OIL DEPLETION ALLOWANCE

Oil depletion allowance refers to deductions allowed in petroleum industry taxation. Mineral resources, including oil and gas, are finite and may become exhausted from area to area. Although difficult to estimate the amount of the deposit left, the allowance takes into account that production of a crude oil uses up the asset. Depletion deductions provide incentives to stimulate investment in oil discovery in hazardous or financially risky areas. The deduction, a fixed percentage of sales, is subtracted from a business' gross income, thus lowering its taxable income.

The oil depletion allowance has been an integral part of the U.S. taxation system applied to oil since the end of World War I (1916–1918). First called the "discovery depletion," the allowance evolved to the "percentage depletion" in 1926 when, regardless the amount invested, corporations deducted a specific percentage of total sales. Long set at 27.5 percent, the deduction came under fire as being overly favorable to the extractive industries. Congress lowered the percentage to 22 in 1969.

In 1975 there were approximately 35 major oil producers but roughly 10,000 smaller independent producers. The oil depletion allowance again entered the political arena with opponents arguing that it constituted a special treatment gift to the oil and gas industry. Fear of losing the allowance completely lead independents to break with the majors and fight to retain it for themselves. Congress agreed that the independents indeed were America's hazardous oilfinders. Congress voted to eliminate the allowance for the majors but, although gradually reducing it to 15 percent by 1984, retain it for the independents and royalty owners. For the first time in U.S. history, a definition for an "independent producer" appeared in the basic U.S. tax code. The explicit legal definition allowed independents to be considered separately from major oil producers in legislation and saved the independents millions of dollars in the last quarter of the twentieth century. Attempts to eliminate the 15 percent tax shelter in 1985–1986 failed when sinking world oil prices alone sent the oil industry into decline.