Oil and Natural Gas Industry Tax Preferences
November 23, 2016
Oil and Natural Gas Industry Tax Preferences
Corporate income tax policy was an issue in the 2016
again with limits to the applicable volumes. However, in
presidential campaign and is also expected to be taken up
the case of the marginal wells credit, unlike that of the
by the 115th Congress. Debate has centered both on the tax
enhanced recovery credit, a determination was made that
rate as well as the tax base. The issue with respect to the tax
market prices were not low enough during 2015 to activate
rate is whether the current top federal corporate rate of 35%
the credit.
is too high compared to that levied by other countries,
reducing the competitiveness of U.S. firms. However, some
While both the enhanced oil recovery credit and the credit
say that the average effective federal corporate income tax
for oil and gas production from marginal wells might
rate may be as low as19%-20% due to a variety of
provide some incentive to produce more oil when prices are
specialized tax deductions and credits, known as tax
low, that result might have the effect of reducing the
preferences. These tax preferences tend to reduce the tax
pressure for prices to rise, which would provide greater
base for the firms that meet the qualifications to use them,
benefits for more oil producers.
reducing their tax payments and yielding a lower effective
tax rate. Not all industries have access to the same set of tax
The expensing of intangible drilling costs has been part of
preferences, and, as a result, companies in different
the federal tax code since 1913. Current expensing from
industries, with the same net taxable income, might be
income in the year incurred is preferred by industry because
liable for different tax payments. The result is unequal
it allows costs to be recouped more quickly. Intangible
treatment under the tax law which can amount to a subsidy
drilling costs include the cost of items that have no salvage
for some firms in some industries.
value, but are necessary for the drilling of an exploratory
well, or to develop a well for production. Intangible drilling
The oil and natural gas industries have access to a variety of
expenses include a wide variety of activities and physical
favorable tax preferences which might reduce the industry’s
supplies, including ground clearing, draining, surveying,
overall tax burden. These tax preferences have been a target
wages, repairs, supplies, drilling mud, chemicals, and
for repeal by the Obama Administration since 2009, but
cement required to begin drilling, or to prepare a well for
Congress has not acted on Administration proposals. In
development.
many cases, the tax preferences proposed for repeal are
technical in nature, and have a long history in the oil
Under current law, full current year expensing of intangible
industry. In addition, some tax preferences are not equally
drilling costs is available only to independent oil producers.
available to all firms in the industry. For example, in the oil
Since 1986, the integrated oil companies have been able to
industry, percentage depletion allowances can be taken by
expense 70% of their intangible drilling cost and capitalize
independent oil companies but not by the major oil
the remaining 30% over a 60-month period. Eliminating
companies.
this provision could contribute to equalization of the tax
treatment of independent and major oil companies,
Tax Preferences
eliminating an incentive for smaller, independent oil firms
The enhanced oil recovery credit provides for a tax credit
to engage in oil and natural gas exploration.
of 15% of allowable costs associated with the use of oil
recovery technologies, including the injection of carbon
The tertiary injection deduction applies to well injections
dioxide to supplement natural well pressure, which can
above and beyond natural well pressure, or secondary
enhance production from older wells. The availability of the
injection of water, and allows the expense associated with
credit depends on official guidance establishing that oil
these activities to be fully deducted in the current tax year.
prices are “low” during the previous calendar year as
The deduction includes costs associated with acquiring or
defined in statute. While the credit was not available due to
producing the injectant, as well as the costs associated with
high oil prices from tax years 2006 through 2015, low oil
injecting, re-injecting, and recovering the injected
prices in 2015 allow the full 15% credit to be used by oil
materials. Carbon dioxide may be one of the materials
companies in tax year 2016.
injected into wells. Oil firms must choose between using
this deduction or the enhanced oil recovery credit to avoid
The credit for oil and natural gas from marginal wells
duplicate expensing of the same costs.
was implemented as the result of a recommendation by the
National Petroleum Council in 1994. The purpose was to
The passive loss exception for working interests in oil
keep low-production oil and natural gas wells in production
properties exempts investments in oil and natural gas
during periods of low prices for those fuels. For oil wells,
exploration and development from being categorized as a
the credit of $3 per barrel applies to the first three barrels
“passive income” (or loss) with respect to the Tax Reform
produced per day by a well, yielding a maximum tax credit
Act of 1986. The passive loss exception permits the
of $9 per well, per day. For natural gas, the credit is set at
deduction of losses accrued in oil and natural gas projects
$0.50 per thousand cubic feet of natural gas production,
against other active income earned without limitation. The
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Oil and Natural Gas Industry Tax Preferences
provision is designed to provide an incentive for oil and
The most favorable treatment of these costs from the point
natural gas financial investment.
of view of the oil industry would be to allow current
expensing. The longer the amortization period, the longer is
Percentage depletion is the practice of deducting from an
the period over which these costs might be recovered
oil company’s gross income a percentage of value, in the
through a tax deduction. Whether a zero, two, or seven year
current law 15%, which represents, for accounting and
period is chosen depends on the balancing of the incentive
income tax purposes, the total value of the oil deposit that
given to the oil industry to explore new oil fields, compared
was extracted in the tax year. Percentage depletion has a
to the benefits of granting favorable treatment to smaller oil
long history in the tax treatment of the oil industry, dating
firms.
back to 1926. The purpose of the percentage depletion
allowance is to provide an analog to normal business
Tax Rates, Tax Base, and Tax Revenues
depreciation of assets for the oil industry, in effect equating
The Office of Management and Budget (OMB), in the
the tax treatment of oil deposits to the tax treatment of
Analytical Perspectives publication, part of the Fiscal Year
capital equipment in more traditional manufacturing
2017 federal budget, estimated the revenue implications of
industries. The analogy is based on the idea that both
eliminating in 2016 the oil and natural gas industries tax
capital equipment and oil deposits are “wasting resources”
preferences as described in this In Focus. OMB projects the
in the sense that they both require capital investment to
increased revenues that might accrue in each year from
generate income, and they both will eventually become
2017 through 2021 as well as a long term estimate over the
non-productive.
period 2017 through 2026.
Percentage depletion was eliminated for the major oil
Over the period 2017-2021, eliminating these tax
companies in 1975. In its current form, the allowance is
preferences was estimated to yield about $19.2 billion. Over
limited to domestic U.S. production by independent
the period 2017-2026 almost $40 billion could be gained.
producers on the first 1,000 barrels per day, per well, of
The key tax preferences with respect to generating tax
production, and is limited to 65% of the oil producer’s net
revenue are the enhanced oil recovery credit, the expensing
income.
of intangible drilling expenses, percentage depletion, and
the domestic manufacturing deduction. Eliminating these
The domestic manufacturing tax deduction provision was
four preferences account for approximately 94% of the
enacted in 2004 as part of the American Jobs Creation Act
estimated revenues gained over the 2017-2021 time period.
(P.L. 108-357) to encourage the expansion of American
employment in manufacturing. The oil industry was
Tax revenue is the product of multiplying the tax rate times
categorized as a manufacturing industry, and hence, eligible
the tax base. This suggests that the growth in tax revenue
for the deduction, which was to be phased in over several
(either positive or negative) is the sum of the growth rates
years, beginning at 3% in 2005 and rising to a maximum of
of the tax rate and the tax base. If, for example, the tax base
9% in 2010. However, the rate available to the oil and
is broadened by a certain percent, a specific percent cut in
natural gas industries was capped at 6%. The tax base is
tax rates is possible with no expected change in revenues. A
corporate net income from domestic manufacturing
greater percentage cut in the tax rate is likely to reduce
activities, capped by a limitation depending on the size of
revenues and a smaller cut might increase revenues.
the company’s payroll.
However, interactive effects might change the simple
relationship. If changes in the tax rate change the incentives
Questions have arisen concerning whether it is appropriate
of the taxpayer, a change in tax rates might affect the tax
to classify the oil and natural gas industries in the
base, altering the simple relationship.
manufacturing sector if the objective of the deduction is to
increase domestic employment by lowering the company’s
Conclusion
tax liability. Lower labor costs are less likely to result in
While the eight oil and natural gas industry tax preferences
higher output and lower product prices in the domestic oil
may be considered for repeal in the current environment of
market because of the convergence of domestic and
tax reform, their repeal is likely to be opposed by the
international market prices for oil.
segments of the industry that benefit from them. However,
a reduction in the general tax rate is likely to be seen as a
The geological and geophysical amortization period for
benefit for the industry in general.
the major integrated oil companies is seven years.
Independent producers amortize these costs over a period of
two years. Equal treatment would have equal amortization
periods for all firms.
Robert Pirog, Specialist in Energy Economics
IF10512
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Oil and Natural Gas Industry Tax Preferences
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