10 May 26, 1977 IRS IDCs AND FARMOUTS A CRITICAL ANALYSIS OVERV I E W i In an attempt to alleviate the problem of individuals with high incomes paying little or no taxes, the Congress inadvertently placed a major barrier along the path towards energy suf ficiency. With the enactment of certain provisions of the Tax Reform Act of 1976, Intangible Drilling Costs became a tax preference item. This change in the tax policies regarding IDCs has seriously reduced the amount of investment capital available for e x ploration and development in the oil industry. While there have been some moves attempting to alleviate the inequities created by the 1976 Act, they do not appear to present a complete solution.to the .problem. At present there remains a significant barri er to the availability of risk capital to independent drillers.

INTANGIBLE DRILLING COSTS Intangible Drilling Costs, or IDCs as they are known, are those items associated with the drilling of an oil well which have no salvage value.

They include such cost s as labor and the specialized "drilling mud used in the drilling process. They actually constitute an expense to the operator and are not so-called "artificial losses These expenses may be contrasted with such other tax preference items as percentage dep l etion which do not entail an actual cash outlay. As IDCs entail an actual expenditure of cash, the application of the minimum tax to them runs contrary to all of the principles on which the concept of the minimum tax was based. It is not uncommon for IDCs to represent as much as 60% to 70 of the total cost of drilling an oil well.

THE PURPOSE OF MINIMUM TAXES In considering the unique position of the independent driller with re gard to IDCs, one must first consider the purpose of applying a minimum tax. As early as 1969 the Congress began to take steps to insure that Americans with high incomes paid some income taxes. It was this effort which eventually led to the enactment of the 1976 Tax Reform Act. Central to the attempt to see all individuals bear some portion of the tax burden -2 was the limitation on artificial losses. These "artificial losses actually were a mixed bag of incentives, tax expenditures, and special treatments which had come into existence over the years. For the most part, these artific i al losses .represented attempts by the Congress to either correct'some inequity which existed in the tax code or to- create some sort of stimulus to a particular type of investment Among more commonly understood "artificial losses are such items as -accel erated depreciation on equipment and the percentage depletion.

Individuals with high incomes who wished to minimize their tax burdens frequently took advantage of VarioustypesQf artificial losses by form ing partnerships which then invested money in busine sses which enjoyed them. One result of such investments was that some individuals with ex tremely high incomes were able to escape paying any taxes at all. Be cause one of the more popular 'Itax shelters" was the percentage depletion from oil wells, much C ongressional attention was focused on oil drilling operations when this problem was considered. The end result of the de liberations by the House Ways and Means Committee was to attempt to place limitation on artificial losses. While it was the intent of t he Congress to keep incentives for legitimate investment, the Members wished to in sure that all individuals would pay some taxes Two of their actions in this regard directly impacted the independent oil driller: the phaseout of the percentage depletion a n d the imposition of the minimum tax on IDC s. In the case of IDC S, the result of their deliberations is clearly in conflict with their intent THE INDEPENDENT'S TAX BURDEN The independent oil driller generally pays a substantial amount in taxes without th e imposition of the minimum tax on IDCs. Part of this is the result of the phase-out of the depletion allowance. Currently, the per centage depletion is limited to 65% of taxable income. This limitation in essence imposes a minimum tax on these individuals ' incomes. While a recently passed amendment to tlie 1976 Act corrects some of tlie prob lemswith the minimum tax on IDCs, counterproductive.

The way that the tax on IDCs operates is that the amount of Intangible Drilling Costs in excess of what might have been deducted from gross income if they were amortized over 10 years and capitalized is added to the amount of IDCs in excess of the individual's net oil and gas income.

This sum is usually equal to the total amount of IDCs for a given well.

These IDCs are then added to the other .tax preference items. The in dividual may deduct either $10,000 or half of his income tax liability from the total amount of preference-items he has and then must pay a 15% tax on the balance. The way that this works out is th at the inde pendent driller usually winds up paying the 15%-tax on all of his IDCs.

Under previous tax law, the individual could deduct 100% of his income from his preference items deduction by half has removed much of the incentive for risk capital to mak e itself available for drilling operations the imposition of any tax seems Lowering the percentage of the allowable -3 Prior to enactment of the 1976 Tax Reform Act when 100% of the taxes paid by an individual were deducted from the minimum tax, there exi s ted a powerful incentive for outside investment. At a time when our nation is facing serious shortages of both oil and natural gas, it seems unrea sonable to eliminate incentives for ca9ital formation in the industry which is directly involved in the sear ch .for additional supplies of these commodities.

With the phase-out of the percentage depletion through 1984, one of the major cash-generating tools available to the independent driller will be eliminated Price controls on the sale of oil and natural gas have fur ther limited the independent's ability to generate a cash flow. Now we have the creation of a tax preference with regard to IDCS. The net re sult of these various measures :is to hamper all of the driller's tradi tional sources of operating capit a l. At a minimum, the tax on IDCs represents a surcharge on successful wells and creates a strong disin centive for the ope.ration of marginal units. It should also be noted that 14% of the oil and gas produced in the United States comes from marginal well s J FARMOUTS A common practice in the oil industry is for the owner of the oil right on a given property to "farm out" the drilli,ng of an oil well on that property. This practice of "farmouts" is particularly important to Louisiana where it is fairly comm o n for an individual to own the mineral rights to an extensive block of acreage. The manner in which this farm ing out of drilling operations is generally carried out is that an in dependent driller agrees to drill what is called an "obligati'on well This w ell is drilled on the owner's property with the: understanding that the independent operator assumes the risk of drilling a dry well. If the well is.successfu1, the independent drkller is assigned title to a previously agreed upon portion of the acreage s u rrounding the drilling site. This portion of. acreage is intended to represent the owner's por tion of the costs of the drilling operation driller holds 100% of the well until he recovers his costs; and there after, the owner of the property and the drill e r each will have eq.ual shares in the operation age is to act as an incentive to attract independents to drill on the property as it allows them to drill additional wells if the first is As a rule the i-dent The actual purpose of the assignment of acre su c cessful RECENT IRS ACTION Under a reccnt IRS ruling, the land'which the driller receives from the owner of the property is treated as current income means that the receipt of the property is the same as receipt of cash in an amount equal to the fair marke t value of the land in the eyes of the Internal Revenue Service. The IRS ruling also states that the transfer of the pro2erty from the owner to the driller would be considered as if Put plainly, this 4 it were greceeded by a cash sale of the property. This means that the owner of the property also may face a tax liability on the basis of whatever profit a cash sale of tlie property would have realized. In both cases, however, neither individual has actually received any cash.

This means that they mav be faced with a tremendous tax burden without the resources to pa? it divert capital from other more productive uses to pay their tax liability.

At a minimum, both individuals will have to What the Internal fiction. It has both sides would tlie owneri'.of the h ave sold propert taxable income individual had so to create such fi Revenue Service has actually done i essentially said that a transaction be treated as if they were sellers mineral rights, it is as.if that ind y for cash at which time he is consi In the case of the independent drill Id a service. While it is true that ctions, this ,particular instance str s to create a legal took place in which In the case of ividual.were to dered to have had er, it is as if the lawyers are not etches cre.dibili ty Not o n ly is there a strong disincentive to exploration and development inherent in the IRS ruling, but there is a strong disincentive to capi tal formation as well. It is obvious that as of the ruling, any operator who enters into a "farmout" agreement will hav e to set aside a significant portion of his resources to provide for the payment of the-taxes generated by the transfer of the property. At the same time owners of the property, who might have also been investors in drilling operations (in fact, they frequ e ntlyare would also suffer a severe strain on their cash flow. The net result of the ruling is to make less capital available for the purpose of finding and pumping more oil CONCLUSION At a time when our nation is facing a crisis of monumental proportions w ith regard to oil and gas, it is outrageous to follow policies which hamper the development of additional supplies of these resources. In dependent drillers are involved in a particularly risky area of endeavor and therefore have enough difficulty in obta i ning investment capital as is. To place additional barriers in the path of capital.formation con stitutes a gross inequity. Further, to the extent that we hamper domes tic development of oil.and natural gas, we become more dependent on un reliable foreign sources. While Prince Fahd had indicated that the Saudies do.not intend to use oil as a political weapon, the memory of the 1973 embargo is still fresh in the minds of most Americans. The only real s'afeguard against a repeat of the embargo lies in the de v elopment of our own oil and natural gas. This development cannot proceed, however without the investment capital to finance it. It would, therefore, ap pear counterproductive to tax IDCs or the transfer of acreage in farm outs, but only time will tell if our legislators will have the foresight to see this By Milton R. Copulos Policy Analyst