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Sun Co. v. Commissioner of Internal Revenue

decided: April 16, 1982.



Before Gibbons, Weis and Garth, Circuit Judges.

Author: Garth


In this appeal we are asked to decide whether the costs of drilling offshore exploratory oil and gas wells from mobile rigs are deductible in the year in which they are incurred as "intangible drilling and development costs" under 26 U.S.C. § 263(c) and Treas.Reg. § 1.612-4(a) ("the IDC option"). The Tax Court ruled in favor of the taxpayer, Sun Co., and against the Commissioner, in holding that such drilling costs are immediately deductible under § 1.612-4(a). We agree with the Tax Court's holding and affirm its decision.


Taxpayers in this case are an affiliated group of corporations of which Sun Company, Inc. is the common parent, (hereinafter "Sun" will be used when referring to the group of corporations). As part of its business, taxpayers, during the period in question, participated in the exploration, leasing, and development of numerous offshore oil and gas properties. The dispute before this court involves the taxpayers' participation in two separate joint ventures: one engaged in developing certain offshore Louisiana oil and gas properties; and another engaged in developing North Sea oil and gas properties.

The Tax Court's findings and opinion contain a detailed factual statement involving offshore oil and gas operations in general and the seventeen specific wells at issue. The factual statement is derived largely from the parties' stipulations. See A.160 n.1, 168-191. We see no need to repeat that statement here, and instead briefly summarize the portions that are relevant to this appeal.

The process of exploring for and producing oil and gas in offshore areas can generally be divided into three stages. The first step in any oil and gas operation, both offshore and onshore, is to collect and interpret geological and geophysical information to determine if the area in question contains subterranean structures which constitute potential traps for accumulations of oil and gas. The only way to determine whether such potential traps actually contain hydrocarbons is to drill into the structures.

Thus, the second stage in offshore operations involves drilling exploratory wells or "wildcat wells" to determine if particular structures contain oil or gas in commercial quantities. Such exploratory offshore wells are drilled from mobile rigs which are floated to the location and either anchored or set on the ocean floor for drilling. If oil or gas is discovered in commercial quantities, however, the well is not completed from the mobile rig. Instead, during the third stage of offshore operations, involving production of the hydrocarbons, it is necessary to install a permanent production facility to complete an offshore well.*fn1 The operator often permanently plugs and abandons the wells drilled from mobile rigs and then produces the hydrocarbons through another well drilled from a fixed production platform. Less frequently, the operator will temporarily abandon the well and preserve it for possible future production after reentry from a fixed production platform.*fn2 (App. 172).

By far the most common permanent offshore production facility is a fixed multiwell drilling and production platform which enables the operator to tap several sources of hydrocarbons. A fixed production platform located in 100 feet or more of water can cost millions, if not tens of millions, of dollars. Thus, exploratory wells are always drilled from mobile rigs to determine if sufficient quantities of oil and gas exist to justify the installation of such a platform. (A. 170-71).

The primary factors in determining whether to use an exploratory well drilled from a mobile rig for production are the amount of hydrocarbons in the particular well and the location of the well in relation to the optimum site for the fixed production platform. (App. 173). The optimal site enables the exploitation of several separate hydrocarbon reservoirs from the same platform. Such a site is not normally determinable until a number of exploratory wells have been drilled. Thereafter, reservoirs located by successful exploratory wells can be exploited by the installation over the optimal site of a fixed platform, from which several separate producing wells may be drilled. Often, those producing wells, because of the relation between the location of the fixed platform and the hydrocarbons, must be drilled at an angle from the platform, rather than through the vertical exploratory wells drilled initially from mobile rigs. Thus, the majority of the exploratory wells, even those which locate substantial quantities of hydrocarbons, will never be used as producing wells.

With respect to the particular offshore, exploration and production activities involved in this case, these operations followed the general pattern of offshore development as has already been outlined. Of the fifteen Gulf of Mexico wells at issue in this case, seven encountered hydrocarbons, but these exploratory wells were permanently plugged and abandoned. The eight other wells were either dry or experienced mechanical difficulty before reaching their intended depth. Following the drilling of the fifteen exploratory wells at issue and others, the combine in which Sun participated installed three fixed production platforms from which a total of forty-four producing wells were drilled.

In the North Sea, of the two wells here at issue, one was permanently plugged and abandoned, and the other temporarily plugged and abandoned. No production facility was ever ordered or built in this area.

Sun filed a consolidated corporate federal income tax return for 1971, in which it deducted from its gross income its allocable share of the costs incurred in that year in drilling the seventeen exploratory wells at issue, on the theory that such costs qualified as intangible drilling and development costs (IDC) deductible Treas.Reg. § 1.612-4(a). On audit, the Commissioner determined a deficiency in taxpayers' taxes based on the conclusion that the costs of the exploratory drilling here in question did not qualify for the IDC operation. The Commissioner asserted that no deduction was available since the drilling took place at an exploratory stage in the operations at a time when no decision had been made to develop the properties in question through the installment of production facilities. Taxpayers petitioned the Tax Court for redetermination. Rejecting the Commissioner's distinction between merely exploratory and developmental drilling, the Tax Court ruled that all of the drilling costs qualified for the IDC option.


Section 263(a) of the Internal Revenue Code states the general rule that taxpayers cannot deduct amounts paid "for permanent improvements or betterments made to increase the value of any property or estate." I.R.C. § 263(a)(1) Such expenses are capital in nature and are subject to eventual recovery by way of deductions for depreciation. See I.R.C. § 167. In this case, the parties do not dispute that under Section 263(a)(1), absent any other code provision, the costs of drilling exploratory wells from mobile rigs in offshore oil fields would be regarded as capital in nature and thus, not deductible other than through depreciation. However, Section 263(a)(1) is not the only Code provision bearing on this subject.

Section 263(c) exempts "intangible drilling and development costs in (connection with) oil and gas wells" from the general rule of ...

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