Businesses are generally allowed to recoup capital costs associated with acquiring or creating an asset by deducting these costs from their taxable income. Typically, the costs are depreciated—deducted each year in proportion to the remaining useful life of the asset, corresponding to the income it generates. For natural resource assets, the costs of acquiring the reserve, such as the costs of the lease, are recovered through cost depletion—deducted in proportion to how much of the reserve has been depleted to generate income in a given year.
Instead of cost depletion, the oil and gas industry is allowed to use percentage depletion. For these assets, companies can deduct a set percentage of the gross income generated from the asset—15 percent for oil and gas wells and up to 25 percent for marginal wells, depending on oil prices. The deduction is limited to independent oil and gas producers who operate domestically, and only the first 1,000 barrels of oil (or, for natural gas, oil-equivalent) per well, per day, qualify, up to 65 percent of overall taxable income. Oil and gas companies can deduct up to 100 percent of the net income produced by the asset. Because the amount that can be deducted is not limited to the actual capital cost of acquiring the asset, companies can claim deductions in excess of their original investment in the asset.
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