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The IRS covered most of the check
The postwar tax rate
After World War II, the top tax rate exceeded 90% of gross income, because Washington had committed to paying down its immense war debts. At the same time, the government wanted more domestic drilling and offered tax incentives for it. Highly taxed people had every reason to invest in the search for oil and gas.
The math for an investor
Picture an investor who puts $200,000 into one of Apache's drilling programs. The investor gets an immediate deduction of 80% of that, or $160,000. At a 90% bracket, that deduction cuts taxes by about $144,000, so the $200,000 check costs roughly $56,000 out of pocket.
If the wells find enough oil to double the investment, the investor receives another $200,000. Oil royalties carry a second benefit, the depletion allowance, which lets owners of oil-producing properties treat part of the income as a return of the oil being depleted underground. With 27.5% excluded, $55,000 of that $200,000 is tax-free and only the remaining $145,000 is taxed.
Why Apache wanted it
The structure solved a financing problem for Apache, a young company without much capital. Even if the wells were only moderately successful, the tax benefits alone shrank the investor's downside, and a discovery added upside. That made it easier to raise millions of dollars for leases and drilling without borrowing huge sums from banks.
The loopholes were eventually closed, which forced the company's founder to reinvent Apache again and again.
Why were postwar tax rates so high?
World War II pushed federal spending and debt to unprecedented levels. According to the US Treasury and the Office of Management and Budget, federal debt peaked at about 106 percent of GDP in 1946. Congress raised income tax rates sharply during the war, and the top rate reached 94 percent in 1944 and 1945, according to the Tax Policy Center's historical tables. The top rate stayed above 90 percent for much of the 1950s and early 1960s, before cuts in 1964 and 1965 brought it down to 70 percent.
How does the depletion allowance work?
Percentage depletion lets an oil and gas producer deduct a fixed share of a property's gross income each year, regardless of what the producer originally paid for it. Congress introduced it for oil and gas in 1926 at a rate of 27.5 percent. Because the deduction follows income instead of cost, the total deducted over the years can exceed what the property cost. The Tax Reform Act of 1969 reduced the rate to 22 percent, and a 1975 law eliminated percentage depletion for most large producers.
Why could drilling costs be deducted at once?
Much of what it costs to drill a well goes to wages, fuel, drilling fluids, site preparation, and rig time, none of which leave physical equipment behind. US tax rules call these intangible drilling costs. They have let producers deduct the costs in the year they are paid instead of spreading them over the life of the well. Treasury regulations took this approach in the early twentieth century, and Congress wrote it into the Internal Revenue Code of 1954.
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