Source: https://www.currentfederaltaxdevelopments.com/blog/2018/9/1/seismic-survey-costs-are-costs-to-be-amortized-not-intangible-drilling-costs-per-irs-memorandum
Timestamp: 2019-04-24 04:51:33+00:00

Document:
In CCA 201835004 the question was posed regarding whether seismic surveys information obtained to determine the placement of offshore gas and oil development wells should be treated as geological and geophysical costs, amortizable under §167(h), or as intangible drilling costs, deductible under IRC §263(c).
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.
Section 1.612-4(a) provides that IDCs incurred by an operator 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).
(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.
Any geological and geophysical 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) shall be allowed as a deduction ratably over the 24-month period beginning on the date that such expense was paid or incurred.
The memorandum looked to resolve the issue of which IRC provision was the proper one to apply in this case. The memorandum concluded that, in fact, such expenditures were not intangible drilling costs under IRC §263(c), but rather must be amortized as geological and geophysical costs under IRC §167(h).
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).
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.
The key issue to the IRS is that the expenses were not incurred with regard to a specific well, even if would eventually lead to wells being drilled. Thus, the argument goes, the expenses are not intangible drilling costs under IRC §263(c) for any particular well.
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 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).
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 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.

References: §167
 §263
 § 59
 §263
 §167
 § 167
 § 638
 § 167
 § 167
 §263
 § 167
 § 263
 § 167
 § 167
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