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Tax Changes Coming for Royalty Owners?

by Will Brackett

Without a doubt, much attention is being paid to the big changes taking place in Washington, D.C. with the start of the presidency of Donald Trump. While most of the focus has been on Mr. Trump’s executive orders, changes could be coming from the Republican-controlled Congress as well.

One of the most significant proposals being considered by the Congressional GOP leadership is a major overhaul of the U.S. income tax code. The last major overhaul of the U.S. income tax code was three decades ago and President Trump has indicated his support for tax reform.

According to a report from the Texas Alliance of Energy Producers, an industry group, royalty owners and smaller oil and gas producers could be impacted as Congressional Republicans look to simplify the tax code by eliminating deductions and credits that are specific to certain industries and interests in exchange for lowering overall income tax rates.

The Texas Alliance reports among the deductions that may be on the chopping block is the percentage depletion allowance that is available to royalty owners and smaller producers.

The U.S. federal income tax was established by the 16th Amendment, which was passed in 1909 and ratified in 1913. The percentage depletion allowance was added to the tax code in 1926.

Depletion is essentially akin to accumulated depreciation for a mineral asset and “allows for a deduction from taxable income to reflect the declining production of reserves over time.” (Definition from Energy Tax Facts)

Only royalty owners and independent producers may claim the percentage depletion allowance on their income tax returns. Independent producers are smaller oil and gas companies, at least when compared to major oil companies such as Exxon Mobil, Chevron, and Shell. The percentage depletion deduction is limited to the first 1,000 barrels per day of crude oil production and/or 6,000 Mcf per day of natural gas production, so larger producers don’t qualify.

During his eight years in office, President Barack Obama proposed eliminating the percentage depletion allowance and other oil and gas tax deductions in his proposed budget every year. Oil and gas industry groups fought the proposals and Congress never went along, even when the Democrats controlled both the House and Senate in 2009 and 2010.

If Congress this year proposes to eliminate the percentage depletion deduction as a part of overhauling the tax code, you can be sure that once again there will be pushback from oil and gas interests.

Petroleum economist Karr Ingham, who works with the Texas Alliance of Energy Producers, recently wrote a column making the case for preserving the percentage depletion allowance. Ingham argues that eliminating the deduction would adversely impact marginal-producing, so-called “stripper wells” that Ingham estimates are responsible for 20% of U.S. crude oil production and 12% of U.S. natural gas production.

Without the percentage depletion allowance, Ingham contends many marginal/stripper wells would be uneconomical to continue to operate, to the detriment of royalty owners as well as state and local governments and local economies.

Furthermore, Ingham notes that the reduction in U.S. production from the loss of marginal/stripper wells would contradict President Trump’s goal of growing U.S. energy production and creating more jobs.

Therefore, while simplifying the tax code and reducing overall tax rates are likely to be popular, some oil and gas advocates are warning that eliminating the percentage depletion deduction could have detrimental consequences for U.S. oil and gas production.

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