Oil Speculation Tax Proposal

Introduction
A discussion staff draft of an "Oil Speculation Tax Proposal" was introduced on July 31, 2008 by Senators Grassley (R-Iowa) and Wyden (D-Ore.) that will dramatically affect the taxation of oil, natural gas and related commodities. The Senators are currently soliciting comments on the draft proposal from third parties prior to its final introduction as a Senate bill.

This far reaching bill defines oil, gas and related commodities very broadly and treats any gain or loss received upon their sale or exchange as short term capital gain or loss. It also taxes tax-exempt entities on their oil and natural gas commodity investments. Understanding the force behind this proposal is key to understanding the legislation itself.

Background
The worsening economic conditions in the United States and rising consumer costs are primary concerns this election year. The rising price of oil is widely felt by average Americans each time they fill their gas tanks and is reflected in increased prices for almost all consumer goods resulting from increased transportation and production costs. Oil companies are reporting record profits and the price of oil has risen from 70 dollars a barrel in September 2007 to record heights of 145 dollars a barrel in July 2008. Many factors including bad weather, instability in the middle east and increased demand from developing economies such as India and China are cited as contributing toward this dramatic increase in oil prices. While these may be driving up the price of oil, one school of thought asserts that these factors alone cannot account for the record-breaking oil prices Americans have witnessed this year. Heightened scrutiny of the commodity markets in general, and the oil markets in particular, has led some to conclude that speculation in the commodities market is at least partly to blame for the spike in prices.

Recent Growth in the Commodities Markets
Institutional investors have become much more involved in the commodities markets in recent years. It is argued that the greatest impact on the commodities market is attributable to large institutional investors who now compose a larger market share of outstanding commodities futures contract than any other market participant. Because commodity indexes have been a good investment bet in the past, many institutional investors allocate a percentage of their portfolio to commodity indexes. According to one analyst, financial assets allocated to commodity index trading strategies have risen from $13 billion at the end of 2003 to $260 billion as of March 2008. According to the Wyden-Grassley proposal, speculative trading in the oil futures markets accounted for 37% of crude oil trading on the New York Mercantile Exchange in 2000, and now accounts for more than 70% of trading. It is argued that these massive investments by institutional investors are a major force driving energy prices to extraordinary levels.

Commodities Market Participants
As described by the proposal, commodities market investors are grouped into three categories.

1. Commercial buyers such as airlines, trucking companies, and independent refiners who need to buy oil or other fuels or futures contracts in order to run their businesses;
2. for profit speculators who do not require large quantities of oil but invest in commodities to take advantage of price fluctuations in the market; and,
3. tax exempt investors such as pension funds, and university funds which pay no taxes on their investments.

The Goal of the Oil Speculation Tax Proposal
In light of the concern that increased speculation in the energy commodities market fuels the rising cost of oil and natural gas, the Wyden-Grassley proposal is focused on reducing speculation in these markets. The proposal is aimed at eliminating the "tax incentives that entice speculators into the market." Currently, only commercial buyers pay tax at ordinary income rates from commodity trading. Speculators pay lower capital gains rates on their profits and tax-exempt investors do not pay any taxes on these investments. Eliminating the tax advantages afforded to speculators, both taxable and tax-exempt, is intended to reduce speculation in oil and gas commodities in the hopes that this will result in lower energy prices.

Those Affected
The proposal applies to all holders of natural gas and oil commodities for investment purposes. Taxpayers who currently treat gain or loss from these investments as ordinary including dealers in commodities, those who handle the commodity as inventory and businesses that sell or exchange the commodity as part of genuine commercial hedging transactions are unaffected.

Types of Commodities Affected
The proposal broadly defines oil and gas and related commodities to include: oil or natural gas or any of their primary products that are actively traded, any index fund with a substantial basis in one or more of these commodities; any notional principal contract related to such indexes or commodities; and any related option, forward contract, futures contract, short position or similar instrument.

How the Proposal Works

Taxpayers:
Any capital gain or loss from the sale or exchange of oil or natural gas and related commodities for investment purposes is treated as a short term capital gain or loss, regardless of the holding period. All oil and natural gas contracts which are marked to market under I.R.C. § 1256 are also be treated as 100% short term capital gain rather than receiving the current 60% short-term, 40% long-term treatment.

Tax-exempt entities:
For tax exempt entities any gain or loss from the sale or exchange of oil, natural gas and related commodities would be treated as unrelated business taxable income (UBTI) under I.R.C. § 512 and taxed regardless of the entity's tax-exempt status. The proposal contains certain provisions to prevent avoidance of UBTI through the use of foreign blocker corporations.

Effective Date
The proposal would apply to investments made after the date of public release of the bill - July 31, 2008 and would impact any new speculative commodity investments. The provisions are to be in effect for four years, through January 1, 2013. A Treasury Department study to determine the impact of these provisions on the commodity markets and the tax system is due January 1, 2012, one year before the provisions expire.

Conclusion
While the Wyden-Grassley proposal is still in its draft form, it addresses runaway energy pricing which is one of the nation's most pressing economic concerns. Financial conditions have focused increased attention on the commodities market and added urgency to legislative interventions. Elimination of differential tax treatment for various market participants is an attempt to curtail speculation and bring down oil and natural gas prices. Whether the theories behind this proposal are sound remains to be seen. Regardless, the Wyden-Grassley proposal has potentially wide reaching economic and tax implications and should be closely watched by taxpayers, investors and consumers alike as it makes it way through the legislative process.