STATEMENT OF THE

INDEPENDENT PETROLEUM ASSOCIATION OF AMERICA

TO THE SUBCOMMITTEE

ON TAXATION AND DEBT MANAGEMENT

OF THE

SENATE COMMITTEE ON FINANCE

The Independent Petroleum Association of America is a national organization of some 7,000 independent oil and natural gas producers in every producing area of the United States. IPAA, together with the twenty-nine unaffiliated associations listed on the cover page, represent virtually all independent producers and thousands of royalty owners in the United States. We are grateful for this opportunity to present our views in support of S. 1549 to update the definition of unrelated business taxable income in connection with the hearings held by this subcommittee on August 1, 1983. We respectfully request that this statement be made a part of the permanent record of that hearing.

In general, the statutes now provide that a tax exempt organization is subject to tax at the regular corporate rates on income derived from the active conduct of a trade or business which is not substantially related to the function or purpose upon which the tax exemption is based. These provisions were adopted principally to eliminate a competitive advantage a tax exempt organization would have compared to a taxable entity engaged in the same business. The statutes distinguish income derived from a "trade or business," which is taxable and income derived from investments, which is not taxable. Therefore, income received from interest, dividends, rents or royalties do not affect the tax of the organization except in special situations. In order for the unrelated business tax to be imposed, the exempt organization must be regularly engaged in unrelated activities which constitute a trade or business such as the offering of goods for sale or the performance of services. Where an exempt organization is a member of a partnership, the law currently provides that the partner will receive unrelated business income equal to its share of the income derived from any unrelated business activity conducted by the partnership.

Interests in oil and gas properties may be held by an exempt organization in two general forms. The entity may acquire a "nonoperating interest," that is, a right to the reserves in place which is not required to bear a proportionate share of the costs of exploration, development or production. These nonoperating interests commonly take the form of royalties, net profit interests or, in limited circumstances, a production payment. The income derived from these

interests is not "trade or business" income and is therefore not subject to the unrelated business tax. Oil and gas reserves may also be acquired through an "operating interest," or an interest which shares in the costs of exploration, development and production. These interests are commonly referred to as working interests and unlike a royalty or similar interest, the participation in costs of development and production place the owner in a "trade or business." This determination is not affected by the nature of the activity actually performed by the interest owner. The working interest owner is engaged in a "trade or business" even where the day to day operation of the property is delegated to a third party operator. Thus it is the nature of the interest in the property and not the activities with respect to the property which determines the existence of a "trade or business."

The bill currently before the subcommittee, S. 1549, would amend the definition of unrelated business taxable income to exclude working interests held through certain limited partnerships for pension trusts and educational organizations. These provisions would provide needed flexibility to the investment managers of pension funds and endowments by enabling them to diversify their portfolios. The bill would also make available a new source of funds to the oil and gas industry which is chronically short of investment capital. Provisions which achieve such desirable policy goals in a manner which is essentially revenue neutral, should not be rejected unless the negative potential is both clear and persuasive. The arguments presented against the provisions appear to be neither.

The principal argument against S. 1549 is that it is inconsistent with the theory of the unrelated business tax and that creating an exemption for certain oil and gas limited partnerships will lead to similar treatment for all business activity conducted by limited partnerships. These arguments are clearly strained. The "theory" of the unrelated business tax is to prevent exempt entities from using their exempt status to gain a competitive advantage. An exempt organization which holds a limited partnership interest in a partnership holding working interests has no greater or lesser competitive advantage than if it held the same interest in the form of a royalty. In both situations, the essential source of income is the sale of the production and this function is not affected by the nature of the economic interest held by the exempt entity. The provisions of S. 1549 simply allow exempt entities to acquire ownership of oil and gas reserves in a direct, straightforward manner without placing unwarranted emphasis on the legal nature of the economic interest acquired.

Concerns that the treatment of oil and gas limited partnerships proposed in this legislation will ultimately extend to other limited partnerships do not appear valid. Although Congress has chosen to treat all limited partnership income as "passive" for individuals (the limited business interest provisions of section 55 IRC for purposes of the alternative minimum tax) concerns over the future direction of policy are not appropriate reasons to object to these provisions. In any event, the largest activity conducted through limited partnerships consists of real

estate investments, an activity which generally does not produce unrelated business taxable income. It should also be noted that the presence of substantial investments in equity capital in the real estate markets from exempt institutions has not resulted in significant distortions of the market.

It is also argued that the unique risks of oil and gas investments make this investment inappropriate for institutions such as pension trusts and educational endowments. It is without question that the exploration and development of oil and gas reserves involves great risk. As a result, they are not appropriate investments for those without knowledge and experience in evaluating these investments. The provisions of S. 1549, however, do not create new opportunity for exempt entities to expose themselves to risk; the provisions of the bill simply add flexibility to those investments. Exempt organizations, guided by· prudent investment advice, can and do now make investments in oil and gas either through royalty interest or through the ownership of stock in producing companies. Depending upon the stage of development, the risk in these investments is just as great as in acquiring a working interest. We would not, however, seek to preclude these investments because of risk, but only require that they be guided by the standards of prudent judgement.

It has also been stated in opposition to the bill that there are not sufficient limitations on partnership allocations to prevent the transfer of tax benefits from tax exempt partners to taxable partners. When viewed in context of the existing statutory and regulatory framework, we believe these concerns are overstated. The provisions of the bill when combined with the provisions of section 704, regarding substantial economic effect in partnership allocations, and section 613A, determining basis for depletion provide a solid basis for denying tax benefits in cases of perceived abuse. To determine the potential for abuse, the entire structure of the Internal Revenue Code must be considered, not just this isolated amendment.

In summary, we believe that S. 1549 provides flexibility to institutions and capital to the oil and gas industry with little or no cost to the Treasury. The benefits to be derived from these provisions by both the institutions and the oil and gas industry are obvious, while opposition to the provisions is strained and highly subjective. The provisions of S. 1549 represent a well balanced approach to allow institutions to directly acquire interests which they can now acquire only indirectly. The provisions of the bill are a straightforward attempt to update the definition of unrelated business taxable income to reflect current business realities and should be enacted.

Independent Petroleum Association of America
August, 1983

I am Mamie Lee, President of the National Association of Meal Programs. This is the national association of community meals on wheels and of many congregate meals programs. We presently have 366 members, and anticipate this number to double in the next two years. Traditionally meals on wheels programs have been indeperdent and concerned only with their own community. Since the 1978 reauthorization of the Older Americans Act and the development in the ensuing five years of standards and funding for home-delivered meals, communities have found the need to become part of a national meals association.

We have taken many strides during these five years, are especially proud of our record in building community involvement and support in a program which could easily be turned over to Government. We believe in people helping people. But sometimes those helping people need some help themselves. That is why I am here today to testify on the Volunteer Mileage Bill.

It's not so very long ago that the myth of the rich lady volunteer was believed by most of us. It took the development of such programs as Mals on Wheels to help us all begin to recognize who the volunteers relly are you, me, cur neighbors, friends, colleagues, parents, grandparents, children. Everyone of us needs to give; every One of needs to be needed. And the wonderful part is, we are all needed.

The industrialization and massive technological change of the past few decades have take our society and kind of turned

TESTIMONY ON VCLUNTEER MILEAGE BILL

Submitted by Mamie Hamilton Lee, President,
National Association of Meal Programs

and we