Engineered low-salinity waterflood is a qualified tertiary recovery method for the enhanced oil recovery credit; pre-injection costs allowed on amended returns

Plain-English summary

Section 43 gives oil producers a credit for costs of a "qualified enhanced oil recovery project," but only if the project uses a "qualified tertiary recovery method." Ordinary waterflooding (injecting plain water to push out oil) is specifically excluded. Here a producer plans to inject specially designed water whose chemistry changes the "wettability" of the reservoir rock, loosening oil that a normal waterflood would leave behind. The IRS ruled that this engineered method is a qualified tertiary recovery method (not mere waterflooding) because it works by modifying the properties of the reservoir fluids, so the project can qualify for the credit, provided the taxpayer submits the required petroleum engineer's certification. The IRS also ruled on timing: because first injection is expected years after the costs are incurred (more than 36 months out), the taxpayer may take the pre-injection costs into account on amended returns for the earlier years, which the regulations permit only when a private letter ruling so provides. The ruling does not decide whether any particular cost actually qualifies.

Ruling snapshot

• Question: Is the taxpayer's engineered water-injection method a qualified tertiary recovery method for the § 43 credit, and may pre-injection costs be claimed on amended returns more than 36 months before first injection?
• Outcome: Approved (method qualifies; pre-injection costs allowed on amended returns)
• Key authorities: IRC §§ 43, 193(b)(3); Treas. Reg. §§ 1.43-2(e), 1.43-3, 1.43-4(d)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202203005 [Third Party Communication:
Release Date: 1/21/2022 Date of Communication: Month DD, YYYY]
Index Number: 43.00-00
Person To Contact:
------------------ ---------------, ID No. ------------
---------------------- Telephone Number:
--------------------------------- --------------------
---------------------------------- Refer Reply To:
---------------------------- CC:PSI:B06
PLR-110848-21
Re: ---------------------- Date:
October 25, 2021

LEGEND:

Taxpayer = -----------------------------------------------
Field = ------------
Location = ----------------------------------------------------------------------
-----------------
a = --------
b = --------
c = --------
d = ----------
e = ----------
f = --------------
x = -----------------
y = -------
Co-owner A = ------
Co-owner B = -----------
Method = ----------------------------------------------------------------------
---------------------------------------------------------
Injectant = ------------
Year A = -------
Year B = -------
Year C = -------
Platform = --------------------

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

This letter responds to your letter, dated May 3, 2021, requesting a ruling under § 43 of
the Internal Revenue Code.
PLR-110848-21 2

FACTS

Taxpayer is an accrual taxpayer utilizing a calendar taxable year. Field is situated in
Location. Field is operated by Taxpayer with a% equity; co-owners are Co-Owner A
(b%) and Co-Owner B (c%). Ownership of Field is structured as an “elect-out”
partnership for federal income tax purposes.

Field has an estimated d barrels of oil in place, and over e barrels of recoverable oil
(gross). Taxpayer asserted that the existing development at Field cannot access a
significant portion of the remaining resources. Therefore, Taxpayer intends to use
Platform to continue the development of Field, allowing further access to over f barrels
of oil equivalent (net). Initial production at Field from Platform is anticipated in Year C.

To support production at Field, Taxpayer determined that a waterflood injection was
necessary to provide access to the reserves for Field. Furthermore, Taxpayer’s
engineers performed core flood tests using rock samples from Field and determined
increased incremental reserves could be recovered through the use of Method.

Taxpayer represents that the use of Method will lead to changes in the reservoir fluids,
the interaction between these fluids and the rock surfaces, and thus changes in the
wettability of the reservoir rock.

Taxpayer has provided a substantial amount of literature, including laboratory study and
simulation data showing that wettability alteration is the primary cause of the extra oil
recovery using Method. Prior to extraction, oil reservoirs have contained crude oil for
millions of years. Over time, the pore surface of these rocks develops an affinity for
crude oil, mediated by the polar compounds within these oils and available cations in
the reservoir brine. This preference for crude oil leads to oil being left behind during a
conventional waterflood.

The level of preference of the rock surface for oil or water can be characterized as
“wettability”, and it depends on the composition of the brine contacting the oil. Taxpayer
represents that, by carefully designing the composition of the water injected, the
chemistry of the rock surface can be altered, leading to a decrease in the affinity of
these pore surfaces for oil, i.e., make them more water-wet. This acts to reduce the
adhesive force of the oil to the rock surface and oil which otherwise would have been
trapped, may be produced.

Based on its work using Method, Taxpayer has estimated incremental reserves that can
be recovered from Field through the use of Method, specifically with Injectant, is in the
range of x million barrels of oil equivalent (gross), a range of y% increase versus base
accessible reserves without the use of Method.

RULINGS REQUESTED
PLR-110848-21 3

1. The use of Injectant is a qualified tertiary recovery method within the meaning of
   Treas. Reg. § 1.43-2(e).
2. Pursuant to Treas. Reg. § 1.43(d)(2), qualified enhanced oil recovery costs
   incurred by Taxpayer in Year A and Year B taxable years may be taken into
   account by Taxpayer in those taxable years, prior to first injection expected in
   Year C.
3. Pursuant to Treas. Reg. § 1.43-4(d)(3), qualified enhanced oil recovery costs
   incurred by Taxpayer may be taken into account on an amended return for the
   Year A and Year B taxable years, more than 36 months prior to first injection.

LAW AND ANALYSIS

Ruling 1

Section 43(a) provides a credit in an amount equal to 15% of certain costs paid or
incurred by a taxpayer in connection with a qualified enhanced oil recovery project.

Section 43(b)(1) provides that the amount of the credit determined under subsection (a)
for any taxable year shall be reduced by an amount which bears the same ratio to the
amount of such credit (determined without regard to this paragraph) as — (A) the
amount by which the reference price for the calendar year preceding the calendar year
in which the taxable years begins exceeds $28, bears to (B) $6.

Section 43(b)(3)(B) requires the Secretary to publish an inflation adjustment factor. The
enhanced oil recovery credit under § 43 for any taxable year is reduced if the “reference
price,” determined under § 45K(d)(2)(C), for the calendar year preceding the calendar
year in which the taxable year begins is greater than $28 multiplied by the inflation
adjustment factor for that year.

The term “inflation adjustment factor” means, with respect to any calendar year, a
fraction the numerator of which is the Gross National Product (GNP) implicit price
deflator for the preceding calendar year and the denominator of which is the GNP
implicit price deflator for 1990.

Notice 2021-47, 2021-32 IRB 269, is the latest notice which publishes the
§ 45K(d)(2)(C) “reference price”.

Section 43(c)(2)(A) defines the term "qualified enhanced oil recovery project" to mean
any project that: (1) involves the application (in accordance with sound engineering
principles) of one or more qualified tertiary recovery methods (as defined in section
193(b)(3)) that reasonably can be expected to result in a more than insignificant
increase in the amount of crude oil that ultimately will be recovered; (2) is located within
the United States (within the meaning of section 638(1); and (3) with respect to which
PLR-110848-21 4

the first injection of liquids, gases, or other matter commences after December 31,
1990.

Section 1.43-2(e)(1) of the regulations defines the term "qualified tertiary recovery
method" to mean any one or combination of the tertiary recovery methods described in
section 1.43-2(e)(2) or a method not described in section 1.43-2(e)(2), which has been
determined by revenue ruling to be a "qualified tertiary recovery method." A taxpayer
may request a private letter ruling that a method not described in section 1.43-2(e)(2) or
in a revenue ruling is a qualified tertiary recovery method. Generally, methods identified
in revenue rulings or private letter rulings will be limited to those methods that involve
the displacement of oil from the reservoir rock by modifying the properties of the fluids in
the reservoir or providing the energy and drive mechanism to force the oil to a
production well.

Section 1.43-2(e)(3)(i) states that waterflooding is not a qualified tertiary recovery
method. Waterflooding is defined as the injection of water into an oil reservoir to
displace oil from the reservoir rock and into the bore of the producing well.

Section 1.43-3(a)(1) states that a petroleum engineer must certify, under penalties of
perjury, that an enhanced oil recovery project meets the requirements of section
43(c)(2)(A). A petroleum engineer's certification must be submitted for each project. The
petroleum engineer certifying a project must be duly registered or certified in any State.

Section 1.43-3(a)(2) states that the operator of an enhanced oil recovery project must
submit a petroleum engineer's certification to the Internal Revenue Service Center,
Austin, Texas, or such other place as may be designated by revenue procedure or other
published guidance, not later than the last date prescribed by law (including extensions)
for filing the operator's federal income tax return for the first taxable year for which the
enhanced oil recovery credit is allowable.

Section 1-43-3(a)(3) states that the petroleum engineer's certification must contain the
following information:

   The name and taxpayer identification number of the operator or the designated
   owner submitting the certification;

   A statement identifying the project, including its geographic location;

   A statement that the project involves a tertiary recovery method (as defined in
   section 43(c)(2)(A)(i)) and a description of the process used as including the
   descriptors noted in Section 1.43-3(a)(3)(i)(C)

   A statement that the application of a qualified tertiary recovery method or
   methods is expected to result in more than an insignificant increase in the

PLR-110848-21 5

   amount of crude oil that ultimately will be recovered including the descriptors
   noted in Section 1.34-3(a)(3)(i)(D); and

   A statement that the petroleum engineer believes that the project is a qualified
   enhanced oil recovery project within the meaning of section 43(c)(2)(A).

Taxpayer represents that the increase in oil recovery at Field from using Method was
due to an increase in the fractional flow of oil in the reservoir rock. Taxpayer submitted
studies that postulated that the methodology behind this increase was from a multiple
cation exchange, which increased the wettability of the reservoir rock by reducing the
interfacial tension between the oil, reservoir rock, and water. The increase in wettability
of the reservoir rock improves the displacement efficiency by reducing the residual oil
saturation, thus increasing the fractional flow of oil through the reservoir. Section 1.43-
2(e)(1) of the regulations states that a qualified method generally is limited to methods
that involve the displacement of oil from the reservoir rock by modifying the properties of
the fluids in the reservoir or that provide the energy and drive mechanism to force the oil
to a production well. According to the statement submitted by Taxpayer, this project
does both.

The Method resembles waterflooding, an excluded method under § 1.43-2(e)(3), in that
in both cases water is injected into an oil reservoir to displace oil from the reservoir rock
and into the bore of the producing well. However, the proposed method causes changes
in the properties of the fluids in the reservoir which do not occur with conventional
waterflooding.

Taxpayer has represented that the proposed project is within the United States and first
injection will occur after December 31, 1990 as required under § 43(c)(2). Also,
Taxpayer has represented that the project involves the application (in accordance with
sound engineering principles) of a recovery method which can reasonably be expected
to result in a more than insignificant increase in the amount of oil that will ultimately be
recovered.

Based on these facts as represented by Taxpayer, we conclude that the recovery
method Taxpayer will implement at Field, is a qualified tertiary recovery method not
described in § 1.43-2(e)(2) or in a revenue ruling, and therefore, the project using the
method is a qualified tertiary recovery project provided it otherwise meets the
requirements of § 43 and the regulations thereunder. We note that §1.43-3 requires
that the Taxpayer must submit a petroleum engineer’s certification containing those
items listed in that section not later than the date described in §1.43-3(a)(2), along with
a copy of this letter ruling.

Rulings 2 and 3

Treas. Reg. § 1.43-4(d)(2) provides that, except as provided in Treas. Reg. § 1.43-
4(d)(3), if the first injection of liquids, gases, or other matter occurs or is expected to
PLR-110848-21 6

occur after the date the taxpayer files the taxpayer’s federal income tax return for the
taxable year with respect to which the costs are allowable, the costs may be taken into
account on an amended return (or in the case of a Coordinated Examination Program
taxpayer, on a written statement treated as a qualified return) after the earlier of (i) the
date the first injection of liquids, gases, or other matter occurs; or (ii) the date the IRS
issues a private letter ruling that provides that the taxpayer may take costs into account
prior to the first injection of liquids, gases, or other matter.

Treas. Reg. § 1.43-4(d)(3) provides that if the first injection of liquids gases, or other
matter occurs more than 36 months after the close of the taxable year in which costs
are paid or incurred, the taxpayer may take the costs into account in determining the
credit only if the IRS issues a private letter ruling to the taxpayer that so provides.

The Treasury Decision for the Enhanced Oil Recovery Credit, TD 8448, 57 FR 54917,
54919, noted that in the proposed regulations for the Enhanced Oil Recovery Credit
costs may be taken into account in determining the amount of the credit only after first
injection occurs. If first injection occurs on or before the date the taxpayer files a return
for the year the credit is allowable for the costs, the taxpayer may claim the credit for the
costs on the return. However, if first injection occurs after the return is filed, the taxpayer
may claim the credit on an amended return for the year the credit is allowable for the
costs. If first injection occurs more than 36 months after the close of the taxable year in
which the costs are paid or incurred, the costs may not be taken into account in
determining the credit for any taxable year.

However, commentators argued that deferring the credit until first injection has occurred
penalizes both large-scale projects that require lengthy construction periods and
operations with limited transportation opportunities. Commentators suggest that the 36-
month limitation on claiming the credit for pre-injection costs should be eliminated or
that the pre-injection “window” should be widened from 36 months to 48 months to take
into account operational and technical parameters.

In response to the comments, the final regulations for the Enhanced Oil Recovery Credit
allowed for more flexibility regarding costs paid or incurred prior to first injection. As in
the proposed regulations, if first injection occurs on or before the date a taxpayer files a
federal income tax return for the taxable year in which the costs are paid or incurred
(the initial return), the costs may be taken into account on that return; and if first
injection occurs later, the costs may be taken into account on an amended return. The
final regulations add that if first injection occurs or is expected to occur after the initial
return is filed (including at a time that is more than 36 months after the close of the
taxable year in which the costs are paid or incurred), the taxpayer may include the costs
in the credit base on a return filed before first injection if a private letter ruling is
obtained.

Accordingly, Taxpayer may deduct qualified enhanced oil recovery costs paid or
incurred in Year A and Year B while using Method at Field on their respective amended
PLR-110848-21 7

Year A and Year B tax returns to the extent that the Enhanced Oil Recovery Credit is
allowable in those years.

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 any particular item
constitutes a qualified enhanced oil recovery cost.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent. A copy of this letter must be
attached to any income tax return to which it is relevant.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

This letter is being issued electronically in accordance with Rev. Proc. 2020-29, 2020-
21 I.R.B. 859. A paper copy will not be mailed to Taxpayer.

                                             Sincerely,



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

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