PLR 1210003: Oil and gas subsidiaries retain independent producer status despite retail activities

Plain-English summary

The IRS ruled that an oil and gas company's producing subsidiaries would continue to qualify as independent producers for percentage depletion purposes under IRC § 613A(c). The ruling covered a corporate group with related entities involved in gas gathering, marketing, refining, and proposed natural gas fueling stations. The IRS concluded that the described retail activities would not make the producing subsidiaries retailers under § 613A(d)(2), and the described refinery would not make them refiners under § 613A(d)(4). The subsidiaries therefore would not be treated as integrated oil companies under § 291(b), assuming the facts and representations remained as described.

Ruling snapshot

• Question: Would related retail, refining, and natural gas market activities disqualify the producing subsidiaries from independent producer treatment?
• Outcome: Approved on the stated facts and representations.
• Key authorities: IRC §§ 291(b) and 613A(c), (d); Treas. Reg. §§ 1.611-1(a) and 1.613A-7.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201210003 Third Party Communication: None
Release Date: 3/9/2012 Date of Communication: Not Applicable
Person To Contact:
Index Number: 613A.03-01, 613A.04-02 ------------------------, ID No. ----------
Telephone Number:
--------------------------------------------------
--------------- Refer Reply To:
---------------- CC:PSI:06
-------------------------------------------- PLR-122594-11
-------------------------------------- Date:
------------------------------------ November 29, 2011

LEGEND:

Taxpayer = --------------------------------------------
-------------------------
Subsidiary 1 = ------------------------------------------------
Subsidiary 2 = --------------------------------------------------------
Subsidiary 3 = -------------------------------------
Subsidiary 4 = -----------------------------
Subsidiary 5 = ---------------------------------------------------------------
Subsidiary 6 = ----------------------------------------------------
Subsidiary 7 = ------------------------------------
Subsidiary 8 = ----------------------------------
Subsidiary 9 = ------------------------------------
Refinery = ----------------------
Company A = ----------------------------
Date 1 = --------------------------
Date 2 = ----------------

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

    This letter responds to your letter dated May 26, 2011, requesting a ruling that

Taxpayer’s oil and gas producing subsidiaries will qualify as independent producers for
purposes of § 613A(c) of the Internal Revenue Code, and will not be treated as
integrated oil companies for purposes of § 291(b) if other subsidiaries of Taxpayer
engage in retail activities.

Facts
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   Taxpayer represents the facts 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.

   Taxpayer is the corporate parent of an affiliated group of entities primarily

involved in exploring for and producing oil and natural gas. Taxpayer is focused on
discovering and developing unconventional natural gas and oil fields onshore in the
United States. Taxpayer does not directly perform any oil and gas production activities
or own any oil or gas upon production. Rather, Taxpayer’s wholly owned subsidiaries
perform these activities. Taxpayer’s oil and gas producing subsidiaries are eligible to
claim percentage depletion as independent producers of oil and gas under § 613A(c).

    Taxpayer, through various wholly owned subsidiaries also owns and operates

natural gas gathering systems that transport natural gas produced by Taxpayer’s oil and
gas producing subsidiaries in addition to natural gas produced by third parties.
Taxpayer’s wholly owned subsidiary, Subsidiary 1, purchases and markets the vast
majority of Taxpayer’s natural gas, in addition to production owned by certain partners
in those wells. Subsidiary 1 purchases the gas either at the wellhead or at the tailgate
of the gathering system. The limited amount of Taxpayer’s natural gas that Subsidiary 1
does not purchase is sold directly to natural gas pipelines located in close proximity to
its wells.

     Subsidiary 1 sells the purchased natural gas to persons unrelated to Taxpayer,

except for gas sold directly to Subsidiary 2 and Subsidiary 3. Subsidiary 2, an energy
trading and management firm, is in the business of purchasing natural gas from certain
natural gas suppliers, including Subsidiary 1, and selling this natural gas in bulk form to
certain large commercial and industrial users. Subsidiary 3 is wholly owned by
Taxpayer and serves as the well operator for the wells operated by Taxpayer’s oil and
gas producing subsidiaries. Subsidiary 3 uses natural gas purchased from Subsidiary 1
in its field operations as a rig fuel source and for gas lift purposes. Except for sales to
Subsidiary 2 and Subsidiary 3, Taxpayer neither knows nor controls the final disposition
of the natural gas carried in its gathering systems.

   Taxpayer’s refining activity consisted of its ownership, through its wholly owned

subsidiary, Subsidiary 4 of Refinery. As of Date 1, Refinery was not operational and
Taxpayer represents that it has no intention of making Refinery operational in the near
future. Furthermore, if Refinery were currently operating, its maximum daily refinery
runs would be below 75,000 barrels per day.

    Taxpayer has no current retail activities as defined in § 613A(d)(2). However,

Subsidiary 5 does own the land on which several independently owned and operated
retail stations are located and has entered into certain incentive contracts with various
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retail stations related to the construction of compressed natural gas (CNG) fueling
facilities. None of these leases or incentive contracts involves the purchase or sale of
natural gas produced, transported or marketed by any of Taxpayer’s subsidiaries or
affiliates.

     Subsidiary 5 receives a fixed, market-based rental from each station and does

not share in any income earned by the stations. Neither Subsidiary 5 nor any Taxpayer
affiliated company has a marketing arrangement, trademark use, or other business
relationship with any of these service stations other than as described herein. The
operators of the stations are solely responsible for the operations of these stations and
no Taxpayer affiliated entity derives any benefit from the operations of these stations.

    Taxpayer made a cash grant to Company A to induce investment in CNG

infrastructure, and pledged a portion of its future fleet CNG purchases to Company A, at
market prices, to secure a CNG supply for its subsidiaries’ fleet vehicles that use CNG.

   On Date 2, Taxpayer created new wholly owned subsidiaries, Subsidiary 6,

Subsidiary 7 and Subsidiary 8, collectively NewCo. NewCo will be entirely dedicated to
specific natural gas market development projects. NewCo will not own any assets
involved in the exploration and production operations of Taxpayer’s oil and gas
producing subsidiaries. The natural gas vehicle market development projects
contemplated are the direct construction, ownership and operation of natural gas fueling
stations, and the direct investment in various natural gas market research, development
and demonstration initiatives.

   Taxpayer, through NewCo, proposes to own and operate natural gas fueling

stations. As part of this transaction, NewCo would construct a natural gas fueling
station on a tract of land either owned and/or leased by NewCo and another Taxpayer
subsidiary at arm’s length, market-based rental prices. NewCo would be the owner of
the natural gas infrastructure and would be solely responsible for the operations of the
natural gas fueling station.

    NewCo would negotiate and execute a natural gas supply agreement with a local

distribution company, natural gas utility, natural gas wholesaler or similar entity for
purchase of its natural gas. At no time will NewCo acquire any of its natural gas supply
from Taxpayer, from any of Taxpayer’s oil and natural gas producing subsidiaries, from
any oil or gas producer related to Taxpayer, or through a product exchange involving
any of these parties. NewCo potentially will enter into a service agreement with
Subsidiary 9, a subsidiary of Taxpayer, for the maintenance of compressors located at
the natural gas fueling station near existing Taxpayer operated areas. The fees
associated with these services will be based on the market rate charged for similar
services in an arm’s length transaction. In the short term, the natural gas fueling
stations will be strategically positioned to serve as a primary fuel supply for Taxpayer’s
CNG fleet vehicles; however, they will be open to the public. In the long term, Taxpayer
PLR-122594-11 4

may expand its natural gas fueling stations operations to new, non-operating Taxpayer
markets. Notwithstanding the fact that NewCo will not purchase its CNG from any
Taxpayer entity, it most likely will brand its natural gas fueling stations with a reference
to the Taxpayer’s name.

     NewCo may also invest in various natural gas market research, development and

demonstration initiatives through a grant process, financing transactions, or direct equity
investments. Such initiatives will not be related to the exploration or production of oil
and natural gas. The initiatives will likely include direct investments in non-Taxpayer
affiliates in the business of constructing, owning and operating natural gas fueling
stations on similar terms and subject to limitations. The initiatives will be aimed at
developing technologies and economies of scale. NewCo would seek aggressive
capitalization of home-fueling technology and station facility improvement. NewCo
would also seek to engage in lobbying efforts and would be responsible for identifying
and developing technologies related to all aspects concerning the efficient and
beneficial use of natural gas as a transportation fuel.

Law and Analysis

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

reduce by 30 percent the amount of intangible drilling and development costs allowable
as a deduction under § 263(c) and amortize the amount not allowable as a deduction
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
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
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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 the 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).

   Section 613A(d)(4) provides that a refiner is a taxpayer whose average daily

refinery runs for the taxable year exceed 75,000 barrels.

    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
PLR-122594-11 6

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 in 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
(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.

    In Witco Chemical Corp. v. United States, 742 F.2d. 615 (Fed. Cir. 1984), the

court held that Witco, an oil producer, was not a retailer, despite the fact that it sold its
petroleum products in packaging bearing its trademarks. The court based its conclusion
on an analysis of Witco’s distribution agreement which did not require a distributor to
use Witco’s trademark in marketing and distributing its product and which expressly
restricted Witco from exercising control over the retail pricing of its products.
PLR-122594-11 7

    In Quaker State Oil Refining Corp. v. U.S., 994 F.2d 824, (Fed. Cir. 1993), the

court held that the taxpayer was a retailer because it used its mark to control the retail
pricing of its products. Congress had levied a windfall profits excise tax on the
production and sale of crude oil and refined products, excluding independent producers
of crude oil from stripped well properties from that tax. The court concluded that Quaker
State’s distribution agreement imposed affirmative and direct obligations on its
distributors to use Quaker State’s trademark or trade name in marketing or distributing
its motor oil.

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

that Taxpayer’s oil and gas producing subsidiaries will qualify as independent producers
for purposes of § 613A(c) and will not be treated as integrated oil companies for
purposes of § 291(b) if other subsidiaries of Taxpayer engage in retail activities.

    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
                                  Office of Associate Chief Counsel
                                  (Passthroughs & Special Industries)