Oil and Gas Transactions (Portfolio 605)

Tax Management Portfolio, Oil and Gas Transactions, No. 605-3rd, analyzes the principal domestic federal income tax aspects of acquiring various types of interests in oil and gas properties; exploring, developing, and operating the properties; the various types of arrangements and organizations used in the process; the depletion allowance; intangible drilling and development costs; production payments; and the application of other areas of the Code to the oil and gas industry.

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Tax Management Portfolio, Oil and Gas Transactions, No. 605-3rd, analyzes the principal domestic federal income tax aspects of acquiring various types of interests in oil and gas properties; exploring, developing, and operating the properties; the various types of arrangements and organizations used in the process; the depletion allowance; intangible drilling and development costs; production payments; and the application of other areas of the Code to the oil and gas industry.

The acquisition, exploration, and development of properties for the production of oil and gas require the investment of considerable capital and often involve the assumption of considerable risk, particularly with respect to previously undeveloped properties. The owners and operators of such properties use a variety of techniques, in addition to the usual debt financing, for financing the development of the properties and for spreading the associated risk. The selection of a particular financing technique involves the consideration of tax, economic, and other factors. The tax considerations can materially affect the anticipated income to be realized on the investment of capital and often determine the form and feasibility of the particular investment in the property. This Portfolio examines the tax considerations in detail.


Noah S. Baer

Noah S. Baer, B.A., Yeshiva University; J.D., Columbia University; M.L.T., Georgetown University; Executive Director, Ernst & Young, National Tax Department; Domestic and International Tax Counsel, Mobil Corporation; Senior Attorney, Office of Chief Counsel (Passthroughs and Special Industries Division), Internal Revenue Service; Senior Litigation Attorney, Office of Chief Counsel, Department of Energy; Litigation Associate, Tenzer, Greenblatt, Fallon & Kaplan, New York, NY; Member, District of Columbia bar; Speaker at various natural resource tax conferences.

Table of Contents

Detailed Analysis

I. Introduction

A. Background

B. Summary of Basic Concepts

1. Investment in the Oil and Gas Property

a. Economic Interest

b. The “Property” Concept

c. Operating and Nonoperating Interests

2. Expenses and Cost Recovery

a. Leasehold Costs

b. Exploration Costs

c. Intangible Drilling and Development Costs

d. Depletion

3. Conveyances - Sale or Lease

a. General Considerations

b. Royalties

c. Production Payments

4. Joint Investments

a. Pool of Capital

b. Sharing Arrangements

II. Acquisition of Interest

A. General Principles

B. Economic Interest

1. Investment in the Minerals in Place; Income Derived from Extraction

2. Sale of Oil and Gas for a Return of Capital

C. Types of Conveyances

1. Exploration Option

2. Lease or Sublease

a. General Principles

b. Working and Operating Interests

c. Royalty

d. Net Profits Interest

e. Shut-In Royalty

f. Minimum Royalty

g. Lease Bonus and Delay Rentals

h. Production Payments

3. Sale or Exchange

4. Like-Kind Exchanges

a. General Principles

b. Application to Oil and Gas Transactions

(1) Operating Interests

(2) Royalty Interests

(3) Production Payments

c. Partnerships

d. Pipelines

e. Crude Oil

D. Assignment of Non-Operating Interest

1. Overriding Royalty

2. Carved-Out Production Payment

a. General Principles

b. Historical Background

c. Tax Treatment

3. Net Profits Interest

4. Sharing Arrangements

a. General Principles

b. Production Payment Pledged for Exploration or Development

c. Service Providers

E. Assignment of Operating Interest

1. Sublease

2. Retained Production Payment

a. Historical Background

b. Tax Treatment

3. Sharing Arrangements (Retention of Part of Operating Interest)

a. General Principles

b. Farm-Out Agreement

c. Carried Interests

(1) Pay-Out Arrangement

(2) Free Well Arrangement

d. Service Provider

F. The Property Concept

1. General Principles

2. Aggregation of Operating Interests

3. Aggregation of Non-Operating Interests

G. Unitizations and Pooling Arrangements

1. General Considerations

2. Formation

a. General Principles

b. Like-kind Exchange Analysis

c. Partnership Analysis

III. Cost Recovery - Exploration and Development

A. General Principles

B. Exploration Costs

1. General Principles

2. Types of Agreements

3. Geological and Geophysical Costs

C. Intangible Drilling and Development Costs

1. Definition

2. Election

a. In General

b. Foreign Wells

c. Partnerships

d. Affiliated Groups

3. Prepayments

a. General Principles

b. Cash Method Taxpayers

c. Accrual Method Taxpayers

4. Drilling for an Interest

5. IDC Recapture on Disposition

a. Section 1254 Property and 1254 Costs

b. Dispositions

c. Partnerships and S Corporations

6. Effect on Earnings and Profits

7. Section 59(e) Election

8. Alternative Minimum Tax Treatment

D. Depreciation

1. General Principles

2. The Modified Accelerated Cost Recovery System (MACRS)

3. Drilling for Interest

4. Unitization Exchanges

5. Recapture of Depreciation

6. Alternative Minimum Tax Treatment

E. Uniform Capitalization

1. General Principles

2. Application to Oil and Gas Property

a. Preacquisition Costs

b. Postacquisition Costs

c. Development Costs

d. Interest Costs

F. Section 199 Deduction

1. Qualified Production Property (QPP) and Domestic Production Gross Receipts (DPGR)

a. Extraction

b. Transportation

2. Qualified Production Activities Income (QPAI)

a. Depletion

b. IDC and G& G

c. Extracted Product Used On-site

3. Joint Ventures

4. Construction Activities

5. Exchanges and Hedges

a. Exchanges

b. Hedges

G. Other Expenses

1. Tertiary Injectant Expenses

2. Dry Hole and Bottom Hole Expenses

H. Losses

1. Section 165 Losses

2. At-Risk Provisions

3. Passive Activity Losses

4. Section 172(f) Specified Liability Losses

IV. Cost Recovery - Depletion

A. General

B. Cost Depletion

1. General

2. Bonus

3. Restoration of Depletion on Bonus

4. Selection Bonus

5. Production Payment

6. Net Profits Interest

C. Percentage Depletion

1. Background

2. Independent Producers and Royalty Owners

a. General

b. Related Parties

c. Marginal Production

d. Exclusions

(1) Retailers

(2) Refiners

e. Transfers after October 11, 1990

D. Gross Income from the Property

1. General

2. Production and Manufacturing

3. Stored Minerals

4. Take or Pay Contracts

E. 100% Taxable Income Limitation on the Property

F. Taxpayer's 65% Taxable Income Limitation

G. Special Taxpayers

1. Partnerships

2. S Corporations

3. Trusts and Estates

4. Controlled Group of Corporations, Businesses under Common Control, and Members of the Same Family

5. Fiscal Year Taxpayers

6. Income in Respect of Decedents

7. Community Property

H. Excess Percentage Depletion

1. Adjusted Basis for Determining Gain on Sale

2. Alternative Minimum Tax Treatment

I. Recapture of Depletion

V. Tax Credits

A. Credit for Producing Fuels from Nonconventional Sources (Section 45K)

B. Credit for Enhanced Oil Recovery (Section 43)

1. In General

2. Qualified Enhanced Oil Recovery Costs

3. Qualified Enhanced Oil Recovery Project

a. General Principles

b. Application of One or More Qualified Tertiary Recovery Methods

c. First Injection of Liquids, Gases, or Other Matter Occurs After December 31, 1990

d. Project Certification

e. Election to Have Section 43 Not Apply

4. IRS Examination Guidance

C. Marginal Well Production Credit (Section 45I)

1. In General

2. Qualified Crude Oil and Natural Gas Production

3. Credit Reductions

4. Carryback

D. Low Sulfur Diesel Fuel Production Credit (Section 45H)

VI. Joint Operations

A. Forming and Electing Out of Tax Partnerships

1. In General

2. Forming a Tax Partnership

3. Electing Out of Partnership Status

a. Determination of Partnership Taxable Income

b. Co-ownership Requirement

c. Take In-kind Requirement

d. No Joint Selling

e. Gas Balancing Rules

f. Making the Election

g. Effect of the Election on Non-Subchapter K Code Sections

(1) Interdependence

(2) Foreign Partnerships

4. Use of Tax Partnerships

a. Special Allocations

b. Avoiding Rev. Rul. 77-176

c. Reimbursement of Preformation Capital Costs

B. Operating the Partnership

1. Basis

a. Partner's Basis in the Partnership (“Outside Basis”)

b. Depletable Basis (“Inside Basis”)

2. Partnership Elections

a. General Principles


3. Depletion

4. Special Allocations

a. Economic Effect

b. Substantiality

c. Capital Accounts

(1) General Principles

(2) Simulated Depletion

(3) Tax Credits

(4) Regulation Example 19

5. Built-in Gain or Loss

6. Sale or Exchange of Partnership Interest

a. General Rule

b. After 761 Election

VII. Additional Topics

A. Geothermal Wells

1. Depletion

2. Intangible Drilling and Development Costs

3. Recapture of Depletion and IDC

4. Depreciation

5. Tax Credits

a. Energy Produced from Certain Renewable Resources (Section 45)

b. Energy Credit (Section 48)

6. Sections 465 and 469

B. Nonconventional Fuel Credit (Section 45K)

1. Qualified Fuels

a. Oil Produced from Shale and Tar Sands

b. Gas Produced from Geopressured Brine, Devonian Shale, Coal Seams, and a Tight Formation

c. Gas Produced from Biomass

d. Liquid, Gaseous, or Solid Synthetic Fuels Produced from Coal (including Lignite), including such Fuels When Used as Feedstocks

(1) “Qualified Fuel” Private Letter Rulings

(2) Placed in Service

(3) Coke and Coke Gas

2. The Credit

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 IRS Petroleum Industry Overview

Worksheet 2 GCM 22730, 1941-1 C.B. 214

Worksheet 3 IRM Figure 3-1 on Tax Treatment of Payments Under an Oil and Gas Lease

Worksheet 4 IRS Field Directive on Cost Depletion - Determination of Recoverable Reserves

Worksheet 5 IRM Exhibit 4.41.1-5 (7-31-2002) Classification of Expenditures in Acquisition, Development, and Operation of Oil and Gas Leases

Worksheet 6 IRM Exhibit 4.41.1-3 (7-31-2002) Useful Examination Techniques - Lease Acquisition Costs

Worksheet 7 IRM Exhibit 4.41.1-4 (7-31-2002) Useful Examination Techniques - Intangible Development Costs (IDC)

Worksheet 8 Coordinated Issue Paper on North Sea IDC Transition Rule

Worksheet 9 Coordinated Issue Paper on Capitalization of Delay Rentals

Worksheet 10 Coordinated Issue Paper on Deductibility of Estimated Dismantling Cost for Offshore Platforms

Worksheet 11 Coordinated Issue Paper on Recoverable Reserves for Cost Depletion

Worksheet 12 Industry Director Directive #1 on Enhanced Oil Recovery Credit

Worksheet 13 Industry Director Directive on IRC Section 172(f) Specified Liability Losses

Worksheet 14 American Petroleum Institute Model Tax Partnership Agreement

Worksheet 15 Commentary to API Model Tax Partnership Agreement

Worksheet 16 Oil and Gas Elections

Worksheet 17 Section 45K Inflation Adjustment Factors, Reference Prices and Phase-Out Amounts





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