REVENUE RULE 90-20

1990-1 C.B. 117, 1990-9 I.R.B. 8.

Internal Revenue Service
Revenue Ruling

CARRYING PARTY'S COSTS TO EXPLORE, DEVELOP, AND OPERATE A MINERAL PROPERTY; DEDUCTIBILITY

Published: February 26, 1990

Section 617. - Deduction and Recapture of Certain Mining Exploration Expenditures, 26 CFR 1.617-1: Exploration expenditures.

(Also Section 616; 1.616-1.)

Carrying party's costs to explore, develop, and operate a mineral property; deductibility. The taxpayer may deduct all amounts it paid or incurred prior to payout that qualify as exploration expenditures under section 617(a) of the Code if it has made a proper election under that section. The taxpayer also may deduct all amounts it paid or incurred prior to payout that qualify as development expenditures under section 616(a).

ISSUE

If a taxpayer agrees to explore, develop, and operate a mineral property in return for all income from the property until recoupment of its costs (payout), to what extent may the taxpayer deduct the exploration and development costs that it pays or incurs?

FACTS

Y agreed to assign to X, a mining company, an interest in a mineral property in the United States. In return, X agreed to explore, develop, and operate the property. Under the agreement, X, the carrying party, bore all exploration, development, and operating costs. X was also entitled to 100 percent of the income from mining the property until payout, that is, until X recovered all costs incurred in exploring and developing the property and operating the mine to produce such an amount. X had no right to transfer any interest to a third party prior to payout. The agreement provided that after the payout period X would hold 51 percent of the operating interest and Y, the carried party, would hold 49 percent.  X explored the property and, after discovering a commercially marketable mineral deposit, developed and operated a mine on the property.

LAW AND ANALYSIS

Section 617(a) of the Code allows taxpayers to elect to deduct expenditures paid or incurred during the tax year for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other mineral (other than oil or gas or any mineral with respect to which a deduction for percentage depletion is not allowable under section 613) if the expenditures are paid or incurred before the beginning of the development stage of the mine. Expenditures deducted under section 617(a) are subject to recapture under section 617(b) when the mine reaches the producing stage, as well as in certain other circumstances.

Section 616(a) of the Code provides that, if the taxpayer does not elect otherwise, expenditures paid or incurred during the tax year for the development of a mine or other natural deposit (other than an oil or gas well) located within the United States are allowed as a deduction if they are paid or incurred after the existence of ores or minerals in commercially marketable quantities has been disclosed.

Section 1.617-1(b)(3) of the Income Tax Regulations, with respect to exploration expenditures, and section 1.616-1(b)(3), with respect to development expenditures, provide that such expenditures paid or incurred by a taxpayer in connection with the acquisition of a fractional share of a working or operating interest are deductible only to the extent of the fractional interest acquired. Expenditures attributable to the remaining fractional share are considered as part of the cost of the interest acquired by the taxpayer and must be capitalized and recovered through depletion allowances.

Section 263(c) of the Code authorizes the Secretary to prescribe regulations under which taxpayers may elect to deduct intangible drilling and development costs in the case of oil and gas wells located within the United States. Section 1.612-4(a) of the regulations provides that taxpayers that hold a working or operating interest in an oil or gas property may elect to deduct intangible drilling and development costs they incur with respect to that property. If, however, any drilling or development project is undertaken for the grant or assignment of a fraction of the operating rights, only that part of the costs thereof that is attributable to that fractional interest is within the option; costs of the project to the extent allocable to fractions of the operating rights held by others must be capitalized as a depletable cost of the fractional interest acquired by the taxpayer.

In Rev. Rul. 71-207, 1971-1 C.B. 160, the taxpayer, the carrying party in a carried interest arrangement, agreed to pay all costs to drill, complete, equip, and operate a well on an oil and gas lease. The taxpayer was entitled to recoup its costs from the income attributable to the entire operating interest in the well. After payout, the taxpayer and the carried party each held an undivided one-half operating interest in the lease. Applying section 1.612-4(a) of the regulations, Rev. Rul. 71-207 concludes that because the taxpayer held the entire operating interest in the well during the complete payout period, the taxpayer was entitled to elect under section 263(c) of the Code to deduct as an expense all its intangible drilling and development costs, even though the taxpayer held only a fractional interest in the lease after payout. See also Rev. Rul. 69- 332, 1969-1 C.B. 87, which reaches a similar result in the case of an oil and gas well completed and plugged as a dry hole. Cf. United States v. Cocke, 399 F.2d 433 (5th Cir. 1968), cert. denied, 394 U.S. 922 (1969) (in which the carried party was denied deductions for intangible drilling and development expenditures incurred by the carrying party prior to payout).

Under Rev. Rul. 71-207 and other rulings concerning the treatment of intangible drilling and development costs for oil and gas wells, the determination of the complete payout period requires an interpretation of the carried interest agreement and the performance of the parties under the agreement. As a general principle, the complete payout period ends when the gross income attributable to all of the operating mineral interests in the well (or wells in the case of agreements covering more than a single well) equals all expenditures for drilling and development (tangible and intangible) of such well(s) plus the cost of operating the well(s) to produce such an amount.

In the present situation, X paid or incurred all of the exploration, development, and production costs, and received all of the income from the property until X fully recovered its exploration and development costs as well as the related costs of production. Under the terms of the agreement, it was not possible for Y or another party to acquire a fractional operating interest prior to complete payout. Factually, X's situation is similar to the situation of the carrying party in Rev. Rul. 71-207, except that Rev. Rul. 71- 207 concerns oil and gas intangible drilling and development expenditures rather than mining exploration and development expenditures. With respect to the requirement that the taxpayer seeking a current deduction must hold an operating interest, and with respect to the rules that apply in the case of the acquisition of a fractional operating interest, the regulations regarding mining exploration and development expenditures are substantively the same as the regulations regarding intangible drilling and development costs. Because of these factual and legal similarities, X's exploration and development costs should receive the same treatment as the taxpayer's intangible drilling and development costs in Rev. Rul. 71-207. Accordingly, for purposes of sections 1.617-1(b)(3) and 1.616-1(b)(3) of the regulations, X is considered to hold 100 percent of the operating interest in the mineral property through the complete payout period.

HOLDING

The taxpayer, X, may deduct all amounts it paid or incurred prior to payout that qualify as exploration expenditures under section 617(a) of the Code if it has made a proper election under that section. Also, X may deduct all amounts it paid or incurred prior to payout that qualify as development expenditures under section 616(a). These actions are permissible because X held 100 percent of the operating interest in the mineral property through the complete payout period. This ruling does not address the treatment of any unrecovered basis in equipment at the end of the payout period.

DRAFTING INFORMATION

The principal author of this revenue ruling is Jack P. Hadfield of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Mr. Hadfield on (202)535- 9095 (not a toll-free call).

Rev. Rul. 90-20, 1990-1 C.B. 117, 1990-9 I.R.B. 8.