Rev. Rul. 80-49

1980-1 C.B. 127, 1980-8 I.R.B. 13.

                       Internal Revenue Service
                                 Revenue Ruling

                    OIL AND GAS LEASES; FIRST YEAR PAYMENTS

                          Published: February 25, 1980

Section 612.--Basis for Cost Depletion, 26 CFR 1.612-3: Depletion; treatment of bonus an advanced royalty.

(Also Section 162; 1.162-1.)

  Oil and gas leases; first year payments. Examples illustrate certain first year payments made by a lessee upon obtaining an oil and has lease that are delay rentals that may be capitalized or expensed at the election of the lessee or are lease bonuses that must be capitalized; Rev. Ruls. 56-252 and 67-25 superseded.

ISSUE

  Whether, under the various factual situations described below, first year payments made by a lessee upon obtaining an oil and gas lease on tracts of land are delay rentals that may be capitalized or expensed in the year paid at the election of the lessee, rental payments that are ordinary and necessary business expenses in the year paid or incurred, or lease bonuses that must be capitalized.

FACTS

  The taxpayer bid competitively for federal oil and gas leases, filed entries under the simultaneous filing procedure for noncompetitive leasing of federal oil and gas lands, and leased oil and gas properties from private individuals.

  The various situations in which the taxpayer makes first year payments when leasing oil and gas properties are as follows:

    Situation 1.  Under the competitive bidding procedure, the leases are awarded to the bidder offering the largest bonus for a specified lease.  The taxpayer when awarded the lease is required to pay the Bureau of Land Management any unpaid balance of the bonus, and also a payment designated as first year rental.  Each year thereafter a similar rental payment is due on the anniversary date of the lease unless a discovery has been made or the lease terminated.

    Situation 2.  Under the simultaneous filing procedure for noncompetitive leasing of federal lands, a nonrefundable filing fee must accompany each lease application.  The successful applicant is determined by lottery.  The taxpayer, when awarded the lease, is required to make a first year rental payment.  Similar payments will be due on the anniversary date of the lease unless a discovery has been made or the lease terminated.

    Situation 3.  The taxpayer negotiates for an oil and gas lease with a private individual for a term of three years.  The terms of the lease require a bonus payment.  A yearly payment designated as rent is required to be made at the end of the first year and, if drilling has not then commenced, at the end of each succeeding year of the primary term of the lease.

    Situation 4.  The taxpayer negotiates for an oil and gas lease with a private individual for a term of three years.  The terms of the lease require a bonus payment.  An additional payment, designated as rent, is required to be made at the time the lease is signed.  The additional payment extends for two years the primary term of the lease.

LAW AND ANALYSIS

  Section 1.162-1 of the Income Tax enue Code provides that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

  Section 1.162-1 of the Income Tax Regulations provides that the business expenses deductible under section 162 of the Code include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer's trade or business.

  Section 1.612-3(a)(3) of the regulations provides that lessee's payment of a bonus is a capital investment made to acquire an economic interest in a mineral deposit and is recoverable through the allowance for depletion.

  Section 1.612-3(c)(1) of the regulations defines 'delay rental' as payments made for the privilege of deferring development of the property that can be avoided by abandoning the lease, commencing development operations, or by obtaining production.

  Section 1.612-3(c)(2) of the regulations provides that a delay rental is in the nature of rent and that the payor may, by election, deduct such amount as an expense or charge it to a depletable capital account.

  In distinguishing a delay rental from a bonus in Fitzsimmons v. Commissioner, 37 T.C. 179 (1961), the court held that when payments designated as rentals could not be avoided by drilling, the leasing instrument did not indicate such payments were for delay in drilling, and the payments were greater than the sums provided for delay in drilling, such payments were in the nature of a bonus paid in installments.

  The first year payments designated as rentals in the federal leasing transactions are in substance the same as the succeeding

delay rental payments.  United States v. Dougan, 214 F.2d 511 (10th Cir. 1954); Commissioner v. Miller, 227 F.2d 326 (9th Cir. 1956); and Featherstone v. Commissioner, 22 T.C. 763 (1954).

  The first year payments in situations 1 and 2 are in substance delay rentals and not payable for subsequent years if the lessee abandons the lease for which such rentals were paid or obtains production on the lease.

  In addition, those payments in situations 1, 3, and 4 that are designated as bonuses are for the right to enter upon and explore for oil and gas and therefore are bonuses within the meaning of section 1.612-3(a)(3).  Bonuses are capital investments that must be recovered through the deduction for depletion.

  The payment in situation 3 that extends the time period within which the lessee must commence drilling of a well is a delay rental.

  The additional payment in situation 4, designated as rent by lessee, extends the primary term of the lease and therefore is a bonus.  Bonuses are capital investments for federal income tax purposes.

HOLDINGS

  In situation 1 above, the lessee must capitalize the bonus paid. The first year rental payment may, at the lessee's option, be capitalized or expensed in the year paid or incurred.

  In situation 2, the lessee must capitalize the filing fee. The first year rental may, at the lessee's option, be capitalized or expensed in the year paid or incurred.

  In situation 3, the lessee must capitalize the bonus paid and may elect to capitalize or expense the delay rental payment.

  In situation 4, the lessee must capitalize the initial bonus and the additional payment.

EFFECT ON OTHER REV. RULS.

  Rev. Rul. 56-252, 1956-1 C.B. 210, and Rev. Rul. 67-25, 1967-1 C.B. 156, are superseded because the positions set forth therein are restated in this Revenue Ruling.

Rev. Rul. 80-49, 1980-1 C.B. 127, 1980-8 I.R.B. 13.