Rev. Rul. 84-65

1984-1 C.B. 229, 1984-18 I.R.B. 5.

                       Internal Revenue Service
                                 Revenue Ruling

        WINDFALL PROFIT TAX;  COSTS INCURRED IN DRILLING INJECTION WELLS

                           Published: April 30, 1984

Section 4988. - Windfall Profit;  Removal Price, 26 CFR 51.4988-2: Windfall profit, removal price.

  Windfall profit tax;  costs incurred in drilling injection wells.  Costs incurred in drilling injection wells must be capitalized into the taxpayer's "as if" cost depletion basis for the purposes of determining the taxpayer's net income from the property under section 4988(b) of the Code.  These costs cannot be excluded as costs of drilling a nonproductive well.

ISSUE

  Under the circumstances described below, how are costs incurred in drilling and completing injection wells taken into account in determining the taxpayer's net income from the property under section 4988(b) of the Internal Revenue Code?

FACTS

  The taxpayer owned an economic interest in all of the oil and gas contained in a certain "oil field."  For several years the taxpayer, an operator, produced oil by natural flow from the central part of the field.  The perimeter area of the field, however, could not be developed for production in commercial quantities in the absence of a water flooding program because the natural reservoir energy in this area was inadequate.  The taxpayer developed the perimeter area of the field by setting up several "five-spot" well patterns. The taxpayer drilled water injection wells at four points with one oil producing well in the center.  The injection of water supplemented the natural reservoir energy (pressure) causing oil to flow to the oil wells in the center of the "five spot" patterns. Production from these oil wells was maintained by water flooding through the injection wells from a central plant.

LAW AND ANALYSIS

  Section 4988(b) of the Code provides for a net income limitation on the windfall profit attributable to a barrel of crude oil. Section 4988(b)(2) defines net income in terms of the taxable income from the property.  Section 4988(b)(3) states that taxable income from the property for purposes of section 4988(b)(2) is determined under section 613(a) with certain exceptions.  Two of these exceptions are that no deduction is allowed, in computing this taxable income from the property, (1) for section 263(c) costs, and (2) for depletion other than cost depletion computed in accordance with section 4988(b)(3)(C). Under section 4988(b)(3)(C), this cost depletion deduction is that amount that would have been allowed if all section 263(c) costs incurred by the taxpayer had been capitalized and taken into account in computing cost depletion and cost depletion had been used by the taxpayer for all taxable years. Section 4988(b)(3)(D) defines the term "section 263(c) costs" for these purposes as intangible drilling and development costs incurred by the taxpayer that, by reason of an election under section 263(c), may be deducted as expenses, but that such term does not include costs incurred in drilling a nonproductive well.

  Section 51.4988-2(b)(3)(iii) of the regulations provides that for purposes of calculating the net income limitation a nonproductive well is any well that has been abandoned or is reasonably expected never to produce oil or gas in commercial quantities.  Implicit in this definition is that the well was drilled for the purpose of producing oil or gas through it.

  Injection wells are not drilled for the purpose of producing oil and gas through them.  Therefore, wells drilled and completed as injection wells cannot be treated as nonproductive wells under section 4988(b)(3)(D) of the Code and section 51.4988-2(b)(3)(iii) of the regulations.

  The manner in which the costs of drilling injection wells are taken into account for purposes of section 4988(b) depends on how these costs are treated in computing the income from the property for federal income tax purposes.

  If the drilling costs are properly expensed under section 263(c), for federal income tax purposes, then for windfall profit purposes they are capitalized into the hypothetical basis of the property used to calculate the cost depletion that would have been allowable if certain costs had been capitalized and the taxpayer had used cost depletion for prior tax years.  Section 4988(b)(3)(C)(i)(I) of the Code and section 51.4988-2(b)(3) of the regulations.

  If the drilling costs are capitalized, however, the taxpayer may allocate the costs as provided in section 1.612-4(b) of the regulations.  Most of the expenses are allocated to the hypothetical cost depletion basis.  Costs representing physical property such as the amounts paid for wages, fuel, repairs, hauling, supplies, etc., used in installation of casing and equipment or in the construction on the property of derricks and other physical structures, must be allocated to depreciable property and are taken into account over the depreciable life of that property.

HOLDING

  Under the circumstances described, the costs of wells drilled and completed as injection wells, whether capitalized or expensed under section 263(c) of the Code, are not costs of drilling nonproductive wells.  In determining the taxpayer's net income from the property under section 4988(b) and the cost depletion that would have been allowable for the taxable year under section 4988(b)(3)(C), such costs must be capitalized.

Rev. Rul. 84-65, 1984-1 C.B. 229, 1984-18 I.R.B. 5.