Shell Oil Co. v. Comm'r of Internal Revenue

• Decision Date: 01 September 1987
• Docket Number: Dkt. No. 13180-84
• Citation: 89 T.C. No. 33,89 T.C. 371
• Parties: SHELL OIL COMPANY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

89 T.C. 371

89 T.C. No. 33

SHELL OIL COMPANY, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Dkt. No. 13180-84

United States Tax Court

Filed September 1, 1987.

Petitioner is an integrated oil company. Following the enactment of the Crude Oil Windfall Profit Tax Act of 1980, Pub. L. 96-223, 94 Stat. 229, petitioner changed its method of calculating ‘taxable income from the property‘ under section 613(a). Consequently, petitioner claimed a net income limitation benefit against its windfall profit tax liability pursuant to section 4988(b), I.R.C. 1954, totaling $241 million, which respondent disallowed in full. HELD, petitioner may treat net interest expense incurred in the acquisition of oil and gas properties through one of its wholly owned subsidiaries as financial overhead allocable, in part, to its producing properties in the calculation of taxable income from the property. HELD FURTHER, dry hole costs incurred on petitioner's abandoned and nonproducing properties, abandoned geological and geophysical costs, and costs of abandoned leaseholds may not be treated as indirect costs of its producing properties in the calculation of taxable income from the property. HELD FURTHER, if otherwise deductible for income tax purposes, costs of exploration efforts may be deducted in the calculation of taxable income from the property. HELD FURTHER, exploratory or developmental efforts not directly or indirectly attributable to producing properties may not be allocated to producing properties in the calculation of taxable income from the property. HELD FURTHER, intangible drilling costs currently deducted under sec. 263(c), I.R.C. 1954, are properly included in the stipulated allocation base used to allocate indirect expenses in the calculation of taxable income from the property. HELD FURTHER, petitioner's windfall profit tax liability is properly included in the stipulated allocation base used to allocate indirect expenses in the calculation of taxable income from the property. HELD FURTHER, current geological and geophysical expenditures must be included in the stipulated allocation base used to allocate indirect expenses in the calculation of taxable income from the property. Sec. 613(a), I.R.C. 1954, sec. 1.613-5(a), Income Tax Regs., interpreted. Charles W. Hall, S.C. Stryker, Charles R. Herpich, Jr., Jim D. Brown, Kenneth W. Gideon, William S. Lee, Robert H. Wellen, and Jasper G. Taylor, III, for the petitioner.

David W. Johnson, Sheri A. Wilcox and Jeffrey N. Kelm, for the respondent.

GOFFE, JUDGE:

The Commissioner determined deficiencies in petitioner's windfall profit tax under section 4986 ¹ for the taxable quarters ended March 31, 1980, June 30, 1980, September 30, 1980, and December 31, 1980 as follows:

+-----------------------------------+
                ¦Taxable quarter ended--¦Deficiency ¦
                +-----------------------+-----------¦
                ¦3/31/80                ¦$12,050,373¦
                +-----------------------+-----------¦
                ¦6/30/80                ¦54,129,746 ¦
                +-----------------------+-----------¦
                ¦9/30/80                ¦73,773,559 ¦
                +-----------------------+-----------¦
                ¦12/31/80               ¦101,841,218¦
                +-----------------------------------+
                

Alternatively, the Commissioner determined a deficiency in petitioner's windfall profit tax under section 4986 for the entire taxable year ended December 31, 1980 in the amount of $241,810,176.17.

The issues in this case concern the attribution and allocation of expenses for the calculation of the taxable income from petitioner's oil and gas properties under section 1.613-5(a), Income Tax Regs., for purposes of the windfall profit tax net income limitation. We must decide (1) whether net corporate interest of $145,585,641 incurred in the acquisition of Belridge Oil Company by a subsidiary of petitioner should be treated as general corporate overhead and allocated, in part, to petitioner's exploration and production activity; (2) whether petitioner correctly attributed several overhead expenses, indirect exploration expenses, and abandonment losses to its producing and nonproducing properties; (3) whether intangible drilling and development costs (IDC) and windfall profit tax (WPT) should be included as direct expenses when the relative direct expense method is used to allocate overhead and indirect expenses to determine taxable income from the property.

FINDINGS OF FACT

Most of the facts have been stipulated. The stipulations of fact and accompanying exhibits are incorporated by this reference.

Shell Oil Company (petitioner) is a corporation organized under the laws of Delaware with its principal office in Houston, Texas. petitioner is an integrated oil company involved in all facets of the petroleum industry from exploration through development and production to purchasing, refining, manufacturing, transportation, and marketing. During the taxable periods in issue, petitioner was organized into two primary organizations referred to as the Products organization and the Exploration and Production organization. The Exploration and Production organization had the responsibility for finding and producing crude oil and natural gas. The Products organization included all other activities of petitioner such as refining, marketing, and the manufacture of chemicals derived, in whole or in part, from petroleum. In addition, petitioner had an administration group composed of service departments such as employee relations, legal, public affairs, and finance departments, which supported the two operating organizations.

The Exploration and Production organization was divided into four regions, Eastern Region Operations, Western Region Operations, Mining Operations, International Operations. Mining and International Operations contributed less than one percent of the total gross income from the Exploration and Production organization and their activities are generally not germane to the issues in this case. During the taxable year 1980, Eastern Region Operations and Western Region Operations were composed of three divisions, each of which are separately engaged in oil and gas exploration, development, and production activities within defined geographic areas.

The search for, acquisition and exploitation of oil and gas reserves may be referred to as the exploration and production cycle. Petitioner's exploration and production cycle began when its geologists or geophysicists selected areas with potential oil and gas reserves. If petitioner decided to investigate these potential reserves further, the exploration and production cycle entered the ‘probe‘ stage. During this stage preliminary studies were made by the exploration department, including regional geological studies and seismographic testing, and by the land department, which determined the amount of acreage available in the area and the probable cost of the mineral rights in terms of lease bonuses and royalty provisions. The production department was also involved at this stage providing information for the economic analysis to determine whether the probe should be developed further. When the exploration department decided, with the input of the land and production departments, that a probe warranted further exploration, it was termed a ‘play.‘ At this stage the exploration department obtained more seismographic data and attempted to map multiple prospects within the play so petitioner could benefit from any successful development efforts. At this stage petitioner's exploration, land, and production departments pooled their information in an attempt to calculate the present value of the production department profit on development or PDPOD for a prospect. If the decision were made to discontinue exploratory efforts, the land department assumed primary responsibility for dropping the prospects either through farm-out arrangements or surrender of the leases. If petitioner decided to drill one or more exploratory or wildcat wells, the exploration department authorized the land department to acquire mineral leases in specified areas. The exploration department then sent a request to the production department for a detailed plan for drilling the wildcat well or wells and an estimate of the drilling cost. The exploration department then authorized and provided funds for the drilling of the wildcat well or wells. The production department drilled the wildcat well or wells typically through use of a contract driller.

After a wildcat well was drilled, the production department evaluated the well to determine if it appeared to be capable of producing oil or gas or both in commercial quantities. Many such wells were dry holes and clearly incapable of commercial success; others were clearly commercially productive wells. In cases where it was not obvious whether the well was capable of producing oil and gas in commercial quantities, the exploration department and the production department worked together to assess the commercial potential of the well. Disputes as to whether an exploratory well was commercially productive were resolved by the division general manager.

If it were determined that an exploratory well was capable of producing oil and gas in commercial quantities, the supervision of the prospect was transferred from the exploration department to the production department, which was responsible for developing the prospects included in the play. The production department then drilled wells to fully exploit the newly discovered reserves. The exploration department often remained involved during the development phase by making additional seismographic tests and reinterpreting earlier exploratory data with the additional information provided by the wildcat, and by advising the production department concerning the locations of the wells.

The land department continued to be involved during the production phase of the exploration and production cycle. The land department maintained petitioner's lease files and was responsible for...