The Rise And Fall of the Drilling Program

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Abstract THE drilling program first appeared on the national scene in Canada- in 1976. During its heyday it attracted hundreds of millions of dollars a year which were channeled into Canadian oil exploration and development, with relatively minor amounts going to the U.S. Yet by the second half of 1981 it had virtually disappeared as a method of financing. What happened? This article will attempt to trace the events of that brief period and explain the demise of this innovative method. Tax, and the avoidance of tax, are always of paramount importance. In Canada, "tax shelter" really means "tax deferral" although in some cases "(ax shelter" can mean "conversion of taxable income into capital gain". An important point must be made here. Tax shelters are not tax loopholes arising out of shortcomings in the Income Tax Act. They are tax concessions granted to encourage investment in endeavours which the government conceives to be in the national interest. This same method has been used time and again in Canada since the early thirties, and also elsewhere in the western world. Is capital investment by industry lagging? Then let the government offer accelerated depreciation for new capital investment. Is there a shortage of high quality residential rental properties? Then let's have MURBs. Would it be desirable for Canada to become self-sufficient in oil and gas? Then let's encourage drilling programs. The general principle for taxation of business enterprise in Canada allows a personal or corporate taxpayer in computing taxable income to deduct all expenses, including such non-cash expenses as depreciation and depletion, from gross income. The exception to that general rule is that the application of these allowances by private citizens in their personal investment activities is very severely limited. The exception to the exception is that in tax shelters the Income Tax Act allows the generated deductions to be applied by all taxpayers to income from any source. With that as general background it is illuminating to examine how governments (both the "feds" and provincial) stimulated investment by private citizens in oil and gas. In 1976 the vehicles available for direct investment by persons and corporations were joint venture, direct ownership or participation in a limited partnership, with the last being by far the preferred vehicle for persons. The principal deductions available were: Canadian Exploration Expense-The cost of exploratory wells including the land could be written off by the declining balance method at the rate of 300/0 annually. This meant that if a share of a well cost $10,000, $3,000 could be deducted from taxable income in the year the well was drilled, 30% of the remaining $7,000 or $2,100, in the following year, and so on. After May 26, 1976, however, the rate was increased to 100%, where it remains today, so that a $10,000 well generated a $10,000 deduction. Canadian Development Expense-A well classified as development rather than exploration was and is eligible for 30% declining balance treatment.