PLR 1131008: IRS allowed independent-producer treatment despite a related retailer

Plain-English summary

An oil and gas exploration company was part of a consolidated group that also included a related natural-gas retailer. The producer sold its production to unrelated persons, and the retailer bought gas from unrelated parties or through market transactions rather than acquiring the producer's output for resale. The IRS concluded that the producer was not precluded from being treated as an independent producer under section 613A(c). It also concluded that the producer was not an integrated oil company subject to the section 291(b)(1)(A) limitation on certain intangible drilling and development cost deductions. The ruling was based on the submitted facts and representations and expressed no opinion on other section 613A requirements.

Ruling snapshot

• Question: Whether a natural-gas producer remained an independent producer when a related company conducted retail activities.
• Outcome: Approved.
• Key authorities: IRC §§ 291(b), 611, 612, 613, and 613A(c) and (d); Treas. Reg. §§ 1.611-1 and 1.613A-7; Rev. Rul. 85-12 and Rev. Rul. 92-72.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201131008 Third Party Communication: None
Release Date: 8/5/2011 Date of Communication: Not Applicable
Index Number: 613A.04-02, 613A.04-03
Person To Contact:
-------------------- ------------------------, ID No. ----------
-------------------------------- Telephone Number:
------------------------------ --------------------------------------------------
--------------------- Refer Reply To:
-------------- CC:PSI:06
-------------------------------- PLR-143965-10
Date:
April 20, 2011

LEGEND:

Taxpayer = ------------------------------
-------------------------
Parent = ---------------------------
Sister 1 = --------------------------------------
Sister 2 = ---------------------------------
Sister 3 = ----------------------------
Subsidiary 1 = ----------------
Subsidiary 2 = ---------------------------------------
Country = ----------

Dear --------------------:

   This letter responds to your letter dated -----------------------, requesting a ruling

that Sister 1 is not precluded from being treated as an independent producer for
purposes of § 613A(c) of the Internal Revenue Code, and is not treated as an integrated
oil company for purposes of § 291(b)(1)(A) if a related sister company in Taxpayer’s
consolidated group engages in retail activities.

Facts

     The facts are represented by Taxpayer to be as follows:

 Taxpayer uses a calendar taxable year accounting period, and the accrual

method of accounting for filing its federal income tax return.
PLR-143965-10 2

     Parent is incorporated in Country, and conducts exploration, production and

retail activities wholly within Country. Parent does not sell any of its product directly or
indirectly to related retailers within the United States (U.S.). Parent does not and will
not purchase any product from Sister 1 for Parent’s retail activities in Country.

   Taxpayer is the holding company for Parent’s U.S. operations, and files a

consolidated return for its affiliated group. Sister 1, Sister 2, Sister 3, Subsidiary 1, and
Subsidiary 2 all are members of Taxpayer’s consolidated group. Sister 1, Sister 2, and
Sister 3 are all wholly-owned by Subsidiary 1. Subsidiary 2 is wholly-owned by Sister 1.

   Sister 1 is an exploration company that holds various working interests in oil and

gas leases, and is engaged in the exploration for and production of natural gas and oil
in the U.S. Natural gas produced by Sister 1 is transferred to Subsidiary 2 for industrial
and commercial sales and transportation on pipelines pursuant to Federal Energy
Regulatory Commission (FERC) regulations.

   Sister 2 is a retail company that has entered into contracts for the purchase of

natural gas from Subsidiary 2 and third parties. Sister 2 will convert the natural gas to
compressed natural gas and/or liquefied natural gas and sell it to a variety of users,
including industrial, commercial, and individual customers, through retail outlets.
Neither Sister 2 nor Subsidiary 2 knows or controls the final disposition of the natural
gas sold by Subsidiary 2 into the open market or the original source of the natural gas
acquired by Sister 2 from Subsidiary 2. Sales by Sister 2 to end users are expected to
exceed $5 million.

   Sister 2 may utilize employees of the consolidated group to perform services on

behalf of Sister 2, such as accounting and administrative services provided by
employees of Parent, Sister 1, and Sister 3. In addition, employees of Sister 1 may
provide servicing and maintenance of retail facilities to Sister 2. Any consolidated group
employees or assets used will be reimbursed at arms-length market price. Sister 2 will
not pay trademark fees to Sister 1.

   Subsidiary 2 is a marketing and transportation company that owns certain

reporting and tracking software. Subsidiary 2 holds a blanket marketing certificate to
sell natural gas on pipelines pursuant to the FERC. FERC regulations require that the
transporter hold title of the product when it enters the pipeline. Subsidiary 2 sells
natural gas produced by Sister 1 into the stream of commerce to multiple purchasers at
market prices. Neither Sister 1 nor Subsidiary 2 has knowledge of or control over what
happens to the natural gas after it is sold.

    Subsidiary 2 does not have any exploration or development activities. To

accommodate the purchasing of natural gas for Sister 2, Subsidiary 2 will enter into
back to back contracts: (1) contracts with unrelated third parties to purchase natural gas
off the open market, and (2) contracts to resell the third party natural gas to Sister 2.
PLR-143965-10 3

Each month, pursuant to the third party contract terms, Subsidiary 2 will be invoiced by
the unrelated third party for the amount of natural gas delivered to Sister 2’s retail sites.
Subsidiary 2 will invoice Sister 2 monthly for the identical amount and volumes.

   Taxpayer has made the following representations:

   (1) Sister 1 does not own a significant ownership interest in Sister 2;

   (2) Sister 1’s production is sold to persons unrelated to Sister 1 and unrelated to

Sister 2;

  (3) Sister 2 does not purchase oil or natural gas from Sister 1’s customers or

persons related to Sister 1’s customers;

  (4) There are no arrangements whereby Sister 2 acquires for resale oil or natural

gas that Sister 1 produced or made available for purchase by Sister 2;

   (5) Neither Sister 1 nor Sister 2 knows or controls the final disposition of the oil or

natural gas sold by Sister 1 or the original source of the petroleum products acquired for
resale by Sister 2;

   (6) The gathering lines, pipelines, and interconnections used by Sister 2 to

procure and resell natural gas are connected solely to gas lines owned by unrelated
third parties. Accordingly, Sister 1 has no specific knowledge that Sister 1’s oil or
natural gas is or will be commingled with other producers’ oil or natural gas that is or
may be acquired for resale by Sister 2.

Law and Analysis

  Section 291(b)(1)(A) provides that an integrated oil company is required to

reduce the deduction for certain intangible drilling and development costs allowable
under § 263(c) by 30 percent, and amortize such costs over a period of 60 months.

   Section 291(b)(4) provides that for purposes of § 291(b), the term “integrated oil

company” is defined as any producer of crude oil to whom § 613A(c), relating to
independent producers, does not apply by reason of § 613A(d)(2) or (d)(4), relating to
certain retailers or refineries, respectively.

   Section 611 generally provides for a depletion deduction in the case of mines, oil

and gas wells, other natural deposits, and timber. Section 1.611-1(a) of the Income Tax
Regulations provides that in the case of exhaustible natural resources, other than
timber, the allowance for depletion is computed upon either the adjusted depletion basis
of the property (see § 612, relating to cost depletion) or upon a percentage of gross
PLR-143965-10 4

income from the property (see § 613 relating to percentage depletion), whichever
results in the greater allowance for depletion for any taxable year.

  Section 613A(a) provides that except as otherwise provided in § 613A, the

allowance for depletion under § 611 with respect to any oil and gas well is computed
without regard to § 613.

    Under § 613A(c), “independent producers and royalty owners” are allowed a

deduction for percentage depletion with respect to limited quantities (depletable
quantities) of domestic crude oil or natural gas production. However, § 613A(c) does
not apply to any taxpayer that is a “retailer” or “refiner” as defined in § 613A(d)(2) and
(d)(4), respectively.

    Section 613A(d)(2) provides that a retailer is any taxpayer who (subject to a $5

million de minimis sale rule) directly, or through a related person, sells oil or natural gas
(excluding bulk sales of such items to commercial or industrial users), or any product
derived from oil or natural gas (excluding bulk sales of aviation fuels to the Department
of Defense)—

   (A) through any retail outlet operated by the taxpayer or a related person, or

   (B) to any person—

  (i) obligated under an agreement or contract with the taxpayer or a related

person to use a trademark, trade name, or service mark or name owned by such
taxpayer or a related person, in marketing or distributing oil or natural gas or any
product derived from oil or natural gas, or

   (ii) given authority, pursuant to an agreement or contract with the taxpayer or a

related person, to occupy any retail outlet owned, leased, or in any way controlled by
the taxpayer or a related person.

   Section 613A(d)(3) provides that for purpose of § 613A(d), a person is a related

person with respect to the taxpayer for purposes of § 613A(d) if a significant ownership
interest in either the taxpayer or such person is held by the other, or if a third person
has significant ownership interests in both taxpayer and such person. Section
613A(d)(3) provides that the term “significant ownership interest” means, with respect to
any corporation, 5 percent or more in value of the outstanding stock of such corporation.

   Section 613A(c)(8)(A) provides that for purposes of § 613A(c), persons who are

members of the same controlled group of corporations are treated as one taxpayer.
This provision, however, does not apply to the provisions within § 613A(d).
PLR-143965-10 5

    Section 1.613A-7(r)(2)(ii) provides that a taxpayer may be deemed to be a

“retailer” by virtue of selling oil or natural gas or products derived therefrom through a
related person in certain cases in which the taxpayer may benefit by reason of the
taxpayer’s direct or indirect ownership interest in the related person.

   Section 1.613A-7(r)(3) provides that the term “any product derived from oil or

natural gas” means products that are recovered from petroleum refineries or extracted
from natural gas in field facilities or natural gas processing plants. The term retail outlet
means “any place where sales of oil or natural gas (excluding bulk sales of such items
to commercial or industrial users), or a product of oil or natural gas (excluding bulk sales
of aviation fuels to the Department of Defense), accounting for more than 5 percent of
the gross receipts from all sales made at such place during the taxpayer’s taxable year,
are systematically made for any purpose other than for resale.”

    In Rev. Rul. 85-12, 1985-1 C.B. 181, a wholly-owned subsidiary of a holding

corporation produced oil and gas that it sold at or near the wellhead to unrelated parties.
Another wholly-owned subsidiary of the same holding corporation was a retailer of
petroleum or petroleum products it purchased from unrelated parties, selling more than
$5,000,000 annually to end users. The holding corporation filed a consolidated return
with its subsidiaries. The revenue ruling concludes that the producer subsidiary had no
direct or indirect ownership interest in the retailer subsidiary, and, thus, did not benefit
from the retail sales. Although the two subsidiaries were related persons for purposes
of § 613A(d), none of the producer subsidiary's production was, in form or substance,
sold through the retailing subsidiary. Thus, the producer subsidiary was not precluded
from taking the percentage depletion deduction as provided in § 613A(c) or from being
treated as an independent producer for purposes of the former windfall profit tax.

    Rev. Rul. 92-72, 1992-2 C.B. 118, describes a situation under which a taxpayer

is not considered to be selling oil or natural gas through a related retailer and therefore
is not considered a retailer itself for purposes of § 613A(d)(2). In the revenue ruling:

   (1) the taxpayer does not own a significant ownership interest in the retailer;

   (2) the taxpayer sells its production to persons unrelated to the taxpayer and

unrelated to the retailer;

  (3) the retailer does not purchase oil or natural gas from the taxpayer’s

customers or persons related to the taxpayer’s customers;

   (4) there are no arrangements whereby the retailer acquires for resale oil or

natural gas that the taxpayer produced or made available for purchase by the retailer;
and
PLR-143965-10 6

    (5) neither the taxpayer nor the retailer knows or controls the final disposition of

the oil or natural gas sold by the taxpayer or the original source of the petroleum
products acquired for resale by the retailer.

   Based on the information submitted and the representations made, we conclude

that Sister 1 is not precluded from being treated as an independent producer for
purposes of § 613A(c), and is not treated as an integrated oil company for purposes of
§ 291(b)(1)(A).

    Except as expressly provided herein, we express or imply no opinion concerning

the tax consequences of any aspect of any transaction or item discussed or referenced
in this letter. Specifically, we express or imply no opinion whether the transactions in
this case otherwise meet the requirements of § 613A.

  This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3)

provides that it may not be used or cited as precedent.

                                   Sincerely,



                                   Brenda M. Stewart
                                   Senior Counsel, Branch 6
                                   (Passthroughs & Special Industries)
                                   Office of Associate Chief Counsel