Elimination of the Depletion Deduction for Fossil Fuels
| Publication year | 2002 |
I. Introduction
The Appalachian region is a coal-producing area that has been environmentally devastated over the years by the effects of coal mining and fossil fuel extraction. One problem has been that fossil fuel companies and mine operators have been granted tax incentives to extract the minerals, but little money has gone back into preserving the environment from whence the minerals came. One of the most significant tax incentives, and the subject of this article, is the "depletion deduction," codified in Internal Revenue Code section 611.
The depletion deduction allows fossil fuel companies and mine operators to deduct an amount equal to the reduction in value of their mineral reserves as the mineral is extracted and sold.(fn1) The deduction is intended to allow the taxpayer to recover his capital investment so that it will not be impaired as the minerals are extracted and sold.(fn2) Notwithstanding this purpose, the taxpayer need not have invested any money in the mineral rights, and legal title is not required in order to take advantage of the deduction.(fn3) Both the Internal Revenue Service (I.R.S.) and the taxpayers who extract oil or mine coal have been in mutual agreement for nearly a decade regarding the entitlement to a deduction for the depletion of the operator's fossil fuel reserves pursuant to section 611. Through the depletion deduction, fossil fuel exploiters avoid approximately $10 billion in taxes every year.(fn4)
In past decades, a significant number of cases have examined whether mineral rights operators who did not own the surface land, and in many cases had no title to the minerals, were entitled to the deduction.(fn5) Although there have been fewer reported cases in recent years, as well as little debate regarding whether the operator or surface owner was entitled to the deduction, it is time to take a step back to reexamine the wisdom of allowing depletion deductions for mineral rights. The rising costs of fossil fuels and expected fuel shortages, coupled with the recent emergence of technologically feasible and economically viable renewable energy sources, make this a timely topic.
The mineral depletion deduction is a unique one. Other businesses are not allowed to deduct the reduction in value of their raw materials or inventory as they sell their products. For example, bakers are not allowed a deduction for the depletion of their flour supply, and boat builders are not allowed a deduction for the depletion of their boat inventory, nor even for the parts that go into the finished boats. So why are mineral extractors granted a deduction for depletion of their product as it is extracted?
This article argues that the depletion deduction provision is a misguided incentive that has been falsely analogized and justified, and it should be abolished in order to provide funds to protect and preserve the environment. The additional revenue generated should be used to encourage the development of renewable resources and to remediate the harm caused by the extraction and use of fossil fuels. Specifically, the depletion deduction for reduction in the supply of nonrenewable resources such as coal and oil should be eliminated to (1) ensure certain and equal treatment under the tax laws; (2) encourage development of renewable energy resources thereby abating further environmental harm caused by mining and extraction of fossil fuels; and (3) increase tax revenue to fund reparations for damages caused by coal mining and oil extraction.
In order to provide the reader with a greater understanding of the characteristics of the depletion deduction, Part II compares the mineral depletion deduction with the standard business depreciation tax deduction. Part III examines in greater detail the benefits that would be realized from eliminating the depletion deduction, including ensuring greater certainty and equal treatment in the law, encouraging the use and development of renewable resources, and increasing tax revenues that might be used to repair some of the damages done to the environment and society by fossil fuel extraction. Part IV sums up the issues in a conclusion.
II. Depletion vs. Depreciation
The depletion deduction is often compared to the depreciation deduction available to businesses.(fn6) In actuality, the purposes of the two deductions are different because they deal with different types of assets.(fn7) Moreover, the depletion deduction results in unequal treatment under the tax laws.
When a tangible business asset is used to perform services or produce products, the cost of the asset may be depreciated over time by the taxpayer.(fn8) If the business asset has a useful life of more than one year, the asset cannot be deducted as an expense in one year, but it may be deducted over a number of years through depreciation.(fn9) The purpose of the depreciation deduction is to accurately report income; if the asset were deducted as an expense in one year, then income for that year would be distorted to appear less than it actually is.(fn10)
In comparison, the depletion deduction is available only to businesses that extract natural resources such as coal and other minerals, oil and gas, geothermal deposits, and standing timber.(fn11) The depletion deduction is calculated in one of two ways:(fn12) by means of the "cost depletion" method(fn13) or the "percentage depletion" method.(fn14) Cost depletion is calculated by dividing the cost of the mineral rights by the number of tons of ore estimated in the property, multiplied by the number of tons extracted and sold that tax year.(fn15) Percentage depletion, on the other hand, is calculated by multiplying the gross income by a figure set by the I.R.S.(fn16) The reasons for favoring one calculation over the other depend upon on income, reserves, and other factors specific to each mineral rights owner.
No matter which computation method is used, the depletion deduction is still different in character and effect from the depreciation deduction. One primary difference is in the type of assets to which each deduction applies. The depreciation deduction compensates the taxpayer for the capital loss that accrues when an asset that is used to produce a product or provide a service declines in value with age.(fn17) In contrast, the depletion deduction for minerals or other natural resources compensates taxpayers for reduced value of assets that are not used to
A second difference between the two deductions is that, unlike taxpayers utilizing the depreciation deduction, fossil fuel exploiters are allowed to deduct for double the value of their assets. A significant number of mineral extractors lease, rather than own, their mineral rights, and therefore can deduct the lease payments as business expenses.(fn19) Allowing a deduction for the depletion of the asset as well as for the lease payments results in the deduction exceeding the initial investment in the asset.
This article does not propose to eliminate all deductions currently allowed mine operators and fossil fuel companies. Those taxpayers retain the deductions for expenses related to the development of mines or other natural deposits(fn20) and for intangible drilling costs,(fn21) as well as the credit for investment in fossil fuels.(fn22) There are also significant state tax incentives for investing in fossil fuels that remain viable; for example, some states provide tax incentives when electricity-generating stations utilize coal mined in-state.(fn23) Although many of the arguments used against the depletion deduction could also be applied to oppose these alternative tax incentive provisions, this article is limited to the federal income tax depletion deduction.
III. Benefits of Eliminating the Depletion Deduction
Eliminating the depletion deduction would ensure certainty and equal treatment under the tax laws; encourage the development of renewable energy sources, thereby abating further environmental harm caused by mining and extraction of fossil fuels; and create increased tax revenue to fund reparations for damages caused by coal mining and oil extraction. Each of these benefits is examined in turn below.
The depletion deduction has...
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