YEAR OF INCLUSION OF DEFICIENCY TAKING AMOUNT UNDER GAS PURCHASE CONTRACTS

ISSUE

In what tax year must "deficiency taking" amounts be included in gross income under the circumstances described below?

FACTS

Corporation X, whose tax year is fiscal year ending June 30 and who uses an accrual method of accounting, is a natural gas producer. X sells gas under a "take or pay" gas purchase contract (the "contact") entered into with Corporation Y, a pipeline company. Under the terms of the contract, which became effective January 1, 1982, Y agrees to purchase a quantity of gas equal to 70 percent of X's delivery capacity during each calendar year accounting period (referred to in the contract as "aggregate daily contract quantities"). Y agrees to pay X by the end of each month for gas delivered to Y during the preceding month. However, if Y fails to take delivery of a quantity of gas equal to the aggregate daily contract quantities during the calendar year accounting period, Y is nevertheless required to pay X, within 30 days after the end of the calendar year accounting period, for the quantity of gas equal to the difference between the aggregate daily contract quantities and the quantities of gas actually purchased and taken (the "deficiency taking"). Under the terms of the contract, Y is entitled to receive the quantity of gas paid for but not taken in installments during the next succeeding four calendar year accounting periods (the "make-up" period), by applying the previously paid deficiency taking amounts as payment for gas taken in excess of the aggregate daily contract quantities during the make-up period. The contract life is 20 years.

Although X is on a fiscal year ending June 30 for federal income tax purposes, deficiency takings are calculated on a calendar year basis; that is, "deficiency takes" (a calculation for any period less than the contract year) occurring in the first six months of the calendar year accounting period may be offset by "overtakes" occurring in the last six months of the calendar year accounting period. Under the terms of the contract, payments for overtakes on one gas well may offset the amount due for deficiency takes on another gas well. Moreover, Y may reduce deficiency takes occurring during the calendar year to the extent. Y requests delivery of a quantity of gas and X fails to deliver such quantity of gas.

Although deficiency takes occurred during the period January 1, 1982 through June 30, 1982, the first six months of the calendar year accounting period ending December 31, 1982, X did not include the amount of the deficiency takes in gross income for its tax year ended June 30, 1982. Since the existence and amount of the deficiency taking was not fixed and determinable until December 31, 1982, the last day of the contract year, X did not include the amount of the deficiency taking in gross income until its tax year ended June 30, 1983.

LAW AND ANALYSIS

Section 451(a) of the Internal Revenue Code provides that the amount of any item of gross income shall be included in the gross income for the tax year in which received by the taxpayer, unless under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.

Section 1.451-1(a) of the regulations provides that under an accrual method of accounting, income is includible in gross income when all the events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.

The terms of the take or pay contract provide that Y is liable for payment to X for a minimum amount of gas even though Y does not take the required minimum amount in any given contract (calendar) year. All the events that fix the right to receive income under an accrual method of accounting occur when (1) the required performance occurs, (2) payment therefore is due, or (3) payment therefore is made, whichever happens first. See. Rev. Rul. 74-607, 1974- 2 C.B. 149.

In the instant situation, the required performance occurs during the contract year that X makes available to Y a quantity of gas. Under the terms of the contract, payment for deficiency takings, if any, is not due until 30 days after the end of the contract (calendar) year. Moreover, under the terms of the contract the amount of the deficiency taking, if any, is not determinable until the end of the contract (calendar) year. That is, "deficiency takes" occurring from January 1 through June 30 of any given year (the first six months of the contract year) may be offset (1) by "overtakes" occurring during the last six months of the contract year and (2) to the extent Y requests delivery of a quantity of gas during the last six months of the contract year and X fails to deliver such quantity of gas. To the extent there is a deficiency taking at the end of the contract year, X's right to receive the deficiency taking amount becomes fixed as of the last day of the contract (calendar) year. "Keeping accounts and making returns on the accrual basis, as distinguished from the cash basis, import that it is the right to receive and not the actual receipt that determines the inclusion of the amount of gross income." Spring City Foundry Co. v. Commissioner, 292 U.S. 182, 184, XIII-1 C.B. 281 (1934). While there were in fact deficiency takings for the period January 1, 1982 through June 30, 1982, the amount thereof was not fixed and determinable at June 30, 1982. Therefore, X is not required under the all events test of section 451 of the Code and the regulations thereunder to include the deficiency taking amounts in gross income for its tax year ended June 30, 1982.

HOLDING

The deficiency taking amount determined at December 31, 1982, the last day of the contract year, must be included in X's gross income for its tax year ended June 30, 1983, the tax year in which the amount of the deficiency taking became fixed and determinable.

Any change in the taxpayer's present method of accounting for take or pay deficiency amounts to the method described in this revenue ruling is a change in method of accounting to which the provisions of sections 446 and 481 of the Code apply.

This ruling is identified as a designated ruling pursuant to section 5.12 2 of Rev. Proc. 80-51, 1980-2 C.B. 818.