Depletion allowance as was approved in Israel before Sheshinski is an unusual fiscal feature in today’s world. It is the same rate (27.5%) as the old depletion allowance in the US that originated in 1926 and lasting into the 1980s. with this kind of allowance the producer has the option of choosing either cost depletion using the unit of production formula or percentage depletion (27.5% of gross revenues less royalty)

A term for either (1) a periodic assignment to expense of recorded amounts or (2) an allowable income tax deduction that is related to the exhaustion of mineral reserves. Depletion is included as one of the elements of amortization. Under certain conditions governments allow owners of oil wells to take a tax savings on their initial investment for selling their oil.

Deduction from gross income due to depletion of the field. The theory behind the depletion allowance is that an incentive is required in order to encourage investment in a high risk industry: when the field starts to be depleted, the oil and gas company needs to start re-investing in exploration to find new reserves. Depletion allowances were only granted by a restricted number of governments such as the US, Canada, Pakistan and Barbardos (and also Israel). In the Philippines there is a similar allowance called FPIA known as Philippine participation incentive allowance.

Depletion is similar to depreciation in that it is a deduction made to recover capital invested in the oil and gas as it is removed from the ground and sold–being depleted. Just as real estate is assumed to depreciate (drop in value) as it grows older, the oil and gas is assumed to be depleted and drop in value as it is used up.

One of two types of depletion allowance may be available to an investor. Cost depletion is always available, while percentage depletion is available only for certain types of products and certain producers and retailers. Where both types are available, the investor is required to compute the depletion allowance which would be provided by each, and must deduct whichever produces the greater amount.

Under the cost depletion method, the amount of the allowance is determined by a formula based on actual costs and units (such as barrels of oil). Cost of Units divided by Estimated Number of Units to be Recovered, times Units Sold in Period.

While cost depletion is based in part on the investor’s actual costs, percentage depletion has no direct relationship to the individual investor’s costs in the initial calculation. Instead, it is a percentage of the property’s gross income less royalties and rents. The percentage is determined by law.

In the US, Percentage depletion is limited to amounts received for actual production. This excludes lease bonuses, advance royalties, or any amounts unrelated to actual production. The deduction, however, is limited to no more than 50% of the taxable income the individual investor receives from the investment.

Another limitation also applies to the percentage depletion. When determining whether to use cost or percentage depletion, the investor must determine whether using the percentage depletion allowance will result in a deduction that is more than 65% of total personal income for the year (not just income from the investment). If it does exceed 65%, but if the investor still must use percentage depletion (because it is greater than cost depletion), the excess over the 65% limit may be carried forward to any future years where it may be used as a deduction under the limitations specified.