INSIGHT: Cost of Oil Company’s Seismic Survey Must Be Capitalized

The Internal Revenue Service Office of Chief Counsel recently attempted to make a distinction between geological and geophysical (G&G) expenditures, which must be amortized over a period of time, and intangible drilling costs (IDCs), which can be expensed when incurred.

The office’s determination resembles the shadowy distinction between start-up expenditures and expenses incurred in carrying on a trade or business. In both cases, it’s difficult to discern when expenditures cross the imaginary line between, in this case, G&G and IDC.

The taxpayer was engaged in offshore oil and gas drilling and development activities within the U.S. Through wholly-owned subsidiaries, the taxpayer owned a working interest in the “A field” and in the “B field.” The taxpayer was the operator of both fields. In the tax year at issue, the taxpayer approved net funding for the acquisition of a seismic survey of the A and B fields. The taxpayer used the data gathered by the seismic survey to optimize placement of development wells in the A and B fields. The taxpayer deducted the costs of the seismic survey related to the A field as IDCs.

The office determined in CCA 201835004 that these costs should be treated as geological and geophysical expenditures. G&G expenditures, unlike IDCs, cannot be expensed as incurred.

Exploration vs. Development

G&G expenditures are costs incurred by an oil and gas exploration and production company “to obtain, accumulate, and evaluate data that will serve as the basis for the acquisition or retention of oil and gas properties,” according to the office. G&G expenditures are usually associated with a survey, such as a seismic survey. Prior to the enactment of tax code Section 167(h), G&G expenditures were treated by the IRS and the courts as capital expenditures allocable to the cost of the property acquired or retained; and were deducted as a loss if the project was abandoned.

The office said the legislative history of Section 167(h) “demonstrated Congress’ intention to adopt “the long-standing definitions of the terms used in Section 167(h).” The office cited the 2007 “Bluebook,” which said “G&G costs are costs incurred by a taxpayer for the purpose of obtaining and accumulating data that will serve as the basis for the acquisition and retention of mineral properties by taxpayers exploring for minerals.”

“Section 167(h)(1) provides for any G&G expenditures paid or incurred in connection with the exploration for, or development of, oil or gas within the U.S. to be allowed as a deduction, ratably, over the 24-month period beginning on the date that such expense was paid or incurred.,” the office said. Section 167(h)(5)(A) provides that, in the case of “a major integrated oil company,” Section 167(h)(1) is to be applied by substituting “seven years” for “24 months.” Section 263(c) directs the Treasury Department to issue regulations permitting taxpayers to elect to deduct IDCs, without describing or defining the costs affected by the election.

Traditionally, the ofice noted, “exploration costs end and well development costs begin at the point when the operator determines the location for the drilling of the well” (emphasis added). In Standard Oil Company (Indiana) v. Commissioner, the court held that “the dividing line between ‘exploratory’ work, which must be capitalized, and ‘development’ activities coming within the IDC option is the point at which the preparations for drilling begin.” The IRS had argued in Standard Oil that “development did not begin until an operator of an offshore oil and gas property made the decision to commence development drilling.”

Treasury Regulation Section 1.612-4(a) provides that IDCs incurred by an operator in the development of oil and gas properties may, at his option, be charged to capital or to expense. Section 1.612-4(a) applies to all expenditures made by an operator “incident to and necessary for the drilling of wells and the preparation of wells for the production of oil or gas.”

Locate, Identify Properties

The function of G&G expenditures is to “locate and identify properties with the potential to produce commercial quantities of oil and natural gas, as well as to determine the optimal location for exploratory and developmental wells,” the office said. Here, the office noted, the seismic survey “involved no drilling and was not used to site specific wells. The costs of the Seismic Survey were ‘incurred in connection with the exploration for, or development of, oil or gas within the United States.’ Therefore, the costs are geological and geophysical expenditures within the meaning” of Section 167(h). Notably, while the legislative history of Section 167(h) “refers to G&G expenditures as costs attributable to exploration activities, the definition of G&G expenditures can extend to the same activities that occur within the development phase of an oil and gas project,” the office said.

The office concluded that the present case was analogous to Louisiana Land & Exploration Co. v. Commissioner. There, the taxpayer owned a property for 10 years and then incurred costs for a geological survey to determine whether subsurface structures on the property justified drilling for oil and gas. The U.S. Tax Court determined that the cost of the survey must be capitalized because it resulted in the acquisition or retention of a capital asset. Importantly, the court noted that “this survey was not connected with the drilling of any particular well or wells and was not confined to any restricted area which had been tentatively singled out as the location of a well.” Conversely, the Tax Court noted that the IDC option “is directed to the costs of preparations for the drilling of particular wells after the drilling has been at least tentatively decided upon.”

In the present case, the A field was discovered over a decade before development work began. The taxpayer used the data generated by the seismic survey “to optimize placement of development wells in the A and B fields. Taxpayer did not use this data to prepare for the drilling of a specific well or wells but to determine where generally to drill within two project areas. Accordingly, under the rationale of Louisiana Land & Exploration Co. v. Commissioner, the costs that Taxpayer incurred to acquire the Seismic Survey” were non-deductible G&G expenditures within the meaning of Section 167(h), the office said.

Almost as an afterthought, the office pointed out that, under Section 1.612-4(c), the IDC expensing option does not apply “to expenditures by which the taxpayer acquires tangible property ordinarily considered as having a salvage value.” In the instant case, the taxpayer “incurred costs to acquire the data generated by a Seismic Survey. If such data was exclusively licensed or sold to the taxpayer in some tangible form, the cost of the acquisition could not qualify as IDCs,” the office said. See Texas Instruments Inc. v. United States and Texas Instruments Inc. v. Commissioner.