Final Regs on Percentage Depletion

 [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations relating to limitations on percentage depletion in the case of oil and gas wells. Changes to the applicable tax law were made by the Tax Reduction Act of 1975 and the Tax Reform Act of 1976. These regulations clarify the circumstances under which percentage depletion is available in the case of oil and gas wells.

 EFFECTIVE DATE: The amendments are effective on January 1, 1975 and apply to oil or gas which is produced after December 31, 1974, and to which gross income from the property is attributable after such year.

 FOR FURTHER INFORMATION CONTACT: Lisa A. Fagan, 202-566-4821 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection of information contained in this final regulation has been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-0919. The average burden associated with the collection of information in this final rule is reflected on forms 1065, 1041 and 706.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attention: IRS Reports Clearance Officer, T:FP, Washington, D.C. 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of Treasury, Washington, D.C. 20503.

BACKGROUND

 On May 13, 1977, the Federal Register published proposed amendments to the Income Tax Regulations (26 CFR Part 1) under sections 612, 613, 613A, 702, 703, and 705 of the Internal Revenue Code of 1954. These amendments were proposed to conform the regulations to section 501 of the Tax Reduction Act of 1975 (89 Stat. 47) and sections 1901(a)(86) and 2115 of the Tax Reform Act of 1976 (90 Stat. 1779, 1907). A public hearing was held on August 31, 1977. After consideration of all comments regarding the proposed amendments, those amendments are adopted as revised by this Treasury decision.

IN GENERAL

 With certain exceptions, the Tax Reduction Act of 1975 repealed percentage depletion for oil and gas produced and sold after December 31, 1974. In general, exemption from the repeal of percentage depletion is provided for certain production of independent producers and royalty owners, sometimes called the small producer exemption. Initially, an exemption of 2,000 barrels of average daily production for oil (or up to 12,000,000 cubic feet for natural gas if the taxpayer so elects) was provided. The amount was reduced by 200 barrels a year for 5 years from 1976 through 1980, when the permanent exemption of 1,000 barrels per day was reached. The depletion rate for oil and gas covered under this exemption was also phased down gradually from 22 percent to 15 percent. In 1981, the rate was 20 percent; in 1982, 18 percent; in 1983, 16 percent; and in 1984 and thereafter the rate is reduced to a permanent level of 15 percent. In the case of secondary or tertiary production prior to 1984, the small producer exemption permits a taxpayer to take percentage depletion at a 22 percent rate on the exempt quantity.

 Section 613A provides for certain limitations on the application of the small producer exemption. The deduction resulting from the small producer exemption may not exceed 65 percent of the taxpayer's taxable income from all sources (computed without regard to depletion, net operating loss carrybacks and capital loss carrybacks). Moreover, the exemption relating to average daily production is generally not available to a transferee of any interest in a proven oil or gas property transferred after December 31, 1974. The small producer exemption does not apply to a taxpayer who directly or through a related person sells oil or natural gas, or any product derived from oil or natural gas, through a retail outlet or to certain persons. If the taxpayer or a related person engages in the refining of crude oil and has refinery runs that exceed 50,000 barrels on any day during the taxable year, the small producer exemption is also not available to such taxpayer.

BUSINESSES UNDER COMMON CONTROL

 A comment on the notice of proposed rulemaking suggested that section 1.613A-3(g) (redesignated as section 1.613A-3(h)) be clarified to indicate which subparagraph is applicable in a case where a group of corporations meets both the definitions of "component members of a controlled group" in subparagraph (1) and "businesses under common control" in subparagraph (2). The regulations have been revised to provide that the rules relating to aggregation of business entities under common control in subparagraph (2) are inapplicable to component members of a controlled group of corporations that are subject to subparagraph (1).

 Subparagraph (2) of section 1.613A-3(h) (as redesignated) has also been revised to clarify that in determining whether the requisite ownership interest is held an interest owned by or for a corporation, partnership, trust, or estate is treated as owned directly both by itself and proportionately by its shareholders, partners, or beneficiaries, as the case may be.

 An additional example has been provided in redesignated section 1.613A-3(h)(5) to illustrate the inapplicability of the requirement to allocate the tentative quantity among business entities under common control to a retailer entity.

BONUS AND ADVANCED ROYALTY

 The proposed regulations provided that a bonus payment does not qualify for percentage depletion and that advanced royalties, to the extent that actual production during the taxable year is insufficient to earn such royalties, do not qualify for percentage depletion. However, the Supreme Court, in Commissioner v. Engle, 464 U.S. 206 (1984), held that the adoption of section 613A by the Congress was not intended to disallow percentage depletion on a bonus or advanced royalty payment even when there was no actual production in the year of receipt. In light of the Engle case, the final regulations provide rules consistent with Announcement 84-59 (May 18, 1984) allowing percentage depletion for lease bonuses and advanced royalties received or accrued before August 17, 1986.

SIXTY-FIVE PERCENT LIMITATION

 Several comments indicated that it is improper for the regulations under section 1.613A-4(a) to require a reduction of the taxpayer's taxable income upon which the 65 percent limitation is computed by cost depletion on a property where cost depletion exceeds percentage depletion (before application of any of the limitations in section 613A) and asked that this provision be deleted. This suggestion was not adopted. Section 613A(d)(1) provides that only depletion on production from an oil or gas property which is subject to the provisions of section 613A(c) is to be disregarded. Since section 613A(c) is inapplicable to an oil or gas property the production of which is entitled to cost depletion, the taxpayer's taxable income must be reduced by the cost depletion deduction.

RETAILER EXCLUSION

 It was suggested that example (1) in section 1.613A-4(b)(2) be revised to provide that the retailer exclusion is inapplicable to both A and Corporation M if neither A nor Corporation M has gross receipts from retail sales in excess of $5 million even though their aggregate gross receipts exceed $5 million. This suggestion was not adopted. Section 613A(d)(2) provides that the computation of the $5 million is to be based on the combined gross receipts of all retail outlets. Accordingly, the gross receipts from retail outlets owned by the taxpayer or a related person of the taxpayer must be taken into account for this purpose since such retail outlets are relevant to the determination of retailer status. An additional example has been provided to illustrate the application of this rule.

 In response to a comment, example (5) (designated as example (4) in the proposed regulations) has been revised to make it clear that only gross receipts exceeding 5 million dollars from the sale of production by B to Corporation T would result in the characterization of B as a retailer.

DEFINITION OF NATURAL GAS SOLD UNDER A FIXED CONTRACT

 In response to several comments, the regulations have been revised to increase the number of situations in which taxpayers may demonstrate by clear and convincing evidence that the price increases after February 1, 1975, do not take increases in tax liabilities into account.

AVERAGE DAILY PRODUCTION

 Under the proposed regulations, the term "average daily production" means the taxpayer's aggregate production extracted after December 31, 1974, and to which gross income from the property is attributable during the taxable year, divided by the number of days in such year. Thus, under this provision, the applicable exemption amount and percentage depletion rate for production extracted in one year and sold in the next year are determined in accordance with the exemption amount and percentage depletion rate for the year to which gross income from the property is attributable, i.e., the year of sale. Several comments suggested that the year of extraction should be the sole determinant of the exemption amount and the depletion rate since these limitations are expressed in section 613A in terms of the taxpayer's production and not in terms of sale. These comments were not adopted.

 Section 613A(c)(1) provides that the allowance for depletion under section 611 shall be computed "in accordance with section 613" with respect to average daily production that does not exceed a taxpayer's depletable oil quantity. Section 613(a) provides that the allowance for depletion under section 611 shall be the specified percentage of the "gross income from the property." "Gross income from the property" in the case of oil and gas wells is the amount for which the taxpayer sells the oil and gas in the immediate vicinity of the well. (See section 1.613-3(a)). Accordingly, while section 613A(c) imposes limitations on the amount of qualified production in each calendar year and the percentage depletion rate for such year, the year to which production is attributable is the year in which percentage depletion is allowable and that is the year in which there is gross income from the property.

 Furthermore, failure to adopt the rule in the proposed regulations would result in the exclusion of current-year production sold in a subsequent year from the calculation of percentage depletion with respect to the gross income from the property from such sale in such subsequent year. Thus, the income from the production would not be offset by the depletion deduction attributable to it. A similar mismatching would result in the calculation of percentage depletion with respect to production in excess of the depletable oil quantity under section 613A(c)(7).

 The regulatory rule is not inconsistent with the holding in Rev. Rul. 81-168, 1981-1 C.B. 384. That ruling was concerned with whether oil produced in 1974 and sold in 1975 was subject to the limitations of section 613A which became effective on January 1, 1975. On the question of the effective date, the ruling holds that since the oil was extracted in 1974 it is not subject to the section 613A restrictions applicable to oil produced in 1975. The ruling deals solely with the effective date of section 613A and does not purport to interpret the provisions of section 613A. The ruling does not deal with the interaction of sections 613(a) and 613A when production occurs in 1975 or subsequent years.

SECONDARY OR TERTIARY PRODUCTION

 Several comments suggested that the term "secondary or tertiary production" should be defined to mean all production recovered from a well after the application of enhanced recovery processes (as distinguished from the increase in production after that application). This suggestion was not adopted because the higher statutory rate was intended to apply only to oil that would not have been produced absent the introduction of such processes. Furthermore, allowing all production to qualify for the higher rate would provide an incentive to introduce secondary or tertiary processes prematurely and in cases where the incremental production would otherwise be uneconomical even at the higher depletion rate.

ALLOCATION OF BASIS TO PARTNERS

 Section 613A(c)(7)(D) provides that, in the case of a partnership, the depletion allowance shall be computed separately by the partners based on each partner's proportionate share of the adjusted basis of each partnership oil or gas property. Proposed regulations interpreting this section are being reproposed and these new proposed regulations appear in the same issue of the Federal Register as this final regulation.

RETAILER DEFINITION

 Section 1.613A-7(r)(2) has been revised to provide that in determining whether a taxpayer satisfies the $5 million small retailer exception of section 613A(d)(2), only sales by the taxpayer to a person specified in section 613A(d)(2)(B)(ii) shall be included (rather than all sales by that person). This provision is consistent with the holding in Witco Chemical Corp. v. United States, 742 F.2d 615 (Fed. Cir. 1984). However, in view of the statutory language of section 613A(d)(2), the regulations do not follow the holding of Witco with respect to the definition of a retail sale. The statute clearly indicates that the bulk sales exclusion rule extends only to bulk sales of oil and natural gas and not to products derived from oil or natural gas. (See placement of parenthetical in section 613A(d)(2)). This is consistent with the legislative intent which was to exclude producers having large volume sales of crude or natural gas to industrial or commercial users from being deemed to be retailers.

 The definition of "any product derived from oil or natural gas" has been revised to mean any product recovered from petroleum refineries or extracted from natural gas in field facilities or natural gas processing plants. As amended, this definition would not treat residue methane gas as a product. This revision is made solely for purposes of the retailer exclusion rule and does not in any way affect or change the cut-off rules for determining gross income from the property.

 In response to a comment, the regulations have been revised to make it clear that bulk sales of oil or natural gas to industrial and commercial users are to be disregarded for purposes of determining a retail outlet.

 As revised, the regulations define bulk sales of oil or natural gas to mean sales of such items in very large quantities. It is not necessary that the quantity sold be in excess of the quantity customarily sold to be considered sold in bulk.

REFINER DEFINITION

 The regulations have been revised to provide that the refinery runs of the taxpayer are to be based on the input into the refining process as opposed to the output. The regulations further provide that a refinery run will include only inputs of crude oil as opposed to crude oil products (feedstock) into the refining process.

DRAFTING INFORMATION

 The principal author of this regulation is Walter H. Woo of the office of Assistant Chief Counsel (Passthroughs and Special Industries) of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulation, both on matters of substance and style.

SPECIAL ANALYSIS

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. Chapter 5) and the Regulatory Flexibility Act (5 U.S.C. Chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required.

LIST OF SUBJECTS

26 CFR 1.611-0 through 1.617-4

Income taxes, Natural resources, Reporting and recordkeeping requirements.

26 CFR 1.701-1 through 1.771-1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority for part 1 continues to read in part as follows.:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Paragraph (d) of section 1.612-3 is revised to read as follows:

SECTION 1.612-3 DEPLETION; TREATMENT OF BONUS AND ADVANCED ROYALTY.

* * * * *

(d) PERCENTAGE DEPLETION DEDUCTION WITH RESPECT TO BONUS AND ADVANCED ROYALTY. In lieu of the allowance based on cost depletion computed under paragraphs (a) and (b) of this section, the payees referred to therein may be allowed a depletion deduction in respect of any bonus or advanced royalty for the taxable year in an amount computed on the basis of the percentage of gross income from the property as provided in section 613 and the regulations thereunder. However, for special rules applicable to certain bonuses and advanced royalties received in connection with oil or gas properties, see paragraph (j) of section 1.613A-3.

* * * * *

Par. 3. Section 1.613-1 is revised to read as follows:

SECTION 1.613-1 PERCENTAGE DEPLETION; GENERAL RULE.

(a) IN GENERAL. In the case of a taxpayer computing the deduction for depletion under section 611 with respect to minerals on the basis of a percentage of gross income from the property, as defined in section 613(c) and sections 1.613-3 and 1.613-4, the deduction shall be the percentage of the gross income as specified in section 613(b) and section 1.613-2. The deduction shall not exceed 50 percent of the taxpayer's taxable income from the property (computed without allowance for depletion). The taxable income shall be computed in accordance with section 1.613-5. In no case shall the deduction for depletion computed under this section be less than the deduction computed upon the cost or other basis of the property provided in section 612 and the regulations thereunder. The apportionment of the deduction between the several owners of economic interests in a mineral deposit will be made as provided in paragraph (c) of section 1.611-1. For rules with respect to "gross income from the property" and for definition of the term "mining," see sections 1.613-3 and 1.613-4. For definitions of the terms "property," "mineral deposit," and "minerals," see paragraph (d) of section 1.611-1.

(b) DENIAL OF PERCENTAGE DEPLETION IN CASE OF OIL AND GAS-WELLS. Except as otherwise provided in section 613A and the regulations thereunder, in the case of oil or gas which is produced after December 31, 1974, and to which gross income is attributable after that date, the allowance for depletion shall be computed without regard to section 613.

Par. 4. New section 1.613A-0 is added and the text of sections 1.613A-2, 1.613A-3, 1.613A-4, and 1.613A-7 are added to read as follows:

SECTION 1.613A-0. LIMITATIONS ON PERCENTAGE DEPLETION IN THE CASE OF OIL AND GAS WELLS; TABLE OF CONTENTS.

This section lists the paragraphs contained in sections 1.613A-0 through 1.613A-7.

 SECTION 1.613A-1 POST-1974 LIMITATIONS ON PERCENTAGE DEPLETION IN CASE OF OIL AND GAS

(a) The allowance for depletion under section 611 shall be computed in accordance with section 613 with respect to:

(1) Regulated natural gas (as defined in paragraph (c) of section 1.613A-7),

(2) Natural gas sold under a fixed contract (as defined in paragraph (d) of section 1.613A-7), and

(3) Any geothermal deposit in the United States or in a possession of the United States which is determined to be a gas well within the meaning of former section 613(b)(1)(A) (as in effect before enactment of the Tax Reduction Act of 1975),

and 22 percent shall be deemed to be specified in section 613(b) for purposes of section 613(a).

(b) For special rules applicable to partnerships, S corporations, trusts, and estates, see paragraphs (e), (f), and (g) of section 1.613A-3.

(c) The provisions of this section may be illustrated by the following examples:

EXAMPLE 1. A is a producer of natural gas which is sold by A under a contract in effect on February 1, 1975. The contract provides for an increase in the price of the gas sold under the contract to the highest price paid to a producer for natural gas in the area. The gas sold by A qualifies under section 613A(b)(1)(B) for percentage depletion as gas sold under a fixed contract until its price increases, but is presumed not to qualify thereafter unless A demonstrates by clear and convincing evidence that the price increase in no event takes increases in tax liabilities into account.

EXAMPLE 2. B is a producer of natural gas which is sold by B under a contract in effect on February 1, 1975. The contract provides that beginning January 1, 1980, the price of the gas may be renegotiated. Such a provision does not disqualify gas from qualifying for the exemption under section 613A(b)(1)(B) with respect to the gas sold prior to January 1, 1980. However, gas sold on or after January 1, 1980, does not qualify for the exemption whether or not the price of the gas is renegotiated.

SECTION 1.613A-3 EXEMPTION FOR INDEPENDENT PRODUCERS AND ROYALTY OWNERS.

(a) GENERAL RULES.

(1) Except as provided in section 613A(d) and section 1.613A-4, the allowance for depletion under section 611 with respect to oil or gas which is produced after December 31, 1974, and to which gross income from the property is attributable after that date, shall be computed in accordance with section 613 with respect to:

(i) So much of the taxpayer's average daily production (as defined in paragraph (f) of section 1.613A-7) of domestic crude oil (as defined in paragraphs (a) and (g) of section 1.613A-7) as does not exceed the taxpayer's depletable oil quantity (as defined in paragraph (h) of section 1.613A-7), and

(ii) So much of the taxpayer's average daily production of domestic natural gas (as defined in paragraphs (a) and (b) of section 1.613A-7) as does not exceed the taxpayer's depletable natural gas quantity (as defined in paragraph (i) of section 1.613A-7), and the applicable percentage (determined in accordance with the table in paragraph (c) of this section shall be deemed to be specified in section 613(b) for purposes of section 613(a).

(2) Except as provided in section 613A(d) and section 1.613A-4, the allowance for depletion under section 611 with respect to oil or gas which is produced after December 31, 1974, and to which gross income from the property is attributable after that date and before January 1, 1984, shall be computed in accordance with section 613 with respect to:

(i) So much of the taxpayer's average daily secondary or tertiary production (as defined in paragraph (k) of section 1.613A-7) of domestic crude oil as does not exceed the taxpayer's depletable oil quantity (determined without regard to section 613A(c)(3)(A)(ii), as in effect prior to the Revenue Reconciliation Act of 1990), and

(ii) So much of the taxpayer's average daily secondary or tertiary production of domestic natural gas as does not exceed the taxpayer's depletable natural gas quantity (determined without regard to section 613A(c)(3)(A)(ii), as in effect prior to the Revenue Reconciliation Act of 1990), and 22 percent shall be deemed to be specified in section 613(b) for purposes of section 613(a).

(3) For purposes of this section, there shall not be taken into account any production with respect to which percentage depletion is allowed pursuant to section 613A(b) or is not allowable by reason of section 613A(c)(9), as in effect prior to the Revenue Reconciliation Act of 1990.

(4) The provisions of this paragraph may be illustrated by the following examples:

EXAMPLE 1. A, a calendar year taxpayer, owns an oil producing property with 100,000 barrels of production to which income was attributable for 1975 and a gas producing property with 1,200,000,000 cubic feet of production to which income was attributable for 1975. Under section 613A(c)(4), the oil equivalent of 1,200,000,000 cubic feet of gas is 200,000 barrels, bringing A's total production of oil and gas to which income was attributable for 1975 to the equivalent of 300,000 barrels of oil. A's average daily production was 821.92 barrels (300,000 barrels / 365 days) which is less than the depletable oil quantity (2,000 barrels) before reduction for any election by A under section 613A(c)(4). Accordingly, A may make an election with respect to A's entire gas production and thereby be entitled to percentage depletion with respect to A's entire 1975 income from production of oil and gas. A's allowable depletion pursuant to section 613A(c) for A's oil and gas properties would be the amount determined under section 613(a) computed at the 22 percent rate specified in section 613A(c)(5), as in effect prior to the Revenue Reconciliation Act 1990, for 1975.

EXAMPLE 2. B, a calendar year taxpayer, owns oil producing properties with 365,000 barrels of production to which income was attributable for 1975. B was a retailer of oil and gas for only the last 3 months of 1975. B's average daily production for 1975 was 1,000 barrels (365,000 barrels / 365 days).

EXAMPLE 3. C, a calendar year taxpayer, owns property X with 500,000 barrels of primary production to which income was attributable for 1975 and property Y with 200,000 barrels of primary production to which income was attributable for 1975. Property Y had been transferred to C on January 1, 1975, on which date it was a proven property. Therefore, the exemption under section 613A(c)(1) does not apply to C with respect to production from property Y. In determining C's depletable oil quantity for the year, the production from property Y is not taken into account. Thus, C's average daily production for 1975 was 1,369.86 barrels (500,000 barrels / 365).

EXAMPLE 4. D owns an oil property with producing wells X and Y on it. In 1975 D converts well X into an injection well. Prior to the application of the secondary process, it is estimated that without the application of the process the annual production from well X would have been 50x barrels of oil and from well Y would have been 100x barrels of oil. For the taxable year in which injection is commenced production from well X is 10x barrels and from well Y is 180x barrels. Forty x barrels of oil [190x barrels of oil (actual production from the property) - 150x barrels (estimate of primary production from the property)] qualify as secondary production.

EXAMPLE 5. E, a calendar year taxpayer, owns a domestic oil well which produced 100,000 barrels of oil in 1980. The proceeds from the sale of 15,000 barrels of that production are not includible in E's income until 1981. The 15,000 barrels produced in 1980 are included in E's average daily production for 1981 and excluded from such production for 1980. The tentative quantity and the percentage depletion rate for 1981 are applicable to the 15,000 barrels of oil.

(b) PHASE-OUT TABLE. For purposes of section 613A(c)(3)(A)(i) and section 1.613A-7 (h) (relating to depletable oil quantity) --

 In the case of production               The tentative quantity

 In the case of production               The applicable

(i) If the taxpayer's average daily production of domestic crude oil exceeds his depletable oil quantity, the allowance for depletion pursuant to section 613A(c)(1)(A) and paragraph (a)(1)(i) of this section with respect to oil produced during the taxable year from each property in the United States shall be that amount which bears the same ratio to the amount of depletion which would have been allowable under section 613(a) for all of the taxpayer's oil produced from the property during the taxable year (computed as if section 613 applied to all of the production at the rate specified in paragraph (c) of this section) as the amount of his depletable oil quantity bears to the aggregate number of barrels representing the average daily production of domestic crude oil of the taxpayer for such year.

(ii) If the taxpayer's average daily production of domestic natural gas exceeds his depletable natural gas quantity, the allowance for depletion pursuant to section 613A(c)(1)(B) and paragraph (a)(1)(ii) of this section with respect to natural gas produced during the taxable year from each property in the United States shall be that amount which bears the same ratio to the amount of depletion which would have been allowable pursuant to section 613(a) for all of the taxpayer's natural gas produced from the property during the taxable year (computed as if section 613 applied to all of the production at the rate specified in paragraph (c) of this section) as the amount of his depletable natural gas quantity in cubic feet bears to the aggregate number of cubic feet representing the average daily production of domestic natural gas of the taxpayer for such year.

(2) SECONDARY OR TERTIARY PRODUCTION.

(i) If the taxpayer's average daily secondary or tertiary production of domestic crude oil exceeds his depletable oil quantity (determined without regard to section 613A(c)(3)(A)(ii), as in effect prior to the Revenue Reconciliation Act of 1990), the allowance for depletion pursuant to section 613A(c)(6)(A)(i), as in effect prior to the Revenue Reconciliation Act of 1990, and paragraph (a)(2)(i) of this section with respect to oil produced during the taxable year from each property in the United States shall be that amount which bears the same ratio to the amount of depletion which would have been allowable pursuant to section 613(a) for all of the taxpayer's secondary or tertiary production of oil from the property during the taxable year (computed as if section 613 applied to all of the production at the rate specified in paragraph (a)(2) of this section) as the amount of his depletable oil quantity (determined without regard to section 613A(c)(3)(A)(ii), as in effect prior to the Revenue Reconciliation Act of 1990) bears to the aggregate number of barrels representing the average daily secondary or tertiary production of domestic crude oil of the taxpayer for such year.

(ii) If the taxpayer's average daily secondary or tertiary production of domestic natural gas exceeds his depletable natural gas quantity (determined without regard to section 613A(c)(3)(A)(ii), as in effect prior to the Revenue Reconciliation Act of 1990), the allowance for depletion pursuant to section 613A(c)(6)(A)(ii), as in effect prior to the Revenue Reconciliation Act of 1990, and paragraph (a)(2)(ii) of this section with respect to natural gas produced during the taxable year from each property in the United States shall be that amount which bears the same ratio to the amount of depletion which would have been allowable pursuant to section 613(a) for all of the taxpayer's secondary or tertiary production of natural gas from the property during the taxable year (computed as if section 613 applied to all of the production at the rate specified in paragraph (a)(2) of this section) as the amount of his depletable natural gas quantity in cubic feet (determined without regard to section 613A(c)(3)(A)(ii), as in effect prior to the Revenue Reconciliation Act of 1990) bears to the aggregate number of cubic feet representing the average daily secondary or tertiary production of domestic natural gas of the taxpayer for such year.

(iii) This paragraph (d)(2) shall not apply after December 31, 1983.

(3) TAXABLE INCOME FROM THE PROPERTY. If both oil and gas are produced from the property during the taxable year, then for purposes of section 613A(c)(7)(A) and (B) and paragraph (d) of this section the taxable income from the property, in applying the taxable income limitation in section 613(a), shall be allocated between the oil production and the gas production in proportion to the gross income from the property during the taxable year from each. If both gas with respect to which section 613A(b) and section 1.613A-2 apply and oil or gas with respect to which section 613A(c) and this section apply are produced from the property during the taxable year, then for purposes of section 613A(d)(1) and paragraph (a) of section 1.613A-4 the taxable income from the property, in applying the taxable income limitation in section 613(a), shall also be so allocated. In addition, if both primary production and secondary or tertiary production (to which gross income from the property is attributable before January 1, 1984) are produced from the property during the taxable year and the total amount of production is in excess of the depletable quantity, then for purposes of paragraph (d) of this section the taxable income from the property, in applying the taxable income limitation in section 613(a), shall also be so allocated.

(4) EXAMPLES. The application of this paragraph may be illustrated by the following examples:

EXAMPLE 1. A owns Y and Z oil producing properties. With respect to properties Y and Z, the percentage depletion allowable pursuant to section 613(a) (computed as if section 613 applied to all of the production at the rate specified in section 613A(c)(5)) for 1975 was $100x and $200x, respectively. A's average daily production for 1975 was 4,000 barrels. A's allowable depletion pursuant to section 613A(c) with respect to property Y was $50x: [$100x depletion (2,000 depletable oil quantity/ 4,000 average daily production)]. A's allowable depletion pursuant to section 613A(c) with respect to property Z was $100x ($200x depletion x 2,000 depletable oil quantity/ 4,000 average daily production).

EXAMPLE 2. B owns gas producing properties which had secondary gas production for 1975 of 3,285,000,000 cubic feet, which under section 613A(c)(4) is equivalent to 547,500 barrels of oil. B's average daily secondary production of gas for 1975 was equivalent to 1,500 barrels (547,500 barrels / 365). B elected to have section 613A(c)(4) apply to the gas production. With respect to the production, the percentage depletion allowable pursuant to section 613(a) (computed at the rate specified in section 613A(c)(6)(A), as in effect prior to the Revenue Reconciliation Act of 1990) was $150x. B also owns an oil producing property which had primary oil production for 1975 of 365,000 barrels. B's average daily production of oil for 1975 was 1,000 barrels (365,000 / 365). With respect to the oil property, the percentage depletion allowable pursuant to section 613(a) (computed as if section 613 applied to all of the production at the rate specified in section 613A(c)(5), as in effect prior to the Revenue Reconciliation Act of 1990) was $100x. B's depletable oil quantity for 1975 was 500 barrels (2,000 barrels tentative quantity - 1,500 barrels average daily secondary production). B's allowable depletion pursuant to section 613A(c) with respect to the oil property was $50x ($100x depletion x 500 depletable oil quantity / 1,000 average daily production).

EXAMPLE 3. Assume the same facts as in Example 2 except that B's primary production was 6,000,000 cubic feet of natural gas daily rather than its equivalent under section 613A(c)(4) of 1,000 barrels of oil and that B elected to have that section apply to such gas. B's allowable depletion pursuant to section 613A(c) with respect to B's primary production is $50x, the same as in example (2).

EXAMPLE 4. C is a partner with a one-third interest in Partnerships CDE and CFG with each partnership owning a single oil property. C's percentage depletion allowable under section 613(a) (computed as if section 613 applied to all of the production at the rate specified in section 613A(c)(5), as in effect prior to the Revenue Reconciliation Act of 1990) for 1975 was $20x with respect to 495,000 barrels (his allocable share of Partnership CDE production) and $40x with respect to 600,000 barrels (his allocable share of Partnership CFG production). C's average daily production is 3,000 barrels (1,095,000 total production / 365 days). C's allowable depletion pursuant to section 613A(c) with respect to C's share of the production of Partnership CDE is $13.33x ($20x depletion x 2,000 depletable oil quantity/ 3,000 average daily production). C's allowable depletion pursuant to section 613A(c) with respect to C's share of the production of Partnership CFG is $26.67x ($40x depletion x 2,000 depletable oil quantity/ 3,000 average daily production). See section 1.613A-3(e) for the rules on computing depletion in the case of a partnership.

EXAMPLE 5. H owns a property which, during H's fiscal year which began on June 1, 1975, and ended on May 31, 1976, produced gas qualifying under section 613A(b) and oil qualifying under section 613A(c). For the fiscal year H's gross income from the property was $400x, of which $100x was from gas and $300x was from oil. For the oil his gross income from the property for the period beginning June 1, 1975, and ending December 31, 1975, was $100x and for the 1976 portion of the fiscal year was $200x. The percentage depletion allowance (before applying the 50 percent limitation of section 613(a) or the 65 percent limitation of section 613A(d)(1)) was $22x for the gas, $22x for the oil in 1975, and $44x for the oil in 1976. H's taxable income from the property for the fiscal year was $100x. In accordance with paragraph (d)(3) of this section, the taxable income from the property is allocated $25x to the gas:

 [$100x taxable income from the property

(e) PARTNERSHIPS. [Reserved]

(f) S CORPORATIONS. [Reserved]

(g) TRUSTS AND ESTATES.

(1) In the case of production from domestic oil and gas properties held by a trust or estate, the depletion allowance under section 611 shall be computed initially by the trust or estate. The determination of whether cost or percentage depletion is applicable shall be made at the trust or estate level, but such determination shall not result in the disallowance of cost depletion to a beneficiary of a trust or estate for whom cost depletion exceeds percentage depletion. The limitations contained in section 613A(c) and (d), other than section 613A(d)(1), shall be applied at the trust or estate level in its computation of percentage depletion pursuant to section 613A and shall also be applied by a beneficiary with respect to any percentage depletion apportioned to the beneficiary by the trust or estate. The limitation of section 613A(d)(1) shall be applied by each taxpayer (i.e., trust, estate or beneficiary) only with respect to its allocable share of percentage depletion under section 611(b)(3) or (4). For purposes of adjustments to the basis of oil or gas properties held by a trust or estate, in the absence of clear and convincing evidence to the contrary, it shall be presumed that no beneficiary is affected by any section 613A(d) limitations or by the rules contained in section 613A(c)(8) and (9) (relating to businesses under common control and members of the same family and to transfers, respectively), as in effect prior to the Revenue Reconciliation Act of 1990, or has any oil or gas production from sources other than the trust or estate.

(2) The provisions of this paragraph may be illustrated by the following examples.

EXAMPLE 1. A is the income beneficiary of a trust the only asset of which is a domestic producing oil property. The trust instrument requires that an amount which equals 10 percent of the gross income from the property be set aside annually as a reserve for depletion. In 1975 the property had production of 1,095,000 barrels of oil. The trust's gross income from the property in 1975 was $30,000x. In that year, after setting aside $3,000x of income for the reserve for depletion, the trustee distributed the remaining income to A which represented 80 percent of the trust's net income. The percentage depletion computed by the trust with respect to the production (computed as if section 613 applied to all of the production at the rate specified in section 613A(c)(5), as in effect prior to the Revenue Reconciliation Act of 1990) for 1975 was $6,600x. The trust's average daily production for 1975 was 3,000 barrels (1,095,000 / 365 days). The trust's allowable depletion pursuant to section 613A(c) with respect to the production was $4,400x:

 [                   (2,000 depletable oil quantity )]

EXAMPLE 2. B, a retailer of oil and gas, is the income beneficiary of a trust the only asset of which is a domestic producing oil property. In 1975 the trustee distributed one-half of the trust's net income and accumulated the other one-half for the benefit of the remainderman. One-half of the percentage depletion computed by the trust with respect to the production from the property was apportioned to B. Since B is a retailer of oil and gas, B is not entitled to deduct any of the percentage depletion apportioned to B. However, B is entitled to take cost depletion with respect to one-half of the production from the oil property, notwithstanding the fact that depletion was computed at the trust level on the basis of percentage depletion.

(h) BUSINESSES UNDER COMMON CONTROL; MEMBERS OF THE SAME FAMILY -- (1) COMPONENT MEMBERS OF A CONTROLLED GROUP. For purposes of only the depletable quantity limitations contained in section 613A (c) and this section, component members of a controlled group of corporations (as defined in paragraph (1) of section 1.613A-7) shall be treated as one taxpayer. Accordingly, the group shares the depletable oil (or natural gas) quantity prescribed for a taxpayer for the taxable year and the secondary production of a member of the group will reduce the group's depletable quantity prior to its allocation among members in proportion to their production.

(2) AGGREGATION OF BUSINESS ENTITIES UNDER COMMON CONTROL. If 50 percent or more of the beneficial interest in any two or more entities (i.e., corporations, trusts, or estates) is owned by the same or related persons (taking into account only each person who owns at least 5 percent of the beneficial interest in an entity and with respect to such person his or her entire interest) as defined in paragraph (m)(2) of section 1.613A-7, the tentative quantity determined under the table in section 613A(c)(3)(B) (as in effect prior to the Revenue Reconciliation Act of 1990) for a taxpayer for the taxable year shall be allocated among all such entities in proportion to their respective production. This paragraph (h)(2) shall not apply to component members of a controlled group of corporations (as defined in section 1.613A-7(l)). For purposes of determining ownership interest, an interest owned by or for a corporation, partnership, trust, or estate shall be considered as owned directly both by itself and proportionately by its shareholders, partners, or beneficiaries, as the case may be.

(3) ALLOCATION AMONG MEMBERS OF THE SAME FAMILY. In the case of individuals who are members of the same family, the tentative quantity determined under the table in section 613A(c)(3)(B) (as in effect prior to the Revenue Reconciliation Act of 1990) for a taxpayer for the taxable year shall be allocated among such individuals in proportion to the respective production of barrels of domestic crude oil (and the equivalent in barrels to the cubic feet of natural gas determined under paragraph (h)(4)(ii) of this section) during the period in question by such individuals.

(4) SPECIAL RULES. For purposes of section 613A(c)(8) and this section --

(i) The family of an individual includes only his spouse and minor children, and

(ii) Each 6,000 cubic feet of domestic natural gas shall be treated as 1 barrel of domestic crude oil.

(5) EXAMPLES. The application of this paragraph may be illustrated by the following examples:

EXAMPLE 1. A owns 50 percent of the stock of Corporation M and 50 percent of the stock of Corporation N. Both corporations are calendar year taxpayers. For 1975 Corporation M's production of domestic crude oil was 8,000,000 barrels (365,000 of which was secondary production) and Corporation N's was 2,000,000 barrels (all of which was primary production). The tentative quantity (2,000 barrels per day) determined under the table in section 613A(c)(3)(B) (as in effect prior to the Revenue Reconciliation Act of 1990) must be allocated between the two corporations in proportion to their respective barrels of production of domestic crude oil during the taxable year. Corporation M's allocable share of the tentative quantity is 1,600 barrels:

 [      ( 8,000,000)]

EXAMPLE 2. Assume the same facts as in Example 1 except that Corporation M is a retailer and Corporation N is not selling its oil through Corporation M. Because Corporation M is a retailer, no portion of the tentative quantity is allocated to Corporation M. Accordingly, Corporation N's depletable oil quantity is the entire 2,000 barrels per day because section 613A(c), which contains the allocation requirements, is inapplicable to retailers.

EXAMPLE 3. Corporations O and P are members of a controlled group and are treated as one taxpayer as provided in paragraph (h)(1) of this section. Corporation O owns oil properties A and B. Property A had primary production for 1975 of 800,000 barrels of oil. Property B had secondary production for 1975 of 365,000 barrels of oil. Corporation P owns oil property C which had primary production of 660,000 barrels for 1975. The allowable percentage depletion with respect to property B's secondary production was $360x. The controlled group's average daily production was 4,000 barrels [(800,000 + 660,000) / 365]. The controlled group's depletable oil quantity was 1,000 barrels [2,000 tentative quantity - 1,000 average daily secondary production (365,000 / 365)]. The allowable percentage depletion pursuant to section 613(a) (computed as if section 613 applied to all of the production at the rate specified in section 613A(c)(5), as in effect prior to the Revenue Reconciliation Act of 1990) was $800x with respect to production from property A and $660x with respect to production from property C.

Corporation O's allowable depletion pursuant to section 613A(c) with respect to property B's secondary production (for which depletion is allowable before primary production) for 1975 was $360x. Corporation O's allowable depletion pursuant to section 613A (c) with respect to property A was $200x:

 [                (1,000 depletable oil quantity )]

 [                (1,000 depletable oil quantity )]

(1) GENERAL RULE -- (i) IN GENERAL. Except as provided in paragraph (i)(2) of this section, in the case of a transfer (as defined in paragraph (n) of section 1.613A-7) of an interest in any proven oil or gas property (as defined in paragraph (p) of section 1.613A-7), paragraph (a)(1) of this section shall not apply to a transferee (as defined in paragraph (o) of section 1.613A-7) with respect to production of crude oil or natural gas attributable to such interest, and such production shall not be taken into account for any computation by the transferee under this section.

(ii) EXAMPLES. The provisions of this subparagraph may be illustrated by the following examples:

EXAMPLE 1. On January 1, 1975, Individual A transfers proven oil properties to Corporation M in an exchange to which section 351 applies for shares of its stock. Since there is no allocation requirement pursuant to section 613A(c)(8) between A (the transferor) and Corporation M (the transferee), the transfer of the proven properties by A is a transfer for purposes of section 613A(c)(9) (as in effect prior to the Revenue Reconciliation Act of 1990) and percentage depletion is not allowable to Corporation M with respect to such properties.

EXAMPLE 2. On January 1, 1975, Corporation N sells proven oil property to Corporation O, its wholly-owned subsidiary. Because the transfer was made between corporations which are members of the same controlled group of corporations, Corporation O is entitled to percentage depletion with respect to production from the property so long as the tentative oil quantity is allocated between the two corporations. If Corporation N were a retailer, the tentative oil quantity would not be required to be allocated between the two corporations (see example (2) of section 1.613A-3(h)(5)), and Corporation O would not be entitled to percentage depletion on the production from the property.

EXAMPLE 3. B, owner of a proven oil property, died on January 1, 1975. Pursuant to the provisions of B's will, B's estate transferred the oil property on April 1, 1975, into a trust. On July 1, 1976, pursuant to a requirement in B's will, the trustee distributed the oil property to C. The transfer of the oil property by the estate to the trust and the later distribution of the property by the trust to C are transfers at death. Therefore, the trust was entitled to compute percentage depletion with respect to the production from the oil property when the property was owned by the trust and C is entitled to percentage depletion with respect to production from the oil property after the trust distributes the property to C.

EXAMPLE 4. On January 1, 1975, property which produces oil resulting from secondary processes was transferred to D. The exemption under section 613A(c) applies to D because section 613A(c)(9) (relating to transfers of oil or gas property), as in effect in 1975, does not apply with respect to secondary production. In addition, even if at the time of the transfer the production from the property was primary and D applied secondary processes to the property transferred and obtained secondary production, D would be entitled to percentage depletion with respect to the secondary production.

EXAMPLE 5. On July 1, 1975, E and F entered into a contract whereby F is given the privilege of drilling a well on E's unproven property, and if F does so F is to own the entire working interest in the property until F has recovered all the costs of drilling, equipping, and operating the well. Thereafter, 50 percent of the working interest would revert to E. In accordance with the contract, 50 percent of the working interest reverted to E on July 1, 1976. F is entitled to percentage depletion because the transfer of the working interest to F occurred when the property was unproven on July 1, 1975, which is the date of the contract establishing F's right to the working interest. E is entitled to percentage depletion with respect to this working interest since the reversion of such interest with respect to which E was eligible for percentage depletion is not a transfer. However, if on the date of the contract E's property was proven (although not proven when E acquired the property), F would not be entitled to claim percentage depletion with respect to any of the working interest income. Nonetheless, E would still be entitled to percentage depletion with respect to E's working interest since the reversion of the interest is not a transfer.

EXAMPLE 6. On January 1, 1975, G subleased an oil property to H, retaining a 1/8 royalty interest with the option to convert G's royalty into a 50 percent working interest. On July 1, 1975, the property was proven and on July 1, 1976, G exercised G's option. G is entitled to claim percentage depletion with respect to G's working interest since the conversion of the royalty interest which is eligible for percentage depletion pursuant to section 613A(c) into an interest which constituted part of an interest previously owned by G is not a transfer pursuant to section 1.613A-7(n)(8).

EXAMPLE 7. I and J (both of whom are minors) are beneficiaries of a trust which owned a proven oil property. The oil property was transferred to the trust on January 1, 1975, by the father of I and J. For 1975, the trustee allocated all the income from the oil property to I. For 1976, the trustee allocated all the income from such property to J. On January 1, 1977, the trustee distributed the property to I and J as equal tenants in common. Since I, J, and their father are members of the same family within the meaning of section 613A(c)(8)(C), the transfer of the property to the trust by the father, the shifting of income between I and J, and the distribution of the oil property by the trust to I and J are not transfers for purposes of section 613A(c)(9) (as in effect prior to the Revenue Reconciliation Act of 1990). However, the distribution of the oil property will constitute a transfer to each distributee on the date on which the distributee reaches majority under state law.

EXAMPLE 8. In 1975, K transferred a proven oil property productive at 5,000 feet to L. Subsequent to the transfer, L drilled new wells on the property finding another reservoir at 10,000 feet. The two zones were combined under section 614 as a single property. L is not entitled to percentage depletion on the gross income attributable to the production from the productive zone at 5,000 feet, but is entitled to percentage depletion on the gross income attributable to the production from the productive zone at 10,000 feet because that zone was not part of the proven property until the date of development expenses by L, which is after the date of the transfer. Accordingly, L's maximum allowable percentage depletion deduction for 1975 would be zero percent of gross income from the property with respect to the production from 5,000 feet, plus 22 percent of gross income from the property with respect to the production from 10,000 feet. This maximum deduction would be subject to the limitation provided for in section 613(a), i.e., 50 percent of "taxable income from the property (computed without allowance for depletion)," such taxable income being the overall taxable income resulting from the sale of production from both zones, and would also be subject to the limitations provided in section 613A. The production from the productive zone at 5,000 feet is not taken into account in determining K's depletable oil quantity for the year.

EXAMPLE 9. On July 1, 1975, M transferred an oil property with a fair market value of $100x to N. On February 1, 1976, N commenced production of oil from the property. The fair market value of the property on February 1, 1976, as reduced by actual costs incurred by N for equipment and intangible drilling and development costs, was $300x. Because the value of the property on transfer was not 50 percent or more of the value on February 1, 1976, the property transferred to N was not a proven property (see section 1.613A-7(p)). However, if there had been only marginal production from the property so that the fair market value of the property on February 1, 1976, was $40x rather than $300x, the property transferred to N would have been a proven property provided the other requirements of a proven property were met.

EXAMPLE 10. O is the owner of a remainder interest in a trust created January 1, 1970. On that date, the trust held oil and gas properties. On January 1, 1976, O's interest for the first time entitled O to the trust's income from oil and gas production from the properties. The reversion of the remainder interest to O is not a transfer (see section 1.613A-7(n)(7)). Accordingly, the transfer of the interest in oil and gas property to O is deemed to have occurred on January 1, 1970, the date O's interest was created.

EXAMPLE 11. On January 1, 1976, P, Q, and R entered into a partnership for the acquisition of oil and gas leases. It was agreed that the sharing of income will be divided equally among P, Q, and R. However, it was further agreed that with respect to the first production obtained from each property acquired P will receive 80 percent thereof and Q and R each will receive 10 percent thereof until $100x has been received by P. Assume these allocations have substantial economic effect under section 704 of the Code and the regulations thereunder. On February 1, 1976, Partnership PQR acquired an unproven property and production therefrom was shared pursuant to the partnership agreement. P is entitled to percentage depletion with respect to the production allocated to him since the transfer of right to the production is deemed to have been made on the date the partnership agreement became applicable to the specific property, at which time the property was unproven. See section 1.613A-7(n) for rules relating to the definition of transfer. Similarly, when $100x has been obtained and Q and R each commence receiving 33-1/3 percent of the revenue, Q and R are entitled to percentage depletion with respect to their entire interests. However, if the property had been proven when acquired by the partnership, P, Q, and R would not be entitled to claim any percentage depletion with respect to production from the property.

EXAMPLE 12. On December 30, 1960, S placed producing oil property in trust for the benefit of S's nephew, T, and executed a trust agreement which required the trustee of the trust to transfer the oil property to T on January 1, 1975. The trustee's transfer of the oil property to T on January 1, 1975, is deemed to have occurred on December 30, 1960 (see section 1.613A-7(n)). Since the transfer is deemed to have occurred before January 1, 1975, section 613A(c) applies with respect to the production from the oil property. Moreover, if the trustee was not required to transfer the oil property on a specific date but was given discretion to select the date of transfer, the transfer of such property would still be deemed to have occurred on December 30, 1960. However, the result would be different if the trust agreement had provided that the trustee, at the trustee's discretion, may transfer the oil property to T on January 1, 1975, but is not under any obligation to transfer the property to T on January 1, 1975, or on any other date. Since the transfer was discretionary, the date of the actual transfer governs.

EXAMPLE 13. On January 1, 1974, U acquired an oil property. On February 1, 1974, U granted V an option to purchase the oil property. V exercised V's option on March 2, 1975, and subsequently the oil property was conveyed to V. The date of the transfer was March 2, 1975, the day V exercised V's option (on which date both parties were bound).

EXAMPLE 14. On July 1, 1974, W executed a deed conveying oil and gas property to X. W delivered the deed to X on January 1, 1975. Under state law, the mere execution of the deed without delivery did not give X any rights in the property. Title to the oil property passed to X on the date of delivery. Therefore, the date of transfer was January 1, 1975.

EXAMPLE 15. Y, owner of a proven oil property, transferred Y's interest therein on July 25, 1975, to a revocable trust of which Y is treated as the owner under section 676. Y is not deemed a transferee and section 613A(c) applies to Y because immediately preceding the transfer Y was entitled to percentage depletion on the production from the property.

EXAMPLE 16. On January 1, 1975, a proven oil property was transferred to Z; therefore, section 613A(c)(1) did not apply with respect to the production from such property. After Z's death, neither Z's estate nor its beneficiaries are entitled to percentage depletion with respect to the decedent's oil property since Z was a transferee of proven property.

EXAMPLE 17. Partnership ABC, owner of proven oil and gas properties, admitted D as a partner in 1975 in consideration of cash. The shares of Partners A, B, and C of the partnership income were proportionately reduced so that D had a 25 percent interest in the income. D is not entitled to percentage depletion with respect to D's share of partnership oil and gas income because D is a transferee for purposes of section 613A(c)(9) (as in effect prior to the Revenue Reconciliation Act of 1990). See section 1.613A-7(n).

EXAMPLE 18. On January 1, 1975, E and F formed Partnership EF to which E contributed proven oil property. For 1975, pursuant to the partnership agreement 70 percent of the mineral income from the property was allocated to E and 30 percent of the mineral income from the property was allocated F. F is not entitled to percentage depletion with respect to production from the property because F is a transferee of an interest in proven property. However, E is not a transferee of an interest in proven property because E was entitled to percentage depletion on the oil produced with respect to the property immediately before the transfer. Therefore, E is entitled to percentage depletion with respect to the income allocated to E. However, if in 1976 the partnership agreement were revised so that E's interest in the income was increased by 10 percent, E would not be entitled to percentage depletion with respect to the additional 10 percent interest because E is a transferee with respect thereto.

EXAMPLE 19. G is the owner of a 1/3 interest in a partnership owning a proven oil property, and as such is entitled to 1/3 of the income from the property. G received a distribution on July 1, 1975, from the partnership of a 1/3 interest in the proven oil property. Although the transfer of such interest is a transfer for purposes of section 613A(c)(9) (as in effect prior to the Revenue Reconciliation Act of 1990), G is still entitled to percentage depletion with respect to the 1/3 interest in the oil production from the property since G was entitled to percentage depletion on such production with respect to such property immediately before the transfer. If the entire property were distributed to G, G's percentage depletion allowance would still be based on only 1/3 of the oil produced.

EXAMPLE 20. H and I contributed property X and property Y respectively to Partnership HI. The partnership agreement provides that all the gross income from property X is to be allocated to H and all the gross income from property Y is to be allocated to I. Assume these allocations have substantial economic effect under section 704 of the Code and the regulations thereunder. For 1975 H and I each received 100x gross income. Although the contributions of the properties by H and I are transfers for purposes of section 613A(c)(9) (as in effect prior to the Revenue Reconciliation Act of 1990), both H and I are entitled to percentage depletion with respect to the $100x income received since each was entitled to a percentage depletion allowance with respect to the property contributed immediately before the transfer. However, if no special allocation of income were made but H and I are to share equally in the income from both properties, each would be entitled to a depletion allowance based on only one-half of the production with respect to the property he had contributed. If property X produces $100x of gross income from the property and property Y produces $200x of gross income from the property, H would be entitled to percentage depletion but only with respect to $50x (50 percent of $100x) of gross income from the property and I would be entitled to percentage depletion with respect to $100x (50 percent of $200x) of gross income from the property.

(2) TRANSFERS AFTER OCTOBER 11, 1990. [Reserved]

(j) PERCENTAGE DEPLETION WITH RESPECT TO BONUSES AND ADVANCED ROYALTIES -- (1) AMOUNTS RECEIVED OR ACCRUED AFTER AUGUST 16, 1986. [Reserved]

(2) AMOUNTS RECEIVED OR ACCRUED BEFORE AUGUST 17, 1986. (i) A lease bonus or advanced royalty received or accrued before August 17, 1986, with respect to oil or gas property shall be taken into account for purposes of percentage depletion in the taxable year such payment is includible in income. Percentage depletion shall be determined according to the depletion rate and depletable oil and natural gas limitations of section 613A(c)(1) and section 1.613A-3(a) applicable on the date of such inclusion. The payee of the bonus or advanced royalty shall apply the depletable oil and natural gas quantity limitations by attributing a specific number of barrels of oil or cubic feet of natural gas to the lease bonus or advanced royalty. The determination of the number of barrels of oil or cubic feet of natural gas shall be based on the average price of oil or gas produced from the property during the taxable year. If oil or gas is not produced from the property during that year, or if the oil or gas is not sold before conversion or transportation from the premises, the number of barrels of oil or cubic feet of gas shall be based on a price (as of the date of the bonus or advanced royalty) determined under the constructive pricing principles applicable under section 613(a), generally the representative market or field price. In the case where no oil or gas has been produced in such year, the constructive price applicable to the type of production expected to be produced from the property shall apply. However, if the first actual production from the property in a later year is different from the type of production upon which the conversion of the bonus or advanced royalty into barrels of oil or cubic feet of gas was based and the period of limitations on assessment has not expired (see section 6501) for the year in which the lease bonus or advanced royalty is includible in income, the taxpayer should promptly file an amended return, if necessary. In the amended return the conversion shall be recomputed taking into account the pricing applicable to the actual production. For purposes of paragraph (f) of section 1.613A-7, the number of barrels of oil or cubic feet of natural gas attributed to a lease bonus or advanced royalty is deemed to have been extracted on the date the bonus or advanced royalty is includible in the payee's income.

(ii) For purposes of applying the depletable oil and natural gas quantity limitations in taxable years after the year in which the advanced royalty payment is included in income, the payee of an advanced royalty which is recouped out of future production shall not include production which recoups the advanced royalty in such later years. The payor of a bonus or advanced royalty that is not recouped from future production may reduce the production to be taken into account for purposes of applying the depletable quantity limitations in each year in which the payor's gross income from the property is adjusted under section 1.613-2(c)(5)(ii) to reflect the bonus paid by an amount determined by dividing the portion of the bonus required to be excluded from the payor's gross income from the property by the price of oil or gas applicable to the payee for converting the bonus into barrels of oil or cubic feet of gas.

(iii) See section 1.612-3(a)(2) and (b)(2) for rules relating to the requirement that certain depletion deductions allowed with respect to lease bonuses and advanced royalties be restored to income.

(k) SPECIAL RULES FOR FISCAL YEAR TAXPAYERS. In applying this section to a taxable year which is not a calendar year, each portion of such taxable year which occurs during a single calendar year shall be treated as if it were a short taxable year.

(1) INFORMATION FURNISHED BY PARTNERSHIPS, TRUSTS, ESTATES, AND OPERATORS. Each partnership, trust, or estate producing domestic crude oil or natural gas, and each operator of a well from which domestic crude oil or natural gas was produced, shall provide each partner, beneficiary, or person holding a nonoperating interest, as the case may be, with all information in its possession necessary to determine the amount of his depletion deduction allowable with respect to such crude oil or natural gas. For example, for each property a partnership is required to provide each partner with partnership information relating to the partner's allocable share of gross income from the property, the partner's allocable share of operating expenses, the partner's allocable share of depreciation, the partner's share of allocated overhead, the partner's share of estimated reserves, the partner's share of production in barrels or cubic feet for the taxable year, the partner's original share of the partnership adjusted basis of properties producing domestic crude oil or domestic natural gas, the partner's allocable share of any adjustments made to the basis of such properties by the partnership, and the percentage by which existing partners must reduce their bases in a partnership oil or gas property upon entry of a partner by contribution. In addition, upon the disposition of an oil or gas property by the partnership, the partnership shall inform each partner of his allocable portion of the amount realized from the sale of the property.

SECTION 1.613A-4 LIMITATIONS ON APPLICATION OF SECTION 1.613A-3 EXEMPTION.

(a) LIMITATION BASED ON TAXABLE INCOME.

(1) The aggregate amount of a taxpayer's deductions allowed pursuant to section 613A(c) for the taxable year shall not exceed 65 percent of the taxpayer's taxable income (reduced in the case of an individual by the zero bracket amount for taxable years beginning after December 31, 1976, and before January 1, 1987) for the year, adjusted to eliminate the effects of:

(i) Any depletion with respect to an oil or gas property (other than a gas property with respect to which the depletion allowance for all production is determined pursuant to section 613A(b)) for which percentage depletion would exceed cost depletion in the absence of the depletable quantity limitations contained in section 613A(c)(1) and (6) (as in effect prior to the Revenue Reconciliation Act of 1990) or the taxable income limitation contained in section 613A(d)(1);

(ii) Any net operating loss carryback to the taxable year under section 172;

(iii) Any capital loss carryback to the taxable year under section 1212; and

(iv) In the case of a trust, any distributions to its beneficiaries, except in the case of any trust where any beneficiary of such trust is a member of the family (as defined in section 267(c)(4)) of a settlor who created inter vivos and testamentary trusts for members of the family and such settlor died within the last 6 days of the 5th month in 1970, and the law in the jurisdiction in which such trust was created requires all or a portion of the gross or net proceeds of any royalty or other interest in oil, gas, or other mineral representing any percentage depletion allowance to be allocated to the principal of the trust.

The amount disallowed (as defined in paragraph (q) of section 1.613A-7) shall be carried over to the succeeding year and treated as an amount allowable as a deduction pursuant to section 613A(c) for such succeeding year, subject to the 65-percent limitation of section 613A(d)(1). For rules relating to corporations filing a consolidated return, see the regulations under section 1502. With respect to fiscal year taxpayers, except as provided in section 1.613A-1 for taxable years beginning before January 1, 1975, and ending after that date, the limitation shall be calculated on the entire fiscal year and not applied with respect to each short period included in a fiscal year. For purposes of basis adjustments and determining whether cost depletion exceeds percentage depletion with respect to the production from a property, any amount disallowed as a deduction after the application of this paragraph shall be allocated to the respective properties from which the oil or gas was produced in proportion to the percentage depletion otherwise allowable to such properties pursuant to section 613A(c). Accordingly, the maximum amount which may be allowable as a deduction pursuant to section 613A(c) after application of this paragraph (65 percent x adjusted taxable income) shall be allocated to properties for which percentage depletion pursuant to section 613A(c) would be allowed in the absence of the limitation contained in section 613A(d)(1) by application of the same proportion. However, once it is determined that after application of this paragraph cost depletion exceeds percentage depletion with respect to a property, the maximum amount determined under the preceding sentence shall be reallocated among the remaining properties, and the portion of the amount disallowed which is allocable to such property shall be the amount by which percentage depletion pursuant to section 613A(c) before application of this paragraph exceeds cost depletion. See Example 1 of paragraph (a)(2) of this section. If the taxpayer becomes entitled to the deduction in a later year (i.e., because the disallowed depletion does not exceed 65 percent of the taxpayer's taxable income for that year after taking account of any percentage depletion deduction otherwise allowable for that year), then the basis of the taxpayer's properties must be adjusted downward (but not below zero) by the amount of the deduction in proportion to the portion of the amount disallowed to the respective properties in the year of the disallowance. However, if the property in question was disposed of by the taxpayer prior to the beginning of such later year, the amount of the deduction in such later year shall be reduced by the difference between the taxpayer's adjusted basis in the property at the time it is disposed of and the adjusted basis which the taxpayer would have had in the property in the absence of the 65-percent limitation.

(2) The application of this paragraph may be illustrated by the following examples:

EXAMPLE 1. A owns producing oil properties M, N, and O. With respect to property M, the depletion allowable pursuant to section 613A(c) for 1975 without regard to section 613A(d)(1) was $60x (cost depletion would have been $40x). With respect to property N, the depletion allowable pursuant to section 613A(c) for 1975 without regard to section 613A(d)(1) was $90x (cost depletion would have been zero). With respect to property O, the depletion pursuant to section 613A(c) for 1975 without regard to section 613A(d)(1) was $50x (cost depletion would have been $10X). A's taxable income (as adjusted under section 1.613A- 4(a)(1)) for 1975 was $100x; accordingly, A's percentage depletion pursuant to section 613A(c) for 1975 must be reduced from $200x to $65x (65 percent x $100x taxable income). Of that amount, $19.5x:

 [             ( $60x             )]

• to property O. Since cost depletion of $40x with respect to property M exceeded the percentage depletion of $19.5x allowable on such property, A claimed the cost depletion. Accordingly, the only percentage depletion deduction allowable to A pursuant to section 613A(c) for 1975 is with respect to properties N and O. Therefore, the $65x ceiling applies to the percentage depletion allowable on properties N and O. Of that amount, $41.79x:

• to property O. Accordingly, A is allowed a total depletion deduction of $105x ($40x cost depletion on property M + $41.79x percentage depletion on property N + $23.21x percentage depletion on property O). The amount disallowed to A under section 613A(d)(1) is $95x ($200x aggregate depletion allowable before application of section 613A(d)(1) - $105x [$40x cost depletion allowable on property M + $41.79x percentage depletion allowable on property N after application of section 613A(d)(1) + $23.21x depletion allowable on property O after application of section 613A(d)(1)]). For purposes of basis adjustments, $20x ($60x percentage depletion before limitation - $40x cost depletion allowed) of the amount disallowed is allocated to property M. The balance of the amount disallowed of $75x is allocated $48.21x:

EXAMPLE 3. C is a fiscal year taxpayer whose fiscal year ended on May 31, 1975. For purposes of applying the 65 percent of taxable income limitation, the period beginning January 1, 1975, and ending May 31, 1975, is treated as a short taxable year. The depletion allowable pursuant to section 613A(c) without regard to section 613A(d)(1) for such short taxable year was $80x and A's taxable income (as adjusted under section 1.613A-4(a)(1)) during such short taxable year was $100x. Only $65x (65 percent x $100x adjusted taxable income) of the deduction pursuant to section 613A(c) was deductible for such portion of 1975, in addition to any percentage depletion allowable for June 1, 1974, through December 31, 1974. With respect to the taxable year commencing June 1, 1975, and ending May 31, 1976, the 65 percent limitation is applied to the taxable income for the entire taxable year.

EXAMPLE 4. Under the trust law of State X, a trustee is required to allocate 22 percent of gross mineral income to the principal of a trust for purposes of maintaining a reserve for depletion and the depletion deduction is entirely allocated to the trustee. In 1975 the gross income of a trust in State X the only assets of which were oil properties was $1,000. The trust's allowable percentage depletion pursuant to section 613A(c) without regard to section 613A(d)(1) was $220. The trust incurred expenses of $150 for the taxable year and made distributions to beneficiaries (who are not described in the exception for family members set forth in paragraph (a)(1)(iv) of this section) of $630 ($1,000 gross income - $220 allocated to principal - $150 expenses). The trust's deduction for personal exemption under section 642(b) is $300. For purposes of applying the 65 percent limitation, the trust's taxable income was $550 ($1,000 gross income - $150 expenses - $300 exemption). The limitation under section 613A(d)(1) was $357.50 (65% x $550 taxable income). Accordingly, the trust's percentage depletion allowance was unaffected by the 65 percent limitation.

EXAMPLE 5. In 1980 the gross income of the estate of D was $1,000. The only assets of the estate were oil properties. The estate's adjusted basis in the oil properties was $0. The estate's allowable percentage depletion pursuant to section 613A(c) without regard to section 613A(d)(1) was $220. The estate incurred expenses of $150 for the taxable year and made distributions to beneficiaries of $425. The distributions thus equaled one half of the net income of the estate (ignoring depletion). Under section 611(b)(4), the percentage depletion is apportioned equally between the estate and its beneficiary. The distribution amount of $425 is deductible under section 661(a) in computing the taxable income of the estate. For purposes of applying the 65 percent limitation to the percentage depletion apportioned to the estate, the estate's taxable income was $0 ($1,000 gross income - $150 expenses - $425 distribution - $600 exemption). The limitation under section 613A(d)(1) was therefore also $0 (65% x $0 taxable income). Accordingly, the $110 amount is disallowed to the estate for the taxable year but may be carried forward by the estate as a deduction to 1981 and subsequent years. The beneficiaries shall apply the 65 percent limitation to the $110 percentage depletion apportioned to them based on their respective taxable incomes.

EXAMPLE 6. In 1975 E sold an oil property for which E's adjusted basis was $20x. The amount disallowed for 1975 to E under section 613A (d) was $10x. The amount of the carryover under that section to 1976 was $0 ($10x disallowed amount - $10x [$20x adjusted basis of property on sale - $10x adjusted basis which taxpayer would have had in the property in the absence of the 65-percent limitation]). However, if the adjusted basis of the property on disposition had been $0, the amount of the carryover to 1976 would have been $10x ($10x disallowed amount - $0 adjusted basis of property on sale).

EXAMPLE 7. In 1975 F owned producing properties M, N, O, P, Q, and R. With respect to property M, the allowable cost depletion was $100x (the allowable percentage depletion pursuant to section 613A(c) without regard to the depletable quantity and taxable income limitations contained in section 613A(c)(1), (6) and (d)(1) would have been $90x). With respect to property N, the allowable percentage depletion pursuant to section 613A(c) before applying section 613A(d)(1) was $80x (cost depletion would have been $0). With respect to property O, the allowable cost depletion was $60x (the allowable percentage depletion pursuant to section 613A(c) would have been $70x, except that the application of section 613A(d)(1) reduced allowable percentage depletion to less than $60x). With respect to property P, the allowable percentage depletion pursuant to section 613A(b) was $55x (cost depletion would have been $40x). With respect to property Q, which produces both gas subject to section 613A(b)(1)(B) and oil subject to section 613A(c), the allowable percentage depletion was $45x (cost depletion would have been $40x). With respect to property R, the allowable cost depletion was $40x (the allowable percentage depletion pursuant to section 613A(c) would have been $50x, except that the application of section 613A(c)(7)(A) reduced allowable percentage depletion to less than $40x). Under paragraph (a)(1)(i) of this section, for purposes of applying the 65 percent limitation under section 613A(d)(1), F's taxable income must be reduced by the allowable depletion with respect to property M (for which cost depletion exceeded percentage depletion even in the absence of section 613A(c)(1), (6), and (d)) and property P (for which all depletion is determined pursuant to section 613A(b)), but shall not be reduced by the allowable depletion with respect to properties N, O, Q, and R.

(b) RETAILERS EXCLUDED. (1) Section 613A(c) and section 1.613A- 3 shall not apply in the case of any taxpayer who is a retailer as defined in paragraph (r) of section 1.613A-7.

(2) The application of this paragraph may be illustrated by the following examples (those that involve sales through retail outlets assume, unless otherwise stated, that the $5,000,000 gross receipts requirement of section 613A(d)(2) is met):

EXAMPLE 1. A, owner of producing oil and gas properties, also owns 5 percent in value of the stock of Corporation M, a retailer of oil and gas. None of A's production is sold through Corporation M. Since A may benefit from Corporation M's sales of oil and gas through A's ownership interest in Corporation M, A is considered to be selling oil or natural gas through Corporation M, a related person. Accordingly, the exemption under section 613A(c) does not apply to A, even though none of A's production is sold through Corporation M.

EXAMPLE 2. Assume the same facts as in Example 1 except that A has gross receipts of $2 million from sales of oil for the taxable year from A's retail outlets and Corporation M has gross receipts of $4 million from sales of oil for the taxable year from its retail outlets. For purposes of the $5 million gross receipts requirement of section 613A(d)(2), A is treated as having gross receipts of $6 million. Accordingly, the exemption under section 613A(c) does not apply to A.

EXAMPLE 3. Corporation N, a retailer of oil and gas, owns 5 percent in value of the stock of Corporation O, owner of producing oil and gas properties. None of Corporation O's production is sold through Corporation N. Since Corporation O has no direct or indirect ownership interest in Corporation N, and therefore does not benefit from Corporation N's sales of oil and gas, and since none of Corporation O's production is sold through Corporation N, the exemption under section 613A(c) applies to Corporation O.

EXAMPLE 4. Corporation P, a producer of oil, owns 70 percent in value of the stock of Corporation Q. Corporation Q owns 30 percent in value of the stock of Corporation R. Corporation R owns 30 percent in value of the stock of Corporation S, a retailer of oil and gas. P indirectly owns 6.3 percent (70 percent x 30 percent x 30 percent) in value of the stock of Corporation S. Since P may benefit from Corporation S's sales of oil and gas through P's indirect ownership interest in Corporation S, P is not entitled to percentage depletion.

EXAMPLE 5. B is the owner of certain oil and gas properties in Texas and is also the owner of a service station in Washington, D.C., which B leases to Corporation T. None of B's production is sold to Corporation T. The exemption under section 613A(c) applies to B. However, if sales of B's production were made to Corporation T and the gross receipts from such sales of B's production to Corporation T exceed 5 million dollars, the exemption under section 613A(c) would not apply to B because B is selling oil or natural gas to a person given authority to occupy a retail outlet leased by the taxpayer, B.

EXAMPLE 6. C has a 1/8 royalty interest and Corporation U has a 7/8 working interest in an oil property. Corporation V, a retailer of oil, owns 5 percent in value of the stock of Corporation U. C has no interest in either corporation. All of the production from the property is sold through Corporation V, C receiving from Corporation U 1/8 of its receipts therefrom. The exemption under section 613A(c) does not apply to Corporation U because Corporation U is selling oil or natural gas through Corporation V, a related person that is a retailer. However, the exemption applies to C because C, as owner of a nonoperating mineral interest, is not treated as an operator of a retail outlet merely because C's oil or gas is sold on C's behalf through a retail outlet operated by an unrelated person.

EXAMPLE 7. D owns and operates retail grocery stores where refined oil may be purchased. D also owns oil and gas producing properties. If the sales of refined oil at each store location constitute less than 5 percent of the gross receipts from all sales made at that store, D is not considered a retailer by reason of such sales.

EXAMPLE 8. Lessee E sells natural gas to lessor F directly from a wellhead gathering pipeline system for F's local agricultural use, in transactions incidental to the acquisition of a natural gas lease. The sales of natural gas to F are not sales through a retail outlet.

EXAMPLE 9. Corporation W produces natural gas, some of which it sells at retail. For purposes of determining whether Corporation W is a retailer selling gas through a retail outlet within the meaning of section 1.613A-7(r), the business office of Corporation W where a purchaser would normally contact the corporation with respect to its sales to the purchaser is considered the place at which those sales of natural gas are made.

EXAMPLE 10. G, husband, is the sole owner and operator of a retail outlet which sells oil and gas. H, wife, owns producing oil and gas properties. G is not related to H for purposes of section 613A(d).

EXAMPLE 11. I, husband, and J, wife, are community property owners of 10 percent in value of the stock of Corporation X which is a retailer of oil and gas. I and J are each treated as owning 5 percent of Corporation X. Therefore, neither I nor J qualify for the exemption under section 613A(c).

EXAMPLE 12. Corporation Y, an electing small business corporation as defined in section 1371 (as in effect prior to the enactment of the Subchapter S Revision Act of 1982), owns producing oil and gas properties. K, a retailer of oil and gas, is a 50 percent interest shareholder of Corporation Y. None of Corporation Y's production is sold through K. Corporation Y is eligible for percentage depletion.

EXAMPLE 13. Corporation Z, a producer of natural gas, makes bulk sales of natural gas to industrial users. For purposes of determining whether Corporation Z is a retailer under section 1.613A-7(r), the bulk sales are disregarded.

EXAMPLE 14. L, a calendar year taxpayer, is the owner of a producing oil property. On September 1, 1976, L purchased a chain of gasoline service stations. Therefore, L was a retailer of oil and gas for the last 122 days of 1976. L's gross income from the oil property for the taxable year was $150x and L's taxable income from the property was $30x. L is treated as a retailer with respect to $50x of gross income from the property ($150x x 122/366) and $10x of taxable income from the property ($30x x 122/366). Therefore, L is entitled to percentage depletion with respect to $100x of gross income from the property ($150x minus $50x). However, the allowable percentage depletion is limited by the 50 percent of taxable income from the property limitation to $10x (50 percent times $20x taxable income ($30x minus $10x)).

EXAMPLE 15. Corporation M is a partner in Partnership MNO which is the owner of an operating interest in a producing oil property. Corporation P, a retailer of oil and gas, owns 5 percent in value of the stock of Corporation M. Partnership MNO sells its production to Corporation P. Corporation M is retailing oil through Corporation P, a related person, because its share of the oil is being sold on its behalf by the partnership through a retail outlet operated by a person related to Corporation M. Therefore, the exemption under section 613A(c) does not apply to Corporation M.

EXAMPLE 16. AA and BB are beneficiaries of a trust which is a retailer of oil and gas. AA has an interest in the income of the trust for AA's lifetime which, actuarially determined, represents more than 5 percent of the beneficial interests in the trust. BB's interest in the trust, which entitles BB to 5 percent of the corpus of the trust 5 years after AA's death, represents less than 5 percent of the beneficial interests in the trust prior to AA's death and represents more than 5 percent after AA's death. The trust is a related person of AA but not BB while AA is alive. Accordingly, during AA's lifetime BB is not disqualified from the exemption provided by section 613A(c), but AA is.

EXAMPLE 17. Assume the same facts as in Example 16, except that AA's interest in the income of the trust represents 4 percent of the beneficial interests in the trust. AA is disqualified from the exemption provided by section 613A(c) with respect to the income from the trust but not with respect to income from other sources.

(c) CERTAIN REFINERS EXCLUDED. (1) Section 613A(c) and section 1.613A-3 shall not apply in the case of any taxpayer who is a refiner as defined in paragraph(s) of section 1.613A-7.

(2) The provisions of this paragraph may be illustrated by the following examples:

EXAMPLE 1. Corporation M owns a refinery which has refinery runs in excess of 50,000 barrels on at least one day during the taxable year. Corporation M also owns a 5 percent interest in Corporation N, owner of producing oil and gas properties. None of Corporation N's production is sold to Corporation M. The exemption under section 613A(c) does not apply to Corporation N because Corporation M, a related person of Corporation N, engages in the refining of crude oil.

EXAMPLE 2. A and B are equal partners in Partnership AB, which owns oil and gas producing properties. A owns a refinery which has refinery runs in excess of 50,000 barrels on at least one day during the taxable year and which buys all of Partnership AB's production. B has no ownership interest in any refinery. B is not a refiner.

SECTION 1.613A-7 DEFINITIONS.

For purposes of section 613A and the regulations thereunder --

(a) DOMESTIC. The term "domestic," as applied to oil and gas wells (or to production from such wells), refers to wells located in the United States or in a possession of the United States, as defined in section 638 and the regulations thereunder.

(b) NATURAL GAS. The term "natural gas" means any product (other than crude oil as defined in paragraph (g) of this section) of an oil or gas well if a deduction for depletion is allowable under section 611 with respect to such product.

(c) REGULATED NATURAL GAS. Natural gas is considered to be "regulated" only if all of the following requirements are met:

(1) The gas must be domestic gas produced and sold by the producer (whether for himself or on behalf of another person) before July 1, 1976,

(2) The price for which the gas is sold by the producer must not be adjusted to reflect to any extent the increase in liability of the seller for tax under chapter 1 of the Code by reason of the repeal of percentage depletion for gas,

(3) The sale of the gas must have been subject to the jurisdiction of the Federal Power Commission for regulatory purposes,

(4) An order or certificate of the Federal Power Commission must be in effect (or a proceeding to obtain such an order or certificate must have been instituted), and

(5) The price at which the gas is sold must be taken into account, directly or indirectly, in the issuance of the order or certificate by the Federal Power Commission.

Price increases after February 1, 1975, are presumed to take increases in tax liabilities into account unless the taxpayer demonstrates to the contrary by clear and convincing evidence that the increases are wholly attributable to a purpose or purposes unrelated to the repeal of percentage depletion for gas (e.g., where the record of the Federal Power Commission clearly establishes that the Commission did not take the repeal into account). Increases to reflect additional State and local real property or severance taxes, increases for additional operating costs (such as costs of secondary or tertiary processes), adjustments for inflation, increases for additional drilling and related costs, or increases to reflect changes in the quality of gas sold, are some examples of increases that are not attributable to the repeal of percentage depletion for gas. In the absence of a statement in writing by the Federal Power Commission that the price of the gas in question was not in fact regulated, the requirement of paragraph (c)(5) of this section is deemed to have been met in any case in which the Federal Power Commission issued an order or certificate approving the sale to an interstate pipeline company or, in a case in which it is established by the taxpayer that the Federal Power Commission has influenced the price of such gas, an order or certificate permitting the interstate transportation of such gas. In addition, an "emergency" sale of natural gas to an interstate pipeline, which, pursuant to the authority contained in 18 CFR 2.68, 2.70, 157.22, and 157.29, may be made without prior order approving the sale, is deemed to have met the requirements of paragraph (c)(3), (4), and (5) of this section. For purposes of meeting the requirements under this paragraph, it is not necessary that the total gas production from a property qualify as "regulated natural gas." The determination of whether mineral production is "regulated natural gas" shall be made with respect to each sale of the mineral or minerals produced.

(d) NATURAL GAS SOLD UNDER A FIXED CONTRACT. The term "natural gas sold under a fixed contract" means domestic natural gas sold by the producer (whether for himself or on behalf of another person) under a contract, in effect on February 1, 1975, and at all times thereafter before such sale, under which the price for the gas during such period cannot be adjusted to reflect to any extent the increase in liabilities of the seller for tax under chapter 1 of the Code by reason of the repeal of percentage depletion for gas. The term may include gas sold under a fixed contract even though production sold under the contract had previously been treated as regulated natural gas. Price increases after February 1, 1975, are presumed to take increases in tax liabilities into account unless the taxpayer demonstrates to the contrary by clear and convincing evidence. Paragraph (c) of this section provides examples of increases which do not take increases in tax liabilities into account. However, if an adjustment provided for in the contract permits the possible increase in federal income tax liability of the seller to be taken into account to any extent, the gas sold under the contract after such an increase becomes permissible is not gas sold under a fixed contract. If the adjustment provided for in the contract provides for an increase in the price of the contract to the highest price paid to a producer for natural gas in the area, or if the price may be renegotiated, then gas sold under the contract after such an increase becomes permissible is presumed not to be sold under a fixed contract unless the taxpayer demonstrates by clear and convincing evidence that the price increase in no event takes increases in tax liabilities into account. For purposes of meeting the requirements of this paragraph, it is not necessary that the total gas production from a property qualify as "natural gas sold under a fixed contract," for the determination of "natural gas sold under a fixed contract" is to be made with respect to each sale of each type of natural gas sold pursuant to each contract.

(e) QUALIFIED NATURAL GAS FROM GEOPRESSURED BRINE. [Reserved]

(f) AVERAGE DAILY PRODUCTION.

(1) The term "average daily production" means the taxpayer's aggregate production of domestic crude oil or natural gas, as the case may be, which is extracted after December 31, 1974, and to which gross income from the property is attributable during the taxable year divided by the number of days in such year. As used in the preceding sentence the term "taxpayer" includes a small business corporation as defined in section 1371 (as in effect prior to the enactment of the Subchapter S Revision Act of 1982) and the regulations thereunder. Notwithstanding the provisions of section 1.612-3 and except as provided in section 1.613A-3(j)(2), in computing the average daily production for a taxable year only oil or gas which has been actually produced by the close of such taxable year is taken into account. Average daily production does not include production resulting from secondary or tertiary recovery processes to which gross income from the property is attributable.

(2) In the case of a fiscal-year taxpayer, paragraph (f)(1) of this section shall be applied separately to each short taxable year under section 613A(c)(11), as in effect prior to the Revenue Reconciliation Act of 1990.

(3) In the case of a taxpayer holding a partial interest in the production from any property (including an interest of a partner in property of a partnership or a net profits interest) such taxpayer's production shall be considered to be that amount of such production determined by multiplying the total production (which is produced after December 31, 1974, and to which gross income from the property is attributable during the taxable year) of the property by the taxpayer's percentage participation in the gross revenues from the property during the year. However, the portion of trust (or estate) production allocable to a beneficiary shall not exceed that amount of the trust's (or estate's) depletable oil quantity determined by multiplying such quantity by the beneficiary's percentage interest in the trust's (or estate's) gross income from the property.

(g) CRUDE OIL. For purposes of section 613A and the regulations thereunder, the term "crude oil" means --

(1) A mixture of hydrocarbons which existed in the liquid phase in natural underground reservoirs and which remains liquid at atmospheric pressure after passing through surface separating facilities,

(2) Hydrocarbons which existed in the gaseous phase in natural underground reservoirs but which are liquid at atmospheric pressure after being recovered from oil well (casinghead) gas in lease separators, and

(3) Natural gas liquid recovered from gas well effluent in lease separators or field facilities before any conversion process has been applied to such production.

(h) DEPLETABLE OIL QUANTITY. The taxpayer's depletable oil quantity, within the meaning of section 613A(c)(1)(A), shall be equal to the tentative quantity determined under the table contained in section 613A(c)(3)(B) (as in effect prior to the Revenue Reconciliation Act of 1990) and paragraph (b) of section 1.613A-3.

(i) DEPLETABLE NATURAL GAS QUANTITY. The taxpayer's depletable natural gas quantity, within the meaning of section 613A(c)(1)(B), shall be equal to 6,000 cubic feet multiplied by the number of barrels of the taxpayer's depletable oil quantity to which the taxpayer elects to have section 613A(c)(4) apply. The taxpayer's depletable oil quantity for any taxable year shall be reduced (in addition to any reduction required to be made under paragraph (h) of this section) by the number of barrels with respect to which an election under section 613A(c)(4) for natural gas has been made. See section 1.613A-5.

(j) BARREL. The term "barrel" means 42 United States gallons.

(k) SECONDARY OR TERTIARY PRODUCTION. For purposes of section 613A the term "secondary or tertiary production" means the increased production of domestic crude oil or natural gas from a property at any time after the application of a secondary or tertiary process. The increased production is the excess of actual production over the maximum primary production which would have resulted during the taxable year if the secondary or tertiary process had not been applied. The increased production may be due to an increase in either the rate or the duration of recovery. A secondary or tertiary process is a process applied for the recovery of hydrocarbons in which liquids, gases, or other matter is injected into the reservoir to supplement or augment the natural forces required to move the hydrocarbons through the reservoir. However, no process which must be introduced early in the productive life of the mineral property in order to be reasonably effective (such as cycling of gas in the case of a gas-condensate reservoir) is a secondary or tertiary process. A process (such as fire flooding or miscible fluid injection) introduced early in the productive life of the mineral property will not be disqualified as a secondary or tertiary process if a later introduction of the process in the property would still have been reasonably effective.

(1) CONTROLLED GROUP OF CORPORATIONS. The term "controlled group of corporations" has the meaning given to such term by section 1563(a), except that section 1563(b)(2) shall not apply and except that "more than 50 percent" shall be substituted for "at least 80 percent" each place it appears in section 1563(a).

(m) RELATED PERSON.

(1) A person is a "related person" to another person, within the meaning of section 613A(d)(2) and (4), paragraphs (b) and (c) of section 1.613A-4, and paragraphs (r) and (s) of this section, if either a significant ownership interest in such person is held by the other, or a third person has a significant ownership interest in both such persons. For purposes of determining a significant ownership interest, an interest owned by or for a corporation, partnership, trust, or estate shall be considered as owned directly both by itself and proportionately by its shareholders, partners, or beneficiaries, as the case may be. The term "significant ownership" means --

(i) With respect to any corporation, direct or indirect ownership of 5 percent or more in value of the outstanding stock of such corporation,

(ii) With respect to a partnership, direct or indirect ownership of 5 percent or more interest in the profits or capital of such partnership, and

(iii) With respect to an estate or trust, direct or indirect ownership of 5 percent or more of the beneficial interests in such estate or trust. The relative percentage ownership of beneficiaries of an estate or trust in the beneficial interests therein shall be determined under actuarial principles.

(2) A person is a "related person" to another person, within the meaning of section 613A(c)(8)(B) and paragraph (h)(2) of section 1.613A-3, if such persons are members of the same controlled group of corporations or if the relationship between such persons would result in a disallowance of losses under section 267 or 707(b), except that for this purpose the family of an individual includes only the individual's spouse and minor children.

(n) TRANSFER. The term "transfer" means any change in ownership for federal tax purposes after December 31, 1974, by sale, exchange, gift, lease, sublease, assignment, contract, or other disposition (including any contribution to or any distribution by a corporation, partnership, or trust), any change in the membership of a partnership or the beneficiaries of a trust, or any other change by which a taxpayer's proportionate share of the income subject to depletion of an oil or gas property is increased. However, the term does not include --

(1) A transfer of property at death (including a distribution by an estate, whether or not a pro rata distribution),

(2) An exchange to which section 351 applies,

(3) A change of beneficiaries of a trust by reason of the death, birth, or adoption of any vested beneficiary if the transferee was a beneficiary of the trust or is a lineal descendant of the settlor or any other vested beneficiary of the trust, except in the case of any trust where any beneficiary of the trust is a member of the family (as defined in section 267(c)(4)) of a settlor who created inter vivos and testamentary trusts for members of the family and the settlor died within the last six days of the fifth month in 1970, and the law in the jurisdiction in which the trust was created requires all or a portion of the gross or net proceeds of any royalty or other interest in oil, gas, or other mineral representing any percentage depletion allowance to be allocated to the principal of the trust,

(4) A transfer of property between corporations which are members of the same controlled group of corporations (as defined in section 613A(c)(8)(D)(i)),

(5) A transfer of property between business entities which are under common control (within the meaning of section 613A(c)(8)(B)) or between related persons in the same family (within the meaning of section 613A(c)(8)(C)),

(6) A transfer of property between a trust and members of the same family (within the meaning of section 613A(c)(8)(C)) to the extent that both (i) the beneficiaries of the trust are and continue to be members of the family that transferred the property, and (ii) the tentative oil quantity is allocated among the members of such family,

(7) A reversion of all or part of an interest with respect to which the taxpayer was eligible for percentage depletion pursuant to section 613A(c), or

(8) A conversion of a retained interest which is eligible for such depletion into an interest which constituted all or part of an interest previously owned by the taxpayer also eligible for such depletion.

However, paragraph (n)(2), (4), and (5) of this section shall apply only so long as the tentative quantity determined under the table contained in section 613A(c)(3)(B) (as in effect prior to the Revenue Reconciliation Act of 1990) is required to be allocated under section 613A(c)(8) between the transferor and transferee, or among members of a controlled group of corporations. In the case of an individual transferor, the allocation test of the preceding sentence shall not be failed merely because of the death of the transferor. For purposes of paragraph (n)(3) and (6), an individual adopted by a beneficiary is a lineal descendant of that beneficiary. For purposes of paragraph (n)(7) and (8), a taxpayer previously ineligible for percentage depletion solely by reason of section 613A(d)(2) or (4) will be considered to have been eligible for such depletion. A transfer is deemed to occur on the day on which a contract or other commitment to transfer the property becomes binding upon both the transferor and transferee, or, if no such contract or commitment is made, on the day on which ownership of the interest in oil or gas property passes to the transferee.

(o) TRANSFEREE. The term "transferee," as used in section 613A(c)(9) (as in effect prior to the Revenue Reconciliation Act of 1990), paragraph (i) of section 1.613A-3, and this section includes the original transferee of proven property and the original transferee's successors in interest. A person shall not be treated as a transferee of an interest in a proven oil or gas property to the extent that such person was entitled to a percentage depletion allowance on mineral produced with respect to the property immediately before the transfer.

However, a person shall be treated as a transferee of an interest in a proven property to the extent that the interest such person receives is greater than the interest in the property the person held immediately before the transfer. For example, where the owner of a proven oil property transfers his or her entire interest therein to a partnership of which he or she is a member and, as a consequence, becomes entitled to a depletion allowance based on only one-third of the oil produced with respect to that property, the owner (the transferor) is not denied percentage depletion with respect to the one-third interest in oil production which the owner still possesses. If the partnership agreement had made an effective allocation (under section 704 and section 1.704.1) of all the income in respect of such property to the transferor partner, that partner would be entitled to percentage depletion on the entire oil production from that property. For this purpose, a person who has transferred oil or gas property pursuant to a unitization or pooling agreement shall be treated as having been entitled to a depletion allowance immediately before the transfer to that person of the interest in the unit or pool with respect to all of the mineral in respect of which the person receives gross income from the property pursuant to the unitization or pooling agreement, except to the extent such income is attributable to consideration paid by that person for such interest in addition to that person's contribution of the oil or gas property and equipment affixed thereto.

(p) INTEREST IN PROVEN OIL OR GAS PROPERTY. The term "interest in an oil or gas property" means an economic interest in oil or gas property. An economic interest includes working or operating interests, royalties, overriding royalties, net profits interests, and, to the extent not treated as loans under section 636, production payments from oil or gas properties. The term also includes an interest in a partnership, S corporation, small business corporation, or trust holding an economic interest in oil or gas property but does not include shares of stock in a corporation (other than an S corporation and small business corporation) owning such an interest. An oil or gas property is "proven" if its principal value has been demonstrated by prospecting, exploration, or discovery work. The principal value of the property has been demonstrated by prospecting, exploration, or discovery work only if at the time of the transfer --

(1) Any oil or gas has been produced from a deposit, whether or not produced by the taxpayer or from the property transferred;

(2) Prospecting, exploration, or discovery work indicate that it is probable that the property will have gross income from oil or gas from the deposit sufficient to justify development of the property; and

(3) The fair market value of the property is 50 percent or more of the fair market value of the property, minus actual expenses of the transferee for equipment and intangible drilling and development costs, at the time of the first production from the property subsequent to the transfer and before the transferee transfers his or her interest.

For purposes of this paragraph, the property is to be determined by applying section 614 and the regulations thereunder to the transferee at the time of the transfer. If the transfer is of an interest in a partnership, S corporation, small business corporation, or trust, the determination shall be made with respect to each property owned by the partnership, S corporation, small business corporation, or trust. The term "prospecting, exploration, or discovery work" includes activities which produce information relating to the existence, location, extent, or quality of any deposit of oil or gas, such as seismograph surveys and drilling activities (whether for exploration or for the production of oil or gas).

(q) AMOUNT DISALLOWED. The amount disallowed, within the meaning of section 613A(d)(1) and paragraph (a) of section 1.613A-4, is the excess of the amount of the aggregate of the taxpayer's allowable depletion deductions (whether based upon cost or percentage depletion) computed without regard to section 613A(d)(1) over the amount of the aggregate of such deductions computed with regard to such section. The disallowed amount shall be carried over to the succeeding year and treated as an amount allowable as a deduction pursuant to section 613A(c) for the succeeding year, subject to the 65-percent limitation of section 613A(d)(1) and the rules contained in section 1.613A-4(a).

(r) RETAILER. (1) Except as otherwise provided in paragraph (r)(2) of this section, the term "retailer" means any taxpayer who directly, or through a related person (as defined in paragraph (m)(1) of this section), sells oil or natural gas, or any product derived from oil or natural gas --

(i) Through any retail outlet operated by the taxpayer or a related person, or

(ii) To any person --

(A) Obligated under an agreement or contract with the taxpayer or a related person to use a trademark, trade name, or service mark or name owned by such taxpayer or a related person, in marketing or distributing oil or natural gas or any product derived from oil or natural gas, or

(B) Given authority, pursuant to an agreement or contract with the taxpayer or a related person, to occupy any retail outlet owned, leased, or in any way controlled by the taxpayer or a related person.

For purposes of the preceding sentence, bulk sales (i.e., sales in very large quantities) of oil or natural gas (but not bulk sales of any product derived from oil or natural gas) to commercial or industrial users shall be disregarded. In addition, sales of oil or natural gas (whether or not produced by the taxpayer), or of any product derived from oil or natural gas, which are made outside the United States shall be disregarded if no domestic production of oil, natural gas (or products derived therefrom) of the taxpayer or a related person is exported during the taxable year or the immediately preceding taxable year.

(2) Notwithstanding paragraph (r)(1) of this section, the taxpayer shall not be considered a retailer in any case where, during the taxable year of the taxpayer, the combined gross receipts from sales (excluding sales for resale) of oil or natural gas, or products derived therefrom, of all retail outlets taken into account under paragraph (r)(1) of this section (including sales through a retail outlet of oil, natural gas, or a product derived from oil or natural gas which had previously been the subject of a sale described in paragraph (r)(1)(ii) of this section) do not exceed $5 million. If the taxpayer's combined gross receipts for the taxable year exceed $5 million, the taxpayer will be treated as a retailer as of the first day in which a retail sale was made. For purposes of paragraph (r)(1) of this section, a taxpayer shall be deemed to be selling oil or natural gas (or a product derived therefrom) through a related person in any case in which any sale of oil or natural gas (or a derivative product) by the related person produces gross income from which the taxpayer may benefit by reason of the taxpayer's direct or indirect ownership interest in the related person. In such cases (and in any other case in which the taxpayer is selling through a retail outlet referred to in section 613A(d)(2)(A) or is selling such items to a person described in section 613A(d)(2)(B)), it is immaterial whether the oil or natural gas which is sold, or from which is derived a product which is sold, was produced by the taxpayer. A taxpayer shall be deemed to be selling oil or natural gas (or a derivative product) through a retail outlet operated by a related person in any case in which a related person who operates a retail outlet acquires for resale oil or natural gas (or a derivative product) which the taxpayer produced or caused to be made available for acquisition by the related person pursuant to an arrangement whereby some or all of the taxpayer's production is marketed. An owner of a nonoperating mineral interest (such as a royalty) shall not be treated as an operator of a retail outlet merely because the owner's oil or gas is sold on the owner's behalf through a retail outlet operated by an unrelated person. In addition, the mere fact that a member of a partnership is a retailer shall not result in characterization of the remaining partners as retailers. However, any partner of a partnership who has a 5 percent or more interest in any entity actually engaging in retail activities (including the partnership or another entity to which the partnership is related) is treated as a retailer. See paragraph (m)(1) of this section for rules on the ownership interest by partners in an entity related to a partnership. Similarly, if a trust or estate is a retailer, only its beneficiaries having a 5 percent or more current income interest from the trust or estate are treated as retailers. A person who is a retailer during a portion of the taxable year shall be treated as a retailer with respect to a fraction of that person's gross and taxable income from

oil or gas properties for the taxable year, the numerator of which is the number of days during the taxable year in which the taxpayer is a retailer and the denominator of which is the total number of days during the taxable year; except that a person who ceases to be a retailer during the taxable year before the first production of oil or gas during such year shall not be treated as a retailer for any portion of such year.

(3) For purposes of this paragraph (r), the term "any product derived from oil or natural gas" means gasoline, kerosene, Number 2 fuel oil, refined lubricating oils, diesel fuel, butane, propane, and similar products which are recovered from petroleum refineries or extracted from natural gas in field facilities or natural gas processing plants. The term "retail outlet" means any place where sales of oil or natural gas (excluding bulk sales of such items to commercial or industrial users), or a product of oil or natural gas (excluding bulk sales of aviation fuels to the Department of Defense), accounting for more than 5 percent of the gross receipts from all sales made at such place during the taxpayer's taxable year, are systematically made for any purpose other than for resale. For this purpose, sales of oil or natural gas, or any product derived from oil or natural gas, to a person for refining are considered as sales made for resale.

(s) REFINER. A person is a refiner if such person or a related person (as defined in paragraph (m)(1) of this section) engages in the refining of crude oil (whether or not owned by such person or related person) and if the total refinery runs of such person and any related persons exceed 50,000 barrels on any day during the taxable year. A refinery run is the volume of inputs of crude oil (excluding any product derived from oil) into the refining stream. For purposes of this paragraph, crude oil refined outside the United States shall be taken into account. Refining is any operation by which the physical or chemical characteristics of crude oil are changed, exclusive of such operations as passing crude oil through separators to remove gas, placing crude oil in settling tanks to recover basic sediment and water, dehydrating crude oil, and blending of crude oil products.

Par. 5. Section 1.702-1(f) is amended by revising the heading and by adding a new sentence at the end thereof to read as follows:

SECTION 1.702-1 INCOME AND CREDITS OF PARTNER.

* * * * *

(f) CROSS-REFERENCES. * * * In the case of a disposition of an oil or gas property by the partnership, see the rules contained in section 613A(c)(7)(D) and section 1.613A-3(e).

Par. 6. Section 1.703-1 is amended by redesignating paragraph (a)(2)(vii) as paragraph (a)(2)(viii) and adding a new paragraph (a)(2)(vii), to read as follows:

SECTION 1.703-1 PARTNERSHIP COMPUTATIONS.

(a) * * *

(2) * * *

(vii) The deduction for depletion under section 611 with respect to domestic oil or gas which is produced after December 31, 1974, and to which gross income from the property is attributable after such year.

* * * * *

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 7. The authority for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 8. Section 602.101(c) is amended by inserting in the appropriate place in the table "section 1.613A-3(l) . . . 1545-0919"