On February 1, 2010, President Obama’s administration released its 2011 revenue proposals, some of which would eliminate fossil fuel tax preferences (the “Proposals”). If enacted by Congress, the Proposals would become effective for taxable years beginning after, or costs paid or incurred after, December 31, 2010. This legislative update highlights these Proposals.

Oil and Gas Company Provisions 
Enhanced Oil Recovery Credit
This credit is for 15 percent of eligible costs attributable to a qualified enhanced oil recovery (EOR) project (subject to phaseout provisions, which were applicable in 2009). An eligible cost is (1) the cost of depreciable or amortizable tangible property integrally related to an EOR project, (2) deductible intangible drilling and development costs (IDCs), (3) deductible tertiary injectant costs, and (4) any cost incurred in the construction of a gas treatment plant to prepare Alaska natural gas for pipeline transportation. The Proposals would eliminate this credit.

Credit for Oil and Gas Produced from Marginal Wells
This credit is for crude oil and natural gas produced from marginal wells (subject to phaseout provisions which were applicable in 2009). The credit rate is $3.00 per barrel of oil and $0.50 per 1,000 cubic feet of natural gas for taxable years beginning in 2005, and it is adjusted each year for inflation. The Proposals would eliminate this credit.

Expensing of Intangible Drilling Costs
Special rules currently applicable to IDCs (i.e., expenditures that are incident to and necessary for the preparation and drilling of wells, excluding expenses for items with a salvage value) allow a working interest owner who incurs IDCs in the development of a domestic oil or gas property to elect to expense the costs. The Proposals would eliminate this election and require IDCs to be capitalized as depreciable or depletable property, which would generally defer deductions.

Deduction for Tertiary Injectants
Taxpayers may currently deduct qualified tertiary injectant expenses. The deduction is treated as an amortization deduction in determining the appropriate recapture amount upon disposition of the related property. The Proposals would eliminate this deduction and require capitalization.

Exception to Passive Loss Rules for Working Interests in Oil and Gas Properties
Passive loss rules limit deductions and credits available to individuals and certain types of corporations from a business activity in which the taxpayer does not materially participate. A current exception to these rules allows a taxpayer holding a non-operated working interest in an oil or gas property, either directly or through an entity that does not limit the taxpayer’s liability, to avoid these limitations. The Proposals would eliminate this exception.

Percentage Depletion for Oil and Gas Wells
The capital costs associated with oil and gas properties are recoverable by the owner through the depletion deduction via one of two methods: (1) the cost depletion method, under which the recovery is proportional to the annual exhaustion of the recoverable reserves, or (2) the percentage depletion method, under which the recovery is a statutory percentage of gross production income from the property. A qualifying taxpayer may deduct the larger of the two amounts, which is often percentage depletion, for each oil and gas property owned. The Proposals would eliminate percentage depletion, requiring taxpayers to use cost depletion to recover depletable basis of any new properties and the remaining depletable basis of existing properties (including those properties that were previously depleted under the percentage depletion method).

Domestic Manufacturing Deduction for Oil and Gas Production
A manufacturing deduction is allowed with respect to income attributable to “domestic production activities,” which are currently defined to include gross receipts related to oil, natural gas, or primary products thereof produced in the United States. In the case of oil and gas production activities, the deduction is generally equal to 6 percent of the lesser of qualified production activities income or taxable income, and it is limited to 50 percent of the taxpayer’s W-2 wages. The Proposals would exclude gross receipts attributable to oil, natural gas, or primary products thereof from the definition of domestic production activities, thereby eliminating the deduction with respect to such income.

Geological and Geophysical Amortization for Independent Producers
The amortization period for geological and geophysical expenditures incurred in connection with domestic oil and gas exploration is two years for independent producers and seven years for integrated producers.  The Proposals would set the amortization period at seven years for all producers.

Coal and Other Hard Mineral Fossil Fuel Provisions 
Expensing of Exploration and Development Costs
A taxpayer may currently choose to expense costs related to exploration for ore and mineral deposits. These costs are typically recaptured when the associated mine reaches the production stage. The Proposals would eliminate this expensing option and require capitalization of these costs for coal and other hard mineral fossil fuels.

Percentage Depletion for Hard Mineral Fossil Fuels
The capital costs associated with coal mines and other hard mineral fossil fuel properties are currently recoverable by the owner through the depletion deduction via one of two methods: (1) the cost depletion method, or (2) the percentage depletion method. A qualifying taxpayer may deduct the larger of the two amounts for each property owned. The Proposals would eliminate percentage depletion, requiring taxpayers to use cost depletion to recover depletable basis of any new properties and the remaining depletable basis of existing properties (including those properties that were previously depleted under the percentage depletion method).

Capital Gains Treatment of Certain Royalties
Royalties received on the disposition of coal or lignite generally qualify for treatment as long-term capital gain, although the royalty owner does not qualify for percentage depletion with respect to the coal or lignite. The Proposals would repeal this capital gain treatment and, thus, subject the royalties to higher tax rates as ordinary income subject to cost depletion.

Domestic Manufacturing Deduction for Hard Mineral Fossil Fuels
A manufacturing deduction is allowed with respect to income attributable to “domestic production activities,” which are currently defined to include gross receipts related to coal, other hard mineral fossil fuels, or primary products thereof produced in the United States. The deduction is generally equal to 9 percent of the lesser of qualified production activities income or taxable income, and it is limited to 50 percent of the taxpayer’s W-2 wages. The Proposals would exclude gross receipts attributable to coal, other hard mineral fossil fuels, or their primary products from the definition of domestic production activities, thereby eliminating the deduction with respect to such income.

For more information regarding the contents of this legislative update, please contact any of the following V&E tax professionals:

Visit our website to learn more about V&E's Federal Income Tax practice, or e-mail one of the V&E Federal Income Tax practice contacts.

Circular 230 Notice
To ensure compliance with requirements imposed by the IRS under Circular 230, note that any federal tax advice contained in this communication 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.