Originally published in the May/June 2022 issues of The Tax Executive Magazine.
Let’s face it—multiple challenges confront the industry
The US energy industry has faced many challenges in its history, from boom-and-bust oil prices to pressures from overseas oil producers to domestic government regulations. Today the industry continues to confront its share of challenges, including pressures to transition from fossil fuels to alternative renewable energy sources such as wind, solar, and hydrogen power. On top of these pressures is a call for companies to prioritize environmental, social, and governance (ESG) issues.
As the energy industry faces these obstacles, Washington has funneled unprecedented amounts of money to taxpayers in favored industries. Over the past two years, many taxpayers received funding from Washington through the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the Paycheck Protection Program, the Consolidated Appropriations Act, and the American Rescue Plan Act of 2021. With all this money coming out of Washington benefiting so many industries, the question remains, Are there any tax incentives left for the energy industry?
This article explains the types of companies that bring energy to us every day and then examines what tax incentives might be available for them.
Energy Industry Overview
Upstream Exploration and Production (E&P): Seismic
The upstream energy subsector includes seismic companies that develop techniques and processes to identify oil and gas deposits onshore and offshore. These techniques help us to acquire geological information about the earth’s subsurface. They often involve developing equipment to send sound waves through the earth and the ocean and interpreting the information sent back from the vibrations. The technology might involve developing seismic equipment, developing techniques used to deploy the equipment, acquiring seismic information, and reading or interpreting seismic data.
Other E&P Activities
E&P companies also acquire property that they explore for the presence of oil, gas, and other hydrocarbons. Exploration includes drilling and completing oil and gas wells onshore and offshore. These wells might be drilled vertically or horizontally. Completion involves hydraulically fracturing the well bore so as to fracture the shale rock formation around it, thus releasing and increasing the flow of the oil and gas.
Midstream
Midstream companies transport oil and gas from wells to refineries or processing plants and then from the plants either to a storage terminal or directly to retail gas stations. Typically, pipelines are used to transport oil and gas, but so are railroads and trucks. Some limited processing might occur near the wellhead or initial gathering pipelines, which involves separating oil from gas before sending the hydrocarbons to the major transportation pipeline.
Downstream
Downstream companies include refineries and chemical processing plants. These facilities receive oil and gas and then further process the hydrocarbons into products such as gasoline, jet fuel, asphalt, and plastics (polypropylene). These activities typically involve chemically processing crude oil by heating it and introducing other materials—like catalysts—to start the chemical reaction required for generating the products. Research and development (R&D) are often required to develop new chemical products and formulas, as are improvements in the manufacturing process for these products.
Oilfield Services
Oilfield service companies typically drill and complete oil and gas wells. These companies might design and manufacture drill bits and drilling equipment. They also can provide drilling and completion services. Some oilfield service companies provide meals, lodging, transportation, and other services for oilfield work crews.
Electric Utilities
The electric utility subsector can be separated into electricity generation, transmission and distribution, and retail. Electricity generation operators produce and collect electricity through power-producing plants that typically use coal, natural gas, and other sources of energy to heat water to create steam, which powers a turbine that then sends electrons through the electrical power lines. Renewable sources, such as wind power and hydropower, also convert energy to electricity that is then directed to the power grid. Transmission operators typically own and maintain these power line distribution systems throughout the country. These companies sell access to their networks—the power grid—to retail service providers. Retail providers connect retail customers to electric power.
Mining
Companies that mine for energy sources typically search for, extract, and prepare naturally occurring solid minerals and other raw materials for processing and then process them. Raw materials typically include coal used in power plants as well as minerals used in manufacturing, including iron, copper, and zinc, as well as various aggregates including mineral-rich materials such as potash and limestone.
Available Tax Incentives
Federal Incentives
Several federal tax incentives are available for companies in the energy industry, many of which have been in place for years. One of the most lucrative incentives is the R&D tax credit. Internal Revenue Code Section 41 allows taxpayers to claim a credit for their increasing R&D activities. The R&D tax credit, in place since 1981, was established to incentivize investments in technology and innovation in the United States. The R&D credit has been one of the most popular incentives for companies across several industries. It is a dollar-for-dollar credit against a taxpayer’s income taxes. The credit can be calculated using either the regular research credit method or the alternative simplified credit method.
Qualified R&D activities relate to the development of a new or improved product, process, piece of software, technique, formula, or invention. An improvement may enhance the reliability, performance, quality, or functionality of a product. The qualified research must rely on a physical science, such as engineering, biology, chemistry, or computer science. The research activity must be undertaken to eliminate a technical challenge relating to the researcher’s capability, method, or most appropriate design for developing or improving the product or process. Substantially all the claimed activities must constitute a process of experimentation to overcome or resolve the technical challenge.
Three added requirements apply to activities relating to software used for internal functions, such as financial management, human resources, legal, and other support services. First, the internal-use software must also be innovative—that is, it must result in measurable, substantial, and economically significant improvement. Second, the development activity must pose a significant economic risk to the taxpayer—that is, substantial resources must be committed to the development effort with no guarantee that the taxpayer will recover these resources. Finally, the software cannot be commercially available for purchase, leasing, or licensing without modification for use.
Qualified R&D expenses must relate to activities that occur in the United States. Specific expenses that may be included in the R&D tax credit are:
- employee wages;
- supply expenses;
- contractor costs; and
- computer rental expenses.
Several activities are specifically excluded from the R&D tax credit, including:
- ordinary testing or inspection of materials for quality control;
- efficiency surveys;
- management studies;
- consumer surveys;
- advertising or promotions;
- acquisition of another company’s or individual’s patent;
- research relating to literary or historical projects;
- activities incurred after commercial production begins; and
- funded research.
Taxpayers in the energy industry have claimed the R&D credit for their investments in innovative technologies over the past several years. Several key areas of investment within the industry might qualify for the R&D tax credit. Here is a summary of some of the research activities that qualify for the R&D tax credit by energy subsector.
Exploration and Production
The E&P upstream industry performs considerable research into determining where to drill for oil and gas as well as into the drilling and completion technologies to develop wells. The industry typically researches several technologies in this capacity, including:
- seismic imaging technology;
- monitoring and automation capabilities;
- experimental wells and prototype wells;
- unique drilling and fracking techniques;
- stage spacing during the well completion phase;
- experimental plugs;
- experimental fluids and proppant formulas;
- software development;
- digitizing drilling and completion data; and
- remote command of a well site.
In addition to the areas listed, several technologies developed by E&P companies require further R&D. Examples include drilling technology as well as completion techniques, including the spacing of the stages of perforations in the well bore and the formulas relating to the types of fluids and other materials used in the borehole.
Seismic
The seismic industry performs R&D primarily to develop techniques to acquire geological and seismic data and to develop software to process high volumes of data. These companies also develop powerful software with algorithms designed to process the seismic data. In addition, they often design and develop the equipment used to acquire the seismic and geological information. Software development activities may qualify for the R&D credit. Also, the design and development of the seismic equipment will also likely qualify for the R&D credit.
Midstream
The midstream industry, which again transports oil and gas from wells to various sites, often performs R&D related to engineering and designing pipelines as well as the software that manages resources through the transportation systems. These engineering and design activities will often qualify for the R&D credit. Other activities that qualify for the R&D credit include software development related to predictive maintenance for the pipeline and terminal storage assets.
Downstream
The downstream refining and chemical industry invests in several areas that qualify for the R&D credit, including developing new experimental fuel blends. Companies in this subsector also develop technologies and equipment to reduce emissions and improve the manufacturing efficiency of their plants. Many downstream companies experiment with trial runs and consume large quantities of supplies during experiments. All of these types of investments typically qualify for the R&D tax credit.
Oilfield Services
Activities that qualify for the R&D tax credit in the oilfield services subsector include engineering and designing new drill bits and drilling equipment. They also include research into the design and development of hydraulic fracturing equipment used in completing wells.
Utilities
The utilities industry performs qualifying R&D credit activities in several areas, including developing complex software to manage the electrical grid and to protect the power grid from threats such as electromagnetic pulses. The industry also has invested in designing equipment to reduce emissions and meet environmental standards.
Renewables
Innovation in the renewable energy subsector has increased over the past several years. Several areas of research qualify for the R&D tax credit in this subsector including designing new wind power turbine technology, meteorological analysis, and studies of wind patterns. The industry has also invested in developing advanced turbines and magnetic generators.
Environmental, Social, and Governance
Energy companies are developing and implementing innovative technologies related to environmental and regulatory requirements that often qualify for the R&D tax credit. Some examples of qualifying technologies include methane detection equipment in oil fields, emissions control equipment in coal and natural gas power plants, and hazardous chemical prevention technology in the downstream refining and chemical sectors.
Other Federal Incentives
Intangible Drilling Costs
IRC Section 263(c) allows oil and gas companies to deduct their intangible drilling costs (IDCs). These costs include expenditures for wages, fuel, repairs, hauling, and other intangible costs required for drilling wells or preparing them to produce oil and gas. These IDCs can account for as much as sixty percent of the total cost of developing a well. Most companies can deduct these IDC costs or elect to capitalize them and amortize them over sixty months. Integrated oil and gas companies are required to capitalize and amortize thirty percent of their IDC expenditures.
The deduction for intangible drilling costs was established with the introduction of the income tax code in 1916. The deduction has been at risk over the years as opponents have tried to eliminate the deduction for oil and gas companies. Specific rules apply about who can claim the deduction and make the election for capitalization. Typically, the owner-operator of the well is entitled to the deduction. Partners in a partnership owning a working interest in the well may make a separate election to capitalize IDC expenses even if the partnership has elected to expense the IDCs. Only IDCs associated with wells located in the United States or offshore wells may be expensed; wells located outside the United States require capitalization of the IDCs.
Marginal Well Credits
IRC Section 45I allows oil and gas producers a tax credit for production from marginal gas wells. The credit recently was phased out for crude oil production. The marginal well tax credit is a production-based tax credit that provides a $0.51-per-1,000-cubic-feet credit for the production of qualified natural gas from a qualified marginal well. A marginal well is defined as a well under IRC Section 613A(c), has an average daily production of not more than twenty-five barrel-of-oil equivalents (BOEs) or produces water at a rate not less than ninety-five percent of total well effluent. The well credit requires the maximum production amounts produced from a qualifying well during any tax year not to exceed 1,095 barrels or BOEs. The credit is available only to owner-operators of these wells.
Section 45Q Sequestration Tax Credits
IRC Section 45Q allows a credit of $20 per metric ton of qualified carbon oxide captured by a taxpayer using carbon capture equipment that 1) was entered into service before February 9, 2018; 2) is disposed of by the taxpayer in secure geological storage; and 3) is not used by the taxpayer as a tertiary injectant in a qualified enhanced oil recovery or natural gas recovery project.
Before 2018, the tax credit was exclusively for carbon dioxide. The sequestration credit was significantly modified as a part of the Bipartisan Budget Act (BBA) enacted on February 9, 2018. The BBA expanded the Section 45Q credit to include qualified carbon oxide instead of limiting the credit to carbon dioxide. The credit also applies to qualified facilities placed in service after the date of enactment. The credit rate is adjusted for inflation after the BBA enactment date.
Renewable Energy Tax Credits
IRC Section 45 provides for a renewable electricity production tax credit (PTC). The credit is a per-kilowatt-hour (kWh) federal tax credit for electricity generated by qualified renewable energy resources. The PTC provides a corporate tax credit of 1.3 cents per kWh for electricity generated from landfill gas, open-loop biomass, municipal solid waste resources, qualified hydroelectric, and marine and hydrokinetic sources (150 kilowatts or larger). Electricity from wind, closed-loop biomass, and geothermal resources receives as much as 2.5 cents per kWh. The PTC is phased down (forty percent) for wind facilities and has expired for all renewable energy technologies commencing construction after December 31, 2021.
Wind
Tax incentives often drive the timing and magnitude of wind turbine installations in the United States. Enacted in 1992, the US PTC has been extended and modified in the years since. At the end of December 2020, Congress extended the PTC at sixty percent of the full credit amount, or $0.018 per kWh ($18 per megawatt-hour), for another year through December 31, 2021. In 2020, the credit was sixty percent of the full credit amount. Under the new PTC legislation, qualifying wind projects must have begun construction by December 31, 2021.
Wind projects can receive the tax credit based on either the year the project begins operation or the year in which five percent of the total capital cost for the project has been spent and construction has begun. This five percent down method, known as safe harboring, allows wind developers to receive the PTC at a given year’s level, provided they complete construction no more than four calendar years after the calendar year during which construction began.
Solar
The solar investment tax credit (ITC) can be claimed on federal corporate income taxes for thirty percent of the cost of a solar photovoltaic system that is placed in service during the tax year. In 2019, the ITC for solar investments was reduced to twenty-six percent for investments in 2020 through 2022. The credit will be further reduced to twenty-two percent in 2023 and then to ten percent for projects in 2024 and after.
State and Local Incentives
Several state and local tax incentives are available for energy companies, including the R&D tax credit (available in thirty states). Many states offer sales and use tax exemptions for purchasing manufacturing equipment used in the energy industry. Utility tax exemptions for manufacturing also exist, including for oil and gas operations in thirty-three states.
The Future of Energy Tax Incentives
The future of tax incentives for the energy industry remains uncertain as the industry faces headwinds and pressure mounts for it to transition from fossil fuels to renewable energy. Many of the tax incentives highlighted in this article might be eliminated or significantly reduced to dissuade investments in fossil fuel energy innovation. However, there is still reason to be optimistic about the continuation of tax incentives for this industry. Many tax provisions mentioned are permanently enshrined in the tax code. Energy independence still has strong support in the United States, which might encourage tax incentives for energy producers. Gas and oil prices have recently hit highs that haven’t been seen in nearly a decade. Despite the challenges facing the industry, plenty of tax incentives still are available for energy companies to capture.
