Deduction for Section 167(h) Geological and Geophysical Expenses Applies to Non-Owners Also

(Parker Tax Publishing August 2016)

The Tax Court rejected IRS arguments that the deduction under Code Sec. 167(h) for geological and geophysical expenses paid or incurred in connection with the exploration for, or development of, oil or gas within the U.S. only applies to owners of mineral interests. As a result, a corporation that conducted marine surveys and sold data generated by the surveys to companies engaged in oil and gas exploration and development could deduct its survey expenses under Code Sec. 167(h). CGG Americas, Inc. v. Comm'r, 147 T.C. No. 2 (2016).

In 2006 and 2007, CGG Americas, Inc. (CGGA), a Texas corporation, conducted marine surveys of the outer continental shelf in the Gulf of Mexico. The surveys involved the use of geophysical techniques that detected or suggested the presence of oil and gas in the area surveyed. The data initially generated by the surveys was raw acoustic data. CGGA processed this data to create usable information such as visual representations (including maps) of geological formations in the earth's subsurface. CGGA licensed the data - i.e., both the raw acoustic data and the information that resulted from processing it - to its customers on a nonexclusive basis for a fee. CGGA's customers were companies engaged in oil and gas exploration and development. The customers used the data to identify new areas where subsurface conditions were favorable for oil and gas development and production, determine the size and structure of previously identified oil and gas fields, determine how to develop oil and gas reserves and produce oil and gas, determine which oil and gas properties to acquire, and determine where to drill wells.

On its 2006 and 2007 tax returns, CGGA deducted the expenses incurred to conduct the surveys and to process data from the surveys as geological and geophysical expenses. Under Code Sec. 167(h)(1), any geological and geophysical expenses paid or incurred in connection with the exploration for, or development of, oil or gas within the U.S. (as defined in Code Sec. 638) is allowed as a deduction ratably over the 24-month period beginning on the date that such expense was paid or incurred.

The IRS disallowed the deductions. According to the IRS, CGGA's survey expenses were not geological and geophysical expenses paid or incurred in connection with the exploration for, or development of, oil or gas within the meaning of Code Sec. 167(h). The IRS cited two reasons for disallowing the deduction. First, the IRS argued, the phrase "geological and geophysical expenses" used in Code Sec. 167(h) is a term of art that refers only to expenses incurred by taxpayers that own mineral interests, that is, oil or gas interests. For tax purposes, the IRS said, the phrase refers exclusively to expenses related to the exploration for oil or gas incurred by taxpayers who are exploration and production companies or otherwise owners of mineral interests. Since CGGA did not own any mineral interests, the IRS contended that the survey expenses were not "geological and geophysical expenses" as that term is used in Code Sec. 167(h).

Second, the IRS argued that the survey expenses were not paid or incurred in connection with the exploration for, or development of, oil or gas. An expense is paid or incurred in connection with such exploration or development within the meaning of Code Sec. 167(h), the IRS said, only when paid or incurred in connection with the taxpayer's own exploration or development, not when paid or incurred by a taxpayer in connection with the exploration or development by other taxpayers (i.e., CGGA's customers).

The Tax Court rejected the IRS's arguments and held that CGGA was entitled to deduct the survey expenses under Code Sec. 167(h). With respect to the IRS's argument that the phrase "geological and geophysical expenses" is restricted to expenses incurred by taxpayers that own mineral interests, the court looked at the various court cases cited by the IRS to support this conclusion. The court found that none of the opinions cited defined a "geophysical expense" as including only an expense incurred by owners of mineral interests.

The court also reviewed three IRS rulings for the same proposition, including two that were referred to in the legislative history of Code Sec. 167(h). One of those, the court noted, had an introductory statement which clarified that the ruling was written to apply only to a particular subset of geological and geophysical exploration expenditures, and the other had an introductory sentence which clarified that the ruling governed only the treatment of geological and geophysical expenditures in a particular situation. As to the one that was not referenced in the legislation, the court rejected the IRS's interpretation that the ruling implied that geological and geophysical exploration expenses included only expenditures by mineral-interest owners, saying that the ruling did not purport to describe all types of geological and geophysical exploration expenditures.

For a discussion of the amortization of geological and geophysical costs under Code Sec. 167(h), see Parker Tax ¶95,130.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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