Seismic Survey Costs Are Costs to Be Amortized, Not Intangible Drilling Costs, per IRS Memorandum

In CCA 201835004 the question was posed regarding whether seismic surveys information obtained to determine the placement of offshore gas and oil development wells should be treated as geological and geophysical costs, amortizable under §167(h), or as intangible drilling costs, deductible under IRC §263(c).

The CCA describes the facts of the situation as follows:

Based on information acquired from exploration wells, the joint owners of both fields sanctioned development in late Year 5, including drilling development wells. In Year 6, Taxpayer approved net funding of $d million for the acquisition of a Seismic Survey of the A and B fields, which covered an area of approximately e offshore blocks (approximately f square miles) within each of the A and B project areas. Taxpayer used the data generated by the Seismic Survey to optimize placement of development wells in the A and B fields.

The taxpayer claimed the costs of the expenditures as intangible drilling costs under IRC §263(c) which allows for an immediate deduction of the expenditure.  That provision reads:

Notwithstanding subsection (a), and except as provided in subsection (i), regulations shall be prescribed by the Secretary under this subtitle corresponding to the regulations which granted the option to deduct as expenses intangible drilling and development costs in the case of oil and gas wells and which were recognized and approved by the Congress in House Concurrent Resolution 50, Seventy-ninth Congress. Such regulations shall also grant the option to deduct as expenses intangible drilling and development costs in the case of wells drilled for any geothermal deposit (as defined in section 613(e)(2)) to the same extent and in the same manner as such expenses are deductible in the case of oil and gas wells. This subsection shall not apply with respect to any costs to which any deduction is allowed under section 59(e) or 291.

The related regulations are found at Reg. §1.612-4.  As the IRS describes in the advice:

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 chargeable to capital or to expense. If the taxpayer chooses to expense IDCs, the taxpayer also has an option to elect to amortize the IDCs ratably over 60 months under § 59(e).

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. These costs include costs incurred by operators of any drilling or development work performed 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, 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.

Additionally, 1.612-4(a) provides that 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.

The IRS in examination was arguing that these are actually geological and geophysical costs that must be capitalized and amortized under IRC §167(h)(1).  That provision reads:

Any geological and geophysical expenses paid or incurred in connection with the exploration for, or development of, oil or gas within the United States (as defined in section 638) shall be allowed as a deduction ratably over the 24-month period beginning on the date that such expense was paid or incurred.

The memorandum looked to resolve the issue of which IRC provision was the proper one to apply in this case.  The memorandum concluded that, in fact, such expenditures were not intangible drilling costs under IRC §263(c), but rather must be amortized as geological and geophysical costs under IRC §167(h).

First, the memorandum argues that the plain meaning of IRC §167(h) includes development geological and geophysical costs, pointing that the inclusion of the phrase “or development of” in IRC §167(h)(1) “indicates that Congress intended to include the cost of geological and geophysical expenditures during the development phase of an oil and gas project.”

The memorandum applies this logic to the facts of this situation as follows:

The application of the plain language of § 167(h) to our case is straightforward. The Seismic Survey was conducted over a significant area of interest within two project areas. It 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 (as defined in § 638).” Therefore, the costs are geological and geophysical expenditures within the meaning of § 167(h).

Section 167(h)(3) provides an exclusive method of cost recovery for G&G expenditures. Except as provided within § 167(h), no depreciation or amortization deduction is allowed with respect to such payments.

The key issue to the IRS is that the expenses were not incurred with regard to a specific well, even if would eventually lead to wells being drilled.  Thus, the argument goes, the expenses are not intangible drilling costs under IRC §263(c) for any particular well.

The memorandum also finds that the legislative history of IRC §167(h) did not exclude developmental costs from the amortizable geological and geophysical costs.  Rather, looking at the Conference Report from the legislation that enacted IRC §167(h), the IRS concludes Congress relied upon prior IRS administrative guidance in the area:

In the Conference Agreement that accompanied the enactment of § 167(h), Congress relied heavily upon prior IRS administrative rulings noting that they “have provided further guidance regarding the definition and proper tax treatment of G&G costs.”66 The Conference Agreement discusses in detail the guidance provided in Revenue Ruling 77-188,67 which describes a typical G&G exploration program as containing certain activities. The ruling describes the activities undertaken by a taxpayer conducting an exploration program in one or more identifiable project areas. The taxpayer selects a specific project area from which G&G data are desired to conduct a reconnaissance-type survey utilizing various G&G exploration techniques. These techniques are designed to yield data that will afford a basis for identifying specific geological features with sufficient mineral potential to merit further exploration. Each separable, noncontiguous portion of the original project area in which such a specific geological feature is identified is a separate “area of interest.” The taxpayer seeks to further define the geological features identified by the prior reconnaissance-type surveys by additional, more detailed, exploratory surveys conducted with respect to each area of interest. For this purpose, the taxpayer engages in more intensive geological and geophysical exploration employing methods that are designed to yield sufficiently accurate sub-surface data to afford a basis for a decision to acquire or retain properties within or adjacent to a particular area of interest or to abandon the entire area of interest as unworthy of development by mine or well.

While Revenue Ruling 77-188 refers to this sequence of events as an exploration program, this last phase of activity is analogous to the Seismic Survey undertaken by Taxpayer in this case. Revenue Ruling 77-188 states that the taxpayer may acquire or retain a property within or adjacent to an area of interest, based on data obtained from a detailed survey that does not relate exclusively to any discrete property within a particular area of interest. Revenue Ruling 77-188 requires the taxpayer in this situation to allocate the entire amount of G&G costs to the acquired or retained property as a capital cost under § 263(a). With the enactment of § 167(h) as the exclusive method for recovering G&G expenditures, the costs of the Seismic Survey are G&G expenditures within the meaning of § 167(h).

Finally, the memorandum cites case law that it argues supports the amortization of such costs:

The present case is analogous to Louisiana Land & Exploration Co. v. Commissioner.68 As discussed above, in that case, the Tax Court used the acquisition or retention standard to determine whether geophysical survey costs are capital in nature. The taxpayer owned a property for ten years and then incurred costs for a geological survey to determine whether subsurface structures on the property justified drilling for oil and gas. The Tax Court determined that the cost of the geological survey must be capitalized because it resulted in the acquisition or retention of a capital asset. Importantly, the Tax Court noted that “[t]his 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, which preparations are far removed from over-all geophysical exploration such as we are here considering.”

In the present case, the A field was discovered over a decade before development began. An earlier set of surveys were conducted years before Taxpayer incurred costs to acquire the Seismic Survey. The Seismic Survey generated data from a broad area of the seafloor within two distinct project areas. Taxpayer then 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 are G&G expenditures.