The situation described in paragraph 7 prompted the BLM to devise the following plan for determining who was the first qualified applicant for any tract. The BLM announces the tracts by size, legal description, and date they are to be available for leasing.
Interested persons are allowed to file an application to lease any or all tracts, but each separately described lease requires a separately filed lease application. The "winner" is then awarded the lease and must then pay the first year's rental to the BLM. Because of the resemblance to lotteries, it is believed by some people that the successful bidder is actually being awarded a prize and has income to the extent of the difference between the value of the lease and the filing fee.
Prior to , it had been the Service's position that any cash payment paid by the lessee to the lessor upon granting of an oil and gas lease was a capital investment in the property and not deductible as a business expense. This was true even if the payment was termed a rental and was the same amount for each successive year of the lease. After the issuance of this revenue ruling with one exception , all "rentals" paid on Government leases have been treated as business expense, currently deductible.
In the same year, the taxpayer assigned rights under the application to a third party for cash and a further agreement that, if the lease was issued, the third party would pay an additional sum and allow the taxpayer to retain an overriding royalty. Fees paid by successful applicants for participation in bidding for noncompetitive Government leases are capital investments. See IRC and Rev. Certain departmental overhead costs should be allocated to the cost of acquiring oil and gas leasehold properties.
This includes both developed and undeveloped properties. For a discussion of the various items that should be considered for capitalization in property acquisitions, refer to IRM 4. The use of the terms "farm-in" and "farm-out" are found in connection with the transfer of property in a "sharing arrangement. The transferrer will usually retain some type of interest in the property, normally an overriding royalty interest. A farm-out by Taxpayer A , the transferrer, is a farm-in to Taxpayer B , the transferee.
The acquisition or disposition of the interest in property by a farm-in or farm-out will not normally result in a taxable event, except for that property which is outside the "drill site" as described in Rev. The arrangements and details regarding the transfer of any property should be reviewed in detail to ascertain the taxability of the transaction. In the case of oil and gas wells, a taxpayer has an option to treat intangible drilling and development costs as either capital expenditures, under IRC a , or as expenses as provided in IRC c and Treas.
In the event that the taxpayer has elected to capitalize such costs, they become part of the depletable investment recoverable through the depletion deduction Treas.
Refer to United States v. Dakota-Montana Oil Co. If a taxpayer has elected to capitalize IDC, Treas. Intangible drilling and development costs IDC is a phrase peculiar to the law of oil and gas taxation.
It describes all expenditures made for wages, fuel, repairs, hauling, supplies, and other items incident to and necessary for the drilling of wells and the preparation of wells for the production of oil and gas. IRC c provides that intangible drilling and development costs incurred in the development of oil and gas properties may, at the option of the taxpayer, be chargeable to capital or to expense. However, to qualify, the taxpayer must be one who holds a working or operating interest see Treas.
For a definition of "economic interest," see Treas. For a definition of "operating interest," see Treas. For a definition of "complete payout period," see Rev. IRC c provides that Intangible Drilling and Development Costs IDC incurred by an operator in the development of oil and gas properties may, at the taxpayer's option, be chargeable to capital or expense.
For this purpose, "operator" is defined as one who holds a working or operating interest in any tract or parcel of land either as a fee owner or under a lease or any other form of contract granting working or operating rights. The option granted by Treas. If the taxpayer fails to deduct such costs as expenses on such return, the taxpayer shall be deemed to have elected to recover such costs through depletion to the extent they are not represented by physical property.
The election, once made, is irrevocable. For each tax year such taxpayers may elect to capitalize any portion of the IDC and amortize the cost on a straight line basis over 60 months.
The amount that a taxpayer elects to amortize for a particular taxable year is generally irrevocable. Examiners should review Treas. In the case of a corporation which is an integrated oil company, IRC b provides that the amount allowable as a deduction under IRC c is reduced by 30 percent. This provision applies to IDC paid or incurred after The amount not allowable 30 percent as a current expense is allowable as a deduction pro-rated over a month period beginning with the month in which the costs are paid or incurred, and is not to be taken into account for purposes of determining depletion under IRC IRC Refer to IRC b 2 For purposes of IRC b an "integrated oil company," with respect to any taxable year, means any holder of an economic interest with respect to crude oil who is not an independent producer.
An independent producer is a person who is allowed to compute percentage depletion under the provisions of IRC A c. It must be capitalized to the depletable basis of the property or amortized on a straight line basis over 10 years. The capitalized IDC which is attributable to installation of casing, derricks, and other physical property must be recovered through depreciation. There is a special exception for lDC incurred or paid for certain North Sea operations.
The interest must have been acquired prior to The U. The requirement to capitalize foreign IDC does not apply to dry holes or nonproductive wells.
Can a taxpayer file an amended return and deduct the unamortized IDC in the year paid or incurred for wells that prove to be nonproductive after the close of the taxable year? The Service's view is that an amended return may be filed for that year deducting the unamortized IDC for the wells that prove to be unproductive after the close of the taxable year. If the taxpayer previously deducted the unamortized IDC in the year the nonproductive well was plugged and abandoned, an amended return must be filed taking into income the amount that was deducted.
Examiners should be aware that there are some important differences in the tax treatment of Intangible Drilling Costs IDC and "nonproductive well costs". While the treatment of IDC under the IRC is generally favorable for taxpayers, the treatment of nonproductive well costs is even more favorable.
Nonproductive well costs are the IDC incurred in the drilling of a nonproductive well. The term nonproductive well does not include an injection well other than an injection well drilled as part of a project that does not result in production in commercial quantities ". The production of oil and gas in "commercial quantities" is not defined by the code, regulations or revenue rulings.
A brief mention in the Committee Report on P. As explained in Rev. Similarly, a well should not be treated as nonproductive if it is still producing oil and gas, or is capable of being restored to economic production, even if it has not yet generated enough income to offset drilling and equipment costs. For purposes of this section of the IRM the term "successful well" will be used to describe a well that is not a nonproductive well.
Differences in tax treatment of IDC on successful wells and nonproductive wells costs include:. Taxpayers normally elect to currently deduct IDC incurred in the U. For those that elect to capitalize such IDC, Treas. In contrast, nonproductive well costs incurred by U. IRC b requires integrated oil companies to capitalize 30 percent of the IDC incurred in drilling successful wells in the U.
In contrast, percent of nonproductive well costs incurred by integrated oil companies are currently deductible. However, the costs of drilling a nonproductive well are not included in the AMT preference item. However, Treas. Reg 1. Without conclusive evidence that a well is nonproductive as of the date of filing its original tax return, a taxpayer should assume that IDC incurred during the year was related to a successful well. If the well is later determined to be nonproductive the taxpayer may file an amended return to treat the IDC as nonproductive for that taxable year rather than the year in which the well was determined to be nonproductive.
Both IDC on successful wells and nonproductive well costs are normally reported as an Other Deduction on Line 26 of a corporate income tax return. Examiners may find that they are combined and reported only as "Drilling Costs".
Examiners should request separate lists of the two types of costs by well preferably in electronic format so they can be analyzed. Examiners should also look for unusually large figures and also for figures that suggest an estimated amount was deducted e. The tax treatment of drilling costs is dependent to a large degree upon operational decisions made at the conclusion of the drilling phase.
When the drilling of a well reaches total depth the operator must decide how to proceed. Information will first be gathered from well "logging" tools sensors to help determine certain characteristics of the geologic layers and any fluids contained within.
Other tools that can obtain small cores and fluid samples from prospective reservoirs may also be lowered into the well and then retrieved. On rare occasions the operator will attempt to produce the well to verify that a commercial rate of oil and gas can be achieved. Based on the results, the operator will place the well into one of the following conditions:. Cement will be placed within the well in a number of intervals and a metal plate welded to the top near the ground level.
Temporarily Abandoned. The drilling rig may install the final string of casing in the well before leaving the drill site. Future operations, such as installing the tubing and perforating the well, may be performed by a less expensive "completion rig". The operator will file a Temporarily Abandoned or Idle Well report with the appropriate regulatory agency. The final string of casing and the well tubing is installed.
The well is perforated and the christmas tree is installed. A retrievable plug or check-valve may be set in the tubing just below the christmas tree for safety purposes, but the well is otherwise ready to produce.
Shut-in status may occur when there is not yet a pipeline or tank battery for the well to flow into. The operator will file a Shut-in or Idle Well report with the appropriate regulatory agency. The well is completed and production to the pipeline or tank battery has been established.
The operator will file a Completed Well report with the appropriate regulatory agency. Since there are numerous regulatory agencies, the title of the well status reports and the information that must accompany them when submitted varies. Tax Considerations - When a well has been drilled and then placed into either temporarily abandoned or shut-in status, the drilling costs should generally be treated as IDC. Examiners often find that wells that are temporarily abandoned are improperly treated as nonproductive wells or improperly written off as abandonment losses.
When a well is plugged and abandoned immediately after drilling, the well is clearly nonproductive, and drilling costs can be treated as such. The assistance of an IRS engineer may be necessary. The option with respect to IDC does not apply to expenditures by which the taxpayer acquires tangible property ordinarily considered as having a salvage value.
If the taxpayer fails to deduct costs qualifying as intangible drilling costs as expenses on the taxpayer's return for the first taxable year in which the taxpayer pays or incurs such costs, the taxpayer is deemed to have elected to recover such costs through depletion to the extent that they are not represented by physical property, and through depreciation to the extent that they are represented by physical property.
Normally, taxpayers will elect to deduct IDC currently. The timing of a tax deduction for many taxpayers is an important factor in the planning of a good tax program.
The deductions for IDC could be a major item in this tax planning. Like other deductible expenses, the deductions for IDC depend on the taxpayer making the election to deduct the expenses, method of accounting, drilling contract provisions, and many other factors.
For taxpayers using the cash basis method of accounting, IDC is deductible in the year paid, under certain conditions, although the work is performed in the following year. Refer to Pauley v.
Taxpayer A owns percent of the working interest in an oil and gas lease and enters into a drilling agreement with Taxpayer B for the drilling of a well on Taxpayer A's property. Taxpayer A is on the cash basis of accounting and paid Taxpayer B as provided in the agreement on December 29, The Government's position regarding the deduction of prepaid IDC by a cash basis taxpayer is set out in Rev. Commissioner , 79 TC 7 Ordinarily, the prepaid expense is deductible if:.
The drilling contract requires a prepayment of the agreed amount. The prepayment must not be a mere deposit. In the above example, Taxpayer A is entitled to deduct the prepaid amount in since Taxpayer A has met all the conditions set forth in the revenue rulings. The examining agent should be aware that, generally, when there are several working interest owners of the property, the operator of the property is the person that makes the contacts with the drilling company and enters into the drilling contract for the drilling of the well.
The drilling contractor will require the prepayment of the agreed amounts from the operator. It is, therefore, unlikely that a drilling contract would require a prepayment from any interest owners other than the operator. The prepayment to the operator by a nonoperator working interest owner does not satisfy the requirements for a deductible prepayment unless the operator was required to make a prepayment in accordance with the rules set out above.
The method of accounting used by the operator generally controls the deductibility of any amount to the working interest owners. The drilling contract and prepayment agreement should always be examined to learn the facts regarding every material prepayment requirement. The above discussion and revenue rulings apply only to the cash basis taxpayer.
The deduction to the accrual basis taxpayer is controlled by the general rules regarding the accrual of any type of expense including the economic performance requirements of IRC IRC h. The method of accounting used by the individual taxpayer, as well as by the operators of working interests, is very important in determining the year of deduction of intangible drilling and development expenses.
Because the cash basis method of accounting gives the taxpayer more control over the timing of a deduction, most taxpayers use this method of accounting. Cash Method — The cash method of accounting in the oil and gas business is no different than in any other business. The expenses are deductible when incurred and paid, and the income is taxable when received. The general rules of IRM 4. Accrual Method — The accrual method of accounting in the oil and gas business is similar to any other business.
The expenses are deductible when all events have occurred to fix the liability and income is taxable when received or earned. If the taxpayer owns drilling equipment and drills its own wells, the IDC is deductible when incurred.
If the taxpayer has contracted for the drilling of the wells, the provisions of the drilling contract will fix the liability for the accrual of the expense deduction. Special attention should be given to the contract provisions in order to determine the proper accruals of any year end.
Completed Contract Method — The use of the completed contract method of accounting for the deduction of IDC can not be used by the accrual basis taxpayer to postpone the deduction until a succeeding year. The cost must be deducted in the year paid or incurred, depending on the taxpayer's general method of accounting. Turnkey — The Turnkey drilling contract is an agreement that calls for the drilling contractor to drill a well to a specified depth and furnish certain equipment and supplies for a preagreed lump-sum price.
Since this type of contract does not separate the tangible equipment cost from the intangible drilling cost, the agent should make sure that the leasehold and equipment costs are properly capitalized. A common problem is for the taxpayer to deduct the entire percentage of the Turnkey price without regard to the capital items included in the contract.
To the accrual basis taxpayer, the accrual of the expense should only be made when all the events to fix the liability have been satisfied including the economic performance requirements of IRC IRC h.
There are several variations of the general Turnkey contract which might call for different stages of completion and equipping of the well.
The contract provisions should be examined in order to determine the proper tax treatment of the lump sum expenditure. Footage — The Footage contract provides for the drilling contractor to perform specific services to drill the hole at a specified price per foot.
This type of contract usually provides that the contractor will also be paid an hourly or daily work rate for any other service performed during the drilling of the well. If the well is a productive well, additional cost will be incurred for the completion and equipment on the well.
These costs will be in addition to the footage drilling price. The agent should make sure that all tangible equipment costs are capitalized and all IDC identified properly. Day Work — The Day Work drilling contract generally provides for the drilling contractor to drill a well and be paid for services based on an agreed rate per day. This type of contract is usually used by a drilling contractor where problems with the geological formations may be encountered and in unfamiliar areas.
This type of drilling contract avoids the risks to the driller inherent in Turnkey and Footage contracts. The loss of drilling mud, high gas pressure blowouts, "fishing jobs," or unusually hard formations are examples of problems that can cause delays and increase the cost to the contractor.
The lease operators will be charged for "third-party" costs, such as, drilling mud, drilling bits, fuel costs, water and site preparation cost, in addition to the day work rate charged by the drilling contractor. The agent should look at these drilling contracts and agreements to make sure the proper costs and charges are deducted as IDC. It is common practice in the oil and gas industry for joint owners of working interests to designate one owner as the "operator" of their properties.
For this purpose "operator" is considered to be the person who bears the most responsibility for the management and day to day activities of drilling, completing and operating the wells. Normally, the operator performs duties in accordance with an operating agreement that all joint owners have endorsed. The operator manages the drilling, completing, and operating efforts on the property, pays all expenses, and bills joint owners for their share of the expenses.
The operator is usually from one to six months behind in billing to the several joint owners. An agency relationship exists between the operator and the nonoperator, and the timing of the deduction to the nonoperator is an important item. The tax accounting for the cash basis nonoperator will be controlled by the operator's payment of the expense items.
The IDC and operating expenses should be deducted in the year paid or incurred even though they may be reimbursed in a later year. The operator must have incurred and paid the expense before the nonoperator's deduction is allowable. The nonoperator has not paid until payment is made by the operator.
See McAdams v. The deductions of the accrual-basis nonoperator will be allowable only if the accrual-basis operator has an expense that is properly accrued, or if the cash basis operator has actually paid the expense.
The agent should be aware of this problem area, and the legal relationship between the parties should be determined for a proper timing of the expense deductions.
The examination of the operator's and nonoperator's returns should include the examination of the year-end expenses and, where material errors are found, corrected. The right to deduct IDC is available only to the taxpayers who own the working interest or operating rights in the properties on which the expenses are incurred.
If a well is drilled for the acquisition of a fractional working interest in the property, a deduction for the intangibles is allowed only for the cost attributable to the fractional interest acquired. Any IDC attributable to the working interest owned by someone else is a capital cost and must be added to the leasehold basis of the interest acquired. Many times the owner-operator of an oil and gas lease owns drilling equipment as well as the oil and gas wells being drilled.
If the taxpayer has made the election to expense the intangible drilling and development cost, this cost incurred or paid may be deducted.
The timing of the deduction depends on the method of accounting. These expenses include all direct costs, indirect costs, and the current depreciation of the equipment.
Refer to Commissioner v. Idaho Power Co. The scope of the examination of an owner-operator drilling its own wells should be extended to the operating expense accounts to ensure that all costs attributable to the drilling of the wells are properly classified as intangible drilling costs. The proper classification is necessary because of the computations of tax preference items, depletion, and any gain or loss on the subsequent disposition of the property. If the taxpayer owns something less than percent of the working interest and pays all the cost of drilling the well, only the intangible costs attributable to the working interest percentage owned is deductible and the balance is capitalized to the leasehold basis.
If the taxpayer owns only a fractional interest in the working interest and drills the well on the property for all the working interest owners, the taxpayer should realize a profit or loss on the drilling of the well separate from the IDC deduction. Taxpayer A also owns the necessary drilling equipment to drill the well. In this example, notice the factual differences from the preceding example in that Taxpayers B and C are paying for IDC and an interest in a lease.
Assume that Taxpayer A owns percent of the working interest in an oil and gas lease. This is assuming that Taxpayer A is not in the trade or business of selling oil and gas leases, and the oil and gas lease was not held for sale to customers.
The examination of taxpayers that have drilling and development arrangements, such as those mentioned above, should include the examination of the assignment of the property, letter agreements, operating agreements, and drilling contracts. Before making an examination of an oil and gas operator's IDC, the examiner should be familiar with what qualifies as IDC and carried interest arrangements.
Very often the partnership form of doing business is used in the oil and gas industry since it is a convenient means of bringing a large number of widely scattered investors or owners into one joint business undertaking. During the development period of oil and gas properties, the IDC may be allocated to the partners in accordance with the partnership agreement. IRC b and Treas. Commissioner , 55 TC , and Allison v. March 7, If the partnership agreement so provides, subject to the provisions of Treas.
In the examination of oil and gas partnerships, it is important to first verify that a true partnership exists. Once verified, it is very important to always inspect the partnership agreement for provisions regarding allocations of income, expenses, gains, losses, and credits. If there is a change in partners or the ratio of allocations of income, expenses, gains, losses, or credits during the partnership year, refer to Rev.
Special care should be taken to make sure that all items are allocated in accordance with the sharing ratio in effect at the time the income, expenses, gains, losses, or credits were earned or incurred. Many times an interest in an oil and gas lease will be transferred to another person in order to get a well drilled on the property at no cost to the transferrer. Taxpayer A owns percent of the working interest in an oil and gas lease and agrees to assign to Taxpayer B 50 percent of the working interest in the property if Taxpayer B will drill and equip a well on the property at Taxpayer B's expense.
The low price elasticity of demand for oil is quite different from the demand for other goods and services, even other types of energy. For example, higher natural gas prices can lead to more use of solar, coal, and oil for generating electricity. However, most automobiles in still required gasoline, and therefore oil, to function. As a general rule, supply is less responsive to price changes than demand.
However, the supply of oil is fairly inelastic, even by the standards of supply curves. First, it helps to consider why supply is generally less elastic than demand, particularly in the short run.
There is a fixed supply of goods at any given moment, and demand must adapt. For instance, the sudden increase in people working from home during the coronavirus crisis created a shortage of consumer paper products at stores in People previously got toilet paper, facial tissues, and paper towels from different companies via their employers while at work.
In the short term, consumers simply had to reduce their demand. The supply of oil is even less elastic than most other goods because of the specialized investments that are often needed to extract oil. Much of the equipment that is used to mine gold or silver can be diverted to mining platinum or palladium as prices shift. However, expensive equipment used for hydraulic fracturing and offshore drilling often cannot be used for anything else.
As a result, oil companies may take years to develop oil fields when prices are high. Furthermore, they often have to continue producing oil even when prices fall because the equipment has no other uses. Since both supply and demand for oil are not very responsive to price changes, oil price swings tend to be dramatic. Furthermore, oil price changes often impact the rest of the economy.
Sudden disruptions in the oil supply can cause recessions, while a decline in the oil price can fuel an economic boom. Most people in developed countries need oil to go to work, school, or even to the store to get food. We don't want to give up on any of that and are willing to pay more, but everyone else is in the same boat. As a result, oil prices have to go up a lot to get consumers to change their behavior. Oil firms also need to take in those big profits to fund the development of more oil fields, which is very costly and high risk.
High oil prices mean a boom for the oil industry and often a bust for other industries. Everyone who uses a traditional automobile suddenly has to pay more for gas, so they have less disposable income available for other goods. A total of 1. Fossil fuel development can also leak toxic substances into the soil and drinking water sources, causing cancer, birth defects and liver damage. Black, Brown, Indigenous and low-income communities are disproportionately impacted since these groups tend to live in neighborhoods with more pollution.
Not surprisingly, these communities are fighting back. In Greeley, Colorado, residents of a predominantly Latino and immigrant community are trying to close an oil and gas operation located two blocks from a public school. The original plan was to place the wells near a predominantly white school but the location changed after angry parents pushed back.
Climate change is happening here and now. The year was one of the warmest on record, wildfire season in the West is longer and hurricanes are more dangerous. These extreme weather events are directly linked to fossil fuels that release heat-trapping gases into the atmosphere. While we are all impacted, Black, Brown, Indigenous and working-class communities are feeling the heat—quite literally.
Due to unjust housing policies and practices, these communities often live in treeless, concrete neighborhoods that are more susceptible to extreme weather events. These groups also have a harder time accessing natural landscapes that can help mitigate climate impacts. With better management, public lands can be a part of the solution instead of the problem.
We can have less fossil fuel extraction on these lands and more responsible renewable energy. Infrastructure built for oil and gas extraction can leave behind radical impacts on wildlands.
The construction of roads, facilities and drilling sites requires the use of heavy equipment and can destroy big chunks of pristine wilderness. The damage is often irreversible. On public lands, over 12 million acres are being used to produce fossil fuels—the equivalent of six Yellowstone National Parks. These developments typically remove large amounts of rangelands and vegetation that is used by wildlife and people. Even if oil and gas companies eventually abandon these sites, it can take centuries before they fully recover.
The increase in these costs can in turn affect the prices of a variety of goods and services, as producers may pass production costs on to consumers. The extent to which oil price increases lead to consumption price increases depends on how important oil is for the production of a given type of good or service. Oil price increases can also stifle the growth of the economy through their effect on the supply and demand for goods other than oil.
Increases in oil prices can depress the supply of other goods because they increase the costs of producing them. In economics terminology, high oil prices can shift up the supply curve for the goods and services for which oil is an input. High oil prices also can reduce demand for other goods because they reduce wealth, as well as induce uncertainty about the future Sill One way to analyze the effects of higher oil prices is to think about the higher prices as a tax on consumers Fernald and Trehan The simplest example occurs in the case of imported oil.
The extra payment that U. Despite these effects on supply and demand, the correlation between oil price increases and economic downturns in the U. Not every sizeable oil price increase has been followed by a recession. However, five of the last seven U. The two aforementioned large oil shocks of the s were characterized by low growth, high unemployment, and high inflation also often referred to as periods of stagflation.
It is no wonder that changes in oil prices have been viewed as an important source of economic fluctuations. However, in the past decade research has challenged this conventional wisdom about the relationship between oil prices and the economy. As Blanchard and Gali note, the late s and early s were periods of large oil price fluctuations, which were comparable in magnitude to the oil shocks of the s.
However, these later oil shocks did not cause considerable fluctuations in inflation Figure 4 , real GDP growth Figure 5 , or the unemployment rate. Figure 4. Figure 5. A caveat is in order, however, because simply observing the movements of inflation and growth around oil shocks may be misleading. Keep in mind that oil shocks have often coincided with other economic shocks.
In the s, there were large increases in commodity prices, which intensified the effects on inflation and growth. On the other hand, the early s were a period of high productivity growth, which offset the effect of oil prices on inflation and growth. Therefore, to determine whether the relationship between oil prices and other variables has truly changed over time, one must go beyond casual observations and appeal to econometric analysis which allows researchers to control for other developments in the economy when studying the link between oil prices and key macroeconomic variables.
Formal studies find evidence that the link between oil prices and the macroeconomy has indeed deteriorated over time. For example, Hooker suggests that the structural break in the relationship between inflation and oil prices occurred at the end of s. Blanchard and Gali look at the responses of prices, wage inflation, output, and employment to oil shocks.
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