The last income tax change is reform of a foreign tax credit rule that allows for a foreign tax credit that, as described by the CRS, is in effect a royalty (although couched “as taxes”) paid to a host foreign government in consideration for the right to drill for oil in the country. CRS calls the current law “essentially a transfer of funds from the U.S. Treasury to the Saudi government.”
The last two changes are not income taxes-reinstatement of the Superfund tax and an increase in the Oil Spill Liability Trust Fund Tax.
Below are key excerpts from the report:
- The Obama Administration, in the FY2014 budget proposal, seeks to eliminate a set of tax expenditures that benefit the oil and natural gas industries.
- These proposals include repeal of the enhanced oil recovery and marginal well tax credits, repeal of the current expensing of intangible drilling costs provision, repeal of the deduction for tertiary injectants, repeal of the passive loss exception for working interests in oil and natural gas properties, elimination of the manufacturing tax deduction for oil and natural gas companies, increasing the amortization period for certain exploration expenses, and repeal of the percentage depletion allowance for independent oil and natural gas producers.
- The Administration also characterizes repealing these tax preferences as eliminating market distortions and links them to providing resources for investments in clean, renewable, efficient energy resources.
- Many of these proposed tax changes have the effect of equalizing the tax treatment of independent oil producers to that of the major oil companies. Equalization is accomplished by eliminating preferential tax treatment of the independent companies that is not available to the major oil companies. In some cases, for example, the expensing of intangible drilling expense, the major oil companies have been excluded from the benefits of the tax provision for years, while the independent companies continue to receive the benefit.
Repeal Enhanced Oil Recovery Credit
- The enhanced oil recovery credit provides for a credit of 15 percent of allowable costs associated with the use of oil recovery technologies, including the injection of carbon dioxide, to supplement natural well pressure, which can enhance production from older wells. The credit is only available during periods of low oil prices, determined by yearly guidance with respect to what constitutes a low price. The credit has not been in effect over the past several years. Elimination of this credit would likely not have any effect on current, or expected, oil production, since oil prices are generally expected to remain high.
Repeal Credit for Oil and Gas from Marginal Wells
- The marginal well tax credit was implemented as the result of a recommendation by the national Petroleum Council in 1994. The purpose was to keep low-production oil and natural gas wells in production during periods of low prices for those fuels. The tax credit is designed to maximize U.S. production levels even when energy markets result in low world prices for oil, and low regional prices for natural gas. It is believed that up to 29 percent of U.S. oil production and 12 percent of natural gas production might be sourced from wells of this category. The credit was enacted in 2004, but has not been utilized because market prices have been high enough since that time to justify production on economic grounds without the application of the credit.
Repeal Expensing of Intangible Drilling Costs
- The expensing of intangible drilling costs has been part of the federal tax code since 1913. Intangible drilling costs generally include cost items that have no salvage value, but are necessary for the drilling of an exploratory well, or the development of a well for production. Intangible drilling costs cover a wide range of activities and physical supplies, including ground clearing, draining, surveying, wages, repairs, supplies, drilling mud, chemicals and cement required to commence drilling, or to prepare for development of a well. The purpose of allowing current-year expensing of these costs is to attract capital to what has historically been a highly risky investment. Current expensing allows for a quicker return of invested funds through reduced tax payments.
- In recent years, the risk associated with finding oil has been reduced, but not eliminated, through the use of advanced technology, including three-dimensional seismic analysis and advanced horizontal drilling techniques.
- In the current law, the full expensing of intangible drilling costs is available to independent oil producers. Since 1986, major integrated oil companies have been able to expense 70% of their intangible drilling costs and capitalize the remaining 30 percent over a 60-month period. The FY2014 budget proposal would repeal both direct expensing and the accelerated capitalization provision, and replace them with generally applicable accounting procedures for cost recovery.
- Administration estimates are that the repeal of the expensing of intangible drilling costs provision will yield $10 billion in revenue over the decade to 2023.
- With the October 2013 price of oil around $100 per barrel, reflecting political unrest in the Middle East, as well as other factors, the additional tax expense is likely to have a smaller effect on reducing oil development activity.
Repeal Tertiary Injectants Deduction
- Tertiary injection expenses, including the injectant cost, can be fully deducted in the current tax year. Repeal of the deduction, or less favorable tax treatment of the expenses, would be likely to reduce oil output from older producing fields during periods when the profit margin, and the price of oil, is low. During a period of high oil prices, the repeal is likely to have a smaller effect on production levels.
Repeal Passive Loss Exception for Working Interests in Oil Properties
- Repeal of the passive loss exception for working interests in oil and natural gas properties is a relatively small item in terms of tax revenues, estimated at $74 million from FY2014 to FY2023. The provision exempts working interests, investments, in gas and oil exploration and development from being categorized as “passive income (or loss)” with respect to the Tax Reform Act of 1986. This categorization permits the deduction of losses accrued in oil and gas projects against other active income earned without limitation and is believed to act as an incentive to induce investors to finance oil and gas projects.
Repeal Percentage Depletion Allowance
- Percentage depletion is the practice of deducting from an oil company’s gross income a percentage value, in the current law, 15 percent which represents, for accounting and tax purposes, the total value of the oil deposit that was extracted in the tax year. Percentage depletion has a long history in the tax treatment of the oil industry, dating back to 1926. The purpose of the percentage depletion allowance is to provide an analog to normal business depreciation of assets for the oil industry, in effect equating the tax treatment of oil deposits to the tax treatment of capital equipment in more traditional manufacturing industries.
- In its current form, the allowance is limited to domestic U.S. production by independent producers, on the first 1,000 barrels per day, per well, of production, and is limited to 65 percent of the producer’s net income.
- Percentage depletion was eliminated for the major oil companies in 1975. Although major oil companies’ profits were likely affected by the tax change, their production of oil showed little variation as a result. Production of oil within the United States remains attractive for companies, because ownership of the oil is allowed in this country. In most areas of the world, ownership of oil is vested in the national oil company, as a proxy for the state itself. The result is generally a lower share of revenues for private oil companies producing outside the United States. The Administration projects that the repeal of the percentage depletion allowance would yield tax revenues of approximately $10.7 billion over the period FY2014 through FY2023.
Repeal Manufacturing Tax Deduction (§ 199)
- A provision in the proposed budget for FY2014 that affects both independent and the major companies’ oil and natural gas tax liability is the repeal of the domestic manufacturing tax deduction for those industries. The Administration estimates that the repeal of this deduction for the oil and natural gas industries would contribute $1.1 billion in revenue in 2014 and $8.8 billion for the period FY2014 to FY2018. The total increase in tax revenue is estimated to be $17.4 billion from FY2014 to FY2024, according to estimates reported in the budget proposal.
- Section 199(d)(9) of the Tax Code limits the rate available to the oil and natural gas industries to 6%. This tax deduction was intended to provide domestic firms with an incentive to increase domestic employment in manufacturing at a time when there was concern that manufacturing jobs were migrating overseas. If employment did increase, it would have little effect on national employment levels due to the capital-intensive nature of the industry. The Bureau of Labor Statistics reports that oil and natural gas extraction industries employed approximately 185,500 workers in December 2011, of which about 105,700 were classified as production workers.
- The period since 2004, while difficult for American manufacturing as a whole, has been generally one of high profits for the oil industry. The variability and level of expected oil and natural gas prices are likely to be a more important factor in determining capital investment budgets, and, hence, exploration and production development budgets, than the repeal of a tax benefit that is capped by a relatively low wage bill for the companies.
Increase Geological and Geophysical Amortization Period
- Geological and geophysical expenses are incurred during the process of oil and natural gas resource development. The most favorable tax treatment of these costs would be to allow them to be deducted in the year they are incurred. Requiring these costs to be amortized, or spread out for tax purposes, over several years is less favorable. The longer the amortization period, the less favorable the tax treatment, because a smaller amount is deducted each year, and more time is required to recover the entire cost. If the industry were experiencing a time of stagnant oil prices that were near the cost of production, relatively small changes in tax expenditures might affect investment and production activities. However, in a time of high and volatile oil prices, small changes in tax expenses are likely to be overshadowed by price changes derived from other factors.
Other Tax Policies
- The FY2014 budget proposal identifies a number of other proposed tax changes that would likely affect the oil industry. These changes include the repeal of the LIFO accounting method, increasing the Oil Spill Liability Trust Fund taxes, reinstating Superfund taxes and modifying the Dual Capacity Rule.
LIFO
- LIFO, as described by the API, is not a tax loophole, but a well-established accounting methodology to determine taxable earnings. Under LIFO accounting procedures, firms assume that the last unit of a good that the company acquires in its inventory is the first unit of the good that is sold. In periods of price inflation, or periods when the expected cost of acquiring inventories is rising, LIFO is beneficial in reducing taxes by allowing the cost deduction of the most recent (expensive) goods, independently of which goods were actually sold out of inventory.
- The general upward movement of oil prices since 2004 has been, with the significant exception of the period when the effects of the recession drove oil prices down (September 2008 to January 2009), a favorable period for the oil industry to be using LIFO. To the extent that demand conditions and political unrest in oil exporting regions might keep the price of oil rising, keeping LIFO in place could be a tax advantage for the oil industry.
Oil Spill Liability Trust Fund
- The FY2014 budget proposal includes a proposed increase in the Oil Spill Liability Trust Fund financing, by raising the tax on imported and domestic crude oil to 9 cents per barrel in 2014 and to 10 cents per barrel in 2017. The current tax is 8 cents per barrel, and, under current law, is set to rise to 9 cents per barrel in 2016. These proposed tax increases to finance the fund at a higher rate were possibly motivated as a response to the Deepwater Horizon oil spill in the Gulf of Mexico. These changes are expected to generate $64 million in 2014 and $1 billion over the period 2014 to 2023.
Superfund
- The Superfund finances cleanup of the nation’s high-risk contaminated sites for which the responsible parties cannot be found, or cannot pay. Superfund taxing authority expired at the end of 1995. The FY2014 budget proposal would reinstate an excise tax of 9.7 cents per barrel on domestic and imported petroleum products, including crude oil sourced from bituminous deposits and kerogen-rich rock. In addition to the oil excise tax, other dedicated taxes on chemicals and corporate income have been proposed. According to the budget proposal, reinstating the Superfund taxes would raise approximately $1.3 billion in 2014 and $20.2 billion from FY2014 to FY2023.
Dual Capacity Rule and Foreign Tax Credits
- The credit for foreign income taxes paid, upon which the Dual Capacity Rule is based, dates back to 1918. Since that time, corporations have been able to credit, directly from their U.S. income tax liabilities, income tax payments made to foreign governments. The period from the end of World War II to 1950 saw a new interpretation of this tax rule develop with respect to the oil industry. Before that time, oil-producing countries like Saudi Arabia charged the oil companies operating in their countries royalties, based on the resources extracted, as well as other taxes. For U.S. tax purposes, the royalties were treated as costs of doing business, hence, an expense, but not a direct credit against U.S. tax liabilities. In 1950, Saudi Arabia and the U.S. major oil companies operating there began negotiations to transform royalty payments into income taxes. This change had the effect of allowing the companies to pay more to Saudi Arabia, and increasing their after-tax earnings, at the expense of essentially transferring funds from the U.S. Treasury to the Saudi government.
- Proposed modification of the Dual Capacity Rule would restrict companies from claiming the full amount of foreign income taxes as a credit against U.S. taxes. Instead, the oil companies would be allowed to credit only amounts equal to the general corporate tax rate applicable to other industries. Any additional tax payments would be classified as tax-deductible operating expenses. The effect of the change in Dual Capacity Rules would be to reduce after-tax revenues for the companies, as well as returns from overseas investments. This could lead to U.S. firms choosing to invest in fewer marginal overseas projects.
- Modified rules for dual capacity taxpayers are estimated to generate $552 million in revenue in 2014 and $11 billion over the period 2014 through 2023.
