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of adjacent land. This is a problem that exists today and is dealt with by the imposition under state laws of fiduciary obligations on general partners that run to limited partners, taxable and exempt alike, and by the guidelines of the North American Securities Administrators Association Inc. ("NASAA Guidelines"). This is a non-tax matter of disclosure and fair dealing that is essentially unaffected by whether or not the investors in oil and gas programs are exempt organizations.

Mr. Pearlman's final point is that allowing the use of debt financing contained in S. 1549 would lead to the abusive use of exemptions, objecting in particular to the fact that restrictions on sale-leasebacks in the bill do not apply to sale-leasebacks between the limited partnership and a person related to the general partner. The answer to this concern is that it is frequently necessary in the oil and gas industry to permit financing arrangements or property transfers between affiliated entities and the bill not only contains the same antiabuse provisions included by Congress in IRC § 514 (c) (9) (relating to real estate debt financing by pension funds) but also a further safeguard against sale-leaseback abuses, namely, that the terms of any sale or lease must be consistent with the terms of similar transfers in the geographic area. Since such similar transfers would involve taxable persons on both sides of the transaction, it is just not likely, as an economic matter, that oil and gas programs operated by taxable general partners but having exempt limited partners would be able in any fashion to trade on the exempt status of the latter. If so, the Treasury is provided with adequate tools in its arsenal to attack the transaction.

Mr. CAIN. I am representing Apache Corp. as vice president of Government Relations. Apache Corp. is a gas and oil exploration, development and production company with both industrial and agricultural operations, and we have offered registered drilling partnerships to the investing public since 1956. It is somewhat unique that Apache is located in Minneapolis, Minn., which is a nonoil and gas producing State. It seems that our greatest natural resources over the past years have been our presidential candidates rather than our gas and oil. However, our 26-year history in gas and oil investment, and the company's experience in working with tens of thousands of investors, has developed for the corporation a reputation for sound and careful management. And based on our experience and our knowledge of the industry, Apache fully supports S. 1549.

At the present time, both pension trusts and college endowments make passive investments in stocks, bonds, gas, and oil royalties, and other options without being subject to the unrelated business income tax penalty. Pension funds can now invest in real estate limited partnerships, but not in mainstream oil and gas limited partnerships. A purpose of the tax on unrelated business income was to prevent unfair competition between tax exempt and taxable entities. It was not the purpose of the tax to penalize specific types of passive investments or to differentiate between specific investments in a particular industry. Yet this is precisely the situation that exists today.

It is illogical to distinguish between investments in oil and gas royalty and net profits interests and investments in oil and gas working interests when the latter are held in passive form. S. 1549 insures that qualified oil and gas investments are truly passive by requiring that they be held in limited partnership form. For this reason, S. 1549 is consistent with current tax policy and, in fact, maintains and strengthens that very policy. Further, S. 1549 should result in no loss of income to the Federal Government. It is likely that the increased investment in oil and gas working interests by pensions and universities will result in additional investments by other taxpaying limited partners and the taxable general partner. Other passive investments currently exempted from tax require no similar investment by taxpaying entities.

A major concern of Apache is the inability of investors to contribute oil and gas properties to college and university endowments. A recent experience by an Apache corporate officer resulted in a significant donation to a major university being rejected on the basis that it would produce unrelated business income tax. At the present time it is difficult. The proposed legislation does offer beneficial results to colleges and universities, pension funds, and the oil and gas industry. It is therefore difficult to find a valid basis for objection, since the vast majority of independent oil and gas producers support S. 1549.

As mentioned, the Oil and Gas Investment Institute voted unanimously in 1982 to support the changes now articulated in S. 1549. Objection appears to have developed only in the case of those companies who perceive that their existing investment offerings to exempt organizations would be threatened by S. 1549, which broadens the investment opportunities for qualified trusts. For example,

opposition now seems to come from some companies that have established royal trusts. Royalty trusts work in the following manner. They either purchase or acquire by way of distribution from oil and gas operators royalty interests in both producing and nonproducing oil and gas properties. Typically, the trustee receives royalty income and distributes it to the holder of the trust unit, w reports the income as royalty income. Thus, if the unit is held by an exempt organization, this income is not treated as unrelated business taxable income. Nevertheless, the income is entirely dependent on the extent to which oil and gas is produced from the underlying properties, and in the case of nonproducing properties, this return is dependent upon oil and gas yet to be produced.

If the underlying properties are held by a limited partnership instead of a royalty trust, the income allocated to an exempt investor who is a limited partner constitutes unrelated business taxable income. This is only because the partnership's income is income from a working interest rather than from a royalty. In both cases, the role of the investor is entirely passive; the rate of return is dependent on whether or not oil and gas is or will be produced by the operator from the underlying properties. There should be no arbitrary tax distinctions drawn between these essentially similar types of investments.

It has also been stated that S. 1549 will permit exempt organizations to obtain an unfair advantage over taxpaying entities in the acquisition of both producing and nonproducing oil and gas properties. However, this bill in no way affects the direct acquisition of oil and gas properties by an exempt organization. It simply enlarges the opportunity for exempt organizations to invest passively in oil and gas properties.

Mr. Chairman, it is my hope that your committee will soon act favorably on this legislation. And I would like to request that the record be kept open until September 15 for additional testimony. Senator ARMSTRONG. Thank you very much. We appreciate your statement. Senator Long?

Senator LONG. Well I just wanted to ask one of the witnesses, is it not true that we have had anywhere from 50 to 60 percent of our drilling rigs shut down?

Mr. MOORHEAD. Yes, sir. In the last 18 months the drilling rig count has dropped from approximately 4500 to about 1800. It now is showing a little bit of a tendency towards recovery. But I think that is about a 60 percent decline. I would say it is my judgment that if we can facilitate the transfer of some capital from other industries to free the oil industry from the necessity of carrying this tremendous investment in existing producing properties by substituting some of the present oil industry capital with tax exempt capital, that we will be probably putting a lot of folks back to work. I don't know what the accurate numbers are, but a good guess would be that a 2700 decrease in rig count would result in something directly in excess of 50,000 jobs lost, not counting probably a significant percentage of that in service rigs out of work. So we are talking about not only loss of jobs, or jobs potentially being recreated through this bill, or at least going in the right direction. It isn't the point to have drilling rigs working, it is a point to be adding to the Nation's supplies of oil and natural gas, which gets us into the

national defense issues and the whole business. And the industry today is desparately short of capital. We need to mobilize the capital we have within the business while letting people outside the business carry investments that are appropriate.

Mr. CAIN. Could I just respond, Mr. Chairman? Just some statistics. Apache has in particular reduced our drilling expenditures from over $70 million, Senator Long, in 1981 to $37 million, almost half the production, in 1982, and less than $25 million planned for 1983. This is consistent with the rest of the industry. In fact, we are somewhat more aggressive than even some of our colleagues are. It is imperative that these new sources of capital be available for pension funds as a clearly major potential investment.

Senator ARMSTRONG. Senator Matsunaga, do you have any statement that you wish to make or any questions for the panel?

Senator MATSUNAGA. Not at this point, Mr. Chairman.

Senator ARMSTRONG. Thank you.

Mr. Brumley, you made the point, I think, that the investment in working interest might not prove to be as prudent an investment for the institutions that we are talking about here; that they might involve a higher degree of risk. Mr. Overgaard, on the other hand, made the point that this was just in effect one more option that would be available to them. Could you elaborate a little on that? Why wouldn't it be wise in the sense that I have just describedand I hope that was an accurate paraphrase of that aspect of your testimony--why wouldn't it be wise to let the institutions themselves decide what was prudent and what was not? Why should that be a matter of tax policy? And I realize you have testified against the bill on other grounds as well. But on that question, why not let them make that decision?

Mr. BRUMLEY. Well I think if they all acted prudently then there would be no reason not to. You see many banks in the Southwest now acted imprudently on loans in the energy segment of the industry. Some of those loans they thought when they made them were good at the time. They turned out not to be as good. I used to work for an actuarial pension consulting firm, and maybe that is where some of my beliefs come from. But it was my idea at the time, and I still believe that pension funds should be invested conservatively and not in such things as wildcat oil and gas drilling. And I believe that the pension industry would best be served by not putting that capital into drilling funds. That is basically where I come from.

Senator ARMSTRONG. I don't want to pursue you too far on this, but you are not suggesting, are you, that because some banks made imprudent loans to the industry that they should be restricted by tax policy for making loans to the industry in the future?

Mr. BRUMLEY. No, sir. I didn't mean to imply that. All I was saying was that I think that pension funds are very special to this country, and that although you may have some very prudent restrictions placed on the investors and the people that work for those, still I believe that they should not be allowed to invest in very high-risk type of investments as I believe oil and gas exploration is.

Senator ARMSTRONG. I appreciate your comments. As you know, I am a sponsor of the bill. But, nonetheless, I assure you I am going

to go over your statement very carefully and attempt to take into account the issues you have raised.

Mr. BRUMLEY. Yes, sir.

Senator ARMSTRONG. Mr. Moorhead, I want to ask one question that goes back to some testimony this morning from the Treasury. They make the observation that to really be fair this legislation should be broadened to permit tax-exempt organizations to invest in all passive investments. In effect, they say why single out this one group of investments. What do you say to that? Should we broaden the bill?

Mr. MOORHEAD. I was somewhat dismayed to read that testimony this morning. And I am not an expert on many aspects of tax, but it seems to me to be a complete non-sequitor that because there is an established industry pattern in the oil and gas business to the effect that the traditional most common way of investing is through limited partnerships which own working interest, to then say that all other industries should be allowed the same access. There is a tremendous difference. Well it really comes back to the point I tried to make earlier. It is possible today for a tax-exempt institution to invest in oil and gas ventures of any and every kind, but they may not do so through the established industry conventional formats. They have to do so through sort of jury-rigged schemes. I was looking through the Stanger Register which lists and enumerates all of the publicly registered programs. There are 30-odd programs set forth there in summary of their terms, and two of them are designed, by virtue of carving out of a working interest in net profits interest, to allow participation by an exempt institution. However, the tax aspects of an investment so carved out are not attractive or not as attractive to the conventional taxpaying investor. So you have to make a choice if you are an institution to either stay out of this business, incur the unrelated business taxable income if you want to get in it, or though you want to be in a conventional public deal, to go on a tax avoidance design deal. Those are the three alternatives. And it makes no sense to meTreasury's line makes no sense to me to say that because you have an established thing in one industry, you should make it available for all the industries where it is not an established practice. I think they did it to push the argument, sort of ad absurdum, but I don't know their motive.

Senator ARMSTRONG. Thank you. I appreciate your observations. Thank you all. We will be doing some more work on this, and we are very grateful for your input.

Mr. MOORHEAD. Thank you for the opportunity, Senator. [Whereupon, at 2:45 p.m., the hearing was concluded.]

[By direction of the chairman the following communications were made a part of the hearing record:]

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