Rev. Rul. 80-71

1980-1 C.B. 106, 1980-11 I.R.B. 7.

                       Internal Revenue Service
                                 Revenue Ruling

       INTANGILBLE DRILLING COSTS; LIMITED PARTNERSHIP; YEAR OF DEDUCTION

                           Published: March 17, 1980

26 CFR 1.46-1: General rule for taxable year of deduction.

(Also Sections 263, 612; 1.263(c)-1, 1.612-4.)

  Intangible drilling costs; limited partnership; year of deduction. An oil and gas limited partnership made advance payments, at a fixed rate per well, for the costs of drilling oil and gas wells to the parent of its corporate general partner. The parent owned no drilling equipment and subcontracted the actual drilling of wells to independent drilling contractors, who were paid on a footage and day work basis upon completion of the contracts. These payments are not deductible until paid to the independent contractors. Rev. Rul. 71-252 distinguished.

ISSUE

  Whether under the circumstances described below a limited partnership that uses the cash receipts and disbursements method of accounting is entitled to deduct in the tax year amounts that are paid within the tax year as 'intangible drilling and development costs,' and optionally expensed under the provisions of section 1.612-4 of the Income Tax Regulations.

FACTS

  A limited partnership (LP) was organized in 1975 for the exploration and development of oil and gas lands.  LP was formed by 100x limited partners who each contributed $1,000x to the limited partnership.  The general partner of LP is corporation X whose parent, corporation Y, is the general contractor that will arrange for the drilling, completion, and equipping of the oil and gas wells.  The partnership reports its income on a calendar year basis.

  The partnership agreement provides that corporation X will transfer to LP, as its contribution to capital, certain oil and gas leases, mineral rights, equipment, and a specified amount of cash.  The limited partners are allocated the deduction for intangible drilling and development costs.

  As general partner, corporation X has control over the operations of the partnership, including the authority to make any expenditures and incur any obligation that it deems necessary, as well as to make the determination of which wells will be drilled. Corporation Y, as general contractor, will conduct the drilling, testing, and completion, or if nonproductive, the abandonment of each well in which LP participates.  Y will charge a fixed fee for such services.

  In October 1975, corporation X, acting on behalf of LP, entered into an agreement with corporation Y for the drilling of wells on tracts covered by leasehold interests previously contributed to LP by X. For certain of the proposed drill sites the entire working or operating interests were held by LP.  For other proposed drill sites, LP owned only an undivided fraction of the working interest, and drilling was to be a joint undertaking between LP and other co-owners.

  The agreement set forth a fixed price ($10,000x) for the intangible costs of drilling and completion of each well and a separate fixed price ($8,000x) for the drilling and abandonment without attempted completion of any that was abandoned after drilling commenced.  For all wells to be drilled for LP, the agreement required that the designated fixed prices for drilling and completion be remitted to Y on or before December 31, 1975.  In the event that any well was drilled and abandoned without completion, the difference between the price advanced on or before December 31 and the fixed price for drilling without completion was to be credited toward the cost of drilling another well or wells at locations to be designated in the future.  The agreement did not specify any date for commencement of drilling operations by corporation Y.

  In accordance with the terms of the agreement, on December 31, 1975, LP advanced to Y sums representing LP's portion of the fixed prices for well drilling to be performed on or after January 1, 1976.  Having previously elected to expense intangible drilling and development costs, LP deducted the advance payments in its Form 1065 partnership return for the year 1975, a year in which LP had no income or other expense.

  Y owned no drilling equipment, and the actual drilling of the wells was subcontracted to independent drilling contractors. The contracts were of the conventional footage and day work variety and did not require any payments to be made by Y to the drillers prior to completion of performance by the drillers.

LAW AND ANALYSIS

  Section 263(c) of the Internal Revenue Code provides that, notwithstanding section 263(a), regulations shall be prescribed by the

Secretary granting taxpayers an election to deduct, as expenses, intangible drilling and development costs in the case of oil and gas wells.  In accordance with section 263(c), section 1.612-4(a) of the regulations provides that intangible drilling and development costs incurred by an operator in the development of oil and gas properties may at the taxpayer's option be chargeable to capital or to expense.

  Section 446(a) of the Code provides that taxable income shall be computed under the method of accounting the taxpayer employs to regularly compute its income in keeping its books.  Section 446(c) provides that certain methods are permissible subject to the requirement of section 446(b).  Section 446(b) provides that if the method used by the taxpayer does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.

  Section 461 of the Code provides that the amount of any deduction allowed by subtitle A shall be taken for the taxable year that is the proper taxable year under the method of accounting used in computing taxable income.

  Section 1.446-1(a)(1) of the regulations provides that the term, 'method of accounting', includes not only the overall method of accounting of a taxpayer but also the accounting treatment of any item of income or deduction.

  Section 1.461-1(a) of the regulations provides that if an expenditure results in the creation of an asset having a useful life that extends substantially beyond the close of the taxable year, such expenditure may not be deductible or may be deductible only in part, for the taxable year in which made.

  Therefore, if the method adopted by the taxpayer for a particular item or transaction does not clearly reflect income, section 446(b) specifically empowers the Commissioner to compute taxable income under such method as, in the opinion of the Commissioner, does clearly reflect income.

  In Rev. Rul. 71-252, 1971-1 C.B. 146, a taxpayer using the cash receipts and disbursements method of accounting deducted in the year paid intangible drilling and development costs.  In that revenue ruling the taxpayer began in 1969 investigating the oil and gas producing potential of a certain tract of land.  After receiving a favorable report thereon the taxpayer acquired, in October 1969, a lease of the oil and gas operating interest in the tract.  On December 31, 1969, the taxpayer executed a written drilling contract with a drilling contractor.  On the same day, as required by the terms of the contract, the taxpayer paid 100x dollars to the contractor.  In March 1970, the well was completed successfully for the production of oil and gas. After discussing Pauley v. United States, (S.D. Cal., 1963), Rev. Rul. 71-252 holds that the 100x dollars intangible drilling and development costs were deductible by the taxpayer in 1969, the year they were paid.

  The prepayment in Pauley was occasioned by the drillers' concern with Pauley's willingness and ability to pay when the driller needed operating funds.  The driller had no earlier business dealings with Pauley, but knew that he was involved in many other business activities.  The court found that the driller required prepayment of the drilling expenses for sufficient business reasons.  The drilling permit was not issued until December 30, 1947, and other 'complicated and diverse' negotiations were being carried out late in 1947 by Pauley.  Drilling activities commenced immediately after December 31, 1947, and proceeded without any substantial delay until completion on March 12, 1948.

  These findings evidenced a bona fide, arm's length transaction entered into for a valid business purpose, and provided the basis for the court's holding that the prepayment was an allowable expense in the year payment was made and deductible in that year.  Further, the prepayment was exhausted within two and one-half months of payment.

  Intangible drilling and development costs are capital in nature. However, section 263(c) of the Code, as implemented by section 1.612-4(a) of the regulations, provides taxpayers an election to expense intangible drilling and development expenditures that otherwise would be capitalized under section 263(a).  Merely because a taxpayer has elected to charge intangible drilling and developments costs to expense, it does not follow that all amounts paid are deductible in the year of payment when such payment is made in advance of the rendering of services by the drilling contractor. Prepaid intangible drilling and development costs are subject to the same standards applicable to other prepaid expense items.  Section 263(c) does not permit a taxpayer unlimited control of the timing of the deduction for drilling and development costs. Instead, the timing of a deduction must meet the specific limitations of section 1.461-1(a) of the regulations in order to meet the clear reflection of income requirement contained in section 446(b).

  Here, at the time the prepayments were made neither the date for commencing nor completing drilling of the wells was specified. Furthermore, the prepayments for the intangible drilling costs were made by LP (the investor group partnership) to Y, the general contractor (and the parent of X, the general partner), who in turn was to contract with the actual drilling contractor for the drilling of the well.  The prepayments could also be applied to later, not as yet contracted for, wells to the extent of unsuccessful completions.  All of this indicates that the prepayments by LP to Y were not made in accordance with customary business practice.

  The prepayments themselves were assets having useful lives that extended substantially beyond the close of LP's 1975 tax year. Since LP had no income for the year of the deduction, the facts indicate the expenditures here were prompted by the federal income tax advantages that resulted from the deduction.

  Considering the facts and circumstances in the present case in the light of the above analysis, LP's deduction for the prepaid intangible drilling and development costs results in a substantial distortion of LP's income for the year of payments.

HOLDING

  LP's prepayments are not deductible in 1975. However, the payments are deductible in the tax year or years Y pays the independent drilling contractors under their conventional footage and day work contracts with Y, if the clear reflection of income requirements of section 446(b) of the Code are satisfied.

EFFECT ON OTHER REVENUE RULINGS

  Rev. Rul. 71-252 is distinguished.

Rev. Rul. 80-71, 1980-1 C.B. 106, 1980-11 I.R.B. 7.