Opinion ID: 548352
Heading Depth: 1
Heading Rank: 1

Heading: worthless properties

Text: 10 On this first issue relating to Gulf's offshore oil and gas leases, Gulf presents two questions: (1) whether Gulf had abandoned, as a matter of law, particular offshore leases in tax years 1974 and 1975, which would entitle it to an I.R.C. Sec. 165 loss deduction; and (2) if the deduction were permitted, the appropriate calculation of the amount of Gulf's basis in each lease which would properly be allocated to the worthless operating minerals interests. We will affirm the Tax Court's decision, reported at Gulf Oil Corp. v. Comm'r, 87 T.C. 135 (1986), that Gulf failed to prove abandonment of the leases involved.
11 During tax years 1974 and 1975, Gulf held undivided interests in twenty-three offshore oil and gas leases in the Gulf of Mexico, covering blocks located in the offshore areas of Louisiana and Mississippi, Alabama, and Florida (MAFLA). 3 The lessor for one lease, in offshore Louisiana, was the State of Louisiana (the Louisiana lease). The U.S. Department of Interior 4 was the lessor for the other twenty-two leases (the Department leases). Gulf based its bids for these leases on its perception of the value of the underlying minerals. The bids reflected basic geologic evaluations which were used to estimate the amount of oil and gas present in each block of land to be leased. 5 These were balanced against the potential costs of placing the lease into production. From this, Gulf would calculate a geological assessment of risk, the most important factor in determining how much to bid. 12 Successful lease bidders were required to pay the lessor an up-front cash bonus for each lease. For the leases at issue, Gulf and its co-lessees paid cash bonuses ranging from $1.127 to $61.166 million per lease ($15 million average). 6 In addition, lessees were also required to pay a yearly delay rental on each lease to ensure lease retention throughout the primary term, permitting lessees to complete exploration. Delay rentals on the Department leases were $3.00 per acre; 7 thus, to retain rights in twenty-two of the leases, Gulf and its co-lessees would be required to pay approximately $20,000 per lease per year. Delay rentals on the Louisiana lease were one-half of the cash bonus payment for each lease. Since the total cash bonus payment on this lease was $7.713 million, Gulf and its co-lessees would be required to pay approximately $3,856,600 per year to retain rights in this lease. 13 Lessees could relinquish rights to the Department leases in three ways. First, since the primary term of each lease was five years from the effective date of the lease, each lease would expire automatically by operation of law at the end of its five-year primary term, unless the lease was extended by either production in paying quantities or continuation of drilling. Second, the lessee could elect not to pay the required annual delay rental on the lease. Third, the U.S. Department of Interior, pursuant to its regulations, would accept a release or relinquishment of either an entire offshore lease or an officially designated subdivision thereof. However, per regulations in effect since 1954, the Department would not accept relinquishment of horizontal intervals, strata, or sands in an offshore lease. Once the lessee relinquished rights in a lease, the lease became available for bid at a subsequent lease sale. 14 Gulf acquired undivided interests in these twenty-three offshore oil and gas leases from 1972 through 1974. Shortly after acquiring these interests, Gulf personnel determined how many geological strata, i.e., horizontal layers, underlying each lease might contain gas or oil deposits. Determinations were based upon the known geology of other nearby parcels. Gulf personnel determined that each of the ten offshore Louisiana leases potentially contained between six and thirty-nine deposits, and that each of the thirteen offshore MAFLA leases potentially contained between three and eight deposits. Gulf then allocated its total basis in each lease, consisting of the initial cash bonus payment plus any geological and geophysical costs, among the strata believed to contain oil and gas deposits. 8 Pursuant to I.R.C. Sec. 614(b)(2), Gulf made an election to treat each potential mineral deposit (horizontal strata) in each lease as a separate property. 9 Gulf's tax department initiated the process establishing its separate property procedures in the Gulf of Mexico. For a valid I.R.C. Sec. 614(b)(2) election, more than one operating mineral interest must exist in a single tract or parcel of land. 15 During or prior to the tax years in issue, wells were drilled on the leases in question. As a consequence of unsuccessful drilling operations, Gulf determined that some of the potentially productive strata underlying each lease did not contain any oil or gas deposits or commercial quantities of oil and gas. Therefore, Gulf viewed these strata as worthless. Nonetheless, Gulf continued to retain all its rights to the leases and continued to pay the yearly delay rentals on the Department leases to protect its interests in the strata not deemed worthless. Also, Gulf farmed out limited rights in two of the leases, retaining its interest in the depth intervals farmed out and paying a portion of the development costs of subsequently discovered mineral deposits in farmed-out strata. Gulf even claimed production from a deposit in one strata it earlier asserted that it abandoned. 16 Presuming its I.R.C. Sec. 614(b)(2) election was enforceable, Gulf claimed section 165 abandonment loss deductions on its 1974 and 1975 consolidated federal corporate income tax returns of $35,561,455 and $108,108,366, respectively. These loss deductions were based on abandonments and extraordinary retirements of the potential mineral deposits within certain of the offshore leases which Gulf had elected to treat as separate properties and which it now considered worthless. The Commissioner fully disallowed the deductions, determining that Gulf had not established the worthlessness of the mineral interests. The Tax Court agreed with the Commissioner, holding that Gulf failed to prove any act evidencing its present declaration that these properties were worthless and abandoned in tax years 1974 and 1975, whether the property is defined as each of the potential mineral deposits or as the lease itself. Thus, the Tax Court found it unnecessary to decide whether each potentially productive stratum could properly be treated as a separate property under I.R.C. Sec. 614(b)(2). Gulf appeals from this decision.
17 Gulf contends that the Tax Court committed three legal errors: (1) denying the deduction without deciding whether Gulf's potential mineral deposits in each lease qualified as operating mineral interests eligible to be treated as separate properties by way of an election under I.R.C. Sec. 614(b)(2); (2) implicitly concluding that the property at issue is the lease itself and not the prospective mineral deposits; and (3) determining the availability of a loss deduction under I.R.C. Sec. 165 solely on the basis of whether Gulf disposed of legal title to its allegedly worthless operating mineral interests during the tax years in issue. 18 Gulf argues that the legal question of whether an I.R.C. Sec. 165 deduction is available cannot be addressed unless the scope of the property in question is defined. Gulf asserts that the property in question is the potential mineral deposits or each horizontal stratum within the leases, and not the entire lease itself, because the potential mineral deposits within each lease are operating mineral interests and, therefore, separate properties as a result of Gulf's I.R.C. Sec. 614(b)(2) election. Hence, Gulf contends, each potential mineral deposit in each lease is a separate property which could be abandoned for purposes of a loss deduction pursuant to I.R.C. Sec. 165. 19 The Commissioner counters that the Tax Court was not required to decide whether the taxpayer was entitled to treat the potentially productive strata underlying the leases as separate properties since, in any event, the taxpayer failed to show abandonment. The Commissioner also argues that, even if the Tax Court should have determined the nature of the property in question, the taxpayer was not entitled to treat the horizontal strata as separate properties. 20 Under I.R.C. Sec. 165, a taxpayer may take a deduction for any loss sustained during the taxable year and not compensated for by insurance or otherwise. I.R.C. Sec. 165(a). A loss deduction is permitted under I.R.C. Sec. 165 only for a taxable year in which the loss is sustained, as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year. Treas.Reg. Sec. 1.165-1(d)(1). Similarly, a loss deduction is allowed for obsolescence of nondepreciable property, such as an oil lease, where a loss is incurred arising from the sudden termination of the property's usefulness in that business or transaction. The termination can occur, for example, when the business or transaction is discontinued, or when property is permanently discarded from use. Treas.Reg. Sec. 1.165-2(a). For this purpose, the taxable year in which the loss is sustained is not necessarily the taxable year in which the overt act of abandonment, or the loss of title to the property, occurs. Id. 21 I.R.C. Sec. 165 losses have been referred to as abandonment losses to reflect that some act is required which evidences an intent to discard or discontinue use permanently. A. J. Industries, Inc. v. United States, 503 F.2d 660 (9th Cir.1974). [I]n order for a loss of an intangible asset to be sustained and to be deductible, there must be (1) an intention on the part of the owner to abandon the asset, and (2) an affirmative act of abandonment. 503 F.2d at 670. Moreover, mere intention alone to abandon is not, nor is non-use alone, sufficient to accomplish abandonment. Id., citing Beus v. Comm'r, 261 F.2d 176, 180 (9th Cir.1958). 22 Gulf failed to establish that it had taken any affirmative act manifesting its abandonment of the Department property, and, indeed, conceded (see Gulf Oil, 87 T.C. at 163), that none of the leases themselves had been abandoned during the tax years at issue. Gulf can demonstrate no act, such as relinquishment of the lease or nonpayment of delay rentals, 10 which would support its claim of abandonment. Indeed it preserves the right to drill, explore and produce from these strata. Merely abandoning the strata or leases on paper because they are deemed worthless is insufficient to demonstrate abandonment for purposes of an I.R.C. Sec. 165 loss deduction. See Beus, 261 F.2d at 180. 23 The absence of any act manifesting Gulf's intention to abandon is a finding of fact. We have examined the record and conclude that the Tax Court's finding was not clearly erroneous. Thus no error of law in applying section 165 to these facts occurred. 24 No deductions for abandonment loss may be taken with respect to the leases, again a mixed question of law and fact, based upon the absence of an affirmative act of Gulf's intention to abandon. 25 Just as the Tax Court did not feel compelled to reach the question of whether individual strata could be treated as separate properties under section 614(b)(2), we, too, do not comment on it. We leave that difficult question for future resolution when the facts more closely depict abandonment.
26 We hold that the Tax Court properly concluded that Gulf had failed to prove abandonment, whether the property is understood as separate strata or as the entire lease, and hence was not entitled to the deductions under I.R.C. Sec. 165. We will therefore affirm the Tax Court's decision.