Rev. Rul. 83-5
1983-1 C.B. 298.
Internal Revenue Service
Revenue Ruling
WINDFALL PROFIT; NET INCOME LIMITATION; TAXABLE INCOME REDUCED BY COST
DEPLETION; SECTION 263(C) COSTS
Published: January 3, 1983
26 CFR 150.4988-1: Windfall profit; removal price
Windfall profit; net income limitation; taxable income reduced by cost depletion; section 263(c) costs. The taxpayer incurred intangible drilling and development costs (IDC) on wells drilled in 1981. The wells were productive throughout 1981 but one well became nonproductive in 1982 and was plugged and abandoned. The IDC incurred on the nonproductive well that was plugged and abandoned is included in the "as if" cost depletion basis used to determine cost depletion for section 4988(b)(3)(C) of the Code and cannot be deducted from this "as if" basis in determining the net income limitation in the year the well becomes nonproductive.
ISSUE
How are the intangible drilling and development costs (IDC) treated for windfall profit tax purposes under section 4988(b)(3)(C)(i)(I) of the Internal Revenue Code if the IDC were incurred for drilling an oil well that was productive but no longer produces oil and has been plugged and abandoned?
FACTS
In 1981 X incurred IDC in drilling wells to an oil and gas deposit underlying a property. The wells were productive throughout 1981 but one well became non- productive in 1982 and was plugged and abandoned. Other wells on the property continued to produce oil. X made a proper election to expense IDC in the year incurred in accordance with section 1.612-4 of the Income Tax Regulations.
LAW AND ANALYSIS
Section 4988(a) of the Code defines "windfall profit" as the excess of the removal price of the barrel of crude oil over the sum of the adjusted base price of the barrel and the amount of the severance tax adjustment.
Section 4988(b) of the Code provides that the windfall profit on a barrel of crude oil shall not exceed 90 percent of the net income attributable to the barrel. Net income attributable to a barrel is the taxable income from the property for the tax year attributable to taxable crude oil divided by the number of barrels of taxable crude oil from the property taken into account for such tax year.
For purposes of determining the windfall profit, taxable income from the property is determined under section 613(a) without any deductions for depletion, the windfall profit tax, intangible drilling and development costs under section 263(c), or qualified tertiary injectant expenses to which an election under section 4988(b)(3)(E) applies. However, section 4988(b)(3)(C) provides that in determining the net income limitation, taxable income shall be reduced by cost depletion that would have been allowable for the tax year with respect to the property if all "section 263(c) costs" had been capitalized and taken into account in computing cost depletion and cost depletion had been used by the taxpayer with respect to the property for all tax periods.
Section 51.4988-2(b)(3)(ii) of the Excise Tax Regulations provides:
The cost depletion deduction that would be allowable for the taxable year is computed by first determining the depletable basis of the property as of the date of its acquisition by the taxpayer. With regard to transfers of properties before 1979, the taxpayer's original basis in the property is determined under section 1012. The basis of proven oil or gas properties transferred after 1978 is determined under paragraph (c) of this section. Adjustments to basis are then made for expenditures properly chargeable to capital account and depletable under section 612, section 263(c) costs, and qualified tertiary injectant expenses (to which an election under section 4988(b)(3)(E) applies) incurred during the year. A unit cost is then found in accordance with accepted cost depletion principles using the estimated recoverable reserves determined for income tax purposes as of the beginning of the first taxable year in which those reserves were depleted by the taxpayer (whether or not the estimate later proves to be inaccurate). A cost depletion allowance is determined for that year and is subtracted from the depletable basis. The depletable basis minus the cost depletion allowance for that year is carried over to the next taxable year and the same computation is performed for each succeeding year (taking account of revisions of estimated reserves used for that year) until the current year. The cost depletion allowance for the current taxable year is then multiplied by the fraction described in paragraph (b)(2) of this section to determine the cost depletion deduction attributable to taxable crude oil that would be allowable for the taxable year.
Section 4988(b)(3)(D) provides that for purposes of determining net income, the term "section 263(c) costs" means IDC incurred by the taxpayer that, by reason of an election under section 263(c), may be deducted as expenses for purposes of this title. Section 51.4988-2(b)(3)(iii) of the regulations provides:
For purposes of computing the net income limitation, intangible drilling and development costs with respect to a nonproductive well shall be deducted from gross income from the property in the taxable year these costs are paid or incurred. However, section 263(c) costs with respect to a productive well may be deducted only as a part of the cost depletion deduction. For purposes of this paragraph, a nonproductive well is any well that has been abandoned or is reasonably expected never to produce oil or gas in commercial quantities. If the taxpayer is unable to determine with reasonable certainty by the later of the end of the taxable year or the time the return is filed whether a well will produce oil or gas in commercial quantities, the taxpayer shall treat the well as a productive well. If the well later proves to be a nonproductive well, the taxpayer may file an amended return or a claim for credit or refund.
The wells in the present case had been completed as producing wells in 1981. Therefore, the amount of IDC attributable to the wells could not be deducted in determining X's net income limitation, but was required to be capitalized into the "as if" depletion basis for the property.
In 1982 even though one of the wells on the property was plugged and abandoned, X must continue to account for all of its IDC by calculating the "as if" depletion for the entire property. Section 51.4988-2(b)(3)(iii) of the regulations allows a direct write off for the IDC of an unproductive well but this section applies only to IDC incurred for a well that was abandoned before being completed as a producing well, or to IDC that was capitalized at the end of the first year because no reasonable determination could be made as to whether the well would be completed as a producer.
HOLDING
The IDC incurred on the well that no longer produces oil and has been plugged and abandoned shall be included in the "as if" depletion basis of the property and cannot be deducted in determining the net income limitation in the year the property is abandoned.
Rev. Rul. 83-5, 1983-1 C.B. 298.