Treats broad offshore development seismic surveys as section 167(h) G&G costs

Plain-English summary

An offshore oil and gas operator acquired a seismic survey covering broad areas of two fields after development had been approved, then used the data to optimize the placement of development wells. It deducted the portion of the survey cost related to one field as intangible drilling costs under section 263(c). Chief Counsel concluded that the cost was instead a geological and geophysical expenditure under section 167(h). The survey involved no drilling, covered large project areas, and was not used to prepare for or site particular wells, while section 167(h) expressly covers G&G costs incurred in both exploration and development. Section 167(h) therefore supplied the applicable cost-recovery treatment rather than the intangible drilling cost election.

Ruling snapshot

• Question: Were broad-area seismic survey costs used to optimize offshore development wells G&G expenditures or deductible intangible drilling costs?
• Outcome: Advice given, the costs were G&G expenditures under section 167(h).
• Key authorities: IRC §§ 167(h) and 263(c); Treas. Reg. § 1.612-4; Louisiana Land & Exploration Co. v. Commissioner; Rev. Ruls. 77-188 and 83-105

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
Memorandum
Number: 201835004
Release Date: 8/31/2018
CC:PSI:B06: Third Party Communication: None
POSTF-137231-17 Date of Communication: Not Applicable

UILC: 167.13-21, 263.02-01

date: May 10, 2018

to:

Associate Area Counsel

(Large Business & International)

General Attorney

Large Business & International

from: Patrick S. Kirwan
Chief, Branch 6
(Passthroughs & Special Industries)

subject Treatment of Cost of Seismic Surveys Used to Site Offshore Oil and Gas
: Development Wells

This Chief Counsel Advice responds to your request for assistance. This advice may
not be used or cited as precedent.

LEGEND
Taxpayer = ------------------------------------------------------
A = -------
B = -------------
Region = --------------------
Seismic Survey = --------------------------------------------------
a = ----
b = ----
c = ----
d = ------
e = --

f = ----
g = --
h = --
i = --
j = --
Year 1 = -------
Year 2 = -------
Year 3 = -------
Year 4 = -------
Year 5 = -------
Year 6 = -------
Year 7 = -------
Year 8 = -------
Year 9 = -------
Year 10 = -------
Date 1 = ----------------------
Date 2 = ---------------
Date 3 = -------------------

ISSUE

Whether the cost of seismic surveys used to optimize the placement of offshore oil and
gas development wells should be treated as geological and geophysical (G&G)
expenditures under § 167(h) or intangible drilling costs (IDCs) under § 263(c) and
§ 1.612-4(a) of the Treasury Regulations.

CONCLUSIONS

The cost of seismic surveys used to optimize the placement of offshore oil and gas
development wells should be treated as geological and geophysical (G&G)
expenditures under § 167(h).

FACTS

Taxpayer is engaged in offshore oil and gas drilling and development activities within
the United States. Through wholly-owned subsidiaries, Taxpayer owns an a% working
interest in the A field and a b% working interest in the B field. The B field was
discovered in Year 1 and the A field was discovered in Year 2. The A and B fields are
located approximately c miles apart. Taxpayer is the operator of both fields.

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.

Stage 1 development drilling occurred in both fields from Date 1 to Date 2, resulting in g
development wells. A development well first produced oil in Year 8. Through the first
quarter of Year 9, Taxpayer had drilled h exploratory wells and i development or
production wells in the A and B development area. Stage 2 development drilling began
on Date 3 and includes j additional wells. The first oil produced from Stage 2 drilling
was expected in Year 10.

On its Year 7 tax return, Taxpayer deducted the costs of the Seismic Survey related to
the A field as IDCs. Upon Exam, the IRS determined that these costs should be treated
as G&G expenditures.

To support its claim for IDCs, Taxpayer presented an authorization for expenditure
(“AFE”) for the Seismic Survey that stated it was ----------------------------------------------------
----------------- The AFE also stated that the purpose of the Seismic Survey was to
provide better imaging than the seismic data previously obtained in Years 3 and Year 4.
Further, the AFE stated that -------------------------------------------------------------------------------

------------------------------------------------------------------------------------------------------ Taxpayer
also presented a Value of Information (“VOI”) summary for the A and B seismic project.
The VOI stated that the Seismic Survey ---------------------------------------------------------------

LAW

Geological and Geophysical Expenditures (G&G)

Generally, geological and geophysical ("G&G") expenditures are costs incurred by an oil
and gas exploration and production company to obtain, accumulate, and evaluate data
that will serve as the basis for the acquisition or retention of oil and gas properties.
G&G expenditures are usually associated with a survey, such as a seismic, magnetic,
or gravity survey. G&G expenditures can also include the cost of acquiring well logs
and core data, sometimes called "bottom-hole data," that pertains to wells drilled by
other companies.1

In recent years the capability of seismic technology has dramatically increased,
especially with regard to offshore exploration, drilling and production activities. Data
processing and digital imaging have been greatly enhanced by the use of extremely
powerful computers and advanced computer modeling techniques. The clarity of
seismic surveys has been greatly increased with the advent of "3D" seismic surveys

1
Internal Revenue Manual 4.41.1.2.2.3.2(1) (December 3, 2013) [hereinafter I.R.M.].

that are achieved by running tightly spaced seismic lines over the entire survey area. In
some very large oil fields 3D surveys are conducted periodically (known as “4D”
surveys) and evaluated to determine the extent to which fluids have moved within the
reservoir over time in response to the withdrawal of oil and gas and the injection of
water.2

Historical Tax Treatment

Prior to the enactment of § 167(h) by the Energy Policy Act of 2005, the tax
characterization of G&G expenditures was a topic of debate and a source of frustration
for the oil and gas industry. From the industry’s perspective, G&G expenditures were
viewed as ordinary and necessary business expenses, deductible as part of the costs of
the risks taken by the oil and gas industry in exploring for oil needed by the American
economy. Conversely, the Treasury and the IRS considered G&G expenditures to be
capital in nature and the Courts generally supported that characterization.3

In 1928, the Board of Tax Appeals (BTA) issued Seletha O. Thompson v.
Commissioner4 and C.M. Nusbaum v. Commissioner,5 requiring the taxpayers to
capitalize geological expenditures associated with the acquisition of oil and gas
leasehold interests. In 1932, the BTA issued two analogous opinions in Rialto Mining
Corp. v. Commissioner6 and G.E. Cotton v. Commissioner7 confirming the capitalization
requirement in the context of hard minerals extraction.

2
I.R.M. 4.41.1.2.2.3.2(2).
3
Joint Committee on Taxation, Description and Technical Explanation of the Conference Agreement of
H.R. 6, Title XIII, The “Energy Tax Incentives Act of 2005,” JCX-60-05 No. 3, at 55 n.70 (July 28, 2005)
[hereinafter Conference Agreement]. (For purposes of “G&G” expenditures, “property” means an interest
in a property as defined in § 614 and includes an economic interest in a tract or parcel of land.)
4
Seletha O. Thompson v. Comm’r., 9 B.T.A. 1342, 1345 (January 16, 1928) citing generally Appeal of
McCandless, 5 B. T. A. 1114 (January 20, 1927); Gopher Granite Co. v. Comm’r., 5 B.T.A. 1216 (January
26, 1927). (Expenditures for surveys, geological opinions, settlement of suits involving title to lands,
abstracts of title and legal opinions upon titles are not deductible as ordinary and necessary expenses but
are capital expenditures.)
5
C.M. Nusbaum v. Comm’r., 10 B.T.A. 664, 665 (February 13, 1928) citing generally Appeal of Crompton
Building Corp., 2 B.T.A. 1056 (October 28, 1925); Appeal of D.N. & E. Walter & Co., Inc., 4 B.T.A. 142
(June 21, 1926); Appeal of McCandless, 5 B. T. A. 1114 (January 20, 1927). (Amounts paid to a
geologist to investigate the presence of oil on a certain tract of land and recommend acquisition were
determined to be capital expenditures.)
6
Rialto Mining Corp. v. Comm’r, 25 B.T.A. 980, 986 (March 25, 1932) citing generally Seletha O.
Thompson v. Comm’r., 9 B.T.A.1342; Jefferson Gas Coal Co. v. C.I.R., 16 B.T.A. 1135 (June 24, 1929).
(Taxpayer explored and developed a property but discovered no minerals. Held that expenditures made
for the survey and exploration of mining property which the petitioner owned or expected to own and
therefore were capital nature.)
7
G.E. Cotton v. Comm’r , 25 B.T.A. 866, 869 (March 14, 1932) citing generally Illinois Central R.R. Co. v.
Interstate Commerce Comm., 206 U.S. 441 (May 27, 1907). (Held that expenditures made in prospecting
a mineral lease must be treated as capital expenditures and added to the cost of the mine when brought
to production.)

In 1942, the IRS released Field Procedure Memorandum 2418 to its field agents and
engineers. The Memorandum required G&G expenditures incurred in the acquisition or
retention of oil and gas leases to be capitalized to the property. G&G expenditures not
resulting in the acquisition or retention of properties were allowed as ordinary and
necessary expenses.

Contemporaneously with the issuance of Field Procedure Memorandum 241, in
Schermerhorn Oil Corp. v. Commissioner,9 the BTA confirmed that G&G expenditures
must be capitalized. The BTA held that payments from a net profits interest granted to
a geologist in exchange for recommendations on properties for acquisition and
development was a cost of acquiring those properties and therefore a capital
expenditure.10 In so holding, the BTA articulated the test for capital expenditures as
“whether the expenditures are made in connection with the acquisition or preservation
of a capital asset.”11

In 1946, the Tax Court in Louisiana Land & Exploration Co. v. Commissioner12 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 described the point at which acquisition costs end and
well development expenses begin:

It thus appears that the results of this survey were to guide petitioner in
determining generally whether and to what extent these large areas of
land should be explored by drilling wells. Whether or not the scientific
knowledge gained from the survey indicated that drilling would be
successful or unsuccessful, it was undoubtedly the information upon which
would be based further tests and potential drilling operations during the
entire period of petitioner’s exploitation of the land for oil and gas. This
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.13

Under these circumstances it seems abundantly clear that the survey was
the first step in the over-all development for oil of these tracts of land and
8
Field Procedure Memorandum No. 241 (1942).
9
Schermerhorn Oil Corp. v. Comm’r, 46 B.T.A. 151, 161-162 (1942) citing generally Helvering v. Winmill,
305 U.S. 79 (November 7, 1938); Seletha O. Thompson, 9 B.T.A. 1342; Moynier v. Welch, 97 F.2d 471
(9th Cir., November 7, 1938).
10
Id. at 161.
11
Id.
12
Louisiana Land & Exploration Co. v. Comm’r, 7 T.C. 507 (1946), acq. 1946-2 C.B. 3, aff’d. 161 F.2d
842 (5th Cir. 1947).
13
Id. at 515-516, Cf. Parkersburg Iron & Steel Co. v. Burnet, 48 F.2d 163, 165 (March 13, 1931).

that the benefit derived from the expenditure was to be enjoyed by
petitioner in its business during the entire useful life of the asset being
developed.14

The Tax Court also stated the converse, that IDC activities are “directed to the costs of
preparations for the drilling of particular wells after the drilling has been at least
tentatively decided upon...”15

Following the rationale of these cases, in 1950 the IRS issued I.T. 4006,16 which ruled
that G&G exploration costs (a precursor to G&G expenditures) are not deductible as
ordinary and necessary business expenses. The ruling stated that such costs are
incurred for the purpose of obtaining and accumulating data which will serve as a basis
for the acquisition or retention of property. If property is acquired or retained on the
basis of data obtained from exploration, costs of exploration attributable to that property
should be capitalized as part of the cost of such property. Conversely, if no property is
acquired or retained on the basis of such data, the cost of the exploration project is
deductible.

In 1977, the IRS issued Revenue Ruling 77-188,17 which restates and updates the
guidance provided in I.T. 4006 regarding the treatment of G&G expenditures. The
ruling states that G&G exploration expenditures are those “incurred by a taxpayer for
the purpose of obtaining and accumulating data that will serve as a basis for the
acquisition or retention of property.”18 The ruling further states that the expenditures
attributable to such exploration are allocable as a capital cost to the property or
properties acquired or retained. The ruling discusses the allocation of G&G exploration
expenditures among areas of interest located and identified as the result of such
expenditures. The ruling also states that if no property is acquired or retained within or
adjacent to an area of interest, the entire G&G exploration expenditure allocable to the
area of interest is deductible as a loss under § 165 for the taxable year in which that
particular project area is abandoned as a potential source of mineral production.

For the next three decades the requirement that G&G exploration expenditures be
capitalized remained largely unchanged. In Revenue Ruling 80-15319 the IRS ruled that
costs associated with test drilling on another party’s adjoining tract were capitalizable for
the taxpayer who contributed to the costs despite the fact that the well was
nonproductive and thus ultimately plugged. Although the nonproductive well was not
drilled on the taxpayer’s land, the IRS required the contributing taxpayer to capitalize
14
Id., Cf. Repplier Coal Co. v. Comm’r, 140 F. 2d 554 (February 19, 1933); cert. denied, 323 U.S. 736
(October 8, 1944); citing generally Rialto Mining Corp., 25 B.T.A. at 985.
15
Id. at 516.
16
I.T. 4006, 1950-1 C.B. 48, superseded by Rev. Rul. 77-188, 1977-1 C.B. 76.
17
Rev. Rul. 77-188.
18
Id. at 2, citing generally Louisiana Land and Exploration Co., 7 T.C. 507; Schermerhorn Oil Corp., 46
B.T.A. 151; G. E. Cotton, 26 B.T.A. 866; C. M. Nusbaum, 10 B.T.A. 664; and Seletha O. Thompson, 9
B.T.A. 1342.
19
Rev Rul. 80-153, 1980-1 C.B. 10.

the contribution, reasoning that the payment related to the retention of his/her own
property. Similarly, in Revenue Ruling 80-34220 several oil companies formed a
consortium to drill a Continental Offshore Stratigraphic Test (COST) well and shared the
information developed from drilling. The IRS ruled that the expenditures were not IDC
but G&G exploration expenditures and must be capitalized by any member of the
consortium who obtained a lease within the area of interest.

In 1983, the IRS published Revenue Ruling 83-10521 to amplify Revenue Ruling 77-188
by providing significantly greater guidance for the treatment of G&G expenditures. By
using seven factual situations this ruling demonstrates the appropriate allocation of
G&G expenditures and provides that an “identifiable event” is necessary to establish
worthlessness in order to take a loss deduction under § 165 for an abandoned source of
mineral production.

Thus, prior to the enactment of § 167(h), G&G expenditures were treated by the IRS
and the courts as capital expenditures allocable to the cost of the property acquired or
retained and were deducted as a loss if the project was abandoned.

History of Section 167(h)

In the years prior to the enactment of § 167(h), the IRS and taxpayers faced frequent
controversies regarding the tax treatment of G&G expenditures. To reduce audit times
and increase certainty, the IRS and the oil and gas industry worked together to promote
a statutory treatment for G&G expenditures. The result was the enactment of § 167(h)
the “Amortization of Geological and Geophysical Expenditures” in the Energy Policy Act
of 2005.22

The General Explanation of Tax Legislation Enacted in the 109th Congress (Bluebook)
describes Congress’ reasons for enacting § 167(h) as seeking “substantial simplification
for taxpayers, significant gains in taxpayer compliance, and reductions in administrative
cost [that] can be obtained by establishing a clear rule that all geological and
geophysical costs may be amortized over two years, including the basis of abandoned
property.”23 The Bluebook also indicates that when enacting § 167(h), Congress
recognized that providing favorable treatment for such costs would foster increased
exploration for new sources of oil and gas.24

Although § 167(h) changes the treatment of G&G expenditures from capitalization to
amortization it does not define the term “geological and geophysical expenditures.”
Rather, the legislative history of § 167(h) demonstrates Congress’ intention to adopt

20
Rev. Rul. 80-342, 1980-2 C.B. 99.
21
Rev. Rul. 83-105, 1983-2 C.B. 51.
22
P.L. 109-58, § 1329(a), 119 Stat. 594 (August 8, 2005).
23
Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 109th Congress,
JCS-1-07 No. 6 at 51-52 (January 17, 2007) [hereinafter Bluebook].
24
Id.

the long-standing definitions of the income tax terms used in § 167(h).25 Consistent
with the definition of G&G expenditures contained in prior case law and IRS guidance,
the Bluebook states that “[g]eological and geophysical expenditures (“G&G costs”) are
costs incurred by a taxpayer for the purpose of obtaining and accumulating data that will
serve as the basis for the acquisition and retention of mineral properties by taxpayers
exploring for minerals.”26

Additionally, the Conference Agreement prepared for the Energy Policy Act of 2005
(Conference Agreement)27 provides significant background on the tax treatment of G&G
expenditures before the enactment of § 167(h). This Report summarizes the most
important IRS guidance regarding the tax treatment of G&G expenditures and gives the
reader insight into the interpretation of the operative terms in § 167(h). Importantly, the
Conference Agreement effectively incorporates the IRS’ positions in Revenue Ruling
77-188 and Revenue Ruling 83-105.

Amortization of Geological and Geophysical Expenditures - Section 167(h)

Section 167(h)(1) provides for any G&G expenditures paid or incurred in connection
with the exploration for, or development of, oil or gas within the United States (as
defined in § 638)28 to be allowed as a deduction ratably over the 24-month period
beginning on the date that such expense was paid or incurred.

Section 167(h)(2) requires that any payment paid or incurred during a taxable year be
treated as having been paid or incurred on the mid-point of that tax year.

Section 167(h)(3) states that no other depreciation or amortization deduction is
allowable with respect to qualified G&G expenditures.

Section 167(h)(4) provides that if any property with respect to which G&G expenditures
are paid or incurred is retired or abandoned during the 24-month period, no deduction is
allowed on account of such retirement or abandonment and the amortization deduction
continues with respect to such payment.

Section 167(h)(5)(A) provides that in the case of major integrated oil companies,29

25
Conference Agreement, supra note 2, at 55-57.
26
Bluebook, supra note 24, at 49.
27
Conference Agreement, supra note 2, at 55-57.
28
Section 638 provides that the term “United States” includes the seabed and subsoil of those submarine
areas which are adjacent to the territorial waters of the United States and over which the United States
has exclusive rights, in accordance with international law, with respect to the exploration and exploitation
of natural resources.
29
Section 167(h)(5)(B) defines a “major integrated oil company” as, with respect to any taxable year, a
producer of crude oil-- (i) which has an average daily worldwide production of crude oil of at least 500,000
barrels for the taxable year; (ii) which had gross receipts in excess of $1,000,000,000 for its last taxable
year ending during calendar year 2005; and (iii) to which subsection (c) of section 613A does not apply by
reason of paragraph (4) of section 613A(d), determined-- (I) by substituting “15 percent” for “5 percent”

§ 167(h)(1) is to be applied by substituting “7-year” for “24-month.”30

IRS Interpretation of Section 167(h)

The IRS also has applied case law and prior IRS guidance in interpreting § 167(h). In
CCA 201552024,31 the IRS concluded that a taxpayer that acquires seismic data as part
of an asset acquisition has not paid or incurred G&G expenditures within the meaning of
§ 167(h). The seller had acquired non-producing leases and used the seismic data to
drill wells, many of which were successful and producing at the time of the acquisition
by the taxpayer. Although, at the time of the acquisition by taxpayer, there were still
undeveloped properties within the area, many were offset locations directly adjacent to
existing productive wells that were considered proved or probable reserves. After the
acquisition, the taxpayer amortized the allocated value of the seismic data as G&G
expenditures under § 167(h). The CCA noted that case law and prior IRS guidance
have consistently defined G&G expenditures as “costs incurred by a taxpayer for the
purpose of obtaining and accumulating data that will serve as the basis for the
acquisition and retention of mineral properties by taxpayers exploring for minerals.”32
Because Taxpayer acquired properties that were either developed or proved or
probable, Taxpayer did not incur costs to locate and identify properties with the potential
to produce commercial quantities of oil and natural gas. In other words, Taxpayer did
not incur costs to obtain and accumulate data that will serve as the basis for the
acquisition and retention of mineral properties by taxpayers exploring for minerals.
Therefore, the IRS concluded that the Taxpayer did not pay or incur G&G expenditures
within the meaning of § 167(h).

Judicial Interpretation of Section 167(h)

The first judicial interpretation of § 167(h) was the Tax Court’s decision in CGG
Americas, Inc. v. Commissioner.33 In tax years 2006 and 2007, the taxpayer, an oil and
gas services company, conducted geophysical surveys and processed and licensed the
resulting data to various oil and gas companies on a non-exclusive basis. Relying on
§ 167(h), the taxpayer amortized the cost of the geophysical surveys over 24

each place it occurs in paragraph (3) of section 613A(d), and (II) without regard to whether subsection (c)
of section 613A does not apply by reason of paragraph (2) of section 613A(d). For purposes of clauses
(i) and (ii), all persons treated as a single employer under subsections (a) and (b) of section 52 shall be
treated as 1 person and, in case of a short taxable year, the rule under section 448(c)(3) (B) shall apply.
30
Section 167(h) was subsequently amended by the Tax Increase Prevention and Reconciliation Act of
2005, Pub. L. 109-222, § 503(a), 120 Stat. 345 (May 17, 2006) by adding § 167(h)(5)(B) to extend the 24-
month amortization period to five years for G&G expenditures paid or incurred by major integrated oil
companies after May 17, 2006. Section 167(h) was further amended by the Energy Independence and
Security Act of 2007, Pub. L. 110-140, § 1502(a), 121 Stat. 1492 (December 19, 2007) by extending the
five year amortization period to seven years for G&G expenditures paid or incurred by major integrated oil
companies after December 19, 2007.
31
I.R.S. CCA 201552024 (Dec. 24, 2015).
32
Id. citing I.T. 4006; Revenue Ruling 77-188.
33
CGG Americas, Inc. v. Comm’r, 147 T.C. 78 (July 21, 2016).

months. On audit, the IRS asserted that the taxpayer did not qualify to use § 167(h)
because the geophysical data that it collected and licensed was used by other
companies for their exploration and development of oil and gas. The IRS argued that
while § 167(h) contains no requirement that taxpayer engage in the exploration for, or
development of, oil or gas itself, that pre-codification case law, administrative rulings
and legislative materials supported this requirement.

The Tax Court determined that “although the legislative materials involving § 167(h)
show that its supporters were concerned about mineral-interest owners, the material
didn’t show they intended the provision’s effect to be limited to solely mineral-interest
owners.”34 The Tax Court concluded that the taxpayer had incurred G&G expenditures
in connection with oil and gas exploration because its activities were integral to its
clients finding oil and gas deposits. As a result, the taxpayer was found eligible to
amortize its expenditures as G&G under § 167(h).

Intangible Drilling Costs (IDCs)

Law

Section 263(c) directs the Treasury to issue regulations permitting taxpayers to elect to
deduct IDCs, without describing or defining the costs affected by the election, except to
state that the regulations must correspond “to the regulations... which were recognized
and approved by the Congress in House Concurrent Resolution 50, Seventy-Ninth
Congress.” The option codified in § 263(c) to expense or capitalize IDCs (IDC option)
operates as an incentive to encourage capital investment in the development of oil and
gas properties.35 This incentive has existed since the first income tax statute, although
it existed as a regulation unsupported by statutory authority until 1954.

In 1945, the Court of Appeals for the Fifth Circuit held in F.H.E. Oil Co. v.
Commissioner,36 that the regulations permitting the IDC option were invalid because the
statutory predecessor of § 263(a) prohibited any deduction for the cost of “permanent
improvements or betterments made to increase the value of any property or estate.”37
Within weeks of the F.H.E. Oil Co. decision, Congress shored up the regulations by
enacting House Concurrent Resolution 5038 declaring that Congress “has recognized
and approved” the disputed regulations.39

34
Id. at 105-06.
35
Exxon Corp. v. U.S., 547 F.2d 547, 555 (Ct. Cl. 1976). (“Congress has consistently viewed the optional
treatment of IDC as an incentive to oil and gas prospecting and exploration, clearly a continuing objective
of national importance.”)
36 th
F.H.E. Oil Co. v. Comm’r, 147 F.2d 1002 (5 Cir., March 6,1945) (regulations held invalid), reh’g
th th
denied, 149 F.2d 238 (5 Cir. May 4, 1945), second reh’g denied, 150 F2d 857 (5 Cir. August 21, 1945).
37
Id. at 1003.
38 th
H.R. Con. Res. 50, 79 Cong. (1945).
39 th st
H.R.Rep. No. 761, 79 Cong., 1 Sess. 2 (1945). (Accompanied Resolution 50 and provides that
§ 263(c) was enacted because “[t]he uncertainty occasioned by raising doubts as to the validity of these
[predecessor] regulations is materially interfering with the exploration for and the production of oil…”)

Historical Attempts to Define IDCs

Traditionally, exploration costs end and well development costs begin at the point when
the operator determines the location for the drilling of the well. In Louisiana Land &
Exploration Co.,40 the Tax Court described the point at which acquisition costs end and
well development expenses [also known as IDCs] begin as “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.41

In recent years the capability of seismic technology has increased dramatically,
especially in regards to offshore exploration, drilling and production activities.42 This
innovation has increasingly blurred the distinction between exploration and development
costs contributing to controversies regarding the proper characterization of the costs of
offshore oil and gas exploration. What may now be accomplished by more
sophisticated seismic technology previously could be accomplished only by drilling
exploratory wells and similar invasive methods.

For years, the IRS took the position that the IDC option was not available where
offshore exploration wells were plugged and abandoned.43 The IRS asserted that that
the taxpayer’s main purpose in drilling exploration wells was to obtain geological data to
assess the property and that taxpayer had no intention of completing the wells. As a
result, the IRS asserted that such wells were drilled before the taxpayer decided to
commence development and were actually G&G expenditures.44

For example, in Standard Oil Co. (Indiana) v. Commissioner,45 the taxpayer drilled test
wells in numerous locations on an offshore lease. Each of the test wells was drilled to
ascertain the existence, type, quality, and quantity of hydrocarbons and if promising,
completed as a producing well. The IRS asserted that the drilling of offshore
exploratory wells from mobile drilling rigs was merely an extension of exploratory
operations similar to geological and geophysical surveys for which the costs must be
capitalized. Further, the IRS argued that development did not begin until an operator of
an offshore oil and gas property made the decision to commence development drilling
(the time the decision was made to install a permanent drilling and production
platform).46 The IRS asserted that until such decision is made, all costs of exploratory
wells must be capitalized.

In Standard Oil Co., the Tax Court rejected the IRS’ arguments, reasoning that “the

40
See generally, Louisiana Land & Exploration Co., 7 T.C. 507.
41
Id. at 515-516.
42
I.R.M. 4.41.1.2.2.3.2(2).
43
Exxon Corp., 547 F.2d at 548.
44
Id.
45
Standard Oil Co. (Indiana) v. Comm’r, 68 T.C. 325, 353-354 (June 7, 1977), acq. 1983-2 C.B. 1.
46
Id. at 348 (emphasis added).

classification of the activities in issue as ‘exploratory’ lends no support to [the IRS’]
position… Both the terms ‘exploratory’ and ‘development’ have been used in a broad
sense in the field of oil and gas taxation. Both terms have been used to describe
activities which must be capitalized, such as seismic surveys, as well as operations
which clearly fall within the IDC option.”47 Therefore, “the classification of an activity as
exploratory does not necessarily carry with it the requirement of capitalization.”48 The
Tax Court further held that “it is clear from the language of the regulations” and the
holding of this Court in Louisiana Land & Exploration Co. “that the dividing line between
‘exploratory’ work which must be capitalized and ‘development’ activities coming within
the IDC option is the point at which the preparations for drilling begin.”49 The Tax Court
emphasized that “there is nothing in the regulations which either expressly or implicitly
limits the ‘wells’ to those drilled after a decision has been made to install a permanent
drilling and production platform. To so hold would be inconsistent with the long-
standing construction and natural meaning of the regulations.”50 Accordingly, the Tax
Court concluded that as long as the well could actually produce oil or gas if so desired,
the requirements to claim IDCs have been met.

The IRS continued to assert the position that costs of drilling offshore wells must be
capitalized as G&G expenditures. The Tax Court rejected the IRS’ position in Sun Co.,
Inc. & Subs v. Commissioner51 and Gates Rubber Co. & Subs v. Commissioner.52 In
both cases, the Tax Court considered whether the costs of drilling offshore wells by
mobile offshore drilling rigs may be treated as IDCs. The facts of these cases differed
from those in Standard Oil Co. because in that case most of the wells drilled were
capable of commercially producing petroleum products. In Sun Co. and Gates Rubber
many of the wells were dry holes and were plugged and abandoned. It was with
respect to these wells that the IRS argued that because no intent to produce existed,
the wells were merely exploratory wells and the costs were not within the IDC option.53
In Gates Rubber, the Tax Court responded that “[w]e reiterate our clear-cut holding in
the Standard Oil Co. case on the matter of intent: ‘The answer to respondent’s
contention is simply that the regulations contain no requirement of an intention to
complete and produce a particular well.’”54

In 1978, the IRS issued TAM 7837004,55 considering whether costs incurred in drilling
bore holes to determine the extent and existence of an offshore deposit may be treated
as IDCs. The IRS reasoned that while the IDC option includes expenditures for

47
Id. at 346.
48
Id. at 349.
49
Id. at 347 (emphasis added).
50
Id. at 348 (emphasis added).
51
Sun Co., Inc. & Subs v. Comm’r, 74 T.C. 1481 (September 25, 1980), acq. 1983-1 C.B. 1, aff’d, 677
F.2d 294 (3rd Cir., April 16, 1982).
52
Gates Rubber Co. & Subs v. Comm’r, 74 T.C. 1456 (September 25, 1980), acq. 1983-1 C.B. 1, aff’d,
694 F.2d 648 (10th Cir., December 3, 1982).
53
Id. at 1478-1479.
54
Id. at 1479 quoting Standard Oil Co., 68 T.C. at 351-352.
55
I.R.S. TAM 7837004 (January 1, 1978).

geological works as are necessary in the preparation for the drilling of wells, in this
case, the taxpayer drilled the bore holes to determine the extent and existence of the
deposit, and to obtain a guide to the optimum location and number of drainage points,
and the number and location of platforms, if any, that would be constructed.56 As a
result, such costs incurred in determining whether and how to develop the block were
not connected with the drilling of any particular well.57 The IRS concluded that because
the IDC option is directed to the costs of preparation for the drilling of a particular well
after drilling has at least been tentatively decided upon the costs incurred in drilling the
bore holes are not within the IDC option.58

The IRS began to change its treatment of offshore IDCs with the issuance of Revenue
Ruling 88-10.59 In that ruling the IRS determined that the costs incurred to drill
expendable bore holes to determine the location and delineation of offshore
hydrocarbon deposits (and which were capable of conducting hydrocarbons to the
surface on completion) are within the option to expense IDC, regardless of whether
there is an intent to produce hydrocarbons.

In 2013, the IRS updated the Oil and Gas Industry Handbook, which includes Exhibit
4.41.1-5 “Classification of Expenditures in Acquisition, Development, and Operation of
Oil and Gas Leases.”60 This Exhibit lists as leasehold costs (and therefore capital
expenditures) both “geological and geophysical expenditures leading to acquisition or
retention of an oil and gas property” and “the cost of seismic work incurred by an oil and
gas company to determine the size of the reservoir or reserves.” The Exhibit also lists
as Intangible Drilling Costs (and therefore deductible expenditures) “survey and seismic
costs to locate a well site on leased property.”

Current Law

Section 263(a) provides that no deduction is allowed for capital expenditures. However,
notwithstanding the provisions of § 263(a), § 263(c) allows a taxpayer an election, under
regulations prescribed by the Secretary, to expense intangible drilling costs (IDCs).
Those regulations are set forth in Treasury Regulations § 1.612-4.

56
Id. (emphasis added).
57
Id. citing generally, Louisiana Land and Exploration Co., 7 T.C. 507 (emphasis added).
58
Id. (emphasis added). (Later the same year, the IRS issued TAM 7834002 applying the same
conclusion to similar facts. In that ruling, the IRS observed that the Tax Court in Standard Oil Co.
“misreads the regulations in stating that the regulations contain no requirement of an intention to
complete and produce a particular well. The court leaves out of the reading of the regulations the phrase,
‘and the preparation of the wells for production.’”)
59
Rev. Rul. 88-10, 1988-1 C.B. 112.
60
I.R.M. Exhibit 4.41.1-5.

Section 1.612-4(a) provides that IDCs incurred by an operator61 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.

Under § 1.612-4(b)(4), if a taxpayer elects to capitalize IDCs, then an additional election
(within an election) is available to deduct as an ordinary loss those costs incurred in
drilling a non-productive well. A taxpayer must make a proper election on the return for
the first taxable year in which the nonproductive well is completed.

Under § 1.612-4(c), the IDC option does not apply to expenditures by which the
taxpayer acquires tangible property ordinarily considered as having a salvage value.
Examples of such items are the costs of the actual materials in those structures which
are constructed in the wells and on the property, and the cost of drilling tools, pipe,
casing, tubing, tanks, engines, boilers, machines, etc.

Under § 1.612-4(d), a taxpayer may exercise the election to expense IDCs by claiming
IDCs as a deduction on the taxpayer's return for the first taxable year in which the
taxpayer pays or incurs such costs. A taxpayer’s failure to deduct IDC in such taxable
year is treated as an election to capitalize such costs and recover them through
depreciation or depletion.
61
Treas. Reg. § 1.612-4(a) defines an operator 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.

Additionally, under § 291(b)(1), otherwise allowable IDCs that have been expensed by
an integrated oil company are cut back by 30 percent.62 Under § 291(b)(2), the
remaining 30 percent is deductible ratably over the 60 month period beginning with the
month in which the costs are paid or incurred. This provision significantly reduces the
benefit of the IDC option to integrated oil companies.

ANALYSIS

Taxpayer incurred costs for the acquisition of a Seismic Survey of the A and B fields.
The Seismic Survey covered an area of interest 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. Taxpayer deducted the costs of the Seismic
Survey related to the A field as IDCs. Upon Exam, the IRS determined that the costs
that Taxpayer incurred to acquire the Seismic Survey should be treated as G&G
expenditures.

Plain Meaning of Section 167(h) Includes Developmental G&G

Section 167(h)(1) provides that any geological and geophysical expenditures paid or
incurred in connection with the exploration for, or development of, oil or gas within the
United States (as defined in § 638) are to be allowed as a deduction ratably over the 24-
month period beginning on the date that such expense was paid or incurred. The
inclusion of the phrase “or development of” specifically indicates that Congress intended
to include the cost of geological and geophysical expenditures during the development
phase of an oil and gas project.

The function of geological and geophysical activities is to locate and identify properties
with the potential to produce commercial quantities of oil and natural gas, as well as to
determine the optimal location for exploratory and developmental wells. These costs
are an important and integral part of exploration and production for oil and natural gas.
Traditionally, G&G expenditures are associated with a survey, such as a seismic,
magnetic, or gravity survey conducted by a specialized service company. These
expenditures can also include the cost of acquiring well logs and core data, sometimes
called “bottom-hole data,” which pertains to wells drilled by other companies.

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).

62
Section 291(b)(4), by cross reference to § 613A(d)(2) and (4), defines an “integrated oil company” as a
taxpayer, whose combined gross receipts (or those of a related person) from retail sales of oil, natural
gas, or any product derived therefrom, for the taxable year exceed $5,000,000 or whose refinery runs (or
those of a related person) exceed 50,000 barrels on any day during the taxable year.

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.

Legislative History of § 167(h) Does Not Exclude Developmental G&G

Although § 167(h) changes the prior tax treatment of G&G expenditures, it does not
define the term “geological and geophysical expenditures.” Rather, the legislative
history of § 167(h) makes clear Congress’ intention to adopt the long-standing income
tax definitions of the terms used in § 167(h). Consistent with the definition of G&G
expenditures contained in case law and prior IRS guidance, the legislative history
reflects Congress’ adoption of the definition of G&G expenditures as “costs incurred by
a taxpayer for the purpose of obtaining and accumulating data that will serve as the
basis for the acquisition and retention of mineral properties.”63

While the term exploration has often been associated with G&G expenditures the term
development has had very little prior association with G&G expenditures apart from the
Tax Court’s observations in Louisiana Land and Exploration Co. that a geophysical
survey was the “first step in the over-all development for oil of these tracts of land.”64
Additionally, the Tax Court in Standard Oil Co. stated that “[b]oth the terms ‘exploratory’
and ‘development’ have been used in a broad sense in the field of oil and gas taxation.
Both terms have been used to describe activities which must be capitalized, such as
seismic surveys, as well as operations which clearly fall within the IDC option.”65

We interpret the terms “exploratory” and “development” as interchangeable where the
same types of activities occur in both phases. As a result, while the legislative history of
§ 167(h) generally refers to G&G expenditures as costs attributable to exploration
activities, the definition of G&G expenditures can extend to the same activities that
occur within the development phase of an oil and gas project.

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

63
Conference Agreement, supra note 2, at 55 (emphasis added).
64
Louisiana Land and Exploration Co., 7 T.C. at 516.
65
Standard Oil Co., 68 T.C. at 346.
66
Conference Agreement, supra note 2, at 55.
67
Id. at 55-57.

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).

Case Law Includes Developmental G&G

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.”69 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.”70

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
68
See generally, Louisiana Land & Exploration Co., 7 T.C. 507.
69
Id. at 515-516, Cf. Parkersburg Iron & Steel Co. v. Burnet, 48 F.2d at 165.
70
Id.

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.

IDC Option is Not Applicable to Tangible Property Having a Salvage Value

Additionally, under § 1.612-4(c), the IDC option does not apply to expenditures by which
the taxpayer acquires tangible property ordinarily considered as having a salvage value.
In the present case, Taxpayer incurred costs to acquire the data generated by a
Seismic Survey. If such data was exclusively licensed or sold to Taxpayer in some
tangible form, the cost of the acquisition could not qualify as IDCs.71

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

71
For example, in Texas Instruments Inc. v. U.S., 551 F.2d 599 (5th Cir., April 27, 1977) and Texas
Instruments Inc. v. Comm’r., 98 T.C. 628 (May 27, 1992), the courts considered the issue of whether a
taxpayer that acquires data generated by seismic surveys is purchasing intangible data or tangible
property. Both cases considered this issue in the context of the investment tax credit.

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