Rev. Rul. 89-56

1989-1 C.B. 83, 1989-16 I.R.B. 4.

                       Internal Revenue Service

                                 Revenue Ruling

   CAPITAL EXPENDITURES; INTANGIBLE DRILLING AND DEVELOPMENT COSTS; OFFSHORE

                                   PLATFORMS

                           Published: April 17, 1989

Section 263. - Capital Expenditures, 26 CFR 1.263(c)-1: Intangible drilling and development costs in the case of oil and gas wells.

(Also Section 612: 1.612-4.)

  Capital expenditures; intangible drilling and development costs; offshore platforms. Guidance is provided regarding which costs incurred in the course of fabricating, transporting and installing an offshore oil and gas drilling and production platform and the related facilities and equipment are within the option to expense intangible drilling and development costs provided by section 263(c) of the Code Rev. Rul. 70-596 modified and superseded.

ISSUE

  Which costs incurred in the course of fabricating, transporting, and installing an offshore oil and gas drilling and production platform and the related facilities and equipment are within the option to expense intangible drilling and development costs provided by section 263(c) of the Internal Revenue Code?

FACTS

  The taxpayer, an oil and gas company, determined through exploratory drilling and other methods that there was a substantial likelihood of commercial quantities of oil and gas in a domestic offshore property in which the taxpayer held an operating interest. The taxpayer decided to install an offshore platform in a particular location as a base from which to drill wells, prepare for production, and produce oil and gas. The taxpayer contracted for the fabrication of the three major components of the platform.

  The three major components of the particular type of platform constructed for the taxpayer (a 'jacket-type' platform) are (1) the deck, which holds the equipment required to drill the well and produce the oil and gas; (2) the support system, which supports the deck and the operating equipment, and which consists of a 'jacket' (a framework of cross-braced tubular steel legs); and (3) the anchoring system, which stabilizes and anchors the platform to a fixed site, and which consists of pilings (large tubular members fabricated from steel) that are inserted through the hollow jacket legs and driven into the sea floor.

  The platform and its three major components were designed as an integrated unit for a particular well site, taking into consideration the condition of the ocean bed, storm ratings, water depths, tides, wave forces, well spacing, and other factors that affect the number and depth of wells desired and the size and configuration of the components. To the extent the major components were constructed by combining subcomponents also fabricated by the contractor, those subcomponents (such as the tubular jacket members, which were rolled and welded from sheet metal) were also designed and built for use in this specific platform. Once fabricated, neither the platform as a unit, nor the major components or subcomponents of this type of platform, were ordinarily reusable at a different well site without substantial and costly modifications.

  The deck, jacket, and pilings were constructed at the contractor's onshore shipyard. The taxpayer provided engineering and design specifications in addition to technical consultations during the construction process. After construction, the platform (in component form) was removed from the shipyard and transported to the well site by barge. These transportation operations were contracted for separately. At the well site the platform was positioned, erected, and anchored to the ocean bed. On the deck of the platform, the taxpayer installed the necessary drilling and production equipment and facilities, some of which were purchased by the taxpayer and some of which were fabricated for the taxpayer by a contractor. Although some of the drilling equipment was designed and intended for use at this specific platform, all of the equipment was capable of being installed or reinstalled at other drill sites without substantial and expensive modifications.

LAW AND ANALYSIS

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

  Section 1.612-4(a) of the Income Tax Regulations describes the expenditures that are included in this IDC option as:

    all expenditures made by an operator for 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 or gas. . . . They include the cost to operators of any drilling or development work (excluding . . . amounts properly allocable to cost of depreciable property) done for them by contractors under any form of contract, including turnkey contracts. Examples of items to which this option applies are, all amounts paid for labor, fuel, repairs, hauling, and supplies, or any of them, which are used --

    (1) In the drilling, shooting, and cleaning of wells,

    (2) In such clearing of ground, draining, road making, surveying, and geological works as are necessary in preparation for the drilling of wells, and

    (3) In the construction of such derricks, tanks, pipelines, and other physical structures as are necessary for the drilling of wells and the preparation of wells for the production of oil or gas.

    In general, this option applies only to expenditures for those drilling and developing items which in themselves do not have a salvage value. For the purpose of this option, labor, fuel, repairs, hauling, supplies, etc., are not considered as having a salvage value, even though used in connection with the installation of physical property which has a salvage value.

  Section 1.612-4(c)(1) of the regulations describes the nonoptional items that must be capitalized as:

    expenditures by which the taxpayer acquires tangible property ordinarily considered as having a salvage value. Examples of such items are the costs of the actual materials in those structures which are constructed in the wells and on the property, and the cost of drilling tools, pipe, casing, tubing, tanks, engines, boilers, machines, etc. The option does not apply to any expenditure for wages, fuel, repairs, hauling, supplies, etc., in connection with equipment, facilities, or structures, not incident to or necessary for the drilling of wells, such as structures for storing or treating oil or gas. These are capital items and are returnable through depreciation.

  Rev. Rul. 70-596, 1970-2 C.B. 68, considering a situation substantially similar to the situation considered here, concludes that the offshore platform in question was incident to and necessary for the drilling of wells, even though it was useful in connection with subsequent production activities. Rev. Rul. 70-596 holds that the costs of transporting components to the well site and installing the platform are therefore within the scope of the IDC option. Under Rev. Rul. 70-596, however, the costs of fabricating the components onshore (including design costs) must be capitalized. The rationale for this treatment of the fabrication cost is that such a platform is 'tangible property ordinarily considered as having a salvage value' within the meaning of section 1.612-4(c)(l) of the regulations. Expenditures relating to its fabrication are thus costs of acquiring depreciable property. Rev. Rul. 70-596 also notes that the IDC option granted by the regulations does not apply to expenditures incurred in connection with equipment, facilities, or structures not incident to or necessary for the drilling of wells, such as the costs of fabricating, transporting, and installing production facilities or equipment. The conclusions in Rev. Rul. 70-596 regarding the costs of transporting and installing offshore drilling platforms, and the costs of fabricating, transporting, and installing offshore production facilities or equipment have not been the subject of litigation. Several courts, however, have considered the proper treatment of the costs of fabricating offshore platforms.

  In Exxon Corp. v. United States, 547 F.2d 548 (Ct. Cl. 1976), the court considered costs incurred in the fabrication of 'templet-type' platforms, which differ from the jacket-type platforms described above in that their supporting structures are made up from standardized templet units. The templets were designed to be salvaged as a unit and reused, with some modification and reconditioning, when the platforms were dismantled. The court held that the costs for labor, fuel, repairs, supplies, and hauling incurred in fabricating the platform, including the costs of fabricating the standardized components, were eligible for the IDC option. Adopting the decision of the trial judge, the court interpreted the regulations as excluding from optional treatment only expenditures for 'actual materials' -- which, in the court's view, meant only steel beams, pipes, etc. -- used to fabricate the platforms.

  In Standard Oil Co. (Indiana) v. Commissioner, 77 T.C. 349 (1981), the Tax Court considered costs incurred in fabricating jacket-type platforms. Consistent with Rev. Rul. 70-596, the Commissioner took the position that the deck, jacket, and pilings -- as units -- were salvageable 'actual materials,' the costs of which must be capitalized under section 1.612-4(c)(1) of the regulations. See 77 T.C. at 391. Citing Exxon, the taxpayer argued that the term 'actual materials' means only those items purchased by the platform fabricator. See id. at 349.

  The court held for the taxpayer under a different rationale, formulating a 'risk analysis' based on the premise that Congress intended to include within the IDC option expenditures that are 'at risk', that is, that ordinarily are economically unrecoverable should the well be dry, whether those expenditures are represented by physical property or not. Conversely, expenditures for items that ordinarily are recoverable are excluded from the option. See 77 T.C. at 396-97. Under this approach, platform design and fabrication costs must be analyzed in terms of the salvageability of the components at each stage of fabrication. Even if the ultimate tangible property, the platform, is not ordinarily considered as having a salvage value, intangible-type costs expended to create a component that is ordinarily considered as having a salvage value are not IDC and must be capitalized. Intangible-type

costs expended to integrate salvageable materials or components into a component that is, after integration, not ordinarily considered as having a salvage value are deductible IDC, as are any further intangible-type costs expended to integrate this 'first unsalvageable component' into the ultimate tangible property. See id. at 399-400.

  Applying this approach to the facts in Standard, the Tax Court determined that neither the jacket-type platform itself, nor its major components, nor any of the subcomponents above the level of such basic 'materials' as angle iron, sheet metal, etc., were property ordinarily considered as having salvage value. See 77 T.C. at 401-404. There was no evidence that any platforms had been salvaged or reused in their entirety at the end of their normal useful lives, and there was evidence of only occasional salvage of platform components or subcomponents. Thus, all the fabrication costs claimed by the taxpayer were deductible as IDC. The court noted, however, that given a factual finding that a platform component, such as the templet in the Exxon case, was designed to be and was in fact salvageable, the costs of fabricating that component would not be within the option. See id. at 399.

  In Texaco, Inc. v. United States, 598 F. Supp. 1165 (S.D. Texas 1984), and Gulf Oil Corp. v. Commissioner, 87 T.C. 324 (1986), the courts considered several different types of offshore platforms. In each case the courts allowed as IDC the intangible fabrication costs. The district court in Texaco adopted the Tax Court's risk analysis (also agreeing with the Tax Court that the costs of standardized components such as the Exxon templets would not be eligible for the option). See 598 F. Supp. at 1172. In reaching their decisions, both courts emphasized that each type of platform in question was designed and constructed for use at a specific site and that its components were designed for use in a specific platform. Evidence that a platform or component could hypothetically be reused after substantial modifications, or that particular platforms or components were occasionally salvaged, did not establish that the item was 'ordinarily' considered salvageable. See Texaco, 598 F. Supp. at 1176-77; Gulf, 87 T.C. at 347-348.

  In view of these decisions, the Service will no longer follow the holding in Rev. Rul. 70-596 that all expenditures incurred in the onshore fabrication of offshore drilling and production platforms are necessarily ineligible for IDC expense treatment. Instead, each platform will be analyzed separately. Design and fabrication expenditures may be treated as IDC if the evidence shows that the platform in question is incident to and necessary for the drilling of wells (even though subsequently used for production), that the platform is designed and constructed for use at a specific site, and that platforms of that type are not ordinarily reused or otherwise salvaged as a unit. To be considered site-specific, a platform must not ordinarily be useable at another site without extensive modifications. Design and fabrication expenditures are not disqualified by evidence that a type of platform could hypothetically be reused (with substantial modification and expense), or by evidence that platforms of that type have occasionally been salvaged in extraordinary circumstances.

  If, following this approach, a given platform is determined to be unsalvageable, the same analysis will be applied to its structural components and subcomponents. In other words, the intangible-type costs of fabricating such items qualify for the IDC option if the type of component or subcomponent in question is designed for permanent use at a specific site in a specific platform structure and is not ordinarily used or useable at another site without extensive modifications. The Service will not follow the Exxon case to the extent that case holds that costs incurred in the fabrication of a standardized, reusable structural component such as a templet are eligible for IDC treatment. The costs of fabricating such an item must be capitalized, although additional costs incurred to integrate that item into a specific structure may qualify as IDC.

  Several restrictions on the scope of the IDC option as it relates to offshore operations should be noted. First, without regard to salvageability, the option to expense IDC is not available for the costs of items acquired by purchase. The regulations authorize optional treatment only for those intangible costs that are incurred directly by an operator or indirectly by an operator who hires a contractor; they do 'not permit an operator to look behind a mere purchase . . . of materials and claim IDC treatment for intangible costs that his supplier may have incurred in manufacturing those materials. . . .' Texaco, 598 F. Supp. at 1171, n.10.

  Second, costs of fabricating drilling equipment, machinery, and similar items installed on offshore platforms are not eligible for the IDC option, whether they are acquired through purchase, contract, or self-construction. Section 1.612-4(c)(1) of the regulations denies optional treatment not only to 'actual materials' used in construction, but also to the cost of acquiring such items as drilling tools, casing, engines, boilers, machines, etc. Although in a given case such items may be intended for permanent use at a specific site and may in fact have no salvage value at the end of their useful lives, as a class they are not site-specific and can ordinarily be used or reused at another site without significant and expensive modification. Cf. Harper Oil Co. v. United States, 425 F.2d 1335 (10th Cir. 1970) (costs of surface casing are not within the option even though the casing could not be removed under Oklahoma law and had no salvage value). Thus, costs related to the manufacture of such items, even though necessary for drilling, are not subject to the IDC option, although costs incurred in transporting them to the well site and installing them on the platform remain eligible.

  Third, the IDC option applies only to costs that are both incident to and necessary for drilling or development. Expenditures excluded from optional treatment on this basis would include costs relating to a platform that is not incident to and necessary for drilling, as well as costs relating to production structures, facilities, and equipment, such as service facilities for production personnel, pumping equipment, flow lines, separators, storage tanks, treating equipment, salt water disposal equipment, etc. See Rev. Rul. 70-414, 1970-2 C.B. 132.

  Fourth, the option to expense IDC does not apply to IDC paid or incurred after December 31, 1986, in tax years ending after that date, with respect to wells (other than nonproductive wells) located outside the United states. Section 263(i) of the Code. See also Rev. Rul. 87-134, 1987-2 C.B. 69.

HOLDING

  The taxpayer's platform is incident to and necessary for drilling. This type of platform, and the structural components and subcomponents integrated into the platform, are designed for permanent installation at a specific site and are not ordinarily reused or otherwise salvaged. Accordingly, they are not tangible property ordinarily considered as having a salvage value, and all the expenditures incurred in design and fabrication, as well as the transportation and installation costs, are within the option to expense intangible drilling and development costs under section 263(c) of the Code.

  The drilling equipment and machinery installed on the platform is all property of a type that is ordinarily considered as having a salvage value. Therefore, the costs of fabrication (including related design costs) must be capitalized regardless of whether the items were acquired through purchase, under contract, or by self-construction. Costs of transporting and installing the machinery and equipment, however, remain within the option.

  The costs incurred in fabricating, transporting and installing production facilities and equipment are not within the option and must be capitalized.

EFFECT ON OTHER DOCUMENTS

  Rev. Rul. 70-596 is modified and superseded.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Mark H. Ely, (formerly of the Interpretative Division). For further information regarding this revenue ruling call Joseph H. Makurath of the Office of the Assistant Chief Counsel (Passthroughs and Special Industries) on (202) 535-9090 (not a toll-free call).

Rev. Rul. 89-56, 1989-1 C.B. 83, 1989-16 I.R.B. 4.