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EXCERPT FROM: "Oil and Gas: The Unfinished Tax Reform*"
by Mason Gaffney
Besides drawing too much capital into the industry, tax favors also induce serious distortions within the industry. ...
The most consistent, total, unrelieved bias is in favor of investing upstream, "before the Christmas Tree" (Controls at the wellhead). Lease improvements on the surface, after the Tree -- stock tanks, pipes, roads, clearing, drainage, housing, etc. -- receive no special favors. It is rather drilling, pumping, exploring, and especially acquiring and holding leases that get the biggest breaks. These are the most purely acquisitive and appropriative activities in the business, the ones that wrest raw resources from Nature and from rival men, the ones most like rape and the least like husbandry. This set of biases in the law speaks volumes about the social psychology of people who shape and are shaped by them.
Some defend favors to explorers by citing spillover benefits to neighbors lands. Perhaps there is such a case, although, if so, it applies as well to city buildings that upgrade their neighborhoods, to stores that raise neighborhood rents, and to city workers in labor pools that enhance industrial values. But what, then, about the free-riding neighbors? Should they not be singled out to pay the subsidy? Here is where the tax law fails utterly. Free riders with unearned increments get the best breaks of all, through combined expensing of abandonment’s and capital gains for winners. The industry responds by directing most of its new investment into hoarding up millions of acres of leaseholds, held idle, just hitch-hiking.
Another bias is in favor of bonus bidding for leaseholds. Reformers in this field have pushed for years for other leasing policies on public lands, with provisions to defer payments by lessees, thus opening the door to bids from weaker firms with less cash reserves. Weak firms have proven too passive in supporting these reforms. A reason for this is the very favorable tax treatment of bonuses, which are largely expensable by abandonment of losers. But royalties and other deferred payments do much less well. So the whole industry is locked into the bonus system for its tax benefits. A distinguished critic of high bonuses, Adam Smith, found them to be hurtful to lessor, lessee, and everyone else. He advised us to discourage their use by taxing them much heavier than annual payments. Our tax laws do the opposite, to our expense.
Tax law discourages use of certain lease provisions specifically designed to penalize free riding. One is the delay rental, a yearly charge that ends when production begins, an obvious incentive tool. A simple annual rental of modest amount is. expensable, as noted earlier. But the privilege is precarious and may be lost in two ways. A large rental is liable to be construed as a delayed bonus, hence to be capitalized. A returnable rental which is creditable against later royalties -- a double incentive to action -- is considered an "advance royalty" and may not be expensed.
But the loss to the lessee is no gain to the lessor. To him, the receipts are ordinary current income. Bonuses and royalties, to be sure, are also ordinary: but they get offset by cost depletion, which rentals do not.
If the lessor is non-taxable anyway that makes no difference. But industry customs, often binding, grew up long ago when most lessors were private. Lessor and lessee both suffered by using delay rentals. So to this day industry custom treats delay rentals like poor cousins.
Another device of lessors is the work commitment: a lease is auctioned or negotiated subject to the lessee's commitment to spend a given sum on exploration or development, or to perform specified acts. Tax calamity! All the expensable items become lease acquisition costs: expensing denied.
Tax law is also hostile to field unitization. Surplus wells shut in upon unitization are not allowed to be abandoned and deducted. Avocados are treated better! One source says that all intangible outlays must then be capitalized, but I have not confirmed this. It is certain, though, that unitization slows cost depletion. The whole pay zone, and perhaps more, are now treated as a unit.
Cost depletion creates the principle that "cheaply bought is ill used."
Tax avoiders naturally allocate production to leaseholds of higher cost basis. Those of lower basis can be held for sale. Negotiating a sale may take years, in the narrow markets that characterize many fields. A lease may be held by producing a token flow. Others are often extended by complaisant officials. One abandoned lease off Santa Barbara was returned to Pauley Oil, even after several years. when oil was found next door.
But most big finds are cheaply bought under our bonus bidding system of shooting in the dark. Most of the true cost basis is written off by abandoning losers. The funds remaining tied up in the winners are away below their value. Not until the market has churned a few times are many leases ready to milk for the greatest tax advantage. Meantime, the lease speculator sits on his assets with minimal holding costs.
The sum of these tax-induced biases is extremely distorting, and patently inequitable. It is as though the laws were written by and for the free-riders at the expense of all. Thoroughgoing reform is in order. In a nation of hitch-hikers, no one rides.
http://www.earthrights.net/docs/upstreambias.html