Written Comments of MDU Resources Group, Inc. the Determination of Independent MDU Resources Group, Inc. (MDU) is a multidimensional natural resources company having its principal offices in Bismarck, North Dakota. Montana-Dakota Utilities Co., the public utility division of the company, provides natural gas and electricity to customers in parts of North and South Dakota, Montana and Wyoming. The company, through a whollyowned subsidiary, owns Williston Basin Interstate Pipeline Company, Knife River Coal Mining Company, the Fidelity Oil Group and Prairielands Energy Marketing, Inc. MDU appreciates the opportunity to submit this written statement in connection with the Committee's consideration of miscellaneous tax reform proposals that were the subject of hearings on July 11 and 12, 1995. MDU supports the proposal to expand the definition of independent oil and gas producer status for percentage depletion purposes. However, the proposal should be modified to allow a taxpayer to elect current law treatment in order to preserve certain tax benefits which would otherwise be unintentionally eliminated by the proposal. BACKGROUND A. Current Law 1. Percentage Depletion Section 611 of the Code provides taxpayers with a deduction for the depletion of certain natural resources. The extent to which depletion is allowed is generally limited to the taxpayer's adjusted basis in the depletable property. Code section 613A(c), however, allows certain independent producers of oil and gas to take advantage of percentage depletion (the independent producer exception).' Percentage depletion provides taxpayers with a deduction to the extent of a specified percentage of the annual gross income generated by the depletable property. The deduction for percentage depletion constitutes a permanent tax benefit; it is not limited to the basis of the depletable property. In essence, as long as a depletable property is productive, an independent oil and gas producer may take advantage of the percentage depletion deduction.2 Code section 613A(d)(2) limits the scope of the independent producer exception. Specifically, independent oil and gas producers engaged in certain retailing or refining activities cannot take advantage of percentage depletion. A taxpayer meets the retailer exception and is considered an integrated producer if (1) the taxpayer sells oil or natural gas (domestically) through a retail outlet operated by the taxpayer or a related person, and (2) the combined annual gross receipts from the sale of such oil or natural gas exceed $5 million. 1. 2. Prior to the enactment of the Tax Reform Act of 1975 (Act), oil and gas producers were generally eligible for the percentage depletion allowance. Code section 613A, which eliminated percentage depletion with respect to integrated producers, was added by the Act in reaction to the windfall profits reaped by the 25 largest oil companies as a result of increases in foreign oil prices. There is a 1000 barrel per day limitation on the amount of percentage depletion claimed by independent producers. The daily barrel limitation must be applied to the production of all entities related to the independent producer. Only the production barrels eligible for percentage depletion, however, need to be considered for each of the entities. For example, in calculating the limitation, an independent producer need not include the production barrels of a sister corporation required to use cost depletion for its entire production run. In determining whether oil or gas sold "through a related party" would disqualify an independent producer from taking the percentage depletion allowance, Revenue Ruling 85-12 provided that: [w]here none of a producer's production is sold through a related In other words, if an otherwise independent producer does not own or benefit from any gas or oil production which is directly or indirectly sold through a related party (for retail sale to customers), the producer will not be disqualified under the retailer exception. On balance, Revenue Ruling 85-12 allowed gas systems to avoid or lessen the impact of the retailer exception by establishing a separate subsidiary which sells none of its own production through a related utility company. 2. Current Deduction of Intangible Drilling Costs (IDCs) In addition to qualifying a taxpayer for the percentage depletion allowance, independent producer status allows a taxpayer to deduct currently 100 percent of any intangible drilling costs (IDCs) it incurs. Integrated producers can deduct only 70 percent of IDCs in the year incurred and must amortize the balance over a five year period. B. The Proposal The proposal modifies the manner in which a natural gas production company's independent producer status is determined for percentage depletion purposes and for IDCs. MDU's specific concerns are that the proposal would permit retail sales of natural gas by a regulated public utility company to be disregarded in determining whether a related natural gas production company is a retailer for percentage depletion purposes. Accordingly, a natural gas production company would not be precluded from claiming percentage depletion merely because it was owned by a utility which made retail sales in excess of $5 million per year. DISCUSSION Due to its current corporate framework, premised on the guidance provided by the Service in Revenue Ruling 85-12, MDU would be negatively affected by the proposal. MDU's corporate structure currently allows one of its oil and gas subsidiaries to qualify for the independent producer exception and thereby claim a Federal income tax deduction for percentage depletion. MDU has relied upon the guidance provided by Revenue Ruling 85-12 for purposes of the expansion of its oil and gas activities. The effect of the proposal would be to qualify certain other MDU subsidiaries as independent producers, but in doing so, would thereby significantly reduce the percentage depletion tax benefits realized by MDU. Although MDU understands the need to change the definition of the term "independent producer," MDU does not believe that such change should come at the expense of taxpayers that have gone to considerable effort to appropriately structure their oil and gas expansion efforts based upon the guidance provided by the Internal Revenue Service in Revenue Ruling 85-12. Accordingly, MDU suggests that any legislative proposal consider and rectify the impact of such an unintentional adverse change on taxpayers. PROPOSED AMENDMENT In order to preserve tax benefits currently available, MDU would amend the proposal to include an election out of the expanded definition of independent producer. In other words, while the general rule under the proposal would be to disregard incidental sales of natural gas to related public utility companies, MDU believes taxpayers should have the option of electing current law treatment and thus preserve the tax benefits gained as a result of their business structure. MDU's suggested "election out" option will not affect the purpose behind changing the definition of the term independent producer. It will, however, ensure that taxpayers, like MDU, who have invested significant amounts of time and money to structure their operations in order to be eligible for independent producer status do not, as a result of legislation intended to be beneficial, lose the benefits of such efforts. MDU went to considerable effort to position itself to obtain independent producer status in order to obtain what MDU anticipated would be longterm benefits. MDU's return on its investment will be significantly reduced if the benefits associated with MDU's current structure are diminished as a result of a change intended to encourage domestic exploration and production and to distinguish the natural gas utilities from the major oil companies. Placid Refining Company (“Placid”) is the operator and 64% owner of a 50,000 barrel per day rated refinery in Port Allen, West Baton Rouge Parish, Louisiana. Placid operates the refinery on behalf of itself and two other owners. The various owners of Placid and the refinery are independent producers of oil and gas in the United States. Because of their ownership in the refinery they are subject to losing their independent producer status should Placid operate the refinery above 50,000 barrels per day on any one day of a tax year (the "any one day provision"). This loss of independent producer status would damage the various refinery owners causing them the loss of their percentage depletion allowance on oil and gas produced up to the first 1,000 barrels per day, and requiring them to capitalize and depreciate 30% of their intangible drilling costs ("IDC") rather than being able to expense 100% of the IDC. The drastic consequences of operating the Port Allen refinery above 50,000 barrels on any one day forces Placid to operate the refinery at approximately 48,500 barrels per day, which it feels is the safe level required to avoid triggering the "any one day provision." This is a loss of 3% of its capacity because of the "any one day provision." In addition, Placid, although rated at 50,000 barrels per day, could operate the facility without significant capital investment at approximately 52,000 barrels per day. Thus, the present provisions of Section 613 A (d) (4) effectively impose a statutory inefficiency of nearly 7% of Placid's capacity and a corresponding loss of revenue to Placid and taxable income to the federal government. Moreover, with the "any one day provision," Placid cannot make up for volumes lost when the refinery is down for turnaround or maintenance requirements. If the "any one day provision" was changed to "yearly average," Placid could operate the refinery much closer to its 50,000 barrel per day capacity Placid, as a small refiner, is being increasingly squeezed by the ever escalating costs of compliance with government regulations, especially the environmental and safety regulations, while lacking the ability to optimize the capacity and efficiency of the refinery and its people because of the arbitrarily set provisions and definitions of 613 A (d) (4). It should be noted that Placid must comply with all of the same environmental and safety regulations required of the larger refineries running 100,000, 200,000 or 400,000 barrels per day. However, the cost of this compliance is significantly greater on a per barrel basis for Placid than the larger refineries because of the economics of scale attributable to its capacity. Consequently, Placid is at a disadvantage in the market place unless it has the ability to make full use of its assets or even moderately expand its capacity, without penalty, as most of Placid's larger competitors have been doing. The 50,000 barrel per day limit set in 1974 seems to have been arbitrarily chosen without any significant basis or reason for its selection. But notwithstanding the reasons for limiting the size of a small refiner to 50,000 barrels per day, the limit is currently inconsistent with other regulatory definitions such as those set by the Small Business Administration ("SBA"), which after due consideration, effective May 1, 1992, revised its definition of a small refiner for the petroleum refining industry, Standard Industrial Classification ("SIC") Code 2911, from 50,000 barrels per day to 75,000 barrels per day. This increase allows refiners up to 75,000 barrels per day to qualify as a small business for various SBA programs. The MMS also accepts the SBA definition of a small refiner (75,000 BPD or less) in considering the administration of its Royaltyin-Kind oil marketing program. Placid, even though it is a small refiner, is the largest employer in West Baton Rouge Parish, Louisiana, employing approximately 210 people, whose incomes, in turn, support other businesses and industries in the area. Placid is also a major consumer of goods and services provided by many local area vendors. In addition, it is the largest tax payor in the parish and supports many of the parish activities. The SBA, in its review of the definition of a small refiner, stated that approximately one-half of the refineries with a capacity of between 10,000 and 50,000 barrels per day have ceased to exist since 1975. With the refinery business being very competitive, costs on the rise, and refinery margins being very slim, Placid may very well become part of this statistic in the future if it is not allowed to operate at its optimal efficiency. Placid requests that Section 613 A (d) (4) be amended to increase the volume from 50,000 to 75,000 barrels per day and from the “any one day provision" to the "average during the taxable year." This change would allow Placid the ability to be more competitive and make operational and expansion decisions based on true economics and efficiency standards without unduly penalizing its owners. It would also allow Placid the ability to increase its own taxable income and to continue to provide employment to hundreds of citizens in the state of Louisiana.. Very truly yours, PLACID REFINING COMPANY Daniel R. Robinson President |