Phillips Petroleum Co. v. Commissioner, Docket No. 34019-87.
| Decision Date | 06 June 1991 |
| Docket Number | Docket No. 34019-87. |
| Parties | Phillips Petroleum Co. and Affiliated Subsidiaries v. Commissioner. |
| Court | U.S. Tax Court |
Respondent determined the following deficiencies in petitioner's Federal income tax:
Year Deficiency
1975 ......................... $ 3,842,229.12
1976 ......................... 14,706,626.78
1977 ......................... 31,148,144.82
1978 ......................... 45,755,365.67
The present issues for decisions1 are: (1) Whether petitioner erroneously claimed a worthless properties deduction in 1978 with regard to an oil and gas lease, and (2) whether petitioner erroneously claimed interest expense deductions in 1975 through 1978 with regard to certain Federal income tax deficiencies. For convenience, we will separately state our Findings of Fact and Opinion for each issue.
Some of the facts have been stipulated and are so found. The stipulations of fact and exhibits attached thereto are incorporated herein by this reference.
Petitioner is an affiliated group of corporations that filed consolidated Federal income tax returns for the years at issue. They maintained their books and filed the returns on the calendar year basis and according to the accrual method of accounting.
Phillips Petroleum Company (hereinafter Phillips) was the common parent and a member of petitioner. It had its principal office at Bartlesville, Oklahoma, when the petition in this case was filed.
During the years at issue petitioner was primarily engaged in the business of acquiring, exploring, developing, and operating oil and gas properties, and selling the production therefrom.
On October 27, 1977, a lease sale was held by the United States Department of the Interior, Bureau of Land Management. The sale, referred to as "Oil and Gas Lease Sale No. CI," was conducted pursuant to the Outer Continental Shelf Lands Act, 67 Stat. 462, 43 U.S.C. secs. 1331-1343 (1986). It offered, by a competitive bidding process, oil and gas leases of offshore tracts adjacent to the State of Alaska. Phillips participated in this sale, submitted a number of bids, and was awarded several leases. Among these was a lease, Serial Number OCS-Y-0084, to a tract titled "Block 274" (a.k.a. Tract No. CI-8). Phillips' leasehold interest in Block 274 was full and undivided.
Phillips paid a total $48,402,432 "lease bonus" on Block 274. It tendered one-fifth of this amount ($9,680,486.40) when it submitted its bid on October 27, 1977. Phillips paid the remaining $38,721,945.60 on or about November 28, 1977.
The lease commenced on December 1, 1977. It was for a 5-year term, and so long thereafter as oil or gas was produced from the tract in "paying quantities," or certain drilling or well reworking operations were conducted. Phillips agreed to pay, on or before the first day of each lease year, "delay rentals" of $8.00 per hectare, or $18,432,2 for each lease year commencing prior to a discovery of oil or gas. The lease provided that Phillips may surrender the "entire lease or any officially designated subdivision of the leased area" by a written filing. Phillips held the lease until it expired on December 1, 1982. It made delay rental payments on or before December 1st of each of the 5 lease years (1977-81).
Block 274 was located in the Lower Cook Inlet of Alaska. As of the October 1977 lease sale, no oil or gas had been produced in that area, and much was unknown about its geology. It was considered to be a "wildcat" area, and to have expensive operating costs. There had, however, been substantial oil and gas production in the contiguous Upper Cook Inlet and its adjacent onshore areas.
In preparing its bid on Block 274, Phillips personnel consulted and prepared multiple studies and tests of the area. These included seismic information, economic analyses, and assessments of potential oil and gas structures and reserves. Also consulted were data collected from the three offshore wells which had previously been drilled (and plugged) in the Lower Cook Inlet. These wells had been located at distances approximately 10-20 miles from Block 274's location.
Phillips personnel identified several potential oil and gas bearing structures. One of these, the "West Anchor Prospect," covered portions of four blocks,3 including Block 274. The West Anchor Prospect was a large anticlinal structure bisected by a fault. The fault ran through Block 274. Anticlinal structures are considered to bear potential oil and gas reserves because they contain the type of trap in which oil and gas may accumulate.
Following the lease sale, in July 1978, Phillips entered into a "Joint Exploration Agreement" with other companies which held lease interests in the West Anchor Prospect. The agreement designated a "Joint Exploration Area," which included a southeastern portion of Block 274.
Pursuant to the agreement, the parties cosponsored an exploratory well, identified as "Marathon OCS-Y-0086 Well #1" (the Marathon Well), in the northeast corner of Block 318. Block 318 was the block immediately south of Block 274, and the Marathon Well was located approximately 500 feet from Block 274. It was believed that this well would test the "upthrown" or eastern side of the fault which ran through the West Anchor prospect and Block 274.
The Marathon Well was spudded on July 21, 1978. It reached a total depth of 13,315 feet on or about November 27, 1978. The well was plugged and abandoned on or about December 27, 1978.
The data received from the Marathon Well was unfavorable. Although certain amounts of oil and gas were encountered, no commercial deposit was found. A December 15, 1978, press release publicly stated the well's results, and that it was being plugged and abandoned.
Petitioner claimed a total $36,301,824 worthless properties deduction on its 1978 consolidated Federal income tax return. As part of that return, petitioner filed three Forms 927, "Proof of Worthlessness of Mineral Rights." The following three "properties" and their "costs" were identified on the forms:
Property Cost
W. Anchor A - 274T ................. $19,360,972.80
W. Anchor A - 274LK ................ 7,260,364.80
W. Anchor A - 274UJ ................ 9,680,486.40
The forms stated that the entire costs of the properties were allocated to mineral rights. They also stated that title to the properties had not been disposed of, and that the properties had not been offered for sale. In response to a request for information regarding developments on the properties or within one mile, as well as any mineral production thereon, the forms provided the following statement: "Exploratory Dry Hole drilled on adjacent tract (Well O.C.S. Y-0086 #1)." This was a reference to the Marathon Well. No other details were provided; instead, the forms referenced to "Information in taxpayer's files."
The "properties" identified on the Forms 927 were actually references to horizontal subsurface strata in the same tract, identified by their geologic eras. Petitioner had previously, on its 1977 consolidated tax return, attached a document entitled "Election to Treat Separate Operating Mineral Interests in Single Tracts as Separate Properties." That document stated that, pursuant to Reg. section 1.614-8(a)(3)ii (sic), it was identifying separate operating mineral interests within the same tracts or parcels of land. Among these tracts was Block 274, and the "interests" identified therein were "274-T," "274-UK," "274-LK," and "274-UJ." These abbreviations referred to Tertiary, Upper Cretaceous, Lower Cretaceous, and Upper Jurassic strata, respectively.
Phillips based this division of Block 274 upon available geological and geophysical information, including data from the three offshore wells which had been drilled in the Lower Cook Inlet prior to the lease sale. Results from the Marathon well supported the presence of the four strata in Block 274.
Phillips figured the "costs" of the strata listed on its 1978 Forms 927 based upon an allocation of the lease bonus that it had paid on Block 274. It based its allocation of the lease bonus between the strata upon its estimates of the oil and gas reserves in each strata.4
On or about February 20, 1979, Phillips received a notification that, unless the parties agreed to drill a subsequent well, the Joint Exploration Agreement would terminate. No such agreement was reached. On or about March 13, 1979, Phillips received a letter stating that the Joint Exploration Agreement had, by its terms, terminated upon the plugging and abandonment of the Marathon Well, conditioned upon a settlement of all accounts.
Interoffice correspondence and other documents indicate that Phillips had been contemplating drilling a well on Block 274. A chart entitled "Time Schedule for Lower Cook Inlet Drilling Operations," dated August 10, 1978, stated that a well on Block 274 was scheduled for January 1980. A November 30, 1978, interoffice memorandum mentions, inter alia, that an exploratory drilling plan for certain wells had been approved. The prospective wells included one on Block 274, referred to as "West Anchor No. 2." By a letter dated January 3, 1979, Phillips submitted to the District Engineer, United States Army Engineer District, a revised schedule for drilling certain Lower Cook Inlet wells, including West Anchor No. 2. The revised schedule stated that the drilling would be commenced on or about April 15, 1980, and be completed by October 1, 1980. West Anchor No. 2 remained listed as part of Phillips' "original drilling program plan" in an interoffice...
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