Tax credits and incentives for oil & gas producers in a low-price environment
Credits & Incentives talk with Deloitte
“Credits & Incentives talk with Deloitte,” is a monthly column by Kevin Potter of Deloitte Tax LLP, featured in the Journal of Multistate Taxation and Incentives, a Thomson Reuters publication. The May 2017 edition co-authored with Dan Shirley, Irene Manos, and Kelsey Muraoka focuses on some of the federal and state tax benefits potentially available to oil and gas producers in the current low-price environment.
Given the generally low-price environment, oil and gas producers have focused renewed attention on cost reduction, management of their global tax burden and improving cash flow. Utilization of available federal and state tax incentives, exemptions, and exclusions to reduce federal and state tax burdens is one way companies in the oil and gas industry can seek to accomplish these goals. To this end, the US and state governments continue to provide tax incentives for eligible oil and gas companies to encourage domestic oil and gas exploration and recovery during periods of low commodity prices. These incentives may prove to be particularly valuable in the current low-price environment.
Federal tax credits
For federal income tax purposes, there are several provisions in the Internal Revenue Code (IRC) which seek to incentivize oil and gas production, specifically the marginal well tax credit and the enhanced oil recovery credit.
Federal marginal well tax credit: In 2004, Congress enacted a marginal well production tax credit amendment to the Internal Revenue Code that established a tax credit for existing marginal wells. The intent behind the tax credit was to serve as a safety net for marginal wells during periods of low pricing. The tax credit is particularly beneficial to small well producers, who typically produce limited barrels a day. The marginal well credit is only available if commodity prices are below a certain threshold. Since its enactment, the marginal well tax credit has not been available, as prices have remained above the commodity threshold. As noted below, however, this tax credit may become available for qualified natural gas production relative to the 2016 tax year.
The marginal well tax credit provides a $3-per-barrel credit for the production of crude oil and $0.50-per-1,000-cubic-feet (MCF) credit for the production of qualified natural gas.1 The credit is available for domestic production from a "qualified marginal well."2 A qualified marginal well generally refers to a domestic oil well that produces not more than 15 barrel of oil equivalents per day, wells that produce heavy oil, or wells with average production of not more than 25 barrel of oil equivalents a day of oil and produces not less than 95 percent water.3
Thus, qualified marginal gas wells generally include those producing not more than 90 MCF a day (one barrel of oil is equivalent to six MCF).4 The maximum amount of production on which a credit may be claimed is 1,095 barrels or barrel-of-oil equivalent per year, per well.5 There is no limitation on the number of wells on which a taxpayer can claim the credit. There is also a limitation for wells not capable of production during each day of a taxable year.6
To claim a marginal well credit, a taxpayer must own an operating interest in the well.7 To the extent the well has more than one owner, the credit amount is allocated in proportion to the owner's revenue interests in comparison to the interests of all the operating interest owners.8
A key component of the marginal well credit is that it has a special carryback provision where unused credits may be carried back for five years.9 The credit also may be carried forward for 20 years.10
For marginal oil production, the credit becomes unavailable if the reference price of oil exceeds $18.00, with the threshold adjusted for inflation.11 The term "reference price" is defined in IRC Sec. 45K(d)(2)(C) as "the Secretary's estimate of the annual average wellhead price per barrel for all domestic crude oil the price of which is not subject to regulation." The 2015 reference price for oil was $44.39, thereby exceeding the $18.00 threshold, adjusted for inflation. As such a marginal well tax credit for marginal oil production cannot be claimed for the 2016 tax year.12
It appears that the federal marginal well tax credit for natural gas may be available for the first time for the 2016 tax year. For natural gas production, the credit becomes unavailable if the reference price of natural gas exceeds $2.00 (per 1,000 cubic feet).13 Since the inception of the tax credit in 2004, the IRS has never published a reference price for natural gas, nor has it published the inflation adjustment factor to be used in computing the marginal well tax credit. Due to the low price of natural gas in 2015, however, it is anticipated that the tax credit may be available to natural gas producers for the first time relative to the 2016 tax year.14 During a recent American Bar Association Section of Taxation Meeting held in Orlando, Florida, on January 20, 2017, representatives from the Treasury and IRS acknowledged that the tax credit may potentially be available in 2016 and that a reference price is expected to be published in early 2017.15
Federal enhanced oil recovery credit: Similar to the federal marginal well tax credit, the federal enhanced oil recovery credit is dependent upon commodity pricing, although the applicable thresholds for the two tax credits differ. A taxpayer is eligible for the federal enhanced oil recovery credit if the reference price of domestic crude oil does not exceed $28.00, adjusted for inflation.16 The enhanced oil recovery credit will be available for the 2016 tax year given the price of oil. The applicable reference price, $44.39, does not exceed $46.10, the product of $28.00 multiplied by the inflation adjustment factor (1.6464) for 2016. As confirmed by the IRS in Notice 2016-44 issued on July 18, 2016, the enhanced oil recovery credit will be available to taxpayers for the 2016 tax year, which is the first time the credit has been available in nearly 10 years.17
The enhanced oil recovery credit is available for qualified enhanced oil recovery projects. These projects are identified by the utilization of a tertiary recovery technique which increases the amount of crude oil extracted from an oil field.18 These qualified tertiary methods include recovery methods by steam, gas flood, chemical flood, and mobility control.19 However, utilization of one of these methods alone does not qualify a project for the credit; the credit requires more than an insignificant increase in the amount of crude oil that is ultimately recovered.20
Additional requirements of qualified enhanced oil recovery project include that the project must be domestically located, the initial implementation must have commenced after December 31, 1990, and the project must be certified pursuant to Regulation Section 1.43-3.21
Taxpayers who meet these requirements are entitled to a credit equal to 15 percent of the qualified enhanced oil recovery costs incurred in a tax year. Qualified costs include the following designated expenses:
- Amounts paid for depreciable tangible property,
- Intangible drilling and development expenses,
- Tertiary injectant expenses, and
- Construction costs for certain Alaskan natural gas treatment facilities.22
To the extent a credit is allowed for qualified enhanced oil recovery costs, taxpayers must reduce otherwise allowable deductions that are associated with these costs.23 Additionally, taxpayers must reduce the basis of property by the amount of the credit where the basis would otherwise be increased by the qualified enhanced oil recovery costs.24 The credit may be carried back one year or forward 20 years25 and in the event that the carryforward period has expired, any unused credit is fully deductible.26
State tax incentives
In addition to federal tax benefits, various states offer tax incentives, exemptions, and exclusions for the oil and gas industry to maintain and encourage production and incentivize certain recovery activities, particularly in a low oil and gas price environment. This article seeks to highlight some of these tax incentives, focusing on some of the states with significant oil and gas exploration and recovery activity.
Download the PDF to read the full article and to learn more about state tax incentives.
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1 I.R.C. § 45I(b)(1). Please note tax credit amounts are then adjusted for inflation as specified by the statutory language and legislative history.
3 I.R.C. § 45I(c)(3)(A).
4 I.R.C. § 613A(c)(6)(E).
5 I.R.C. § 45I(c)(2)(A).
6 I.R.C. § 45I(c)(2)(B).
7 I.R.C. § 45I(d)(2).
8 I.R.C. § 45I(d)(1).
9 I.R.C. § 39(a)(3).
11 I.R.C. § 45I(b)(2)(A).
12 IRS Notice 2016-43, I.R.B. 2016-29.
13 I.R.C. § 45I(b)(2)(A).
14 See Ari Natter, New Tax Credits Expected for Oil, Gas Producers, Bloomberg BNA Daily Tax Report (May 6, 2016).
15 Id. See also Marie Sapirie, More Clarification Provided on 'Begin Construction' Requirement, 154 Tax Notes 568 (Jan. 30, 2017).
16 I.R.C. § 43(b)(1).
17 See IRS Notice 2016-44, I.R.B. 2016-29.
18 I.R.C. § 43(c)(2)(A)(i).
19 Treas. Reg. § 1.43-2(e)(2).
20 Treas. Reg. § 1.43-2(b).
21 Treas. Reg. § 1.43-2(a).
22 I.R.C. § 43(c)(1).
23 I.R.C. § 43(d)(1).
24 I.R.C. § 43(d)(2).
25 Treas. Reg. § 1.43-1(a)(1).
26 I.R.C. § 196.