G N G Cost and IDC Part I

Whats News in Tax
Analysis That Matters from Washington National Tax
A Primer on Domestic Oil and Gas, Part I:

Geological and Geophysical Costs
This article is the first in a two-part series examining the tax treatment
of two kinds of costs pertaining to domestic oil and gas extraction:
geological and geophysical (G&G) costs and intangible drilling and
development costs (IDC). This article discusses the kinds of costs
included in G&G costs and the historical and current tax treatment of
G&G costs, including capitalization versus deduction.
All large oil and gas operators and many medium-sized ones maintain wellstaffed and adequately budgeted G&G departments, the members of
which devote their full time to testing oil and gas prospects. Smaller
operators may employ independent G&G firms, on a fee basis, to perform
this work for them. Oil companies can pay for and own G&G information or
license desired G&G information from a person that owns it. The tax
Monday, June 4, 2012
by Christine R. Griffith, Houston;
treatment of G&G costs has varied over time. This section will focus on the
current treatment of domestic 1 G&G costs.
and Robert A. Swiech,
Geological Methods
Washington National Tax
There are three primary kinds of geological activities:
Christine Griffith is a partner in KPMG
(1) Surfacestudy, classification, and measurement of outcrops of
LLPs Federal Tax practice (Houston).
rock formations, and the mapping and correlation of data with other
Robert A. Swiech is a director in
observations to produce a geological picture of underground
WNTs Passthroughs group (Houston).
formations
(2) Subsurfacestudy, analysis, and correlation of samples of rock
extracted from wells drilled into the earth
(3) Core drillinga modified form of subsurface geology that
involves drilling shallow slim holes into the top layers of the earths
crust for the purpose of extracting rock samples for study and
analysis. 2
1
2
Within the United States as defined in section 638.

Yarbro, Geological and Geophysical Exploration, P-H Oil and Gas Taxes 2009.1
(1978).
2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of
independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss
entity. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International
Cooperative, a Swiss entity.
A Primer on Domestic Oil and Gas, Part I: Geological and Geophysical Costs
page 2
Geophysical Methods
Geophysical activities involve the accurate measurement and recording of
certain physical quantities in the outer rock shell of the earth, the object
being to learn the nature and contour of underground geological
structures. The five principal methods are:
(1) Seismic, which measures and records the rate of transmission
of shock waves through the earth by a seismograph. Exploration
technology has advanced significantly in recent years. For
example, seismic information can now be obtained showing detail
below salt domes. What once was presented as only fuzzy
pictures of the subsurface formations can now be seen in much
sharper and distinct images and can be viewed in a threedimensional mode. Previously, seismic could be presented only as
wave reflection time differences (PP) but now can also be seen
presented in true depth differences (PS). PS is more expensive
but provides less fuzzy pictures of the subsurface.
(2) Gravity, which measures the intensity of gravity at different
points on the earths surface. Gravity meters can detect variations
of one-one hundred millionth of the total force of gravity. Since
salt is lighter than the rocks above it, the force of gravity is slightly
less over a salt dome. In anticlines, the force of gravity is slightly
greater over the top of the anticline because the denser basement
rocks are nearer the surface. Faults may be detected because the
force of gravity is slightly greater on one side of a fault, the denser
rocks being closer to the surface there.
(3) Magnetic, which measures the magnetic intensity of the
earths field at different points by use of a magnetometer to
obtain data regarding the structure of the earths crust. This
method is employed principally in conjunction with other more
Unless otherwise indicated, references
precise methods of prospecting.
to section or sections in this

article are to the Internal Revenue
(4) Electrical, which measures the electrical resistance of the earth
Code of 1986 (the Code), as most
from place to place. Since oil is a nonconductor of electricity, an
recently amended, or to the U.S.
abnormally high resistance may indicate the presence of oil. This
Treasury Department regulations, as
method is effective in detecting only relatively shallow pools of oil.
most recently adopted or amended.
entity. All rights reserved.
page 3
(5) Geochemical or halo method, which analyzes a series of soil

samples gathered with an auger for their hydrocarbon and mineral
content. Plotting the high values in such samples reveals possible
petroleum deposits if lines connecting the points form a pattern
such as an aureole or halo.
Current Law for Domestic G&G Costs Incurred in Tax Years

Beginning after August 8, 2005
Section 167(h) Amortization of G&G Expenditures
Section 167(h) was enacted by the Energy Policy Act of 2005, to simplify
the tax accounting for G&G costs and reduce the audit time devoted to
these issues. 3 Under section 167(h), any G&G expenses paid or incurred
in connection with the exploration for, or development of, oil or gas within
the United States (as defined in section 638) generally must be taken as a
deduction ratably over the 24-month period beginning on the date that the
expense was paid or incurred. 4 A half-year convention is required,
meaning that any cost paid or incurred during the tax year is deemed to be
paid or incurred on the mid-point of such tax year. 5
For example, if taxpayer A uses a calendar year and the accrual method of
accounting and incurred $140 for G&G expenses in 2012, A would
amortize those expenses as follows: $35 in 2012, $70 in 2013, and $35 in
3
The Committee believes that substantial simplification for taxpayers,

significant gains in taxpayer compliance, and reductions in administrative cost
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. H. Rep. No. 109-45, 109th Cong., 1st Sess. 33 (Apr. 18, 2005). See
also Joint Comm. on Taxn, Study of the Overall State of the Federal Tax
System and Recommendations for Simplification, JCS- 3-01 vol. 2 (Apr. 2001)
(The Joint Committee staff recommends that taxpayers should be permitted
immediate expensing of geological and geophysical costs. The
recommendation would reduce complexity by eliminating the need to allocate
such expenses to various properties and by eliminating the need to make
factual determinations relating to the properties, such as what constitutes an
area of interest and when a property is abandoned.).
Section 167(h)(1). Note the absence of any acquired or retained language
generally associated with geological and geophysical information under prior
law. I.T. 4006, 1950-1 C.B. 48, superseded by Rev. Rul. 77-188, 1977-1 C.B.
76; Rev. Rul. 83-105, 1983-1 C.B. 51. Exploration costs, other than IDC, for
geothermal properties remain under section 617, and section 167(h) does not
apply to such costs. P.L.R. 201210011 (Mar. 9, 2012).
Section 167(h)(2). Note there may be section 461(h) tax basis issues on prepaid
expenses.
page 4
2014. The statute makes no distinctions based on G&G information that is

new or was previously used by another taxpayer, or based on whether the
G&G expenses were incurred directly by the taxpayer, purchased, or
licensed.
Section 167(h) is intended to be the exclusive method for the cost
recovery of certain G&G costs; no other depreciation or amortization
deduction will be allowed with respect to such costs. 6 Further, if any
property with respect to which G&G expenses 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 under this subsection continues with respect to such payment. 7
There is a special rule for a major integrated oil company that lengthens
the amortization to a seven-year period. 8 So, for example, if taxpayer A
was a major integrated oil company, the $140 for G&G expenses incurred
6
7
Section 167(h)(3). For example, G&G expenses cannot be recovered under

section 197.
Section 167(h)(4). The property referred to is the section 614 oil and gas
property, not the G&G information. For depreciable property, retirement is
defined to include sales (Disposition occurs when ownership of the asset is
transferred or when the asset is permanently withdrawn from use either in the
taxpayers trade or business or in the production of income. A disposition
includes the sale, exchange, retirement, physical abandonment, or destruction
of an asset. A disposition also includes the retirement of a structural
component (as defined in 1.481(e)(2)) of a building (as defined in 1.48
1(e)(1)). A disposition also occurs when an asset is transferred to a supplies,
scrap, or similar account.). Section 1.168(i)-8T(b)(1) (emphasis added). See
also section 1.167(a)-8(a). The potential application of that regulation to
depletable property is, at best, unclear. Note that this provision is silent on
what happens if the section 614 property to which the G&G data relates is
acquired by another taxpayer or on a sale of G&G data itself.
Section 167(h)(5)(A). Section 167(h) as originally enacted provided for a uniform
amortization period of 24 months. The 24-month period represented on a
projected macro level an overall small revenue decrease for such expenditures.
The Joint Committee on Taxation scored this provision as raising $292 million
for the first two years and costing less than $1 billion over a 10-year period.
The Tax Increase Prevention and Reconciliation Act of 2005 added the special
rule for major oil companies with a 5-year amortization period for amounts
incurred after May 17, 2006, as a revenue offset provision. Joint Committee on
Taxation, JCX-18-06 (May 9, 2006). The Energy Independence and Security Act
of 2007 increased the amortization time for major oil companies to a 7-year
period for amounts incurred after December 19, 2007, as a revenue-raising
provision. Joint Committee on Taxation, JCX-112-07 (Dec. 12, 2007).
page 5
in 2008 would be amortized as follows: $10 in 2012, $20 in each year from
2013 through 2018, and $10 in year 2019. 9
The Complex Nature of Simplification

The section 167(h) amortization provision, although intended to simplify
matters, has spawned a number of complex issues for oil and gas
companies. Under the pre-section 167(h) law, the nature of G&G costs
was fairly well understood; if acreage was acquired or retained based on
G&G information, its costs were capitalized to the tax basis of the
applicable section 614 property or properties. In essence the G&G
information became real property, the costs of which were subject to
depletion. Is the G&G data, the costs of which are now subject to section
167(h), real or personal property, tangible or intangible property? 10
10
Section 167(h)(5)(B). The term major integrated oil company means, with
respect to any tax 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 billion for its last taxable year
ending during calendar year 2005, and
(iii) to which section 613A(c) does not apply by reason of section
613A(d)(4), determined
(I) by substituting 15 percent for 5 percent each place it occurs in
section 613A(d)(3) (i.e., the refiner exception for percentage depletion),
and
(II) without regard to whether section 613A(c) does not apply by reason
of section 613A(d)(2) (i.e., the retailer exception for percentage
depletion).
For purposes of clauses (i) and (ii), all persons treated as a single employer
under section 52(a) and (b) shall be treated as one person and, in case of a
short tax year, the rule under section 448(c)(3)(B) shall apply. It is well known
that section 167(h)(5) applies to five large oil companies: BP plcs U.S.
subsidiaries; Chevron Corporation; ConocoPhillips, Inc.; ExxonMobil
Corporation; and Royal Dutch Shell plcs U.S. subsidiaries. However, section
167(h)(5) may also apply to other oil companies. The last sentence of section
167(h)(5) incorporates the section 52(a) and (b) definition of a single employer.
Section 52(a) references the section 1563(a)(1) definition of controlled group of
corporations, except that sections 1563(a)(4) and (e)(3)(C) are disregarded for
this purpose. Section 1563(b)(2)(C) would exclude foreign corporations subject
to tax under section 881, but the IRS generally will not look at section 1563(b)
exclusions for determinations under section 52. See section 1.263A-3(b)(3)(ii);
Notice 89-15, Q&A 45. For example, if a foreign major integrated company
enters the United States for the first time post-2005 using a Delaware
subsidiary investing in shale gas leases, it appears that its Delaware subsidiary
would be a major integrated oil company under section 167(h)(5).
It appears that internal salary and overhead costs would not need to be
capitalized on exploratory G&G information under section 263(a). See section
1.263(a)-2T(f)(2)(iv)(A), if tangible, or section 1.263(a)-4(e)(4)(i), if intangible.
page 6
Under the pre-section 167(h) law G&G costs capitalized to a section 614
property and depleted were subject to recapture as ordinary income under
section 1254. The G&G data, the costs of which are now subject to
section 167(h), appears to be subject to recapture as ordinary income
under section 1245. Assume that taxpayer G has a working interest in
Blackacre and associated pre-section 167(h) G&G information and that
taxpayer S has a working interest in adjoining property Whiteacre and
associated post-section 167(h) G&G information. If G and S exchange their
working interests and associated G&G information, is income recognized
under sections 1245(b)(4) and 1254(b)(1)? 11
The enactment of section 167(h) has potentially blurred the line between
G&G expenditures and IDC (discussed below). Section 167(h) applies to
G&G expenses paid or incurred in connection with the exploration for, or
development of oil or gas within the United States. The term
exploration has often been associated with G&G expenses, but the
term development has had limited prior association with G&G
expenses; for example, the Tax Court noted that a geophysical survey was
the first step in the over-all development for oil of these tracts of land. 12
This raises the question whether section 167(h) was intended to cover any
development activities historically viewed as being IDC. It seems
noteworthy that section 167(h) does not use the terms drilling or
production. Therefore, a geophysical survey, generally 3-D seismic,
done to site well drilling locations would seem to continue to qualify for
the option to IDC. 13
Also, 4-D seismic (see Figure 1the fourth dimension being time), often
shot multiple times each year on the same producing reservoir (often
using fixed seismic instruments) and used to monitor the depletion of the
reservoir to optimize production from that reservoir, does not appear to be
covered by section 167(h). This seismic is a part of the production
operation and appears to remain eligible for a section 162 deduction.
11
12
13
Further, there is no consistency requirement with financial book GAAP

treatment (e.g., the full cost method). Note that section 263A does not apply to any
cost allowable as a deduction under section 167(h). Section 263A(c)(3).
Note that a cross-license of the G&G information would appear to be a
nontaxable transaction. Cf. Rev. Proc. 2007-23, 2007-1 C.B. 675.
The Louisiana Land and Exploration Co. v. Commissioner, 7 T.C. 507, 516
(1946).
Section 263(c), which adopted the option to expense intangible drilling costs
contained in previously issued regulations; section 1.612-4(a)(2) (surveying,
and geological works as are necessary in preparation for the drilling of wells).
page 7
Figure 1. Example of 4D Seismic (Schlumberger, 2002).
In the following series of questions, we examine various questions about

the potential tax treatment of G&G expenses.
If speculative seismic is shot by a vendor who will offer that data to oil
companies for purchase, lease, or nonexclusive license, do the vendors
G&G expenses qualify for amortization under section 167(h)? Has the
vendor incurred these costs in connection with the exploration for, or
development of oil and gas within the United States? If the Texas
Instruments cases 14 are a guide, the costs of the vendor who sells or
leases the seismic data could qualify for amortization under section 167(h).
If the vendor transfers the data under a nonexclusive license, this appears
to be a closer call. Section 167(h)s in connection with the exploration
for standard appears to be a lesser standard than former section
48(a)(2)(B)(vi)s used for the purpose of exploring, and therefore the
costs may qualify for amortization.
14
See Texas Instruments Inc. v. United States, 551 F.2d 599 (5th Cir. 1977);
Texas Instruments Inc. v. Commissioner, 98 T.C. 628 (1992).
page 8
Are there any requirements to associate section 167(h) amortization with

the section 614 mineral property? Can a taxpayer still claim a section 165
loss for unamortized G&G costs if the lease sought is acquired by another
taxpayer? If the goal of simplified tax accounting for G&G expenses is the
proper guide here, then probably not.
Is section 167(h) amortization included in determining the section 613(a)
limitation on taxable income from the property? 15 If the goal of simplified
tax accounting for G&G expenses is the proper guide here, then probably
not, as those costs would need to be segregated by a taxpayers individual
section 614 properties. If the G&G costs were required to be allocated to
section 614 properties, then they would probably need to be allocated
based on the methodologies contained in Revenue Rulings 77-188 and 83105. As the main purpose of enacting section 167(h) was to simplify the
tax accounting for G&G by avoiding the complex cost allocations required
by those revenue rulings, it does not appear appropriate to allocate G&G
costs to section 614 properties.
If the G&G data is sold (i.e., not leased or licensed), is any unamortized tax
basis included in the gain or loss calculation? Without detailed rules similar
to general asset accounts under section 168(i)(4), it appears that any
unamortized tax basis for the sold data should be included in a gain or loss
calculation.
Is section 167(h) amortization included in determining the section 199
domestic production deduction? As this calculation is done at an overall
domestic level, not at a section 614 property level, probably yes. 16
Is section 167(h) amortization included in determining the section
57(a)(2)(C) computation of net income from oil and gas properties? This is
more difficult to answer as the computation follows the section 613(a)
taxable income from the section 614 property rules and then aggregates
the income and expense amounts from those properties included in the
computation, and the IRS has not announced whether it will follow the
decision in Shell. 17 If the goal of simplified tax accounting for G&G
15
16
17
Oil and gas percentage depletion is limited to 100 percent of the taxpayers
taxable income from the property computed without the allowance for
depletion and without the deduction under section 199.
Section 1.199-4.
Shell Oil Co. v. Commissioner, 952 F.2d 885 (5th Cir. 1992). This was a windfall
profit tax case where the taxpayer paid less excise tax on properties with low
page 9
expenses is the proper guide here, then section 167(h) amortization is

probably not includible in calculating net income, as it appears the G&G
data costs would need to be segregated by individual section 614
properties.
How does a partnership report G&G expenditures to its partners?
Specifically, section 167(h) does not address the issue of whether a
partnerships G&G expenditures are subject to the extended recovery
period for major integrated oil companies is to be determined on the
partnership or partner level. Consistency with the approach taken under
section 613A would seem to indicate that the partners must separately
determine whether they each are subject to the extended recovery period.
This would seemingly require a partnership to treat each partners
allocable share of G&G expenditures as a separately stated item under
section 1.702-1(a)(8)(ii).
The examples below are intended to illustrate the complexities that can
arise because of section 167(h) in frequently encountered transactions.
Example 1: G and S jointly own the working interest in Blackacre
and its G&G data in a 60/40 ratio, and S owns all of adjoining
Whiteacre. G exchanges 10 percent of Blackacre for a 50 percent
interest in Whiteacre and a copy of the G&G data for Whiteacre.
If both Blackacre and Whiteacre are foreign properties, does the inclusion
of the G&G data in the exchange mean that the exchange is not of likekind property for purposes of section 1031? Under Revenue Ruling 83105, which still provides the rules applicable to G&G expenditures with
respect to foreign property, G&G expenditures generally must be
capitalized to the mineral property. In this case, that would seem to mean
that the G&G data transferred to G does not represent an asset separate
from Whiteacre and that Whiteacre and the G&G costs capitalized to it
were section 1254 property. Therefore, it appears that G and S have
taxable incomes as computed under section 613(a) but with certain
adjustments. The court allowed Shell to apportion losses from abandoned G&G
on nonproducing properties to its producing properties. This was an
apportionment method for G&G that the IRS adopted for the percentage
depletion taxable income from the property limitation computation in June
1941 and quickly abandoned in October 1941. G.C.M. 22689, 1941-1 C.B. 225,
superseded by G.C.M. 22956, 1941-2 C.B.103, obs. Rev. Rul. 68-661, 1968-2
C.B. 607. The IRS has not stated that it would follow the decision in Shell or
readopt the allocation methodology of G.C.M. 22689.
page 10
exchanged like-kind property and solely section 1254 property. A similar

result may have been obtained had Blackacre and Whiteacre been
domestic properties exchanged prior to the enactment of section 167(h).
However, what is the result if Blackacre and Whiteacre are domestic
properties, and the G&G expenditures on Whiteacre were subject to
section 167(h)? Is section 167(h) amortization subject to section 1245
recapture? If so, does G recognize income under section 1254 because
solely 1254 property was transferred and it received both section 1254
property and section 1245 property in return? 18 Does S recognize income
under section 1245 because it transferred both section 1245 property and
section 1254 property and received only section 1254 property? 19 Had
section 167(h) amortization been subject to recapture under section 1254,
rather than section 1245, this issue would seemingly not arise, but may
have required allocation of the amortization to a section 614 property.
Example 2: B and C own interests in the a tax partnership, BC. BC
sells Greenacre (a domestic oil and gas property) to Y at a time
when there are unamortized section 167(h) costs. BC liquidates
immediately after the sale of Greenacre.
How might BC recover the unamortized 167(h) costs? If the G&G
information was sold to Y, it appears that BC could treat the transaction as
a sale of a section 1231 asset, and recognize gain or loss on the sale
(perhaps subject to section 1245 recapture) or could treat each partners
share of the sales proceeds as a separately stated item under section
1.702-1(a)(8)(ii).
If the G&G information was licensed to Y and undivided interests to the
data were distributed in liquidation to B and C, their tax basis would
appear to be determined under section 732(b) and each partner would
appear to step into the shoes of the partnership for the remaining section
167(h) amortization period up to the partners share of the amount of the
partnerships tax basis in the distributed property. Any additional allocated
18
19
Section 1.1254-2(d)(1).
Property such as a pipeline that has been depreciated under section 1245 but
which is real property for section 1031 purposes can be like kind to other real
property (that is not depreciable under section 1245); however, in those cases,
the recapture rules will override the section 1031 deferral and the section 1245
potential recapture can be triggered. Section 1.1245-2(c)(4).
page 11
tax basis from a partners tax basis in its tax partnership interest would
appear to start a new section 167(h) amortization period. 20
*****
Part II: Domestic oil and gas tax treatment of IDC.
KPMGs What's News in Tax is a

publication from Washington
National Tax that contains
The information contained herein is of a general nature and based on authorities that are subject to
change. Applicability of the information to specific situations should be determined through
consultation with your tax adviser.
thoughtful analysis of new

developments and practical,
This article represents the views of the author or authors only, and does not necessarily represent
the views or professional advice of KPMG LLP.
relevant discussions of existing

rules and recurring tax issues.
20
Section 168(i)(7).

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Whats News in Tax

Analysis That Matters from Washington National Tax

A Primer on Domestic Oil and Gas, Part I:

and Robert A. Swiech,

Washington National Tax

There are three primary kinds of geological activities:

Christine Griffith is a partner in KPMG

(1) Surfacestudy, classification, and measurement of outcrops of

LLPs Federal Tax practice (Houston).

Robert A. Swiech is a director in

observations to produce a geological picture of underground

WNTs Passthroughs group (Houston).

Within the United States as defined in section 638.

precise methods of prospecting.

to section or sections in this

(4) Electrical, which measures the electrical resistance of the earth

Code of 1986 (the Code), as most

from place to place. Since oil is a nonconductor of electricity, an

recently amended, or to the U.S.

abnormally high resistance may indicate the presence of oil. This

Treasury Department regulations, as

method is effective in detecting only relatively shallow pools of oil.

most recently adopted or amended.

(5) Geochemical or halo method, which analyzes a series of soil

Current Law for Domestic G&G Costs Incurred in Tax Years

The Committee believes that substantial simplification for taxpayers,

2014. The statute makes no distinctions based on G&G information that is

Section 167(h)(3). For example, G&G expenses cannot be recovered under

The Complex Nature of Simplification

Further, there is no consistency requirement with financial book GAAP

Figure 1. Example of 4D Seismic (Schlumberger, 2002).

In the following series of questions, we examine various questions about

Are there any requirements to associate section 167(h) amortization with

expenses is the proper guide here, then section 167(h) amortization is

exchanged like-kind property and solely section 1254 property. A similar

KPMGs What's News in Tax is a

thoughtful analysis of new

relevant discussions of existing

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