossil fuels:

1. enhanced oil recovery credit for eligible costs attributable to a qualified enhanced oil recovery project;

2. credit for oil and gas produced from marginal wells;

3. expensing of intangible drilling costs;

4. deduction for costs paid or incurred for any tertiary injectant used as part of a tertiary recovery method;

5. exception to passive loss limitations provided to working interests in oil and natural gas properties;

6. use of percentage depletion with respect to oil and gas wells;

7. domestic manufacturing deduction for income derived from production of oil and gas;

8. two-year amortization of independent producers’ geological and geophysical expenditures, instead allowing amortization over the seven-year period used by integrated oil and gas producers;

9. expensing of exploration and development costs;

10. percentage depletion for coal and other hard mineral fossil fuels;

11. capital gains treatment for royalties;

12. domestic manufacturing deduction for income derived from production of coal and other hard mineral fossil fuels;

13. exemption from corporate income tax for publicly traded partnerships with qualifying income and gains from activities relating to fossil fuels.

Fair or Unfair to Industries

The idea of defending tax breaks for renewable energy by criticizing tax breaks for fossil energy regularly comes up in courses on energy economics taught by Kenneth Medlock, adjunct assistant professor at Rice University.

“To be honest, that is not the correct approach or the correct justification for subsidizing wind and solar power,” Medlock said.

He questioned the wisdom of changing the tax code just to reduce breaks for fossil fuels rather than a more general reduction of the myriad tax breaks for industries across the board.

“It always comes down to ‘Is it fair?' You step into the realm of complete subjectivity,” Medlock said.

Calvin Johnson, professor at the University of Texas School of Law, is sharply critical of many tax provisions that benefit corporations in general and those that help oil and gas companies in particular. In testimony to Congress on the oil and gas provisions, Johnson has advocated elimination of many tax deductions not only as a matter of fairness to taxpayers but to reduce the growing federal debt.

On the renewables versus fossil fuels debate, Johnson said, “Subsidies should be cut for all of them.”

Tax Provisions Under Fire

The criticized tax provisions that benefit oil and gas companies come in a variety of financial sizes with a variety of rationales and are variously denounced as subsidies, preferences, loopholes or simply tax breaks. Oil and gas companies have defended the provisions as cost recovery. Among the most criticized:

  •  domestic manufacturing deduction, allowed to varying extents for most U.S. manufacturing (Section 199 of the Internal Revenue Code);
  •  percentage depletion, allowing an annual deduction of 15 percent of revenues from oil and gas wells of independent producers and royalty owners but not integrated companies (Section 613);
  •  expensing of intangible drilling costs (Section 263);
  •  expensing of costs for injectants pumped into aging fields for tertiary recovery of hydrocarbons (Section 193);
  •  accelerated recovery of geological and geophysical costs (Section 167);
  •  foreign tax credit to avoid double taxation (Section 901);
  •  tax credit for producing oil and gas from marginal wells (Section 451);
  •  tax credit for enhanced oil recovery (Section 43);
  •  exception from limitations on claiming working-interest passive losses (Section 469); and
  •  last-in, first-out accounting (a financial reporting rule with tax consequences).

The Obama administration's proposals for repeal of 13 tax provisions includes a few items aimed at coal and one item aimed at capital gains treatment for royalties. Otherwise the Obama proposals largely overlap this list of most criticized provisions.

Domestic Bias for Manufacturing

The domestic manufacturing deduction may draw the most uniform criticism. “I don't think you will find anybody who says anything good about that,” Johnson said.

Bret Wells, associate professor of law at the University of Houston Law Center, described the domestic manufacturing deduction as a complete departure from good tax accounting. Nor is there a good reason to give it just to manufacturers and not to non-manufacturing enterprises, he said.

The domestic manufacturing deduction is complicated by an array of qualifiers, but calculation of it has a starting point of 9 percent for most manufacturers, including wind and solar energy project operators. It is less beneficial for oil and gas producers, the calculations starting at 6 percent for them.

Wells described it as a “giveaway.” Johnson argued that it is an ineffectual way to manipulate international competition, especially given that other countries are similarly able to favor domestic production and may add to their advantage with far lower labor costs, as in China.

The House Republican blueprint would get rid of the domestic manufacturing deduction entirely, for everyone, a change that would be made more politically palatable—at least to Republicans—by reducing the corporate tax rate for everyone to 20 percent from its current 35 percent.

By contrast, the foreign tax credit may get the least criticism from the experts. It makes sense to avoid double taxation, Wells said.

Expensing or Capitalizing Costs

The ability to expense costs rather than capitalize them is an important part of more than one of the criticized tax provisions. “Expensing” refers to immediate deduction in the year incurred, a way to shelter income that can then be invested in projects.

“Capitalizing” refers to treating expenditures as capital investments in assets, such as oil wells. Such costs can be recovered in annual increments over the useful life of the assets as they depreciate in value.

John Stermole, a Colorado School of Mines associate professor who teaches energy economics, said it is common for there to be an internal debate within companies over whether to expense or capitalize some costs. Expensing is preferred for reducing taxes quickly, while capitalizing looks better on financial balance sheets because it reduces the size of the company's costs in the year the expenses are first incurred.

Capitalizing of costs for an oil or gas field can mean recovering the costs over many years, possibly decades, as the field declines in value as an asset.

“It's about the slowest way you can recover costs,” Stermole said of such a “cost depletion” approach. That is not the best way to incentivize investment, he said.

The House Republican tax overhaul would allow all businesses to fully and immediately write off all investments—to expense the investments. A basic goal of the strategy is encouragement of investment and economic growth generally, while the Obama administration aims for growth in renewable energy rather than fossil energy.

Essential Definitions: Expensing v. Capitalizing

Expensing is the deduction of costs in the current year. (Some provisions in tax law also allow a loss carry-forward, meaning expenses not deducted in one year can be deducted in subsequent years.)

Capitalizing is the treatment of costs as capital investments in assets, not as expenses. Such costs can be deducted in annual increments over the useful life of the assets as they depreciate in value, or the deductions may be governed by some amortization schedule specified by law.

Expensing is the option most useful to shelter income in the current year and to free up capital for investment. Capitalizing involves a much slower cost recovery, potentially taking decades in the case of a long-lived oil or gas field.

Expensing Intangible Costs

The ability to expense intangible drilling costs of a well is another departure from good tax accounting, said Wells at the University of Houston.

“I see that as a mistake, but it's a mistake that we've made in other parts of the tax code as well,” Wells said.

Stermole said intangible drilling costs can add up to 60 percent of the cost of a well. Intangible costs are such things as labor costs that cannot be salvaged as steel pipe or valves can. The expensing of intangible drilling costs may be the single most valuable of all of the tax provisions for oil and gas companies, Stermole said.

The same issue expensing versus capitalizing arises with the ability to expense the costs of acquiring injectants and pumping them down into oil or gas fields for tertiary recovery of hydrocarbons.

Laws also create compromises between immediate deduction of expenses and the gradual recovery of capitalized costs. Geological and geophysical costs can be recovered in two years by independent oil and gas producers or seven years by integrated oil and gas companies.

Those costs ought to be capitalized and recovered over time through cost depletions, Wells said.

Odd History of a Deduction

The oddest tax benefit for oil and gas companies may be the percentage depletion deduction. It is an annual deduction of 15 percent of the income from a well, and it can continue beyond the recovery of all costs associated with the well.

Percentage depletion is allowed to independent oil and gas producers and royalty owners but not integrated companies, meaning companies that refine the oil and produce it.

George Yin, professor of law and taxation at the University of Virginia School of Law, said a central figure in creation of that tax break was Norman Beecher, a maritime attorney with mistaken ideas about how the oil and gas industry worked. Beecher, as counsel to a federal energy agency during World War I, testified to the Senate Finance Committee in 1918 that a deduction to be called “discovery depletion” was needed to allow wildcatters, not big companies, recover their exploration expenses at a time when corporate taxes were exceptionally high. Congress went along with the idea.

“My research suggests he was sincere, very confident but, as it turns out, dead wrong in his judgments in several ways,” Yin said.

The deduction hardly helped wildcatters at all and was almost entirely claimed by companies that acquired discoveries from wildcatters or discovered their own fields. “He gave a huge benefit to the folks he kept saying do not need any help,” Yin said.

In 1926 Congress decided not to do the simple thing—repeal discovery depletion—but instead changed it to percentage depletion, and in later decades the deduction was expanded to apply to mining and other extractive industries. It remains one of the more valuable deductions for independent producers.

Looking for Analysis, Overhaul

Typically, when it comes to tax deductions, “the real thing is, nobody did a cost-benefit analysis,” Johnson said.

It is especially unfortunate that lawmakers creating tax deductions tend to think of them as something other than real money, he said.

Some of it is a question of the strategic importance government places on an industry, Stermole said. The more strategic importance you place on oil and gas, the more you might want to allow oil and gas companies to recover their costs on shorter schedules so that more of their income can be reinvested in projects, he said.

The House Republican tax plan in June attached much importance to encouraging business investment and job growth generally and a way to “fix our broken tax code.” The Obama administration in its fiscal year proposals aimed to shift investment from fossil fuels to renewable energy.

“We're definitely due for some reform,” Stermole said. “It's gotten so ridiculously complex,” he said of the tax code. “So yeah, I think reform's in order.”

Medlock at Rice University said he could imagine something like a carbon tax being used not only to encourage consumer efficiency but also to finance investment in alternative energy while eliminating tax breaks and subsidies for fossil fuels and wind and solar energy together.

Medlock said he could envision a complete restructuring of the tax code, but he added it is “kind of a Pandora's box.”

To contact the reporter on this story: Alan Kovski in Washington at

To contact the editor responsible for this story: Larry Pearl at

For More Information

Obama administration explanations of fiscal year 2017 revenue proposals, with oil and gas tax provisions starting on Page 89, are available at

The House Republican blueprint for tax overhaul, released in June, is available at

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