Rev. Rul. 88-10

1988-1 C.B. 112, 1988-6 I.R.B. 5.

                       Internal Revenue Service

                                 Revenue Ruling

          INTANGIBLE DRILLING AND DEVELOPMENT COSTS; EXPLORATORY HOLES

                          Published: February 8, 1988

SECTION 263. - CAPITAL EXPENDITURES, 26 CFR 1.263(a)-1: Capital expenditures; in general.

(Also Section 612; 1.612-4.)

  Intangible drilling and development costs; exploratory holes. Costs incurred to drill expendable holes to determine the location and delineation of offshore hydrocarbon deposits and capable of conducting hydrocarbons to the surface on completion are within the option to expense intangible drilling and development costs (IDC) provided by section 263(c) of the Code regardless of whether there is an intent to produce hydrocarbons.

ISSUE

  Whether costs incurred to drill expendable holes to determine the location and delineation of offshore hydrocarbon deposits are within the option to expense intangible drilling and development costs (IDC) pursuant to section 263(c) of the Internal Revenue Code.

FACTS

  The taxpayer, an integrated oil and gas company, was the successful bidder for certain United States oil and gas leases on the outer continental shelf. The taxpayer had previously obtained favorable geological and geophysical information on the lease area. During the tax year, the taxpayer drilled 16 bore holes from mobile drilling rigs in water depths varying from 170 feet to 370 feet and at locations ranging from 25 to 130 miles offshore. The drilling sites were located according to structural interpretations of geological and geophysical data. The bore holes were drilled to ascertain the existence, extent, and configuration of hydrocarbon deposits. The taxpayer sought this information to determine whether to develop the leases and, if it did so, the optimum number and location of wells and platforms that should be used for development. Although the diameters of the bore holes and the casings were similar to those of wells that would be drilled to comparable depths for the production of oil and gas, the bore holes were drilled without the intention of attempting any completions for the production of oil and gas. Some of the bore holes exhibited producing potential, but after testing and logging were plugged and the casings cut off below the sea floor.

LAW AND ANALYSIS

  Section 263(a) of the Internal Revenue Code provides that no deduction shall be allowed for capital expenditures. Section 263(c) of the Code provides that, notwithstanding section 263(a), regulations shall be prescribed that grant the option to deduct as expenses intangible drilling and development costs in the case of oil and gas wells.

  Section 1.612-4 of the Income Tax Regulations provides that intangible drilling and development costs (IDC) incurred by an operator in the development of oil and gas properties may at the operator's option be chargeable to capital or to expense. Expenditures that are included in this option are listed in section 1.612-4(a) as wages, fuel, repairs, hauling, supplies, etc., incident to and necessary for the drilling of wells and the preparation of wells for the production of oil and gas.

  In Standard Oil Co. (Indiana) v. Commissioner, 68 T.C. 325 (1977), acq., 1983-1 C.B. 1, the Tax Court concluded that the option to capitalize or expense applied to the costs incurred by the taxpayer in drilling offshore expendable holes to determine the location and delineation of offshore hydrocarbon deposits. Although it held that such costs were eligible for the IDC option even under the test urged by the Service, the court went on to add that the dividing line between 'exploratory' work that must be capitalized and 'development' activities that come within the IDC option should be the point at which the preparation for drilling begins. The court noted that the regulations neither expressly or implicitly limit 'wells' to those drilled after a decision has been made to install a permanent drilling and production platform. Accordingly, the court reasoned that the intangible cost of drilling all offshore wells, including those drilled with mobile drilling rigs, should be subject to the IDC option.

  In Gates Rubber Co. v. Commissioner, 74 T.C. 1456 (1980), acq., 1983-1 C.B. 1, aff'd per curiam, 694 F.2d 648 (10th Cir. 1982), the Tax Court confirmed its dicta from the Standard Oil case, concluding that the cost of drilling exploratory holes at offshore lease sites comes within the IDC option. The court stated that the Commissioner's attempted distinction between exploratory and development activities would deny the deduction for the precise high risk drillings for which the deduction was intended.

  In Sun Co. v. Commissioner, 677 F.2d 294 (3rd Cir. 1982), aff'g 74 T.C. 1481  (1980), acq., 1983-1 C.B. 1, the Third Circuit affirmed the decision of the Tax Court that the cost of drilling exploratory holes at offshore lease sites comes within the IDC option. The third Circuit reasoned that since the IDC regulation does not expressly distinguish between exploratory and developmental drilling, the Service's argument, based upon that purported distinction, was misplaced.

  The Tax Court, in Sun Co. defined the term 'well' for purposes of section 263(c) of the Code and section 1.612-4 of the regulations as a shaft drilled in search of hydrocarbons, which is designed and drilled to be capable, upon encountering hydrocarbons and upon appropriate completion of the shaft by the operator, of conducting or aiding in the conduction of hydrocarbons to the surface. This definition of wells excludes shafts such as core drilling which, because of their design or the manner in which they are drilled, are not capable of conducting or aiding in the conduction of hydrocarbons to the surface; they are capable solely of yielding geological information. If an appropriately designed shaft is drilled in search of hydrocarbons, it is a well regardless of whether there is an intent to produce hydrocarbons.

  In this case, the bore holes drilled offshore from mobile drilling rigs during the tax year fit the definition of a well. Therefore, the costs incurred by the taxpayer are, at its option, intangible drilling costs chargeable to capital or to expense. These wells are distinguished from offshore stratigraphic test wells described in Rev. Rul. 80-342, 1980-2 C.B. 99, drilled to obtain geological data by the participants who do not have an economic interest in the property.

HOLDING

  Costs incurred to drill expendable holes to determine the location and delineation of offshore hydrocarbon deposits are within the option to expense intangible drilling and development costs (IDC) provided by section 263(c) of the Code and section 1.612-4 of the regulations.

DRAFTING INFORMATION

  The principal author of this revenue ruling is David McMunn of the Corporation Tax Division. For further information regarding this revenue ruling contact Mr. Joseph Makurath on (202) 566-4822 (not a toll-free call).

Rev. Rul. 88-10, 1988-1 C.B. 112, 1988-6 I.R.B. 5.