9:31:47 AM SENATE BILL NO. 151 "An Act excepting from the Alaska Net Income Tax Act the federal deduction regarding income attributable to certain domestic production activities; and providing for an effective date." This was the second hearing for this bill in the Senate Finance Committee. JUDY BRADY, Executive Director, Alaska Oil and Gas Association, spoke about the non-profit trade association that represents the majority of the companies that produce, explore, transport and refine oil and gas products in Alaska. She introduced Mr. Williams. 9:34:05 AM TOM WILLIAMS, Chair, Tax Committee, Alaska Oil and Gas Association (AOGA), read his testimony into the record as follows [editorial notations made by author]. AOGA is a private trade association whose 18 members companies account for a majority of the oil and gas exploration, development, production, transportation, refining and marketing activities in Alaska. On behalf of AOGA and its members, I thank you for this opportunity to testify on Senate Bill 151. AOGA opposes this legislation for two reasons. First, the justification for it has been misstated to you and its fiscal impacts have been significantly overstated. Second, the bill represents yet another tax increase on the oil industry from this Administration. To explain our reasons for opposing this bill, let me first provide you briefly with some background. Last year Congress passed the federal Jobs Act creating, among other things, a tax incentive to improve the competitiveness of manufacturing in the United States, which currently is disadvantaged relative to the rest of the world because national income tax rates on such activity overseas are generally lower. This tax incentive takes the form of a new deduction that is equal to a percentage of a taxpayer's "qualified production activity income" ("QPA Income") from manufacturing activity occurring in the United States. The tax deduction equals 3% of this QPA Income initially; it increases to 6% in 2007 and reaches its full size of 9% beginning in 2010. In order to make this work as an incentive to create and keep jobs in the United States, Congress specifically limited QPA Income to income from domestic, U.S. - only activity. Alaska's state income tax automatically adopts sections 1 - 1399 and 6001 - 7872 of the Internal Revenue Code, including new sections within these number ranges as they are enacted, amendments as they are made to existing sections, and even repeals of any of these sections in the federal Code. Alaska picks up these federal changes unless the Legislature enacts a law to prevent such a federal change from taking effect, or modify its effect for state purposes. The new deduction for QPA Income in Section 199 of the Internal Revenue Code and hence has been picked up for state purposes. Senate Bill 151 proposes to undo this automatic adoption of Section 199 and keep it from taking effect for state income-tax purposes. In the fiscal note for this legislation, the Department of Revenue claims that letting Section 199 take effect for Alaska purposes would cost the State between $94.88 million and $104.84 million in total over the FY 05 - FY 10 period. Further, Department of Revenue's fiscal note states it cold cost more than half a million dollars a year for Department of Revenue to administer Section 199 if it takes effect for state purposes. Both of these estimates are, in AOGA's opinion, severely overstated because of a faulty premise in Department of Revenue's analysis. This premise is stated in the fiscal note as follows: In order to avoid impermissible discrimination against economic activity outside of the state, taxpayers will be allowed the QPA [Income] deduction on their Alaskan return for all production profits whether the activity occurred in Alaska, another state, or in a foreign country. Production activity conducted in-state, domestic out of state, or in a foreign country will be awarded an equal deduction. In other words, in assessing the state revenue impact of letting Section 199 take effect, Department of Revenue looked at potential "production activity income" everywhere in the world. It did not look just at "qualified" production activity income as defined by Congress, which is only that income which comes from production activity inside the United States. Despite what Department of Revenue asserts to the contrary in its fiscal note, when Alaska passively adopts a limited federal deduction, it does not legally or logically follow from this fact that Department of Revenue must, under the Foreign Commerce Clause of the U.S. Constitution, completely remove the limitation in the course of administering the deduction for state tax purposes. There is ample precedent where a geographically limited federal provision remains limited in precisely the same way when it is applied under the Alaska income tax. For instance, expenditures for enhanced oil recovery ("EOR") give rise to a federal tax credit that Alaska also allows, and the federal credit is limited to expenditures for EOR projects in the United States - in administering the EOR credit for state purposes, Department of Revenue does not impute a hypothetical credit for EOR projects outside the United States "[I]n order to avoid impermissible discrimination against economic activity outside of the state[;]" instead, Department of Revenue uses the same domestic territorial limitation as the federal credit has. We do not see how the domestic territorial limitation in the new QPA Income deduction would be any different from the one for EOR in terms of its potential for "impermissible discrimination." In other words, since Department of Revenue isn't applying the EOR credit on a worldwide basis, it is inconsistent for Department of Revenue to say it must apply the QPA Income deduction on a worldwide basis. 9:39:36 AM Mr. Williams deviated from his written testimony to state the following. There's another reason too. I'm going to depart briefly from the prepared comments here. For foreign income, taxpayers basically have three possible ways of reporting that to the state. One is to look at their overseas activities and restate the income and expenditures under federal income tax principals, as if those companies were going to file a tax return with the IRS. For state purposes they make the state modifications that we have, but basically that's reporting and paying as if they were federal taxpayers. That's called the "as if federal basis" that they use. But, especially for large international corporations, that restatement to an "as if federal basis" can be very cumbersome and time consuming and often for a relatively small amount of tax. So the Department allows taxpayers to use two other options. For their control foreign operations, they can use what's called an "earnings and profits" that they report on an information return to the IRS. Alternatively, taxpayers may use financial statement income under generally accepted accounting principals in the country where they're headquartered. We basically then have the three choices: the "as if" federal income, the earnings and profits income, and the generally accepted accounting principals, or GAP, income. Taxpayers get to choose those. If a taxpayer voluntarily reports on the basis of earnings and profits there'll be no QPA Income in there because QPA Income is not part of the definition of earnings and profits. There won't be any deduction for it; the income will be there but there won't be this deduction. Similarly, if you have financial accounting income as your basis for reporting your non-US operations income, generally accepted accounting principals don't have a deduction for QPA Income. So that deduction won't show up there. The taxpayers will voluntarily use either of those two methods, voluntarily abandon the claim for a deduction with respect to the non-US QPA activity income. Even if there were theoretically a constitutional issue here, there's no foul, there's no harm. 9:42:05 AM Mr. Williams resumed reading his written testimony as follows. Because of its faulty premise about how broadly the QPA Income is deduced must be applied for State purposes, Department of Revenue's estimated revenue impacts are overstated by at least a factor of two or three or more, depending on how much QPA- ish income it foresaw from non-US production activities. Similarly, the estimated administrative cost of half a million dollars a year is entirely a result of this same faulty assumption. The IRS will audit taxpayers' QPA Income from activities in the US, and there will be nothing left for Department of Revenue to audit and enforce. The half a million dollars a year should, in other words, disappear. AOGA also disagrees with Department of Revenue's conclusion in the fiscal note that the anticipated beneficial effects of the QPA Income deduction at the federal level "cannot be replicated at the state level." At least with respect to oil and gas, the two principal regions of qualified production activity in the United States are the deep-water Gulf of Mexico and Alaska. With only two "hot spots" for the action to occur in, it seems likely that Alaska would be ahead of the game when the incentive works in attracting production activity to the US. Given Department of Revenue's contrary conclusion about these benefits for Alaska, it seems improbable that Department of Revenue made any serious attempt to estimate and include the increases in State tax revenues from the production activities in Alaska that this tax incentive would help attract to this state. Thus, both on policy grounds as well as potential fiscal impacts, the justification that Department of Revenue has given for this legislation has been both overstated and misstated. This brings me to AOGA's second reason for opposing this legislation: it represents yet another tax increase on the oil industry from this Administration. It is a tax increase because Section 199 of the Internal Revenue Code was automatically adopted for state purposes as of January first of this year, when it took effect for federal purposes. Section 199 is, in other words, already the status quo. SB 151 proposes to change this status quo by undoing the adoption of Section 199, and in doing so it will raise corporate income taxes for our industry and every other industry in the state having "qualified production activity." Department of Revenue's just-released Spring 2005 Revenue Sources Book predicts future state oil and gas revenues through FY 15 based on assumptions that tens of billions of dollars of new investments will be made during that time which will hold oil production at the projected levels and keep it from declining at it otherwise will. Fortunately for Alaska, the opportunities for making these investments, and the possibility that they will indeed result in the production being hoped for, are not some wild pipe dream, but a plausible expectation. The key to fulfilling this bright expectation lies in winning the competition for funding so that the potential Alaskan investments will become actual investments. Raising taxes does not make Alaska's investment opportunities more competitive. It makes them less competitive. Some have said that, with today's high oil prices, Alaska can and should raise its oil taxes - the producers can afford to pay a larger share of this "windfall" they say. This reasoning misses the real issues here. From the industry's perspective, the question is not about how much it can afford to pay to Alaska, but how much it can afford to invest in Alaska relative to opportunities elsewhere. Fifty-dollar oil is not $50 just for Alaskan oil, but for all oil wherever produced. High oil prices to not change the fact that Alaska is among the most expensive places in the world to operate and produce oil. From the State's perspective as well, the question is not so simplistic as to be only about what the industry might be able to pay. There is a trade-off between, on the one hand, taking a larger share now and having less available to be shared in the future because some investments cease to be competitive enough to win funding, and on the other hand, taking the same or perhaps even a more modest share and having more available to be shared in the future because more investments become competitive enough to win funding. Or to put it another way, which gives the State more - taking a wider slice out of a smaller pie, or a narrower slice out of a larger pie? And what is the optimum width for that slice so that it has the most fiscal "weight"? Some simplistically believe that $50 oil will justify any and all of the investment opportunities that industry has in Alaska, despite raising taxes as proposed in this bill or raising them by lumping satellite fields with their parent field for ELF purposes. Such reasoning apparently led Department of Revenue and Department of Natural Resources to advise the Governor to introduce this bill, and to make the Prudhoe Bay ELF decision. The Governor was, no doubt assured in both situations that neither action would actually change investment decisions. The advice that the Governor received about the ELF decision has already been proven wrong. The Orion field in the western region of the Prudhoe Bay Unit, for example, is a development that industry has been diligently pursuing to help stem the decline of North Slope production. The producers have already stated that, because of the tax increase under that decision, they will not be able to proceed with the planned expansion of the Orion field as it is currently proposed. This expansion would have been a $650 million project to develop viscous oil in the Prudhoe Bay Unit. An associated casualty is the I-100 Well for viscous oil development that was on this year's drilling schedule for Prudhoe Bay, but now has been removed and indefinitely deferred. The advice that the Governor has been given about this bill is also wrong, for the same reasons. Because it has not become law, there is no hard, empirical evidence to offer you to show that this bill is ill-advised for the State. Fortunately, however, this same circumstance means it is not too late for you, the Legislature, to avoid repeating the mistake of the Governor's advisors. You are in the position of being able to refrain from acting, and you should. AOGA has long said, and we need to say again now, any change to Alaska's existing fiscal regime for our industry needs to be carefully evaluated for its impacts on each of the different kinds of investments there are for getting more oil produced. Otherwise, there is a substantial risk that the anticipated negative effects of that change on other kinds of oil investments. We believe that raising oil taxes now, as SB 151 would do, will send precisely the wrong message to the industry about making the investments that Alaska is so desperately needs and is counting on for its own fiscal future. Accordingly, AOGA opposes this bill and respectfully urges that you oppose it too. 9:50:17 AM LARRY HOULE, General Manager, The Alaska Support Industry Alliance, testified via teleconference from Anchorage in opposition to this bill. He read a statement into the record as follows. The Alliance this year is celebrating its 25th. We are a 501 C6 non-profit statewide trade association representing over 380 businesses, organizations and individuals. The collective workforce represented by Alliance membership exceeds 30,000 Alaskans that live in your districts. The Alliance is very much opposed to this legislation because we see it as yet another industry tax that will further erode Alaska's competitive position as [an] oil and gas province in an ever increasing competitive global market. In short, it represents another tax increase on the oil industry from the Murkowski Administration. Raising taxes does not make Alaska's investment opportunities more competitive. It simply and plainly makes Alaska's investment climate less competitive. A lot of people are saying these days that in a world where oil companies are getting $50 a barrel that they can all afford to pay more taxes. But we forget that $50 oil in Alaska is the same as $50 oil in the Middle East, South America or Indonesia. In the oil and gas industry, it is not the price of oil that matters, but the cost to produce that particular barrel of oil that really matters. Less expensive oil will always get produced before more expensive oil. The reality is relative to other oil and gas providences in the world, Alaska's oil is extremely expensive to produce. I believe this fact was recently validated the Wood Max [spelling not verified] study. We think that SB 151 simply adds to the production costs of Alaska's oil. When we first read through this bill, let me give you a simple sort of metaphoric [indiscernible] of how we talked about this particular bill. I live in the Anchorage neighborhood of College Village. We just received the good news that there was a $5,000 property tax exemption or tax credit that everyone who owns a home in Anchorage in College Village gets to benefit from. However, all of a sudden, the mayor or maybe the local assembly passed an ordinance that says "no this tax exemption is only for those houses - you can only have this tax exemption if your house is painted white." And I happen to live in a white house in College Village. How welcome should I feel? How welcome should an industry feel when they are continually the subject of increased taxes. And also I want to point out this is an increase tax at a time of a $500 million surplus. We agree with Tom in the fact that the advice that the Governor received on the recent field aggregation to raise taxes on the Prudhoe Bay satellites was wrong. The Alliance has been very aggressive in its statements against the Governor's actions. We clearly see that the aggregation of the fields in Alaska up on Prudhoe Bay will probably eliminate 20 to 40,000 barrels of oil that will never get the tax pipeline because of the faction unless it's overturned. Already, Alliance contractors, specifically in the area of engineering, are experiencing a slowdown in work. Senate Bill 151 is, like Tom said, a piling on of another tax for this industry. I've said it before and I will probably say again, that no project has ever been taxed into existence. State officials, the legislature and the public need to remember what some of them seem to have forgotten, that companies wisely invest shareholder money. Corporate officers look to invest in areas where there is an opportunity for reasonable profits and those investments can be made without undue risk. The problem is that most recently, if you take this particular SB 151 you take the arbitrary Administrative action by the Governor to aggregate Prudhoe Bay satellites. It's becoming a high-risk province. Senate Bill 151, we believe is ill-advised legislation. It sends a wrong message to Alaska's largest investors and if passed it would most certainly cost Alaskans that work in oil [indiscernible - patch?] jobs. We respectfully urge you to oppose this particular legislation. 9:55:30 AM DAN DICKINSON, Director, Tax Division, Department of Revenue, testified that the AOGA gave two reasons against this legislation. The first claimed that the Department misstated or overstated the impact with "faulty premises". Mr. Dickenson pointed out that "fundamentally", the Department asserted this legislation would have "a hundred million dollar affect over the next decade." AOGA calculated the amount to be half that, or even $30 million. The dispute is over the size of the affect and AOGA does not question that there would be an affect. He noted this information could not be verified, as the courts would decide the issues. Mr. Dickinson cited an article in the Alaska Budget Report [copy not provided], which asked members of AOGA their intentions if this legislation did not pass. The members responded that they would take advantage of any tax allowances permitable by law. Mr. Dickenson predicted resolution of the matter would take several years, although the Department is confident that the State would prevail. He told of a court decision issued in 1992 [specifics not provided] establishing rules, which the Department has followed since. The "commerce clause issue" that pertains to the "ability to draw extra-territorial lines" has not been permitted. Mr. Dickenson directed attention to the example given by AOGA relating to credits. Credits are "very different from determining income." He surmised that company would not sue the State because of the manner in which credits are treated. He noted a circuit court decision on the treatment of credits that, although does not directly apply to Alaska, is an indicator. 9:58:51 AM Mr. Dickinson spoke to the assertion that prices of $50 per barrel of oil has the same value in Alaska as in the rest of the world. This is untrue. This price has more value in a regressive regime than in a progressive regime. He explained that Alaska has a regressive regime, in that when prices are low, a high percentage of "economic rent" is taken, and as prices rise an "ever lower" percentage is taken. At the price of $50 per barrel, Alaska "is one of the best places in the world to do business." As the price increases in a progressive regime, the host government takes an ever-larger percentage. 9:59:45 AM Mr. Dickinson next addressed the second statement made by AOGA in opposition to this bill, that "this is just another tax increase that's been passed on by the Murkowski Administration." He read a portion of Mr. Williams' testimony to indicate this. Mr. Dickenson reminded the Committee members that at the conclusion of the previous legislative session, the federal government "changed the rules and those rules will flow through to the state laws." This is the first opportunity for the legislature to address the matter and determine whether Alaska should "go along" with those opportunities provided by the federal government to attempt to return certain industrial development to America from abroad. He surmised that Alaska would likely not receive a significant share of investment. He explained that the federal legislation pertains to manufacturing and refining activities rather than resource extraction. The legislature must determine whether this is an unfunded federal mandate and if it is appropriate for the State to lower its taxes. 10:01:48 AM Senator Stedman characterized the title of the American Job Creation Act as a stimulus effort to increase manufacturing jogs in the country. He asked if the State opting to participate or not participate would generate additional jobs. 10:02:45 AM Co-Chair Green asked if this has that been analyzed. 10:02:54 AM Mr. Dickinson qualified the federal Act affects many provisions, including the creation of special depreciation rules for a natural gas pipeline. Many of the provisions would "encourage" job creation in Alaska. The Department is not recommending decoupling those sections. This legislation addresses one provision only and would not reduce any of the federal tax benefit. Mr. Dickinson explained that the State has historically followed the federal income tax guidelines rather than developing separate guidelines. This legislation is necessary to address the reduced federal taxation rates. 10:04:28 AM Co-Chair Green indicated the fiscal note would receive additional review. The bill was HELD in Committee.