What are intangible drilling costs? Why does the oil industry get to deduct these costs from their taxes?

Answer:

When energy companies drill, they incur costs for things like site preparation and labor. No physical asset is received for these costs, and over time they have been termed as intangible costs. Typically, they represent 60 to 80 percent of the cost of the well – the remainder being the physical steel, pumps and casing that become part of the well. Companies have long had the option of deducting these costs in the year they are spent – similar to deductions enjoyed by other industries. For example, many industries are able to expense research labor and other costs under the research and development deduction, and computer software companies can deduct the costs of developing code.  In fact, the administration has been promoting a provision to allow for the immediate expensing of all capital costs that meet certain thresholds.

Like the case with all of these deductions, the policy is that taxpayers use the cash flow generated to invest back in the business. This is especially true for oil and natural gas companies that need to continue to drill to continue to grow. It should be noted, though, that this tax treatment is only a deduction and not a credit – which is a dollar-for-dollar reduction of one’s tax burden. These are tax deductions for business investments that will generate tax revenues in the future.  Unlike credits or grants, the government will still be paid the full amount of tax owed on these operations.

To illustrate, let’s take a look at one of the deductions the president proposes to change, that for Intangible Drilling Costs (IDC). Currently, large integrated oil companies can deduct 70 percent of their IDC costs over the first year and the rest over the next four years. Under the president’s plan, companies would have to spread the deduction over time – let’s say seven years. So, for a well costing $5 million, the deduction schedules look like this:

Under both plans the amount being deducted will be the same, which means the taxes ultimately being generated would be the same. But the industry uses the cash flow from the deduction to invest in equipment and jobs as they continue to drill and develop energy here in the United States.

Repealing the ability for companies to recover these costs would discourage the very things America needs: innovation, risk-taking, investment and new drilling activity – which helps the manufacturing sector as well as overall economic growth. We’re seeing that right now in states like North Dakota, Pennsylvania and Texas.