Oil hedging results are excluded from property income for the IDC preference

Plain-English summary

Chief Counsel considered whether gains and losses from oil-price hedges enter the property-income calculation used for the alternative minimum tax preference for excess intangible drilling costs. The advice concluded that they do not, even when hedge volumes are based on expected production and the hedges serve as price protection rather than speculation. “Gross income from the property” under IRC § 613 concerns the price of the actual oil or gas extracted from each specific property, and depletion is calculated property by property. For the same reason, hedge gains and losses are not income from or deductions allocable to the properties when calculating net oil-and-gas income under IRC § 57(a)(2)(C).

Ruling snapshot

• Question: Are oil-and-gas hedge gains and losses included in gross or net income from the properties for the excess IDC preference?
• Outcome: Advice given. No, the calculation is limited to actual production and property-related deductions.
• Key authorities: IRC §§ 57(a)(2), 611, 613; Treas. Reg. §§ 1.613-3, 1.613-5

Full text (IRS public release)

ID: CCA_2016071114410719
UILC: 56.54-04, 613.02-00

Number: 201722028
Release Date: 6/2/2017

From: -------------------
Sent: Monday, July 11, 2016 2:41:07 PM
To: -------------------------------
Cc: -------------------
Bcc:
Subject: FW: ----------Oil and Gas Issue - IDC Preference Issue

I told you that you would have this by last week; ---------- sent it to my box by mistake. Here it is; sorry
for the delay.

  You requested that we provide comments on ----------------------------------------------------
  concerning the intangible drilling and development costs (IDC) preference issue. ----
  -----------------------------------------------------------------------the -------------------------that the
  amount of its hedging is based on reserves and likely production from drilling,
  assuming that is an important distinction between its hedging transactions and
  “speculative hedging.” That fact is irrelevant, ----------------------------------------------------
  ---------------------------------------------------------------------------------------------------------, it
  “enters into these hedges in order to establish the prices that it will receive with
  respect to its oil and gas inventory.” The key part of the definition ------------------------
  ---------------------------------------------------------------------------------------------------------------
  ------------ – that is “[i]n the case of oil and gas wells, ‘gross income from the
  property,’ means the amount for which the taxpayer sells the oil or gas in the
  immediate vicinity of the well.” While the hedging is not a speculative investment,
  but is intended as price insurance (or assurance perhaps), it has no connection to
  the amount for which the taxpayer sells the oil or gas in the immediate vicinity of the
  well. The oil represented by the hedging contracts is not the oil produced by the
  taxpayer from the property. The -------------------------------gloss over the key
  connection between the reason for the calculation of gross income from the property
  made under § 613 (figuring the depletion allowance under § 611) and the specific oil
  produced from the property. Depletion and gross income from the property by
  extension are determined on a property by property basis. Depletion with respect to
  an oil or gas property is dependent on the production and sale of mineral from that
  property. Oil or gas produced from one property cannot be taken into account in
  determining depletion on another property. Consequently, no hedging or other
  transaction that does not concern the actual oil or gas extracted from the property

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has any relevance in computing the allowance for depletion, which is, after all, a
measure of the diminution of the of the mineral property due to the extraction of the
minerals (oil or gas in this case) from the property. So ---------------------------------------

-----------------------------------------concerning the price of inventory, limits on amounts
of oil represented by the hedging contracts, and examples of -------------------------------
--------------can obscure the simple fact that we are not calculating the price ultimately
received by the taxpayer after all contracts are closed but the gross income received
from the sale of particular oil or gas extracted from a particular property.

Our view on the meaning of § 57(a)(2)(C) is set forth more fully below, in our answer
to question 3, ----------------------------------------------------------------------------- that nothing
in §§ 57(a), 613(a) or the regulations thereunder limits gross income, arguing that
the § 613 reference is only to “gross income” but --------------------------the definition in
§ 57(a)(2)(C)(i) by leaving out the word “all” – the definition reads “gross income
(within the meaning of section 613(a)) from all oil, gas, and geothermal properties of
the taxpayer…” so that the reference is again to specific properties producing
specific income, rather than to oil and gas income generally, ------------------- ------------
------------. We believe that § 1.613-3 demonstrates the difference between “gross
income” and “gross income from the property.” Under that provision, if the oil or gas
produced from a mineral property is not sold at the wellhead but is processed,
refined, or transported prior to sale, the gross income from the property is assumed
to be equivalent to the representative market or field price of the oil or gas before
processing, refining, or transportation, i.e., the price for which the oil or gas would
have been sold in the immediate vicinity of the well. The reasoning underlying this
provision is that when the mineral is processed or transported prior to sale, the
processing or transportation increases the amount for which the oil or gas ultimately
is sold. Although the proceeds from the sale of the refined or transported mineral is
gross income to the taxpayer, the amount in excess of the what the raw mineral
would have sold for is not taken into account in computing depletion. Instead the
taxpayer is required to go back to the wellhead and take into account in computing
depletion only the amount for which the extracted mineral would have sold.

The purpose of § 57(a)(2)’s limitation is to limit for AMT purposes the amount of
deductible IDC to a percentage of the gross income produced by the properties
generating those IDC. That is really the only logical interpretation of the measure of the
limitation sought by congress on excess IDCs; it would make no sense to measure the
amount of IDCs considered “excess” by a calculation including hedging transactions not
related to the oil and gas properties of taxpayer.

---------------------------------------------------an extended analysis of § 613(c), Corn Products
(discussed below), and CCA 2009-008. None of this material addresses the
fundamental limitation provided by the words “from the property.” Section 613(c) relates
to mining and § 613(c)(1) states that the definitions therein relate to “property other than
an oil or gas well” so any relevance here is only by analogy, and the CCA reaches
conclusions ------------------------------------------------------. The discussion of Corn Products

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again focuses on the court’s statements regarding inventory versus investment
transactions, which discussion is completely irrelevant to whether hedging transactions
in a stated amount of oil that is not being extracted from the taxpayers’ oil and gas
properties are considered includible within the gross income from those
properties. Even if one assumes, arguendo, that hedging contracts should be treated
as “surrogates for the raw material itself” -----------------------------or inventory, as are
futures contracts, that conclusion only advances ------------------to having oil or gas
purchased from a third party. The oil or gas represented by the hedging transactions is
still not from the --------------- properties and still not within the definition of “gross income
from the property” within the meaning of § 1.613-3.

-------------------------------------------------------------------------regarding a statement from an
uncited 1978 House Report, the legislative history to section 402 of The Energy Tax Act
of 1978, Pub. L. 95-618, § 402, 92 Stat. 3175, 3201 (1978), states “The bill also
provides that the excess of the intangible drilling and development costs over the
amount of those costs that would have been amortizable on the basis of a 10-year life
and which further exceed the taxpayer’s income from the production of geothermal
resources constitutes a tax preference item for purposes of the alternative minimum tax
on individuals. To ascertain the amount of the intangible drilling and development costs
over the amount amortizable, which is subject to the minimum tax, the taxpayer’s
income from oil and gas properties and geopressurized methane gas properties is to be
determined separately from the calculation of income from geothermal properties.” S.
Rep. 95-529, at 92, 1978-3 C.B. (Vol 2) 284; See also, H.R.Rep. No. 95-496 (Part III), at
247, 1978-3 C.B. 193. While the statute has changed, ----------------------------that the
committee was limiting the preference item to investors in shelters and not to those
engaged in the oil and gas business, the committee reports show that the Congress
intended that the preference be determined by gross income from the actual properties,
even dividing the favored geothermal properties from the less favored oil and gas
properties, and not from all transactions in purchased (or hedged) oil.

2. You asked whether the Corn Products’ ruling that futures contracts were integral to
   the taxpayer’s inventory system and that gains and losses from transactions involving
   those futures contracts were therefore ordinary supports -----------------------------------that
   gains and losses from hedging transactions are included within the calculation of “gross
   income from the property” under § 1.613-3. We view the question before the Court as
   so different from that at issue here that no analogy can be drawn. The definition of
   “gross income from the property” in § 1.613-3 is “[i]n the case of oil and gas wells,
   ‘gross income from the property,’ means the amount for which the taxpayer sells the oil
   or gas in the immediate vicinity of the well. If the oil or gas is not sold on the premises
   but is manufactured or converted into a refined product prior to sale, or is transported
   from the premises prior to sale, the gross income from the property shall be assumed to
   be equivalent to the representative market or field price of the oil or gas before
   conversion or transportation.” The definition makes clear that the “gross income from
   the property” relates to specific oil from a specific well. The purpose of determining
   gross income from the property is in order to calculate the allowance for depletion under
   § 611, which as we noted above is determined on a property by property basis, taking

                                       4
   

into account with respect to a mineral property only the oil and gas extracted and sold
from that property. Thus, while the Supreme Court reasoned from the taxpayer’s
entering into futures contracts due to its need to ensure a steady supply of corn at a
reliable price to concluding that the income or loss from the futures contracts should be
considered as part of the taxpayer’s inventory cost rather than gain or loss from
investment or capital transactions, the issue here is much more narrow. Hedging
transactions give the taxpayer price protection or certainty but the hedging contract,
even if the amount hedged is based on the amount the taxpayer anticipates extracting
from its wells, has no relationship to the particular oil that is extracted from those
wells. The definition is focused narrowly on the oil actually extracted and sold, and not
on income from oil production generally, because the only reason for determining “gross
income from the property” is to calculate the allowance for depletion. Congress
borrowed to this definition in section 57(a)(2)(C) in defining “gross income (within the
meaning of section 613(a)) from all oil, gas, and geothermal properties of the
taxpayer…” in calculating excess intangible drilling cost; this makes perfect sense
because the excess IDC at issue are those with respect to “all oil, gas, and geothermal
properties of the taxpayer” – that is, the specific IDC for the taxpayer’s specific
properties that exceed 65 percent of the net income from those specific properties and
not some unrelated measure of net income from oil and gas production (which could
include income or loss from hedging transactions only tangentially related to the
production from taxpayer’s properties). This is consistent with the general treatment of

3. You ask whether calculation of net income from oil and gas under § 1.613-5 should
   include hedging gains and losses. The term “net income from oil and gas” is used in §
   57(a)(2)(C) uses that term and does not define the term by referencing § 1.613-
4. However, we believe that § 1.613-5 is instructive in limiting the scope of the
   deductions from gross income from the property to calculate net income from oil and
   gas. Section 57(a)(2)(C) defines net income from oil, gas, and geothermal properties
   as “(i) the aggregate amount of gross income (within the meaning of section 613(a))
   from all oil, gas, and geothermal properties of the taxpayer received or accrued by the
   taxpayer during the taxable year, over (ii) the amount of any deductions allocable to
   such properties reduced by the excess described in subparagraph (B) [IDCs] for such
   taxable year.” (emphasis added). The section repeatedly refers to “the properties” as
   the key part of the definition; Congress could have used a more inclusive phrase such
   as “from oil and gas operations’ but it limited the net income calculation to income from
   and deductions allocable to the properties. While §57 does not further define what
   deductions may be allocable to the properties, a similar concept is used in the definition
   of net income from oil and gas under § 1.613-5.

Section 1.613-5(a) defines taxable income from the property (computed without
allowance for depletion) as ‘gross income from the property’ as defined in § 613(c) and
§ 1.613-3 and § 1.613-4 less allowable deductions which are attributable to the mineral
processes, including mineral transportation, with respect to which depletion is
claimed. The remainder of the section lists particular items, processes and
transportation expenses that are included within the calculation all of which apply to
processes applied to that property – as with the gross income from the property

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definition, the relevant deductions are all those that relate to the particular
property. Section 1.613-5(a) provides that “where a taxpayer has more than one
mineral property, deductions which are not directly attributable to a specific mineral
property shall be properly apportioned among the properties.” The deductions are
attributable to several mineral properties and are allocated among them but there is no
provision for overhead in that section. Section 1.613-5(c) lists particular items that go
into the computation of taxable income from the property. Several items such as a
portion of trade association dues (§ 1.613-5(c)(6)) and a reasonable portion of the
expenses of selling a refined product are taken into account but there is no provision for
including overhead generally or expenses related to, or gain or loss from, transactions
not directly related to oil and gas produced and sold. Thus, we believe ----------------------
------------------------------to the calculation set forth in § 1.613-5 does not support the
conclusion that gains or losses from hedging transactions should be included in taxable
income from the property.