SECTION 1.612-4. CHARGES TO CAPITAL AND TO EXPENSE IN CASE OF OIL AND
GAS WELLS.
(a) OPTION WITH RESPECT TO INTANGIBLE DRILLING AND DEVELOPMENT COSTS. In
accordance with the provisions of section 263(c), intangible drilling and
development costs incurred by an operator (one who holds a working or
operating interest in any tract or parcel of land either as a fee owner or
under a lease or any other form of contract granting working or operating
rights) in the development of oil and gas properties may at his option be
chargeable to capital or to expense. This option applies to all
expenditures made by an operator for wages, fuel, repairs, hauling,
supplies, etc., incident to and necessary for the drilling of wells and
the preparation of wells for the production of oil or gas. Such
expenditures have for convenience been termed intangible drilling and
development costs. They include the cost to operators of any drilling or
development work (excluding amounts payable only out of production or
gross or net proceeds from production, if such amounts are depletable
income to the recipient, and amounts properly allocable to cost of
depreciable property) done for them by contractors under any form of
contract, including turnkey contracts. Examples of items to which this
option applies are, all amounts paid for labor, fuel, repairs, hauling,
and supplies, or any of them, which are used:
(1) In the drilling, shooting, and cleaning of wells,
(2) In such clearing of ground, draining, road making, surveying, and
geological works as are necessary in preparation for the drilling of
wells, and
(3) In the construction of such derricks, tanks, pipelines, and other
physical structures as are necessary for the drilling of wells and
the preparation of wells for the production of oil or gas.
In general, this option applies only to expenditures for those drilling
and developing items which in themselves do not have a salvage value. For
the purpose of this option, labor, fuel, repairs, hauling, supplies, etc.,
are not considered as having a salvage value, even though used in
connection with the installation of physical property which has a salvage
value. Included in this option are all costs of drilling and development
undertaken (directly or through a contract) by an operator of an oil and
gas property whether incurred by him prior or subsequent to the formal
grant or assignment to him of operating rights (a leasehold interest, or
other form of operating rights, or working interest); except that in any
case where any drilling or development project is undertaken for the grant
or assignment of a fraction of the operating rights, only that part of the
costs thereof which is attributable to such fractional interest is within
this option. In the excepted cases, costs of the project undertaken,
including depreciable equipment furnished, to the extent allocable to
fractions of the operating rights held by others, must be capitalized as
the depletable capital cost of the fractional interest thus acquired.
(b) RECOVERY OF OPTIONAL ITEMS, IF CAPITALIZED.
(1) Items returnable through depletion: If the taxpayer charges such
expenditures as fall within the option to capital account, the
amounts so capitalized and not deducted as a loss are returnable
through depletion insofar as they are not represented by physical
property. For the purposes of this section the expenditures for
clearing ground, draining, road making, surveying, geological work,
excavation, grading, and the drilling, shooting, and cleaning of
wells, are considered not to be represented by physical property, and
when charged to capital account are returnable through depletion.
(2) Items returnable through depreciation: If the taxpayer charges
such expenditures as fall within the option to capital account, the
amounts so capitalized and not deducted as a loss are returnable
through depreciation insofar as they are represented by physical
property. Such expenditures are amounts paid for wages, fuel,
repairs, hauling, supplies, etc., used in the installation of casing
and equipment and in the construction on the property of derricks and
other physical structures.
(3) In the case of capitalized intangible drilling and development
costs incurred under a contract, such costs shall be allocated
between the foregoing classes of items specified in subparagraphs (1)
and (2) for the purpose of determining the depletion and depreciation
allowances.
(4) Option with respect to cost of nonproductive wells: If the
operator has elected to capitalize intangible drilling and
development costs, then an additional option is accorded with respect
to intangible drilling and development costs incurred in drilling a
nonproductive well. Such costs incurred in drilling a nonproductive
well may be deducted by the taxpayer as an ordinary loss provided a
proper election is made in the return for the first taxable year
beginning after December 31, 1942, in which such a nonproductive well
is completed. Such election with respect to intangible drilling and
development costs of nonproductive wells is a new election, and, when
made, shall be binding for all subsequent years. Any taxpayer who
incurs optional drilling and development costs in drilling a
nonproductive well must make a clear statement of election under this
option in the return for the first taxable year beginning after
December 31, 1942, in which such nonproductive well is completed. The
absence of a clear indication in such return of an election to deduct
as ordinary losses intangible drilling and development costs of
nonproductive wells shall be deemed to be an election to recover such
costs through depletion to the extent that they are not represented
by physical property, and through depreciation to the extent that
they are represented by physical property.
(c) NONOPTIONAL ITEMS DISTINGUISHED.
(1) Capital items: The option with respect to intangible drilling and
development costs does not apply to expenditures by which the
taxpayer acquires tangible property ordinarily considered as having a
salvage value. Examples of such items are the costs of the actual
materials in those structures which are constructed in the wells and
on the property, and the cost of drilling tools, pipe, casing,
tubing, tanks, engines, boilers, machines, etc. The option does not
apply to any expenditure for wages, fuel, repairs, hauling, supplies,
etc., in connection with equipment, facilities, or structures, not
incident to or necessary for the drilling of wells, such as
structures for storing or treating oil or gas. These are capital
items and are returnable through depreciation.
(2) Expense items: Expenditures which must be charged off as expense,
regardless of the option provided by this section, are those for
labor, fuel, repairs, hauling, supplies, etc., in connection with the
operation of the wells and of other facilities on the property for
the production of oil or gas.
(d) MANNER OF MAKING ELECTION. The option granted in paragraph (a) of this
section to charge intangible drilling and development costs to expense may
be exercised by claiming intangible drilling and development costs as a
deduction on the taxpayer's return for the first taxable year in which the
taxpayer pays or incurs such costs; no formal statement is necessary. If
the taxpayer fails to deduct such costs as expenses in such return, he
shall be deemed to have elected to recover such costs through depletion to
the extent that they are not represented by physical property, and through
depreciation to the extent that they are represented by physical property.
(e) EFFECT OF OPTION AND ELECTION. This section does not grant a new
option under paragraph (a) of this section or new election under paragraph
(b) of this section. Section 3 of the Act of October 23, 1962 (Public Law
87-863, 76 Stat. 1142) granted any taxpayer who had exercised an option to
capitalize intangible drilling and development costs under Regulations
111, Section 29.23(m)-16 (1939 Code) or Regulations 118, Section 39.23(m)-
16 (1939 Code) a new option for the first taxable year ending after
October 22, 1962, to deduct such costs as expenses. Unless he has
exercised the new option granted by such Act, any taxpayer who exercised
an option or made an election under the regulations described in the
preceding sentence is, by such option or election, bound with respect to
all intangible drilling and development costs (whether made before January
1, 1954, or after December 31, 1953) in connection with oil and gas
properties. See section 7807(b)(2). Any taxpayer who has not made
intangible drilling and development expenditures in any taxable year
beginning after December 31, 1942, prior to his first taxable year
beginning after December 31, 1953, and ending after August 16, 1954, must
exercise the option granted in paragraph (a) of this section in the return
for the first taxable year in which the taxpayer pays or incurs such
expenditures. If such return is required by law (including extensions
thereof) to be filed before November 1, 1965, the option under paragraph
(a) of this section, or the election under paragraph (b) of this section,
may be exercised or changed not later than November 1, 1965. The exercise
of or change in such option or election shall be effective with respect to
the earliest taxable year to which the option or election is applicable in
respect of which assessment of a deficiency or credit or refund of an
overpayment, as the case may be, resulting from such exercise or change is
not prevented by any law or rule of law on the date such option is
exercised or such election is made. Any such option or election shall be
binding upon the taxpayer for the first taxable year for which it is
effective and for all subsequent taxable years.
[T.D. 6836, 30 FR 8902, July 15, 1965]