Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 66-64

1966-1 C.B. 97

Sec. 165

Sec. 461

Sec. 471

IRS Headnote

Where a purchaser of natural gas for resale enters into a `take-or-pay' contract under which a liability arises to make a payment for a contract year's gas not yet taken, the asset acquired by the incurring of the liability must be treated by the purchaser as a deferred charge. When title to the `make-up gas' vests in the purchaser, such gas enters into the computation of cost of goods sold.

If the gas is not taken and the right to take the make-up gas is not assigned, a loss for the amount paid for such gas is allowable under section 165 of the Internal Revenue Code of 1954, for the taxable year in which it can be determined that the gas will never be taken and that the amount paid will not be refunded.

Full Text

Rev. Rul. 66-64

Advice has been requested whether, under a `take-or-pay' contract, the cost of that portion of a contract year's specified quantity of gas contracted for which is not taken is deductible in the taxable year in which the liability to make payment arose. Advice has also been requested as to the treatment of such payment when it is determined that the gas paid for will not be taken and that the payment will not be refunded.

The taxpayer is on an accrual method of accounting and purchases natural gas for resale. For the year 1960 and subsequent years, the taxpayer entered into take-or-pay gas purchase contracts. Under such a contract, the taxpayer agrees to purchase and make payment for a specified quantity of gas for each contract year. In the event the taxpayer does not take the entire contract year's specified quantity he may accept, in a period (`make-up period') which extends beyond the contract year in which the failure to take occurred, all or part of the contract year's gas not taken. Gas taken in a contract year subsequent to that in which the liability to take such gas arose is termed `make-up gas.' The cost of the make-up gas taken in the make-up period may be based on the unit price of gas effective during the contract year the gas is taken or it may be based on the unit price in effect during the contract year in which the failure to take occurred, depending upon the terms of the contract. In either case, the purchaser is entitled to offset the amount originally paid with respect to the make-up gas against such cost. The make-up gas may be taken only after the purchaser has accepted the quantity of gas specified for the current contract year.

Make-up periods last for the life of the contract or some lesser period. Payments made for gas not taken in the contract year in which the liability to make such payments arose are not refundable if the gas, through no fault of the seller, is not taken. The producer-seller is required to dedicate specific gas reserves and make available specified quantities of gas as stated in the contract. The rights created under the contract to purchase gas and to acquire make-up gas are assignable.

It is clear that the cost of gas purchased for resale and taken during the contract year in which liability for payment was incurred gives rise to the acquisition of an asset. Similarly, the fact that the taxpayer defers the taking of all or any portion of the gas until a contract year subsequent to that in which the failure to take the specified quantity of gas contracted for occurred does not alter the nature of that which was acquired by the payment for such gas- viz , an asset with an ascertainable fair market value.

Accordingly, when the taxpayer incurs a liability under the contract to pay for a specified quantity of gas but defers the taking of all or a portion thereof to a later period, the amount of the liability to pay for the contract year's gas not taken must be treated as a deferred charge. When title to the make-up gas vests in the purchaser, such gas enters into the computation of cost of goods sold. If the gas is not taken and the right to take the make-up gas is not assigned, a loss for the amount paid for such gas is allowable under section 165 of the Internal Revenue Code of 1954, for the taxable year in which it can be determined that the make-up gas will never be taken and that the amount paid will not be refunded.