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The oil and gas industry currently has one of the highest effective tax rates in America, exceeding 38 percent, according to the American Petroleum Institute. But with the election of President Donald Trump and his new administration, including Secretary of State Rex Tillerson, formerly chief executive of Exxon Mobil, government oversight of the oil and gas industry is now poised to be at its most supportive since the early 1960s when Senator Robert S. Kerr (D-OK, founder of Kerr- McGee Corp.) was a powerful voice in the U.S. Senate Finance Committee.
Tax reform, as developed by the House Ways & Means Committee -Tax Reform Task Force Blueprint (the Blueprint), in conjunction with President Trump’s proposals, would offer significant benefits for the oil and gas industry, though there are also some potential concerns. Included in the Blueprint is a border adjustment tax, which presents the largest challenge to the industry among the various reforms. The industry’s reliance on imports for refining operations, as well as equipment and supplies used in drilling and operating wells, concerns many due to the inability to deduct the costs of imports under the border adjustment tax system. The introduction of the border adjustment tax shifts a substantial portion of the corporate tax burden from exporters to importers.
Overall, the Blueprint would present the greatest revision to the tax code since its introduction in 1913. The House’s plan replaces the traditional income tax approach with a variation of the value-added tax (VAT) system used throughout Europe and many other nations. It is referred to as a destination based cash flow tax (DBCFT) system. This moves corporate taxation to a cash-flow consumption tax through the immediate expensing of plant and equipment, elimination of deductibility of net interest expense, a territorial international tax system and a border adjustment tax.
With respect to international taxation, the Blueprint proposes the use of a destination-based territorial tax system, under which sales to customers located in the United States would be included in the tax base and sales to customers located outside the United States may be excluded from the tax base. The Blueprint also provides a 100 percent exemption for dividends received from foreign subsidiaries.
The proposed reduction of the top corporate income tax rate from 35 to 20 percent (President Trump’s proposed rate is 15 percent) would be greatly welcomed by the oil and gas industry. Combine an overall rate reduction with the elimination of the corporate alternative minimum tax (AMT) and immediately the industry is transformed to be one of the most globally competitive. If passed, this would incentivize the industry to locate and develop new production as well as continue to enhance U.S. energy independence.
If lower rates and the elimination of AMT were the only items included in tax reform, the industry would be very pleased, but there is more. As part of the Blueprint, expenditures for capital assets (except land) will be fully deducted–no longer capitalized and subject to depreciation or amortization or depletion. Whether it’s an acquisition of a building or equipment or expenditures for intangible drilling costs–all become immediately and fully deductible. This provision will benefit practically all phases of the industry from upstream to midstream and downstream. In 2016, the industry made capital expenditures of $136 billion (a decline of 36 percent from 2015). Now with more stable energy prices, the industry is anticipating an increase in capital expenditures of 35 to 40 percent in 2017.
Those are the positive aspects of the proposed tax reform (under both the House and the Trump administration’s proposals, with some modifications). On top of these corporate benefits, stockholders would only be taxed on 50 percent of the dividends from corporations as well as on capital gains, which greatly enhance investor’s returns on U.S. companies.
On a negative note, the elimination of a deduction for imported products would be difficult for the industry to adjust to, especially in the near future. This is especially true in the downstream sector that imports a large amount of petroleum products for refining purposes as well as other phases that have grown accustomed to importing tools and equipment used in exploration and production, as well as transportation of the products.
Based on this proposed change in tax structure, the value of the U.S. dollar is expected to increase significantly (possibly as much as 25 percent) which will partially offset this loss of a deduction for imports. Further, to the benefit of exporters, this revenue from exports will not be subject to taxation under the Blueprint. This major shift in tax structure will encourage the U.S. oil and gas industry to export more energy products and import less, resulting in a positive effect on U.S. manufacturers who are able to supply the industry with equipment.
A major benefit that American industry currently has is the low cost of energy compared to other exporting countries. American manufacturers pay close to 20 percent less for energy than European manufacturers, and our low energy costs help bring U.S. overall production costs to a level competing with production costs in China. The fear is that the proposed border adjustment tax will increase energy prices for U.S. consumers (individuals and businesses) at least in the short term. This may negate the U.S. advantage for its low cost of energy.
Another significant component of the House’s tax reform is the potential elimination of deduction for interest expense (to offset the immediate deduction of capital expenditures). This is especially concerning to the industry at this time when every U.S. company has more debt on its balance sheet than it would like to see. However, the net interest expense (interest expense in excess of interest income) is eligible to be carried over indefinitely and used to offset net interest income in future years. Net operating losses would also be eligible to be carried forward indefinitely (and allowed to offset only up to 90 percent of the current year’s taxable income).
The passage of the proposed tax reform will have a profound effect on America’s oil and gas industry. When viewed in the context of overall tax reform and the potential impact on America’s economy, it becomes clear that passage of this reform will greatly enhance our nation’s competitiveness in the global market. The short-term difficulties encountered with the transition to the new tax system will be offset by the long-term growth and strength achieved by American businesses, including the oil and gas industry.
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