Percentage Depletion and the Tax Reduction Act
of 1975
Stephen L. Crain
Independent Research (lhr.)
Prof. Richard Hemingway
146
PERCENTAGE DEPLETION AND THE TAX REDUCTION ACT OF 19 7 5
Prior to March 29, 197 5, the date the Tax Reduction Act
of 1975, (hereafter, the "Act") became law, percentage depletion
was used extensively by owners of economic interests in property
who were entitled to a depletion deduction.
The Act, with
limited exceptions, effectively ended the history of what was
one of the most lucrative of the special industry provisions
in the Internal Revenue Code by repealing percentage depletion
1
for all domestic and foreign oil and gas production.
Before the effective date of the Act, the Internal Revenue
Code provided two methods of computing the depletion allowance;
cost depletion and percentage depletion.
The concept of
depletion, as used in the Internal Revenue Code, involves the
principle that the removal of minerals from their natural
reservoir diminishes the quantity remaining until eventually
the recoverable supply is exhausted.
The Federal income tax
concept of depletion differs from the economic and physical
depletion concept in that the Federal income tax concept depends
not on units produced but upon the income derived from production.
Cost depletion provides for a deduction for the
taxpayer's basis in the mineral property in relation to the
production and sale of minerals therefrom whereas percentage
147
depletion is a statutory concept which provides for a deduction
of specified percentages of the gross income from the property.
For income tax purposes, before the Act, the taxpayer was required
to compute depletion under both the cost and percentage method
2
and then claim the larger of the two sums.
The passage of the Act was hastened by the Arab oil embargo
of 1973, which saw the average price of oil per barrel in the
United States rise from about $3.50 per barrel
in the spring
3
of 1973 to $6.50 by the end of that year.
As the price
of oil per barrel increased, so did the profits of twenty-
4
five large oil companies to the measure of sixty-two percent.
The Congressional committee studying the bill that would
create the Act concluded that the special preference of
percentage depletion afforded owners of economic interests
in oil and gas property would no longer be needed in view
of the substantial rise in prices and profits in the oil
and gas industry.
The Committee stated three basic reasons
for repeal of percentage depletion;
inflationary pressures,
rising unemployment and the windfall profits
of the major
5
oil companies during the 1974 tax year.
The Committee
further stated that the increases in prices per barrel were
many times more valuable to the oil companies than the
percentage depletion allowance and that the rise in per barrel
prices "should provide all of the incentive needed in the 6
period ahead to explore and develop our energy resources.
2
148
EXCEPTIONS TO THE REPEAL
While the passage of the Act eliminated percentage
depletion for oil and gas as a general rule, there are
major exceptions.
Congress did endeavor to avoid working
an undue hardship on smaller owners and operators whose
very ability to compete with the oil "giants" may depend
on the availability of tax incentives.
The existence of
the exceptions restores the availability of percentage
depletion to a limited degree to certain operators and to
certain transactions.
The first exception to the general rule regarding the
repeal of percentage depletion concerns regulated natural
7
gas.
Regulated natural gas is defined as domestic "regulated
gas" which is under the jurisdiction of the Federal Power
Commission and which is sold prior to July 1, 1976, but
only if the selling price has not been increased to reflect
to any extent the increased Federal income tax liability
resulting from the repeal of percentage depletion.
The
proposed regulations concerning the repeal of percentage
depletion impose two requirements to come within this
exception.
First, an order or certificate of the Federal
Power Commission must be in effect or a proceeding to obtain
149
such an order or certificate must be pending.
Second, the
sale price of the gas must be taken into account, directly
or indirectly, by the FPC in issuing the order or certi9
ficate.
According to the proposed regulations, an "emer-
gency" sale of natural gas to an interstate pipeline
may be made without a prior order approving such
sale
10
if the sale is made under existing authority.
The second exception to the general rule that repeals
percentage depletion involves natural gas sold under a
fixed contract.
The term "natural gas sold under a fixed
contract" means domestic natural gas sold by the producer 11
under a contract which was in effect on February 1, 1975.
The contract price must not have been adjusted to reflect
to any extent the increase in tax by virtue of the repeal
of percentage depletion.
This exception may include gas
sold under a fixed contract even though production sold under
the contract had previously been treated as regulated
natural gas.
Any price increases in the contract price
for the gas that occur after February 1, 1975, will be
presumed by the Internal Revenue Service to include increases in tax liabilities due to the repeal of percentage
depletion unless the taxpayer demonstrates to the contrary
by clear and convincing evidence.
However, if the contract
provides adjustment for increases in price to the highest
price paid to a producer for natural gas in the area,
4
150
or if the price may be renegotiated, then gas sold under
the contract after such an increase becomes permissible
is not gas sold under a fixed contract.
The third exception, geothermal deposits, is defined
as a geothermal reservoir consisting of heat, largely
stored in rocks, and to a lesser extent in acqueous fluid
12
in the form of liquid or vapor.
This exception is probably
influenced by recent court decisions that held that
geothermal steam produced from a vapor dominated or
13
hydrothermal system constituted gas for income tax purposes.
Percentage depletion will continue at the rate of 22 percent
on production for geothermal deposits, provided such production is ultimately
held by the courts to be produced
14
from a gas well.
INDEPENDENT PRODUCER AND ROYALTY OWNER EXEMPTION
In addition to the above exceptions, there is an exemption
provided for independent producers and royalty owners on a
limited amount of domestic oil and gas.
Perhaps the most
lucid approach to this exception should begin with an examination of what taxpayers or properties are not embraced by the
term "independent producers and royalty owners."
The first group to be denied the use of the independent
producer and royalty owner exemption are retailers.
151
Section 613A
denies the availability of the independent producer and royalty
owner's exemption to
... any taxpayer who directly, or through a related
person, sells oil or natural gas, or any product
derived from oil or natural g a s —
(A) through any retail outlet operated by the
taxpayer or a related person, or
(B) to any person—
(i) obligated under an agreement or contract
with the taxpayer or a related person to use
a trademark, trade name, or service mark or
name owned by such taxpayer or a related person,
in marketing or distributing oil or natural
gas or any product derived from oil or natural
gas, or
(ii) given authority, pursuant to an agreement or contract with the taxpayer or related
person, to occupy any retail outlet owned,
leased, or in any way controlled by the taxpayer
or a related person.15
The term "related person" is defined by the section as a person
who owns a significant ownership interest in the taxpayer, or
vice versa, or in whom a significant ownership interest is held
by a third party who holds a similar interest in the taxpayer.
A significant ownership interest is five percent in value of
the outstanding stock of a corporation, five
percent
or more interest in the profits or capital of a partnership, or
five percent or more of the beneficial interests in on estate
16
or trust.
However, the retailer exclusion does not apply
to taxpayers whose combined gross receipts from sales of petroleum products and derivatives do not exceed five million dollars.
Additionally, sales outside the United States are not included
152
in gross receipts unless the taxpayer or a related person
exports domestic production during the taxable year or the im17
mediately preceding one.
The second group to be denied the independent producer and
royalty owner exemption are refiners.
The purpose of Section
613A was to repeal percentage depletion for large operations
while retaining percentage depletion for smaller, nonintegral
producers.
Therefore, the independent producer's and royalty
owner's exemption is not available when, on any one day, the
taxpayer and a related person together refine more than 50,000
barrels of crude oil.
The same result would be obtained even
if the taxpayer had no refining capability and the related party
18
alone refined more than 50,000 barrels.
A related person
is defined in the same way as for the retail product exclusion.
The Section, by specifically mentioning crude oil, does not
include the processing of natural gas, and therefore rightly
fails to consider gas, fertilizer and similar plants as refineries.
TERMS EMPLOYED IN THE INDEPENDENT PRODUCER AND ROYALTY OWNER
EXEMPTION
The independent producer and royalty owner exemption,
being defined above by exclusion, can now be examined.
This
exemption includes so much of the average daily production
of the taxpayer's domestic crude as does not exceed the taxpayer's depletable oil quantity and so much of the taxpayer's
153
averaqe daily production of domestic natural gas as does not
20
exceed the taxpayer's depletable natural gas quantity.
The average daily production for the individual taxpayer is
determined by dividing the taxpayer's annual aggregate production
of crude or natural gas by the number of days in the taxpayer's
taxable year without considering gas subject to the "regulated
natural gas" and "fixed contract" natural gas exemptions.
In addition, gas subject to the "transfer rules" (discussed
below) is not considered.
If the taxpayer owns only a
partial interest in the production from a particular property,
the taxpayer's average daily production is determined by multiplying his percentage interest in the
21 property by the property's aggregate annual production.
The taxpayer, in
determining aggregate annual production, shall not take into
account any production of crude or natural gas resulting from
secondary or tertiary recovery.
The crude or natural gas that
results from secondary or tertiary production serves to reduce
the available per day exemption by the taxpayer's average daily
tertiary or secondary production for the taxable year.
The taxpayer's depletable oil quantity is equal to the tentative quantity determined under the Section 613A table.
For
the year 19 80, and thereafter, the taxpayer's depletable oil
quantity is 1000 barrels reduced, but not below zero, by the
taxpayer's average22 daily secondary or tertiary production for
the taxable year.
Today, an independent producer would be
8
iK
entitled to percentage depletion on 1000 barrels of crude oil
per day or, at the election of the taxpayer, 6,000,000 cubic
feet of natural gas per day, or any combination of the two
within applicable limits.
Therefore, a taxpayer's depletable
oil quantity would be reduced for any calendar year by the
number of barrels he chooses to treat as depletable natural
gas quantity.
In determining the percentage depletion depletion allowance, the applicable percentage for 19 81 is twenty percent.
Therefore, in order for a taxpayer to compute his percentage
depletion allowance under the recent enactments, the following
steps are necessary.
First, the taxpayer would segregate
production from "regulated gas" and "fixed contract gas."
As to both the regulated gas and the fixed contract gas,
the percentage depletion would be at the rate of twenty-two
percent.
Second, production must be segregated from secondary
or tertiary processes and then depletion is computed at the
rate applicable to secondary and tertiary production.
After
making these basic calculations and determining whether secondary and tertiary production exceeds the average daily exemption,
percentage depletion is calculated.
At this point, a deter-
mination is made as to whether cost depletion or percentage
depletion is greater for each property subject to the
following limitations.
The depletion allowance for independent producers
155
and royalty owners is subject to a limitation based
24
on taxable income of sixty-five percent.
The sixty-
five percent limitation on the taxpayer's taxable income
will be reduced in that the taxpayer's taxable income will
be recomputed without regard to any depletion for the
independent producer's and royalty owner's exemption, to
any net operating loss carryback, to any capital loss carryback and in the case of a trust, without regard to any
25
distributions to the trust beneficiaries.
Note that the
sixty-five percent limitation for percentage depletion
only applies to the exemption under Section 613 A(c),
independent producers and royalty owners.
The applicable
limitation to all other areas
of percentage depletion
26
remains at fifty percent.
AGGREGATION RULES APPLICABLE TO INDEPENDENT PRODUCER AND
ROYALTY OWNER EXEMPTION
To prevent circumvention of the limits imposed by the
independent producer's and royalty owner's exemption,
provisions were inserted into the Code restricting the number
of exemptions available to related parties, partnerships
and fiscal year taxpayers.
There are basically three rules
pertaining to related parties.
First is the rule requiring that "persons who are
members of the same controlled group of corporations shall
10
156
27
be treated as one taxpayer."
The term "controlled
group of corporations" is defined as having the same
meaning as in Section 1563(a) except that the excluded
members provisions of Section 1563(b)(2) shall not
apply and "at least 80 percent" shall be read as "more
28
than 50 percent."
Four groups are defined in Section
1563(a) as controlled groups.
The first group, the
parent subsidiary group, is characterized by two
stock ownership requirements.
There must be one or more
chains of corporations connected through stock owner ship with a common parent where stock possessing more
than 50 percent of the total voting power of all voting
stock or more than 50 percent of all classes by value
is owned by one or more of the other corporations.
The
second requirement for the first group is that the
parent own more than 50 percent of the voting power
or value of the stock of at least one of the other
29
corporations.
The second group, the brother-sister
group, is a group of two or more corporations where
five or fewer persons own stock having more than
50 percent of the voting power of all voting stock
or more than 50 percent of the total value of all
outstanding shares and where the same persons own more
than 50 percent of the voting power or value of the
stock, taking into account only that ownership of
11
157
shall be comprised of. only the spouse and minor children.
RULES REGARDING TRANSFERRED PROPERTY AND PARTNERSHIPS
The remainder of this paper will explore two additional statutory facets of the amended depletion sections
of the Code that pertain to transferred property and
partnerships under the independent producer and royalty
owner exemption.
Congress probably anticipated the potential
for maximizing the independent producer and royalty
owner exemption by the device of transferring the
production from a property of one taxpayer with an
excess of production to another with an excess of
depletable oil quantity.
Therefore, transfers of
interests in "proven" oil and gas property after
December 31, 1974, generally will not avail the use
of the independent producer and royalty owner exemption
to the transferee for the production of oil or gas from
such interest, and such production will not be taken
into account for any computation by the transferee
relating to its independent producer and royalty owner
34
exemption.
The definition of a proven oil and gas
property is a porperty which, at the time of transfer
has had its principal value demonstrated by prospecting,
exploration or discovery work.
Whether a property has
been prospected, explored or discovered depends,on whether
at the time of transferring, any oil or gas has been
produced from a deposit, prospecting, exploration or
discovery work which indicate that it is probable that the
property will have gross income from oil or gas from
such deposit sufficient to justify development of
the property, and the fair market value of the property
is fifty percent or more of the fair market value
of the property minus actual expenses of the transferee
for equipment and intangible drilling and development
costs, at the time of the first production from the
property subsequent to the transfer and before the
35
transferee himself transfers his interest.
The transfer rule does not apply in two cases.
First, the transfer rule does not apply to transfers
36
at death.
Second, before January 1, 1981, the transfer
rule did not apply in the case of transfers to controlled
corporations to which Section 351 of the Code applies
if following the exchange, the independent producer
and royalty owner exemption is allocated between the
37
transferor and the transferee.
The transfer rule
before January 1, 1981, did apply to Section 351
transactions, if following the exchange, the independent
producer and royalty owner exemption is not allocated
between the transferor and the transferee.
14
159
The tax law
before January 1, 1981, contained no provision whereby
an individual and his or her controlled corporation must
allocate one depletable quantity in order to come
within this exemption to the transfer rule.
As of
January 1, 1981, a provision which allows an elective
exception so that individuals would be allowed to transfer
oil or gas properties to a controlled corporation
without the loss of percentage depletion if several
38
conditions are satisfied.
Only oil or gas proper-
ties could be transferred to the corporation and all
of the corporation's outstanding stock would have to
be issued directly to the individual transferors of
the oil or gas properties solely in exchange for these
properties.
The corporation and the shareholders
would be required to allocate one 1,000 barrel amount
39
eligible for depletion subsequent to the transfer.
In the absence of satisfying these new rules or of
an election under this new provision, the rules of
law applicable before January 1, 1981, would continue
to apply.
Thus production from a proven oil or gas
property which has been transferred by an individual
in an exchange to which Section 351 applies would not
be eligible for percentage depletion.
A transfer, as contemplated by the transfer rule
is defined by the proposed regulations as any change
10
160
in the legal or equitable ownership by sale, exchange,
gift, lease, sublease, assignment, contract, a change
in the membership of a partnership or the beneficiaries
of a trust, or other disposition, or any other change by
which a taxpayer's proportionate share of the income
40
subject to depletion of an oil or gas property is increased.
Definitional problems concerning the independent
producer and royalty owner exemption have arisen in the
area of partnerships.
The depletion allowance, in the
case of partnerships, with respect to production from
domestic oil and gas must be computed separately
by
41
the partners and not by the partnership.
Thus a partner
is required to compute his percentage depletion, taking
into account all of his production from all sources,
so that such partner will not obtain percentage depletion
on more barrels or cubic feet than allowed by the independent producer and royalty owner exemption.
The
partner's proportionate share of the partnership domestic
oil or gas property is determined in accordance with
the partner's interest in the partnership capital.
If the partnership agreement specifies partner's
shares as percentages of partnership income, then such
percentage shall be the partner's proportionate share
unless either written provision has been made for the
10
161
share of any partner or partnership income to be reduced
for any purpose other than merely to reflect the admission of a new partner of if a partner expects his
partnership income to be reduced pursuant to an under42
standing with another partner.
allocation is determined.
Thus, the initial
After this initial allocation
is determined, appropriate adjustments should be made
to the partner's adjusted basis for any partnership
capital expenditures relating to
43 such properties that
are made after such allocation.
Therefore, each
partner must separately keep records of his share of
the adjusted basis in each oil and gas property of the
partnership and adjust such share of the adjusted basis.
CONCLUSION
The above has been a brief discussion of percentage,
depletion after 1975.
Final regulations reaarding
percentage depletion as of yet have not been published
but are due in the near future.
In conclusion, and in
review, percentage depletion for domestic oil and gas
wells is allowed only in four areas:
regulated natural
gas, natural gas sold under a fixed contract, any
geothermal deposit in the United States that is determined
to be a gas well and for independent producers and royalty
10
162
owners.
In addition, the Internal Revenue Service
has announced that no percentage depletion is permitted
a recipient of a lease bonus in connection with oil
and gas.
Advanced royalties received by persons qualified
as small producers are eligible for percentage depletion
only if justified by actual production in the same
year.
Thus, in the absence of actual production, small
producers who are recipients of advanced royalties are
44
limited to claiming cost depletion on such payments.
The repeal of percentage depletion applies only to oil and
gas property.
Other mineral property is still eligible
for percentage depletion.
Therefore, lease bonuses
and advance royalties received in respect to other
mineral leases are still eligible for percentage depletion.
18
3.63
FOOTNOTES
1.
I.R.C., Section 613A(a).
2.
I.R.C., Section 613.
3.
H.R. Rept. No. 93-1502, 93d Cong., 2d Sess. (1974) at 4.
4.
Id.
5.
H.R. Rept. No. 93-1502, 93d Cong., 2e Sess. (1974) at 3.
6.
Id. at 5.
7.
I.R.C., Section 613A(b)(2)(B).
8.
Proposed U.S. Treas. Reg. Section 1.613A-7(c).
9.
Id.
10.
18 C.F.R. Section, 2.68, 2.70, 1.5722 and 1.5729.
11.
Proposed U.S. Treas. Reg. Section 1.613A-7(d).
12.
Proposed U.S. Treas. Reg. Section 1.613A-7(e).
13.
See Reich v. Commr., 454 F. 2d 1157 (1972).
14.
Burke and Bowhay, 1978 Income Taxation of Natural Resources
§ 8.17, p.818 (1978).
15.
I.R.C., Section 613(d)(2).
16.
I.R.C., Section 613A(d)(3).
17.
I.R.C., Section 613A(d)(2).
18.
I.R.C., Section 613A(d)(4).
19.
Burke and Bowhay, Income Taxation of Natural Resources
§ 8. 27, p.843 (1978).
20.
I .R.c., Section 613A(c)(1).
21.
I .R.c., Section 613A(c)(2).
22.
I .R.C., Section 613A(c)(2).
23.
I .R.c., Section 613A(c)(5).
164
Section 613A(d).
24.
I.R.C.f
25.
I.R.C.f Section 613A(d)(1).
26.
I.R.C., Section 613 (a) .
27.
I.R.C.r Section 613A (c) (8) (A) .
28.
I.R.C.f Section 613A (c) (8) (D) (i) .
29.
I.R.C.r Section 1563 (a) (1) (A) , (B)
30.
I.R.C.f Section 1563 (a) (2) (A) , (B)
-
31.
I.R.C.f
32.
I.R.C.r Section 1563 (a) (4) .
33.
I.R.C.r Section 613A(c)(C).
34.
I.R.C.r Section 613A(c) (9) .
35.
Proposed U.S. Treas. Reg. Section 1.613A- 7 (p)
36.
Proposed U.S. Treas. Reg. Section 1.613A-3(h) (2)
37.
Proposed U.S. Treas. Reg. Section 1.613A-3(h) (2)
38.
See 12 6 Cong. Record No. 177, 96th Cong 2d Sess.
39.
Id.
40.
Proposed U.S. Treas. Reg. Section 1.613A-7 (n)
41.
Proposed U.S. Reg. Section 1.613A- 3(e) .
42.
Id.
43.
Id.
44.
I.R.S. Announcement 76-34, I.R.B. 1976-12 ,28.
•
Section 1563 (a) (3) (A) , (B)
•
•
•