By Ken O’Neal, Grant Thornton

The hunt for revenue to cover budget deficits is on. And for the oil and gas companies, that could mean keeping a hand close to their wallets.

Congress and the administration face a laundry list of expensive legislative priorities and a deteriorating budget situation. The President’s budget scorekeepers, the Office of Management and Budget, recently released an updated estimate that shows a projected budget deficit of more than $9 trillion over the next 10 years.

To combat the growing debt load and pay for top priorities, the administration’s first budget blueprint proposes tax increases of over $1 trillion. Oil and gas, especially so-called “Big Oil,” could end up as one of the bigger losers in this tax sweepstakes.

The President’s budget proposal would raise an estimated $31.5 billion over 10 years from increased taxes on oil and gas companies.  The administration essentially pledges to repeal nearly every tax benefit currently enjoyed by the oil and gas industry, plus impose a new levy on offshore oil and gas production.

Keep in mind that the budget proposals are just that: proposals. Many of the budget’s tax revenue raisers are controversial and may never be considered. But the oil and gas industry has reason to worry.
Revenue raisers will almost certainly be enacted in the coming months and years, and oil and gas provisions could be high on the list. Lawmakers have already shown the stomach for taking back oil tax breaks: the financial rescue bill passed late in 2008 (the Emergency Economic Stabilization Act of 2008) included three tax increases for oil and gas companies.

First, the bill limited the section 199 domestic production activities deduction to just 6 percent for oil-related activities. For everyone else, the section 199 deduction will increase from 6 percent to 9 percent in 2010. The bill also tightened limitations on foreign tax credits for oil and gas extraction income, and extended the oil spill tax and increased it from 5 cents per barrel to 8 cents per barrel (going to 9 cents in 2017).

The New Proposals

Many of the administration’s new proposals are even more drastic. For instance, the budget would completely repeal the section 199 deduction for the sale or disposition of oil or natural gas and their primary products. This alone would raise more than $13 billion according to the Treasury Department, or approximately $11 billion according to Congress’s scorekeeper, the Joint Committee on Taxation.

Other provisions aimed directly at oil and gas companies include:

- Enhanced oil recovery credit repeal: This provision would repeal the 15 percent credit for eligible costs attributed to enhanced oil recovery projects.
- Marginal well tax credit repeal: The budget proposes to repeal the credit of $3 per barrel or 50 cents per 1,000 cubic feet of natural gas (adjusted for inflation) that currently exists for production of oil    and gas that qualifies as marginal production.
- Intangible drilling cost expensing repeal: The budget would require intangible drilling and development costs to be capitalized and recovered as depreciable or depletable property, instead of expensed.
- Tertiary injectant deduction repeal: This provision would require tertiary injectant costs to be capitalized and recovered as depletable property, instead of deducted in the current year.
- Passive loss exception repeal: The budget would repeal the exception to limits on passive loss deductions and credits that currently exists for working interests in oil and natural gas properties.
- Percentage depletion repeal: This provision would repeal the depletion deduction for oil and natural gas and allow taxpayers to claim only cost depletion on their adjusted basis, if any, in oil and gas wells.
- Geological and geophysical amortization increase: This provision would increase the amortization period for geological and geophysical expenditures from two to seven years for independent producers.
- Excise tax on offshore production: The budget proposes a new, undefined excise tax on oil and gas produced from the Outer Continental Shelf. No details are provided, but the administration attaches a $5.3 billion revenue target to the proposal.

The administration has not publicly released any details on these proposals, and it is not clear whether the expansion of cost depletion would require every independent producer to make a separate tax determination of recoverable oil and gas, allow the use of Department of Energy filings, or would even allow costs to be recovered over a term of years. The budget also contains several other tax increases that aren’t explicitly aimed at the oil and gas industry, but could nonetheless have a big impact on oil companies. The proposed repeal of the last-in, first-out (LIFO) method of accounting could be particularly significant.

Under the LIFO method, oil and gas companies can effectively claim that their current sales are coming out of their most current inventory, which was likely acquired at a much higher cost than older inventory that can stretch back decades. The repeal of LIFO just for the oil industry was estimated to raise $4.3 billion alone when it was proposed in 2005. Oil and gas companies could also be hit hard by a $17 billion proposal to reinstate Superfund taxes on oil and chemical products. And international oil companies could be affected by proposals to raise more than $150 billion by changing international tax rules.

What’s Next?

So far, none of these proposals have come up yet this year. The economic stimulus bill did not include any revenue offsets, as lawmakers worried it was not the right time for tax increases. Since then, thedebate over healthcare has consumed Congress for much of the year. Oil and gas provisions have not yet been proposed, and are not expected to be proposed, as revenue offsets for healthcare reform.
But money will be needed soon. There are popular tax provisions that will need to be extended as early as this fall, and there are many other expensive priorities to be considered later. As the budget situation worsens and the economy recovers, oil-related provisions could be among the revenue raisers considered in 2010 when Congress begins its search for the revenue offsets it will need in 2011 and 2012.

Ken O’Neal is a Tax Partner in the Denver office of Grant Thornton with more than 20 years of experience in preparation and review of federal and multi-state income tax returns. O’Neal has been extensively involved with partnership and corporation consulting and planning, and his areas of expertise include consulting on acquisition structuring, liquidations, mergers and acquisitions, financing, and initial public offerings. He can be reached at 303-813-4000.