On February 26, 2014, House Ways and Means Committee Chairman Dave Camp released a discussion draft of the “Tax Reform Act of 2014.” The draft bill proposes a host of significant revisions to the Internal Revenue Code, including amendments to certain oil and gas provisions of the Internal Revenue Code that may be applicable to your business.
Some of these proposals have appeared in the most recent Treasury Department general explanation of the Obama Administration’s tax proposals for the 2014 fiscal year budget on April 10, 2013. Some notable similarities and differences between the Camp proposal and the most recent Treasury proposal are discussed herein.
This tax update is intended only to provide a general summary of certain tax provisions. If you would like to discuss how any of these or other tax provisions may impact your operations, please contact any Baker Botts tax lawyer, including the authors of this update listed in the margin.
1. No Repeal of Expensing of Intangible Drilling Costs
Generally, a taxpayer who pays or incurs intangible drilling costs (“IDCs”) in the development of an oil or gas property located in the United States may elect under current law either to expense or to capitalize and amortize those costs, if the taxpayer holds a working or other operating interest in such property. In the case of an integrated oil company that has elected to expense IDCs, 30% of the IDCs on productive wells must be capitalized and amortized over a 60-month period. Further, a taxpayer may elect to capitalize and amortize certain IDCs over a 60-month period beginning with the month the expenditure was paid or incurred.
Recent Treasury Administration proposals, including the most recent proposal, included a repeal of the election to expense IDCs. The Camp proposal would leave the existing law regarding IDCs intact.
2. No Change to Amortization Period for Geological and Geophysical Costs
Geological and geophysical expenditures are costs incurred for the purpose of obtaining and accumulating data that will serve as the basis for the acquisition and retention of mineral properties. Under current law, the amortization period for geological and geophysical expenditures incurred in connection with oil and gas exploration in the United States is two years for independent producers and seven years for integrated oil and gas producers.
The most recent Treasury proposal provided an increase to the amortization period from two years to seven years for geological and geophysical expenditures incurred by independent producers in connection with all oil and gas exploration in the United States. The Camp proposal would leave existing law regarding geological and geophysical costs intact.
3. Repeal Percentage Depletion
The capital costs of oil and gas wells are recovered through the depletion deduction. Under the cost depletion method, the basis recovery for a taxable year is computed on the unit of production method proportional to the exhaustion of the property during the year. Under current law, certain taxpayers qualify for percentage depletion with respect to, among others, domestic oil and gas properties. The amount of the percentage depletion deduction is a specified percentage (generally 15% for oil and gas properties) of the gross income from the property, subject to several limitations, including that the percentage depletion deduction for a year may not exceed 100 percent of the taxable income from the property.
A qualifying taxpayer determines the depletion deduction for each oil and gas property under both the percentage depletion method and the cost depletion method and deducts the larger of the two amounts. Because percentage depletion is computed without regard to the taxpayer’s tax basis in the depletable property, a taxpayer may continue to claim percentage depletion after all the expenditures incurred to acquire and develop the property have been recovered and the property’s adjusted basis has been reduced to zero.
The Camp proposal would repeal the percentage depletion deduction for taxable years beginning after December 31, 2014. Thereafter, all taxpayers would only be permitted to report a deduction for cost depletion to recover their adjusted basis, if any, in oil and gas wells. This proposal is consistent with the most recent Treasury proposal.
The Joint Committee on Taxation (“JCT”) estimates the repeal would increase revenues by $5.3 billion over 2014-2023.
4. Repeal Domestic Manufacturing Deduction, Including for Oil and Gas Production
Under current law, a deduction is allowed with respect to income attributable to domestic production activities. The deduction is equal to 9 percent of the lesser of qualified production activities income for the year or total taxable income for the year, limited to 50 percent of the wages incurred by the taxpayer for the year. The deduction is computed at a 6 percent rate for income attributable to the production, refining, processing, transportation, or distribution of oil, gas, or any primary product thereof.
Qualified production activities income includes a taxpayer’s gross receipts derived from the disposition of oil, natural gas or primary products thereof extracted or produced by the taxpayer within the U.S. minus the cost of goods sold and other expenses, losses, or deductions attributable to such receipts.
Under the Camp proposal, the domestic production activity deduction is phased out to 6 percent for taxable years beginning in 2015 and 3 percent for taxable years beginning in 2016, and the deduction is repealed for taxable years beginning after December 31, 2016. For individuals, the Camp proposal replaces the concept with a special 25% capped tax rate on income earned from these activities directly or through flow through entities (other than publicly traded partnerships). As the Camp proposal relates to oil and gas, it is consistent with the most recent Treasury proposal, which intended to repeal this deduction for oil and gas production and certain other nonmanufacturing activities.
The JCT estimates the phaseout and repeal would increase revenues by $115.8 billion over 2014-2023.
5. Repeal Passive Loss Exception for Working Interests in Oil and Gas Properties
The passive loss rules generally limit the deductions and credits of individuals, trusts and certain closely held C corporations arising from passive activities. Deductions attributable to passive activities, to the extent they exceed income from passive activities, generally may not be deducted against other income. Deductions and credits that are suspended under these rules are carried forward and treated as deductions and credits from passive activities in subsequent years; the suspended losses from a passive activity are allowed in full when a taxpayer disposes of his entire interest in the passive activity to an unrelated person. A “passive activity” is generally defined as any trade or business activity in which the taxpayer does not materially participate.
Current law contains an exception, however, for certain oil and gas working interests. Under this exception, a working interest in an oil or gas property that the taxpayer holds directly or through an entity that does not limit the liability of the taxpayer with respect to the interest is not considered a “passive activity,” even though the taxpayer does not materially participate.
The Camp proposal repeals the oil and gas working interest exception for taxable years beginning after December 31, 2014. As a result, deductions and credits attributable to oil and gas working interests held by an individual, trust or closely held C corporation would become subject to the passive loss limitations described above, unless the taxpayer materially participates in the oil and gas activity. This proposal is consistent with the most recent Treasury proposal.
The JCT estimates this repeal would increase revenues by $0.1 billion over 2014-2023.
6. Repeal of Credits for Enhanced Oil Recovery Projects and Production from Marginal Wells
The Camp proposal includes a repeal of (i) the 15% investment tax credit for domestic enhanced oil recovery projects as of the date of enactment of the bill and (ii) the production tax credit for oil and gas produced from marginal wells for taxable years beginning after December 31, 2014. These proposals are consistent with the most recent Treasury proposal.
The JCT estimates these repeals would have no revenue effect over 2014-2023.
7. Repeal of Recurring Item Exception for Spudding of Oil or Gas Wells
Under current law, an accrual-method taxpayer generally may deduct an expense only when all events have occurred that fix the fact of the liability, the amount of the liability is determinable with reasonable accuracy, and economic performance has occurred. An exception applies to certain expenses that are recurring in nature. To qualify, the expense must be paid no later than eight and a half months after the close of the taxable year to which it relates. The exception is not available for a “tax shelter”, unless the tax shelter involves drilling oil or gas wells and the drilling commences within 90 days of the close of the tax year to which the expenses relate.
The Camp proposal repeals this 90-day exception for oil and gas arrangements that meet the tax shelter definition for taxable years beginning after December 31, 2014.
The JCT estimates this repeal would increase revenues by $0.2 billion over 2014-2013.
8. Repeal of Like-Kind Exchanges
Under current law, a taxpayer may defer gain or loss on an exchange of (i) property held for productive use in the taxpayer’s trade or business, or property held for investment purposes, for (ii) property of a like-kind that is also held for productive use in a trade or business or for investment. For example, under current law, certain oil and gas working interests could be exchanged for other oil and gas working interests (e.g., in an acreage swap) without gain recognition. The taxpayer receives a basis in the new property equal to the taxpayer’s adjusted basis in the exchanged property.
Under the Camp proposal, the deferral of gain on like-kind exchanges would be repealed effective for transfers after 2014, except for exchanges pursuant to a written binding contract entered into on or before December 31, 2014 that is completed before January 1, 2017.
The JCT estimates the repeal would increase revenues by $40.9 billion over 2014-2023.
9. No Repeal of Deduction for Tertiary Injectants
Under current law, taxpayers are allowed to deduct the cost of qualified tertiary injectant expenses for the taxable year. Qualified tertiary injectant expenses are amounts incurred for any tertiary injectant (other than recoverable hydrocarbon injectants) that is used to augment the recoverable amount of hydrocarbons in their reservoir as a part of a tertiary recovery method (as such term is defined by regulation).
The most recent Treasury proposal included a repeal of the deduction for qualified tertiary injectant expenses. The Camp proposal would leave the existing law regarding such expenses intact.
The text of the bill can be found here.
IRS Circular 230 Disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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