On February 14, 2011, the Treasury Department released a general explanation (the “Explanation”) of the Obama Administration’s (the “Administration’s”) tax proposals for its fiscal year 2012 budget. The Explanation describes the following proposed amendments to certain oil and gas provisions of the Internal Revenue Code that may be applicable to your business. These proposals are similar or identical to proposals that were described in the Administration’s fiscal year 2011 budget.

1. Repeal Expensing of Intangible Drilling Costs

Generally, a taxpayer who pays or incurs intangible drilling costs (“IDCs”) in the development of an oil or gas property located in the United States may elect under current law either to expense or to capitalize and amortize those costs, if the taxpayer holds a working or other operating interest in such property. The rule is an exception to the general rules requiring taxpayers to capitalize costs that provide a benefit to the taxpayer in future periods.

If a taxpayer elects to expense IDCs, the amount of the IDCs is deductible as an expense in the taxable year the cost is paid or incurred. In the case of an integrated oil company that has elected to expense IDCs, 30% of the IDCs on productive wells must be capitalized and amortized over a 60-month period. Further, a taxpayer may elect to capitalize and amortize certain IDCs over a 60-month period beginning with the month the expenditure was paid or incurred.

The Administration proposes to repeal the election to expense IDCs, as well as the election to amortize IDCs over a 60-month period. Under the proposal, all IDCs would be capitalized and amortized as depreciable or depletable property, depending on the nature of the cost incurred, in accordance with generally applicable rules. The proposal would be effective for costs paid or incurred after December 31, 2011.

2. Increase Amortization Period for Geological and Geophysical Costs to Seven Years

Geological and geophysical expenditures are costs incurred for the purpose of obtaining and accumulating data that will serve as the basis for the acquisition and retention of mineral properties. The amortization period for geological and geophysical expenditures incurred in connection with oil and gas exploration in the United States is two years for independent producers and seven years for integrated oil and gas producers.

The Administration proposes to increase the amortization period from two years to seven years for geological and geophysical expenditures incurred by independent producers in connection with all oil and gas exploration in the United States. Seven-year amortization would apply even if the property is abandoned, and any remaining basis of the abandoned property would be recovered over the remainder of the seven-year period. The proposal would be effective for amounts paid or incurred after December 31, 2011.

3. Repeal Percentage Depletion

The capital costs of oil and gas wells are recovered through the depletion deduction. Under the cost depletion method, the basis recovery for a taxable year is computed on the unit of production method proportional to the exhaustion of the property during the year. Certain taxpayers qualify for percentage depletion with respect to domestic oil and gas properties. The amount of the percentage depletion deduction is a specified percentage (from 15% to 25%) of the gross income from the property, subject to several limitations, including that the percentage depletion deduction for a year may not exceed 100 percent of the taxable income from the property.

A qualifying taxpayer determines the depletion deduction for each oil and gas property under both the percentage depletion method and the cost depletion method and deducts the larger of the two amounts. Because percentage depletion is computed without regard to the taxpayer’s tax basis in the depletable property, a taxpayer may continue to claim percentage depletion after all the expenditures incurred to acquire and develop the property have been recovered.

The Administration’s proposal would repeal the percentage depletion deduction with respect to oil and gas wells for taxable years beginning after December 31, 2011. Thereafter, all taxpayers would only be permitted to report a deduction for cost depletion to recover their adjusted basis, if any, in oil and gas wells.

4. Repeal Domestic Manufacturing Deduction for Oil and Gas Production

A deduction is allowed with respect to income attributable to domestic production activities. The deduction is equal to 6 percent of the lesser of qualified production activities income for the year or total taxable income for the year, limited to 50 percent of the wages incurred by the taxpayer for the year.

Qualified production activities income includes a taxpayer’s gross receipts derived from the disposition of oil, natural gas or primary products thereof extracted or produced by the taxpayer within the U.S. minus the cost of goods sold and other expenses, losses, or deductions attributable to such receipts.

Under the Administration’s proposal, gross receipts derived from the disposition of oil, natural gas or a primary product thereof would be excluded from the definition of domestic production gross receipts for taxable years beginning after December 31, 2011.

5. Repeal Passive Loss Exception for Working Interests in Oil and Gas Properties

The passive loss rules generally limit the deductions and credits of individuals, trusts and certain closely held C corporations arising from passive activities. A “passive activity” is generally defined as any trade or business activity in which the taxpayer does not materially participate.

Current law contains an exception, however, for certain oil and gas working interests. Under this exception, a working interest in an oil or gas property that the taxpayer holds directly or through an entity that does not limit the liability of the taxpayer with respect to the interest is not considered a “passive activity,” even though the taxpayer does not materially participate.

The Administration proposes to repeal the oil and gas working interest exception for taxable years beginning after December 31, 2011. As a result, deductions and credits attributable to oil and gas working interests held by an individual, trust or closely held C corporation would become subject to the passive loss limitations described above, unless the taxpayer materially participates in the oil and gas activity.

6. Repeal of Credits for Enhanced Oil Recovery Projects and Production from Marginal Wells

The Administration proposes to repeal for taxable years beginning after December 31, 2011 (i) the 15% investment tax credit for domestic enhanced oil recovery projects and (ii) the production tax credit for oil and gas produced from marginal wells.

7. Repeal Deduction for Tertiary Injectants

Under current law, taxpayers are allowed to deduct the cost of qualified tertiary injectant expenses for the taxable year. Qualified tertiary injectant expenses are amounts incurred for any tertiary injectant (other than recoverable hydrocarbon injectants) that is used to augment the recoverable amount of hydrocarbons in their reservoir as a part of a tertiary recovery method (as such term is defined by regulation).

The Administration proposes to repeal the deduction for qualified tertiary injectant expenses for amounts paid or incurred after December 31, 2011. As a result, such costs would be capitalizable and recovered over time.

This tax update is intended only to provide a general summary of certain tax provisions. If you would like to discuss how any of these or other tax provisions may impact your operations, please contact any Baker Botts tax lawyer, including the authors of this update listed above.