The Tax Reform Act and Some Other Recent Developments in Oil and Gas Taxation
Authors: Bullion J.W. , Thompson Knight 
Published: December 2007

Introduction

This paper will discuss changes in oil and gas taxation brought about by the Tax Reform Act of 1969, whether there is an acceptable substitute for the ABC transaction, tax considerations affecting and tax features of drilling funds, and the tax consequences of drilling under farm out and partnership arrangements. partnership arrangements.

Percentage Depletion Percentage Depletion

When the Tax Reform Act is mentioned, the first of its aspects that comes to mind is the reduction in percentage depletion. The Act reduced the allowance from 27 1/2 percent of gross income to 22 percent of gross income, with the deduction both percent of gross income, with the deduction both before and after the Tax Reform Act being limited to the smaller of the gross allowance or 50 percent of the net income from the property for which depletion is being computed. The Tax Reform Act represents the first erosion of this deduction. It is not unlikely that there will be endeavors in the future to reduce further the percentage of gross income to which the deduction is applicable.

Minimum Tax

Into the field of federal taxation the Tax Reform Act introduced a new concept the minimum tax. The philosophy behind its enactment was that a taxpayer who avoids the payment of income tax through utilization of tax preference items should nevertheless pay some minimum tax. The tax is predicated on tax preference items. predicated on tax preference items. The Act specifies eight tax preference items. The first is the excess of investment interest over investment income. This excess is a tax preference item through 1972. Investment interest is the interest paid on passive estimates such as stocks, bonds paid on passive estimates such as stocks, bonds and real estate not used in a trade or business. The excess of the interest paid on borrowings with which to acquire these passive investments over the income from such investments is a tax preference item. preference item. In taxing long-term capital gain, the Internal Revenue Code allows a deduction of 50 percent of the gain. This 50-percent deduction is a tax preference item. Another item is the difference preference item. Another item is the difference between straight-line depreciation and accelerated depreciation that is allowed on real property, and another is the difference between straight-line depreciation and accelerated depreciation on personal property that is subject to a net lease. personal property that is subject to a net lease. The bargain element in stock options, that is, the difference between the option price and the fair market value of the stock subject to the option on be day that be option is exercised, is also a tax preference item. preference item. Two other tax preference items are the amortization of pollution facilities and railroad rolling stock to the extent that the amortization exceeds the depreciation that would otherwise be allowable, and the difference between the deduction banks obtain for additions to their reserves for bad debts under the permitted formula and the deduction they would be allowed if their additions to the reserves were based on loss experience.

The last tax preference item is percentage depletion. Once the deductions taken for percentage depletion exceed a taxpayer's cost in the property, percentage depletion on domestic production is a percentage depletion on domestic production is a tax preference item. Percentage depletion on foreign production may also be a tax preference item if the production may also be a tax preference item if the taxpayer meets certain foreign tax credit specifications.

A taxpayer must add together all of his tax preference items. In the case of a joint or corporate preference items. In the case of a joint or corporate return, a minimum tax at a 10-percent rate is imposed on the excess of the total of all tax preference items over the sum obtained by adding $30,000 to the regular income tax disclosed by the return. In the case of a separate return, the tax is imposed on the excess over the regular income tax disclosed by the return plus $15,000.

An endeavor was made to have intangible drilling and development costs specified as a tax preference item. This endeavor was unsuccessful, and intangible drilling and development costs are not tax preference items. It is not unlikely that this endeavor will be pressed again in case of an extension of the pressed again in case of an extension of the minimum tax to other items.