Oil company tax breaks: fair or not fair?
Five days ago Kansas City Star editorial columnist Tom McClanahan posted an article on this site about oil tax subsidies that have been a point of contention in the national debate. http://voices.kansascity.com/entries/closer-look-those-oil-subsidies/
I posted a question about the oil depletion deduction because I didn’t understand how it worked. And maybe I still don’t, but below is a little more information about the issue.
In a nutshell, what I wanted to know is whether oil companies could end up deducting from income more money than they had invested in an oil well or oil field. I think the answer is yes.
If this is correct (and I am not an accountant, so I could be wrong), it sheds some light on complaints by Democrats about tax subsidies for “Big Oil.”
Most of us in business deal with depreciation of business assets. If I buy a rental house for $100,000, I can depreciate the house over a specified period of time, maybe 15 or 20 years. But I can’t claim depreciation beyond the amount of the total investment.
This appears not to be so for oil production. As the example below shows, an oil company could buy an oil field for $100,000 but take depletion allowances of 27.5% per year on income received, even if the income amounts to millions of dollars over the years of production.
Is this “fair”? Well, that’s a subjective matter. But if an oil company can deduct a sum greater than its overall capital investments, then the oil business is being treated differently than other ordinary businesses that cannot do so.
I invite others with technical or accounting knowledge to educate the rest of us about this issue.
Here are a couple of interesting links:
http://www.spartacus.schoolnet.co.uk/JFKoildepletion.htm
As Robert Bryce pointed out in his book, Cronies: Oil, the Bushes, and the Rise of Texas, America’s Superstate: “Numerous studies showed that the oilmen were getting a tax break that was unprecedented in American business. While other businessmen had to pay taxes on their income regardless of what they sold, the oilmen got special treatment.” Bryce gives an example in his book how the oil depreciation allowance works. “An oilman drills a well that costs $100,000. He finds a reservoir containing $10,000,000 worth of oil. The well produces $1 million worth of oil per year for ten years. In the very first year, thanks to the depletion allowance, the oilman could deduct 27.5 per cent, or $275,000, of that $1 million in income from his taxable income. Thus, in just one year, he’s deducted nearly three times his initial investment. But the depletion allowance continues to pay off. For each of the next nine years, he gets to continue taking the $275,000 depletion deduction. By the end of the tenth year, the oilman has deducted $2.75 million from his taxable income, even though his initial investment was only $100,000.” Such a system was clearly unfair and only benefited a small group of businessmen in Texas. It seemed only a matter of time before Congress removed this tax loophole. However, these oilmen used some of their great wealth to manipulate the politicians in Washington.
The article linked below further explains the accounting mechanism for oil depletion deductions and how it is different from normal cost depletion/depreciation: http://www.mineralweb.com/owners-guide/leased-and-producing/royalty-taxes/depletion-allowance/
Cost Depletion With cost depletion, a taxpayer recovers the actual capital investment throughout the period of income production. Each year, the taxpayer deducts a portion of the original capital investment, less previous deductions, that is equal to the fraction of the estimated remaining recoverable reserves that have been produced and sold that year. The cumulative amount recovered under this method can never exceed the taxpayer’s original capital investment.
Percentage Depletion Allowance Under percentage depletion, the deduction for the recovery of one’s capital investment is a fixed percentage of the gross income (sales revenue) from the sale of the oil or gas. For oil and gas royalty owners, percentage depletion is calculated using a rate of 15% of the gross income based on your average daily production of crude oil or natural gas, up to your depletable oil or natural gas quantity. An attractive element of percentage depletion is that the cumulative depletion deductions may be greater than the capital amount spent by the taxpayer to acquire the property.
Rick Adams
11 months, 2 weeks agoI would like to read Mr. McClanahan’s reply.
Kent Mueller
11 months, 2 weeks agoGeorge. You ask a reasonable question. I am not a CPA, however, I am quite sure the cumulative depletion allowance cannot exceed the cost basis. Even Wikipedia shows that.
http://en.wikipedia.org/wiki/Depletion_%28accounting%29
If there used to be depletion that could exceed cost, even your referenced quote refers to it as having been in the past, not the present.
Stephen Platt
11 months, 2 weeks agoIf you received an income stream of $1MM a year for the next 10 years you could sell that revenue stream for a NPV of around $5MM based on a 15%
Stephen Platt
11 months, 2 weeks agoIf you received an income stream of $1MM a year for the next 10 years you could sell that revenue stream for a NPV of around $5MM based on a 15% rate of return. You would then pay capital gains on this investment. If your investment was worth zero ten years from now you would get to deduct the capital loss of $5MM if you had bought it. This is the rationale for the depletion allowance, the revenue is not all income but also a depletion of your capital gain hence the deduction.
Kent Mueller
11 months, 2 weeks agoThanks, Steve. To clarify. Is it possible for an oil company to accumulate more depletion allowance than capital investment and operating costs? Or, is it capped at the capital investment like it is for depreciation?
George Harris
Kansas City
11 months, 2 weeks agoKent, I went to the Wikipedia article, which says that companies use the cost or percentage depletion method, whichever gets the larger result. The article says over 50% use the cost method, but that leaves a large percentage that use the percentage method, which can result in deductions greater than the total invested. At least that’s how I read this.