The Tax Reform Act of 1986 has made significant changes in the tax laws that affect U.S. industry. The new act lowers tax rates and makes major changes that will affect the ability of taxpayers to shelter income. Generally, profitable companies that for years have used various tax incentives to reduce their liabilities may incur higher taxes under the new act; however, the lower tax rate may reduce the overall tax liability. The objective of this paper is to study the impact of these tax changes on the oil and gas industry. A financial analysis approach is applied to the oil and gas industry in the Appalachian area.

This study also discusses the changes which directly and indirectly affect the oil and gas industry. Intangible drilling costs (IDC) treatment, excess IDC, percentage depletion, recapture on dispositions and depreciation are the oil and gas industry specific changes. The passive loas limitations, alternative minimum tax (AMT), and the capital recovery and investment tax credit affect the industry in general. How these non-industry specific changes impact on the oil and gas industry is also discussed. In addition, a cash flow approach is used to compare the financial situation of the oil and gas companies under the new and old law.

The cash flow analyses are done using Lotus 1-2-3 spreadsheets. The analyses are performed for both a small independent company that produces less than 1000 barrels of oil equivalent per day and an integrated company that is involved in upstream operations of refining and distribution. Under the new tax law, the independent company benefits because of a significant reduction in the tax rate and relatively few changes in the tax rules. However, the integrated company incurs a higher tax liability and AMT payment since the New Tax Reform Act eliminates tax shelters. The capital-intensive oil and gas industry will be less competitive than previously in attracting investment capital. Additional conclusions and recommendations are made to help the industry optimize overall tax costs.

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