Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 67-25

1967-1 C.B. 156

Section 7425 -- Discharge of Liens

IRS Headnote

Where a "first year rental" paid under a competitive government or private nongovernmental oil and gas lease, has the characteristics of a true "delay rental" it may be treated as an expense or capitalized at the option of the lessee. However, in any instance in which a payment is, in substance, a bonus, even though designated as a "first year rental," it must be capitalized and recovered through depletion deductions.

Revenue Ruling 56-252, C.B. 1956-1, 210, modified.

Full Text

Rev. Rul. 67-25

Advice has been requested whether first-year payments, designated as "rentals," under competitive oil and gas leases granted by Federal and State governments are to be capitalized or deducted as an expense by the lessee.

In this case, bonuses were paid in addition to "yearly rental payments" of a stated amount per acre, payable in advance, upon execution of competitive Federal and State government oil and gas leases. These "yearly rental payments" either terminated upon production or were credited against the royalty for that year which was computed at a specified percentage of gross income.

The Mineral Lands Leasing Act of February 25, 1920, as amended, 30 U.S.C. 181, et seq., with respect to government lands, provides for competitive oil and gas leases on lands in a known geological structure and for noncompetitive leases on lands outside such structure. In referring to competitive leases, the Act speaks of "bonus" and "royalty" as well as "rent." However, in referring to noncompetitive leases the Act speaks only of "rental" or "royalty."

Revenue Ruling 56-252, C.B. 1956-1, 210, holds, "that first year 'rental' payments paid in the acquisition of noncompetitive government oil and gas leases are to be treated as nondepletable deductible expenditures." That ruling also holds that "first year rental" payments made by lessees of private, nongovernmental oil and gas leases are capital investments recoverable only through depletion. The question of the treatment of such payments in the case of competitive governmental leases was not considered in that Revenue Ruling.

In the case of a private nongovernmental (commercial) lease, the rental payment is made at or near the end of the first year and each succeeding year prior to development to keep the contract in effect for another year. In the cases of competitive governmental leases, rental payments are paid at the beginning of the first year as well as for each succeeding year prior to development.

Yearly rental payments made with respect to an undeveloped oil and gas lease which extend the period in which the lessee may delay the drilling of wells for the production of oil and gas are termed "delay rentals." Section 1.612-3(c)(1) of the Income Tax Regulations defines a "delay rental" as "an amount paid for the privilege of deferring development of the property and which could have been avoided by abandonment of the lease, or by commencement of development operations, or by obtaining production."

Revenue Ruling 55-118, C.B. 1955-1, 320, holds, under the Internal Revenue Code of 1939, that "delay rentals" paid or accrued in connection with nonproducing oil and gas leases may, at the election of the lessee, be expensed or capitalized, irrespective of their treatment in earlier years with respect to a property and irrespective of the treatment of similar payments in connection with other properties. The same rule applies under the Internal Revenue Code of 1954. See section 1.612-3(c)(2) of the regulations.

Accordingly, to the extent a first-year rental, paid under a competitive Federal or State government or private nongovernmental oil and gas lease, has the characteristics of a true delay rental it may be treated as an expense or capitalized at the option of the lessee. However, in any instance in which a payment is, in substance, a bonus, even though designated as a first-year rental payment, the amount thereof must be capitalized and recovered through depletion deductions. As to both of these points see Houston Farms Development Co. v. United States, 131 F. 2d 577 (1942), rehearing denied, 132 F. 2d 861; Jefferson Lake Sulphur Co. v. Lambert, 133 F. Supp. 197 (1955), affirmed, 236 F. 2d 542 (1956); and Shamrock Oil & Gas Corporation, 35 T.C. 979 (1961) acquiescence, C.B. 1966-1, 3, affirmed, 346 F. 2d 377 (1965).

Revenue Ruling 56-252 is modified to remove therefrom the holding that all first-year rental payments made by lessees of private nongovernmental oil and gas leases must be capitalized.