What is Depletion Allowance?

A depletion allowance is a tax deduction allowed in order to compensate for the depletion or 'using up' of natural resource deposits such as oil, natural gas, iron, timber etc. The allowance is a form of cost recovery for capital investment which, unlike income, is not taxable.

How Does Depletion Allowance Work?

There are two basic forms of depletion allowance, cost depletion and percentage depletion.

Under the cost method, the original investment is recouped by deducting a portion of the capital investment each year from gross income over the estimated life of the resource deposit.

Cost depletion can be illustrated in this way:

An oil company invests $15 million in a property with an estimated oil reserve life of 15 years. The company deducts approximately $1,000,000 ($15 million/15 years) from taxable earnings each year until the initial investment is recouped in tax benefits.

The percentage method involves perpetually deducting a percentage from gross income earned, whereby more than the original cost can be recouped.

For example, a company might simply deduct 10% from gross income for as long as the property produces.

Why Does Depletion Allowance Matter?

Depletion allowance incentivizes companies to continue to develop natural resources by allowing them to offset the disadvantages of operating a depleting asset.

In the case of certain investments such as royalty trusts, depletion is accounted for in a portion of dividend payments that are treated as return of capital, which is not taxed directly but offset against the cost basis and paid as capital gains when the security is sold.