In Uncategorized on 01/12/2012 at 17:41

If You Want a Deduction

 Dear to the hearts of the oil and gas industry is the ability to expense intangible drilling costs (IDCs). These are all the make-readies and put-togethers before the drill touches the ground. As Judge Gustafson explains in Caltex Oil Venture, Caltex Management Corporation, Tax Matters Partner, 138 T.C. 2, filed 1/12/12, these IDCs include “clearing of ground, draining, road-making, and surveying work to all amounts paid for labor, fuel, repairs, hauling, and supplies (e.g., drilling muds, chemicals and cement) incident to and necessary in the drilling and preparation of wells for the production of oil and gas.” 138 T. C. 2, at p. 3, footnote 2.

While ordinarily these costs would be capitalized, they get special tax treatment, so that they can be deducted as expenses. Caltex Oil Venture (Caltex) is a typical oil and gas shelter. Caltex enters into a contract with a drilling services company, whereby the services company does all the work to get the well pumping (a two year process), but Caltex incurs the IDCs and deducts them up front, around $5 million worth. Caltex pays 10% down and the rest by a note (that never gets into evidence, but Judge Gustafson assumes for Rule 121 benefit-of-the-doubt purposes that the note was executed and delivered).

Caltex is an accrual basis taxpayer. Caltex tried to write off its entire investment in Year One, claiming all events had occurred to create its liability to pay, and that the sum due was reasonably ascertainable. Fine, says IRS, but Section 461(h) economic performance hadn’t occurred because, as both Caltex and IRS stipulated, “[n]o drill penetrated the ground for purposes of drilling a well by or on behalf of Caltex Oil Venture” during the years at issue. 138 T. C. 2, at p. 6.

Caltex responds that they have 90 days after the end of their tax year, because Section 461(i)(2)(A) says they can deduct in the previous year if drilling of the well commences within said 90 days. Except it didn’t, says IRS, because you or your servicer didn’t put a drill bit in the ground in either year.

But we did some work, says Caltex; we got permits and did site preparation. And even if we didn’t drill within 90 days, we have the Regulation Section 1.461-4(d)(6)(ii), the 3-1/2 month rule, which says if we reasonably expected performance from the servicer in 3-1/2 months, we can deduct the IDCs.

No good either way, says Judge Gustafson.

As to the 90-day push, the Section 461(i)(2)(A) language is plain: drilling must commence within said 90 days. “According to Webster’s Third New International Dictionary 690 (2002), to ‘drill’ means ‘to make (a rounded hole or cavity in a solid) by removing bits with a rotating drill’, while to ‘commence’ means ‘to begin’.  Id. at 456. Giving effect to the plain meaning of these words, we find it unambiguous that ‘drilling of the well commences’ when the boring of a hole for the well begins. Therefore, we find that the plain language of section 461(i)(2)(A) dictates that, as a matter of law, ‘drilling of the well commences’ when the drill bit penetrates the ground to start the hole for the well.” 138 T.C. 2, at p. 17.

As to the 3-1/2 month rule, IRS says this applies only if all of the work could reasonably be anticipated to be completed within 3-1/2 months after end of tax year, and everyone agrees that’s a “nevah hoppen”. Caltex replies that some work got done in the 3-1/2 months. Judge Gustafson says that, where the contract is divisible or severable, that is, where it calls for work in stages or phases with payment made or due proportionately, economic performance occurs as each stage or phase is completed and the 3-1/2 month rule helps. But here there was a single-shot payment up front, so economic performance of the entire contract must be reasonably anticipated within the 3-1/2 month window before deduction of IDCs allowed.

Caltex says that makes it impossible for the 3-1/2 month window to do any good for investors in what a certain Director in a major accounting firm, stationed in Houston, calls the “owl bidniz”. That’s  “oil business” to you Yankees. Wells just can’t be drilled in less than two years.

Judge Gustafson says so sad, too bad, but the Internal Revenue Code was not written solely for the benefit of the “owl bidniz,” and maybe the 3-1/2 month rule helps somebody else. Besides, the point of the rule was to make it easier for taxpayers to figure out when services or property was provided, and economic performance occurred. With commendable restraint, Judge Gustafson says: “It would be somewhat at odds with such a regime–engineered to avoid difficulties in determining when services have been provided–to allow a taxpayer to accelerate deductions for just the portion of services expected to be provided within 3-1/2 months of payment and, in order to do so, to make ex post facto valuations of those services–valuations that would require fact-intensive analyses by both the taxpayer and the IRS. This is the very difficulty that the regulation sought to avoid.” 138 T.C. 2, at p. 30.

Besides, Caltex, draft your contracts to be divisible, and you’ve solved your problem, at least in part.

By the way, Regulation section 1.461-4(g)(1)(ii)(A), provides that “payment includes the furnishing of cash or cash equivalents and the netting of offsetting accounts. Payment does not include the furnishing of a note or other evidence of indebtedness of the taxpayer, whether or not the evidence is guaranteed by any other instrument (including a standby letter of credit) or by any third party (including a government agency).” 138 T. C. 2, at p. 34. So Caltex would be limited to work actually performed to the extent paid for in cash in Year One plus 90 days, or around $7K, says IRS.

Judge Gustafson leaves that for trial, because Caltex disputes the amount. But Judge Gustafson gives IRS summary judgment knocking out the $5 million deduction.

Takeaway–Drill, baby, drill.

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