Rev. Rul. 73-469

The Internal Revenue Service has reconsidered that part of Rev. Rul. 70-354, 1970-2 C.B. 50, that relates to the Federal income tax treatment of costs incurred for the unrecoverable portion of purchased liquefied petroleum gas injected into a hydrocarbon reservoir to realize a greater recovery of native oil.

Rev. Rul. 70-354 holds, in part, that where a taxpayer can show, by taking into account all the facts and circumstances, that a portion of the injected liquefied petroleum gas cannot be expected to be recovered with subsequent production, the cost of the unrecoverable portion is deductible under section 165(a) of the Internal Revenue Code of 1954 in the taxable year of injection (or in a subsequent taxable year in which it can be shown that such a loss has been sustained).

The unrecoverable portion referred to in Rev. Rul. 70-354 relates only to that portion of the liquefied petroleum gas that is injected into the reservoir, remains in the reservoir, and imparts a benefit throughout the life of the reservoir as it allows a realization of greater recovery of native oil or gas from the reservoir than would otherwise be possible.

The taxpayer, an oil and gas producing company, owned and operated two separate properties identified as reservoirs A and B. The fields in which the reservoirs were located were approximately 30 miles apart. Each field was operated independently. However, it had been determined that both reservoirs would respond to a "miscible-slug drive" treatment to maintain the present production and increase the ultimate recovery of the oil trapped in the reservoirs.

During the taxable year 1969, the taxpayer injected a miscible-slug of purchased liquefied petroleum gas into each of the reservoirs. In 1971, a second slug was injected into reservoir B. Production from reservoir A continued to follow the normal decline experienced before the miscible-slug had been injected. The production from reservoir B indicated that there would be a greater recovery of native oil.

During the taxable year 1971, the taxpayer completed an engineering study and was able to establish that no benefit was being received from the injection of the liquefied petroleum gas into reservoir A, that no portion of the injected slug would ever be recovered through subsequent production, and that the project was a failure at that time.

Section 263(a) of the Code provides that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.

Section 162(a) of the Code provides, in part, that there shall be allowed as a deduction all the ordinary and 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 167(a) of the Code provides that there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) of property used in the trade or business, or held for the production of income.

Section 1.167(a)-2 of the Income Tax Regulations provides, in pertinent part, that the depreciation allowance does not apply to land apart from the improvements or physical developments added to the land. When an expenditure relates to an improvement or physical development added to the land, it may be subject to a depreciation allowance if the property meets all the requirements necessary for the application deduction.

A miscible-slug drive is a displacement process and is accomplished by injecting into a hydrocarbon reservoir a slug of intermediate hydrocarbons such as butane or propane, which is followed by the injection of a lean gas which is miscible with the slug solvent and serves as a displacing agent. The slug, being miscible with the native hydrocarbons, sweeps the reservoir fluid to the producing wells. This type of recovery process requires that the determined amount to be injected into the reservoir be accomplished with the placement of one or two slugs early in the life of the project and not at an ever continuing rate.

Since the hydrocarbon reserve is an asset, any expenditure to increase the ultimate recovery of hydrocarbons is a capital expenditure that increases or enhances the value of the hydrocarbon reserve. The expenditure for the purchased liquefied petroleum gas injected into the reservoir is made to benefit the reservoir beyond the year of injection thereby enhancing the value of the reserve by increasing the recoverable amounts thereof. In a successful project the unrecoverable liquefied petroleum gas provides a continuing benefit during the life of the project.

Accordingly, expenditures for the unrecoverable liquefied petroleum gas used in the miscible drive projects in reservoirs A and B are capital expenditures within the scope of section 263(a) of the Code, and not deductible as ordinary and necessary business expenses under section 162 of the Code. These expenditures are recoverable through depreciation under section 167 of the Code.

However, in the instant case the taxpayer established in 1971 that the remaining liquefied petroleum gas in reservoir A did not benefit production and the project was a failure. Therefore, the undepreciated portion of the expenditure for the unrecoverable liquefied petroleum gas injected into reservoir A is deductible as a loss under section 165(a) of the Code for 1971.

Rev. Rul. 70-354, 1970-2 C.B. 50, is hereby modified to the extent it holds that the costs of the unrecoverable portion of the injected liquefied petroleum gas that provides a benefit over the life of the project are deductible under section 165(a) of the Code in the year of injection.

Pursuant to the authority contained in section 7805(b) of the Code, the principles of this Revenue Ruling will not be applied to require the capitalization of the costs of the unrecoverable portion of the injected liquefied petroleum gas with respect to those taxpayers who treated the costs of such gas consistent with Rev. Rul. 70-354 for expenditures incurred on or before November 5, 1973, the date this Revenue Ruling is published in the Internal Revenue Bulletin.