Kicking the Taxes out of Big Oil

Phil Jackson, the now former coach of the professional NBA Lakers, said with his retirement, we would not have him to kick around anymore. Not to worry, Phil. We always have “Big Oil” to kick around. We can beat them up, berate them, and blame them. Big Oil. It sounds oozing. According to critics, Big Oil has been on the receiving end of federal largess from the days of old man Rockefeller. Tax breaks galore. Tax preferences. Favoritism. Ripping off the consumer without any remorse. Did I mention pollution and climate change?

The Administration and many Congressional Democrats are after Big Oil again. The ultimate boogeyman. Of course, it is all politics but it is interesting to know what they are seeking to do. What are the horrendous tax breaks? How are they special? A complete proposal is not ready to examine in detail but it appears Democrats have identified five large companies: BP, Exxon Mobil, Shell, Chevron and Conoco Phillips as their targets. Their proposals would end a series of tax advantages and increase government coffers about $4 billion a year to be used as the Congress deems fit. Let’s see $4 billion out of a $1.65 trillion anticipated deficit for this year. Bold thinking!

Details are sparse about the legislation to take on Big Oil expected to be released today by Sens. Robert Menendez (D-N.J.), Sherrod Brown (D-Ohio) and Claire McCaskill (D-Mo) However, the first of these tax increases would come from eliminating a domestic manufacturing tax deduction for the Big Oil companies. The American Jobs Creation Act of 2004 established a deduction for domestic production activities to spur job creation. The definition of “production” is very broad to include areas not traditionally referred to as manufacturing, including extraction, soft ware development, music recording, construction and renovation, engineering and architectural services. (The list seems silly, doesn’t it”)? Without going more into the history and workings of this provision, in my opinion, it was a mistake to enact. It is an ineffective way to accomplish its goal and should be repealed not just for oil and gas but totally as part of an expected overhaul of the corporate tax system. Unfortunately, like bad company, once a provision like this gets into the tax code, it never leaves.

Moving further on, the Democrats would like to end deductions for taxes paid to foreign governments. U.S. businesses are currently allowed to write off the cost of taxes paid on overseas earnings as a foreign tax credit. (FTC) Under the Democrat proposal domestic energy companies would be denied its use. By eliminating the foreign tax credit for U.S.-based oil and gas companies, the federal government would be taxing them twice on income for which they also pay foreign levies. Foreign governments collect money from oil companies through royalties -- fees for depleting their national resources and income taxes. There is no doubt some games have been played on what is a foreign tax and what is a royalty. A royalty can be deducted as a cost of doing business, and would reduce a tax bill maybe 25-30 percent. Categorized as an income tax, payments are 100 percent deductible.

Foreign governments understand the U.S. tax code. To reduce costs for producers and attract business, foreign governments have agreed to call some royalties income taxes, allowing oil companies to take the 100 percent deduction. This practice has been sanctioned as far back as the 1950’s by the State Department and has been used by U.S.-based oil companies to reclassify the royalties charged by foreign governments as taxes.

Elimination of the foreign tax credit for only oil companies is a silly idea. In the absence of abuse, it is purely punitive. If there is a problem with the FTC, then revising or eliminating it should apply to all U.S. companies-like large Pharma and technology. This discussion should also be included in a complete revamping of the way the US taxes worldwide income. After all if the FTC is so heinous, why let it exist for some big U.S. international companies and not for others.

Expected to be also included in any bill are provisions that would deny companies the ability to deduct some intangible drilling and development cost (IDCs). When companies drill, costs such as site preparation, labor, engineering and design can be deducted rather than capitalized. These “intangible” costs associated with drilling a well are usually the bulk of the cost of the well. This concept applies to extraction industries largely because there is no salvage value from drilling a hole in the ground. Completion and production facilities for the most part are capitalized. Independent producers can elect to deduct 100 percent of their IDCs while larger, non-independent companies can deduct 70 percent of the costs in year one and amortize the remainder.

The IDC’s are the lifeblood of the industry. However, being able to expense these costs is only a cost deferral since all the costs would eventually be recovered in any event through amortization so there is no real tax deduction here. Writing off the cost frees up capital for reinvestment. It is akin to accelerated depreciation in other industries. My advice, do not worry about the IDCs. They actually serve a purpose.

The last great tax break concerns only a small amount of oil and gas production in what remains of the percentage depletion allowance. This may or may not be what House Speaker John Boehner (R-Ohio) misspoke about last month by saying he didn't believe "the big oil companies need to have the oil depletion allowances."

Once a well is in production, a company is allowed to recover costs and shelter some income from the sale of the hydrocarbon through a depletion deduction. There are two types of depletion available, cost and statutory. Cost depletion is calculated based a nexus between current production as a percentage of total recoverable reserves. The availability of statutory or percentage depletion is quite limited and does not apply to integrated oil companies. (In essence, The Speaker was mistaken, as I do not think he meant oil companies should not be able to recover their actual costs)

The tax break occurs when total depletion charges set by statuary rate exceed all the capitalized costs of a producing property. The currently percentage depletion rate is 15% for independent companies subject to other limitations but has been as high as 27 percent for all companies. President Lyndon Johnson defended and protected the old percentage depletion allowance like it was his child. It was scaled back for major oil companies in 1969 and then eliminated. Therefore, only small independent producers can now use percentage depletion, and their use is limited. Interestingly enough the concept of depletion goes all the way back to the Tariff Act of 1913. Since the proposal floated by the Democrats effects only 5 companies who do not qualify for percentage depletion, this tax break is not in play.

The taxation of oil and gas production, particularity for big multi-national companies is complicated. It is a technical area-but a big political target. The current debate is all about the politics and like most things going on in Congress is a weak attempt to avoid the bigger issues.

These targeted oil companies are huge. It is almost impossible to economically hurt them. For the most part, their tax benefits are no more egregious or better than any other industry. Raising their taxes will not change the way this country consumes energy. Punishing them and their millions of shareholders to make a political point will not put them out of business. But as President Nixon said “ It would be wrong.’” Let’s focus on what is really important and forget the sideshow.

Comments

You can follow this conversation by subscribing to the comment feed for this post.

Very informative and thoughtful piece, although I'm not going to shed an crocodile tears for Big Oil, and think they should be paying their fair share. The author's point on the FTC is good. It should be looked at for all industries

Posted by: taxpayer | 05/10/2011 at 03:09 PM