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Sec. 29 nonconventional fuels credit: 1993 highlights.

Since 1980, a credit under Sec. 29 has been available to oil and gas producers as an incentive to find and produce fuel from designated nonconventional sources (primarily oil from shale and tar sands, and gas from geopressurized brine, Devonian shale, coal seams and tight formations). The credit is available for qualifying nonconventional fuel produced and sold before Jan. 1, 2003, if wells were drilled after Dec. 31, 1979, but before Jan. 1, 1993. Adjusted for inflation, the credit is worth over $5.50/barrel or almost $1.00/mcf. A flurry of drilling activity related to the expiration of the "drilling window" took place at the end of 1992, primarily in Texas, Alabama, Colorado, New Mexico and the Appalachian region, where large deposits of nonconventional fuels have been found. Even though wells were required to have been drilled by Dec. 31, 1992 to qualify for the credit, a number of Sec. 29 issues continued to be debated, and to some extent were resolved, during 1993.

One of the more important issues was how the end of the "drilling window" would be determined. Several years ago, the IRS held in Rev. Rul. 90-70 that a well is considered to have been "drilled" as of the date it is spudded (the commencement of actual drilling operations), provided drilling is continued until the productive horizon is reached. Specifically what satisfies this test was explored during 1993 in two rulings.

In Letter Ruling 9316033, the Service ruled that gas produced from a coal seam perforated, stimulated and brought into production after Dec. 31, 1992 would be gas produced from a well drilled before Jan. 1, 1993, so long as (1) the wellbore was spudded after Dec. 31, 1979 and before Jan. 1, 1993, (2) at the time the wellbore was spudded, such coal seam gas was within the "productive horizon" targeted by the taxpayer, and (3) the perforation and stimulation activity with respect to such coal seam has been continuously pursued in a diligent manner and consistent with sound engineering and development practices. In this ruling, all wells had been spudded and drilled to their total depth before the close of the window period, and were scheduled to be completed before the end of 1993.

In a second ruling, post-1992 recompletions (completing a well again in the same or different producing zone) of wells originally spudded before Jan. 1, 1993 were considered. Rev. Rul. 93-54 discussed two situations. In the first, during the drilling of a well to produce crude oil, it was learned that a coal seam gas deposit had been penetrated above the oil reservoir. In 1994, after all the oil that could be economically produced had been recovered, the taxpayer planned to plug the oil zone and recomplete the well to produce gas from the coal seam. The IRS concluded that because the well was drilled to the productive horizon before Jan. 1, 1993, the gas would qualify for the credit. In a second situation, the taxpayer planned to deepen a wellbore and perforate multiple intervals during 1994 to produce gas from a tight formation below a previously depleted oil reservoir. The Service held the gas recovered from the redrilled well would not qualify for the credit because there had not been continual drilling to the productive horizon. Therefore, so long as a recompletion after Dec. 31, 1993 does not involve the additional drilling to deepen or extend the well, the fuel produced as a result should qualify for the nonconventional fuels credit.

In Texaco Inc. & Subsidiaries, 101 TC No. 38 (1993), the Tax Court ruled that the definition of "tar sands" for the purpose of the Sec. 29 credit did not include high viscosity crude oil that could be produced through current enhanced oil recovery techniques. Texaco claimed that under the common industry definition developed by the Department of Energy, "tar sands" meant a naturally occurring formation containing a hydrocarbon so viscous that it could not be economically produced through primary recovery methods. The IRS argued that the correct definition was the one contained in Federal Administration Ruling 1976-4, which excluded oil recovered by currently available enhanced oil recovery techniques. The court agreed with the Service and held that the definition included only extremely viscous hydrocarbons not recoverable by conventional (primary) oil well production methods, including currently used enhanced recovery techniques. (It is likely that this decision will be appealed.)

Another issue is what actually constitutes a sale of production to an unrelated person, as required by Sec. 29(a). Sec. 29(d)(7) provides that for a corporation that is a member of an affiliated group filing a consolidated return, the corporation is treated as selling qualified fuels to an unrelated person if the fuels are sold to the unrelated person by another group member. Letter Ruling 9322010, involving several subsidiaries engaged in various phases of oil and gas production, marketing and distribution, elaborated on this rule. The market subsidiary was obligated by contract to sell to unrelated persons any qualified gas from tight sands and coal seams bought from the producing subsidiary. The volume of gas the marketing subsidiary sold to unrelated parties was equal to or greater than the volume of qualified gas bought from the producing subsidiary. The Service held that the qualified gas, even though physically commingled with nonqualified gas for transporting and processing, was treated as sold to unrelated persons (as required by Sec. 29(d)(7)).

In addition, several miscellaneous Sec. 29 issues received attention by agencies other than the Treasury during 1993. For example, Sec. 29(c)(2)(A) requires that the determination of whether gas is produced from a qualifying formation be made in accordance with Section 503 of the Natural Gas Policy Act (NGPA) of 1978. The Federal Energy Regulatory Commission (FERC) extended its deadline for receipt of notices of NGPA category determination to Apr. 30, 1994, even though category determinations to the appropriate jurisdictional agencies were required to have been filed by Dec. 31, 1992. After the extended deadline, FERC will no longer approve determinations. The IRS, however, appears to be taking the position that the lack of a FERC approval of category determination will not be fatal to qualification, given the fact pattern and timing of the situations outlined in Rev. Rul. 93-54 (category determination approval of qualifying fuel from the recompleted well probably would not have occurred until after Apr. 30, 1994). It is also likely, based on past technical corrections packages, that a future tax bill will transfer FERC's expired authority to approve determinations to the Treasury.

And in an interesting attempt to fill the Federal coffers, the Acting Inspector General of the Minerals Management Service (MMS) submitted a report during 1993 claiming that MMS should have collected royalties on the value of Sec. 29 credits (whether or not the taxpayer received any tax benefit) related to qualifying production on Federal and Indian lands. It was asserted that the failure to assess royalties on the Sec. 29 credit had cost the government $74 million since 1989 and would cost $210 million over the next 10 years. After review, Interior Department lawyers rightly rejected this attempt to collect additional revenue.
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Author:Lewis, Tara W.
Publication:The Tax Adviser
Date:Jul 1, 1994
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