Rev. Rul. 70-354

Advice has been requested as to the treatment, for Federal income tax purposes, of the costs incurred for the purchase of gas (including liquefied petroleum gas) for injection into hydrocarbon reservoirs to aid in the recovery of native oil and gas under the circumstances described below.

The taxpayer, a producing company, periodically injects purchased gas in the reservoir in order to maintain pressure in the reservoir necessary to continue production of oil and gas at the maximum efficient rate, and to recover additional amounts of native oil and gas that would otherwise not be possible. This process is known in the industry as a "pressure maintenance program."

Alternatively, the taxpayer, by a miscible displacement process (known in the industry as an "enriched gas drive," a "high pressure gas drive," or a "miscible--slug drive,") injects into the reservoir purchased gas or a liquefied petroleum gas, or both, to realize a greater recovery of native oil or gas from the reservoir than would otherwise be possible. For example, an original injection of miscible material is usually followed by an injection of gas or water to maintain displacement in the reservoir of any previously injected material and the native oil and gas.

Institution of a program under either of these situations depends upon a number of factors such as geology and reservoir characteristics, the amount of recoverable reserves, and the probabilities of increased oil recovery through such program. The costs incurred for injected materials in both situations may or may not extend the economic life of the natural reservoir, but they are incurred primarily to maintain production and to increase the total recovery of native oil and gas.

In some cases a portion of the injected gas or liquefied petroleum gas may be recovered and reinjected as part of the pressure maintenance or miscible drive program. In some instances the program is unsuccessful from the beginning, while in others, the success or failure depends upon subsequent events and operations.

The specific questions involved relate to the time, character, and amount of deduction, if any, for Federal income tax purposes, for expenditures incurred for the cost of materials injected into the reservoirs.

Section 162(a) of the Internal Revenue Code of 1954 provides, in part, that there shall be allowed as a deduction all the ordinary and necessary business expenses paid or incurred during the taxable year in carrying on any trade or business.

Section 165(a) of the Code provides that there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise. Section 1.165-1(d) of the Income Tax Regulations provides, in part, that a loss shall be allowed as a deduction only for the taxable year in which the loss is sustained.

Under the circumstances described above, to capitalize these costs and to treat such costs as recoverable as the native oil and gas is produced would result in charging later recoverable units with high costs while earlier recoverable units would be charged with low costs. This situation would be particularly aggravated in those cases where some portion of the injected gas has been lost with little or no chance of recovery during subsequent operations.

On the other hand, to treat the costs of injected material as an ordinary and necessary business expense for the year of injection, under section 162 of the Code, is equally inappropriate since part of the injected material may be recovered and sold during subsequent production activities and in addition it is to be expected that a benefit will extend beyond the year of injection from the presence of the injected materials in the reservoir.

Where the taxpayer can show, by taking into account all the facts and circumstances, that a portion of the injected gas or liquefied petroleum gas cannot be expected to be recovered with subsequent production, the costs of the unrecoverable portion are deductible under section 165(a) of the Code in the taxable year of injection (or in subsequent taxable year in which he can show that such a loss has been sustained). It is the responsibility of the taxpayer to establish that a loss was sustained in accordance with section 1.165-1(d) of the regulations and the amount of such loss. An example of the type of showing which may be acceptable in support of such loss would be sound engineering studies and data reflecting the amount of loss. Under no circumstances will unsupported claims for losses be recognized. Further, so-called "economic losses" will not be recognized. An example of such a loss arises when the price paid for gas purchased for injection is claimed to be higher than the price that may be realized when the gas is subsequently produced and sold.

Costs not recoverable under the above provisions for any taxable year are not deductible under section 162 of the Code but are to be offset against the proceeds of the purchased gas or liquefied petroleum gas as it is produced (recovered) and sold during subsequent production activities to the extent properly allocable to such production.

Where the purchased injected gas or liquefied petroleum gas is produced (recovered) and sold, the proceeds realized in excess of the costs of the injected material properly allocable to such production are to be reported as ordinary income not subject to depletion.

Records must be maintained that clearly indicate the volumes of the injected, produced (recovered), and unrecovered materials and the costs allocable thereto. It is the responsibility of the taxpayer to establish the portion of native oil and gas and the portion of the purchased materials produced and sold. In those instances where a taxpayer is unable to identify the foregoing portions, the first hydrocarbons produced and sold during terminal operations will be considered purchased injected materials; and the net proceeds therefrom, after offset of unrecovered costs of the purchased materials properly allocable thereto, are to be reported as ordinary income not subject to depletion.