As governments focus on clean energy and carbon reduction initiatives, their oil and gas taxation policies have increasingly come under scrutiny. Polsinelli’s attorneys review a few overarching themes concerning expected trends in hydrocarbon taxation, specifically focusing on the effect on U.S. oil and gas producers.

Carbon Pricing

Carbon pricing, whether implemented through a cap-and-trade system, the direct imposition of carbon taxes or a combination thereof, is an emerging trend in world energy markets as countries seek to reduce carbon emissions. Concomitantly, carbon border adjustment mechanism taxes, such as that proposed by the EU, seek to avoid the relocation of carbon-intensive industries to unregulated countries by imposing a tax on the importation of products not burdened by carbon pricing systems in their home countries. While partisan disagreement has kept carbon pricing from gaining traction at the federal level in the U.S., carbon taxes and border adjustment mechanism taxes abroad can still hurt U.S. taxpayers with foreign income.

Domestic taxpayers with foreign income may be allowed a foreign tax credit for direct (and, sometimes, indirect) foreign taxes imposed. However, to be creditable, such foreign taxes must qualify as an income tax in the U.S. sense or an in-lieu-of tax. Without going into the detailed requirements of the foreign tax credit, carbon taxes and carbon border adjustment mechanism taxes imposed by foreign countries are unlikely to be creditable. While a deduction may be possible, any foreign tax incurred which is not creditable against United States’ income taxes will cause a net additional cost to a U.S. taxpayer.

Oil and Gas Deduction Reforms

Oil and gas deductions and timing benefits are sometimes classified as “subsidies” by certain political factions, with some arguing they artificially prop up the industry and discourage investment in renewable energy. In recent years, there has been growing pressure on governments to reduce or eliminate tax preferences for the fossil fuel industry. It is likely this trend will continue as governments seek to meet their carbon emissions targets and potentially offset some costs of incentivizing the development of clean energy technologies.

In the United States, for example, the Biden administration’s recent Green Book budget proposals are aimed in part at phasing out certain provisions that are viewed as encouraging oil and gas production and – not incidentally – generating additional tax revenue. These proposals would repeal or reduce, among other things, the following:

1. Enhanced oil recovery credit for eligible costs attributable to a qualified enhanced oil recovery project.

2. Credit for oil and gas produced from marginal wells.

3. Expensing of a portion of intangible drilling costs.

4. Certain exceptions to passive loss limitations for working interest owners in oil and gas properties.

5. Use of percentage depletion by certain independent producers.

6. Two-year amortization of geological and geophysical expenditures by independent producers.

7. Exception from the publicly traded partnership rules for partnerships with 90% qualifying income and gains from certain fossil fuel-related activities.

In addition, the proposal would repeal the exclusion of foreign oil and gas extraction income (a/k/a “FOGEI”) from tested income for the global intangible low-taxed income rules (a/k/a “GILTI”) applicable to U.S. shareholders of controlled foreign corporations. If passed, these measures may increase the after-tax cost of oil and gas production for U.S. producers.

Royalties and Fees

Governments often collect royalties and fees from oil and gas companies for the right to extract natural resources from public lands. Outside the United States, sub-surface rights are often owned exclusively by foreign governments.

Looking forward, governments will likely consider increasing such royalties and fees as a way to generate revenue and incentivize the development of clean energy technologies (e.g., through increasing the price to extract oil and gas and, potentially, investing these additional revenues in the development of clean energy or clean energy technologies).

Domestic taxpayers with foreign income may be allowed a foreign tax credit for direct (and, sometimes, indirect) foreign taxes imposed. However, to be creditable, such foreign taxes must qualify as an income tax in the U.S. sense or an in-lieu-of tax. Royalties and fees paid for the right to extract oil and gas are generally not considered income or in-lieu-of taxes and, therefore, would generally not be considered creditable taxes for purposes of the U.S. foreign tax credit.

Tax Incentives

Tax incentives can encourage investment and support economic growth in favored industries. We expect to continue to see a trend toward governments reevaluating their tax incentives for the energy industry and potentially shifting these incentives towards renewable energy and other sustainable initiatives. Incentives could include tax credits or deductions for investments in renewable energy, energy efficiency, or carbon capture and storage technologies.

The United States has enacted a number of tax credits to incentive the production of renewable energy, conserve resources or sequester carbon production. These regimes include credits for electricity produced from renewable resources, including wind and solar projects, clean electricity production and investment, production of clean hydrogen, clean fuel production, and carbon sequestration. Some of these regimes were made more attractive because of increased credit values and other taxpayer-favorable changes enacted by the recently passed Inflation Reduction Act.

Concerns remain among multinationals, however, that the value of tax credits they receive may be reduced if the Pillar Two reforms proffered by the OECD are enacted. The chief concern involves the top-up tax, which would require the parent of a covered foreign multinational company to ensure its members pay a minimum tax rate of 15% on enterprise income. Barring an applicable exception, all or a portion of the tax savings resulting from tax credit utilization could be eroded under the income inclusion rule or undertaxed profits rule of Pillar Two legislation. While special rules apply to certain refundable tax credits, this exception would generally not apply to U.S. tax credits earned by multinational enterprises that exceed the proposed €750M consolidated revenue threshold for applying Pillar Two.

Conclusion

In conclusion, oil and gas tax policy will likely continue to evolve in response to environmental concerns, changing market conditions, and shifting geopolitical landscapes. While it is difficult to predict the specifics of tax legislatioins that may result, we can expect the broader trends and developments described above to influence the future of oil and gas tax policy.