[Federal Register Volume 59, Number 246 (Friday, December 23, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31291]
[[Page Unknown]]
[Federal Register: December 23, 1994]
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DEPARTMENT OF THE TREASURY
26 CFR Parts 1 and 602
[T.D. 8578]
RIN 1545-AP23
Election Out of Subchapter K for Producers of Natural Gas
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations that amend the
regulations under section 761 of the Internal Revenue Code relating to
the election out of subchapter K of chapter 1 of the Code. The final
regulations contain certain requirements that must be met by co-
producers of natural gas subject to a joint operating agreement in
order to make or maintain an election under section 761. The final
regulations provide that the co-producers under a joint operating
agreement must use one of two permissible methods described in the
regulations in reporting income from gas sales and certain related
deductions and credits.
EFFECTIVE DATE: January 1, 1995.
FOR FURTHER INFORMATION CONTACT: Grace Kim, 202-622-3060 (not a toll-
free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in these final regulations
has been reviewed and approved by the Office of Management and Budget
in accordance with the requirements of the Paperwork Reduction Act (44
U.S.C. 3504(h)) under control number 1545-1338. The estimated annual
burden per respondent/recordkeeper varies from 15 minutes to 45 minutes
depending on individual circumstances, with an estimated average of 30
minutes.
These estimates are approximations. They are based on such
information as is available to the Internal Revenue Service. Individual
respondents/recordkeepers may require more or less time, depending on
their particular circumstances.
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington,
D.C. 20224, and to the Office of Management and Budget, Attn: Desk
Officer for the Department of the Treasury, Office of Information and
Regulatory Affairs, Washington, D.C. 20503.
Background
On September 16, 1992, a notice of proposed rulemaking (PS-103-90)
was published in the Federal Register (57 FR 42712) proposing
amendments to the Income Tax Regulations (26 CFR part 1, 602) under
section 761 of the Internal Revenue Code (Code). A notice of hearing
relating to the proposed regulations was published in that same issue
(57 FR 42720), and a public hearing was held on November 17, 1992.
After consideration of all written and oral comments regarding the
proposed amendments, the proposed regulations are adopted as revised by
this Treasury decision. These regulations are issued under the
authority contained in sections 446(b), 761(a), and 7805.
Explanation of Provisions
In General
Except for modifications in response to comments, these final
regulations generally provide the same rules as the proposed
regulations. Thus, the final regulations prescribe the methods of
accounting for gas sales that may be used by co-producers of a gas
producing property that seek to make or maintain an election under
section 761(a) of the Code. Co-producers must use either the cumulative
gas balancing method (cumulative method) or the annual gas balancing
method (annual method). The final regulations require permission of the
Commissioner to use the annual method. This is to ensure that the co-
producers (particularly those with different taxable year-ends)
properly take income and deductions into account.
Changes to the Proposed Regulations in Response to Comments
I. Effective Date and Transitional Rules
The proposed regulations apply to co-producers under an existing
gas balancing agreement (GBA) or ``any agreement similar to a gas
balancing agreement'' in effect on or after September 16, 1992, for
taxable years beginning on or after that date. They also provide an
automatic consent procedure for gas co-producers under existing GBAs to
change their method of accounting and the rules for taking the related
section 481(a) adjustments into account.
Commentators have expressed uncertainty as to the meaning of ``an
agreement similar to a gas balancing agreement,'' e.g., whether a joint
operating agreement (JOA), without a formal GBA, is a similar
agreement. Additionally, commentators asserted that the automatic
consent procedure was overly burdensome and the section 481(a)
adjustment rules were in some cases impractical. Some recommended that
the regulations be entirely prospective and that the effective date be
delayed.
The final regulations are revised to remove the uncertainty
concerning the meaning of ``an agreement similar to a gas balancing
agreement,'' and are to apply to all gas co-producers operating under a
JOA, without regard to whether a GBA exists. Additionally, the final
regulations are revised to simplify the automatic consent procedure and
to delay the effective date so as to apply to gas co-producers under
JOAs in effect on or after the start of their first taxable year
beginning after December 31, 1994. If, however, the co-producers under
a JOA do not all have the same taxable year and they are changing to
the annual method, the regulations apply on and after January 1, 1996,
with respect to that JOA. Finally, although the final regulations
maintain the six-year section 481(a) adjustment period, they are
revised to add an election to take an aggregate section 481(a)
adjustment for all JOAs, whether negative or positive, into account in
the year of the change in method of accounting.
II. Entitlements Method as Elective Method
A commentator suggested that the entitlements method be adopted as
an elective method or as a replacement for the annual method. Under the
entitlements method, a co-producer reports income currently only for
its proportionate share of current production under the JOA.
The final regulations do not adopt this suggestion because total
income for tax purposes should be reported on the basis of the relative
economics of current production, rather than entitlement under the JOA.
III. Consequences of Noncompliance
Commentators indicated that the requirement of the proposed
regulations that all co-producers under the same GBA use the same
permissible gas balancing method might be construed as meaning that one
co-producer's noncompliance would cause the section 761 election of all
of the co-producers to be revoked.
Accordingly, the final regulations are revised to require that all
co-producers under a JOA use the cumulative method, unless the co-
producers are eligible to, and agree in writing, to use the annual
method. The final regulations also clarify that the failure of a co-
producer to follow this rule will be treated as the use of an
impermissible method of accounting, but will not cause the co-
producers' section 761 election to be revoked, unless the Commissioner
determines that there was willful failure to comply.
IV. The Standard for Revoking a Section 761 Election Under the
Cumulative Method
The proposed regulations contain an anti-abuse rule under which the
section 761 election of certain co-producers using the cumulative
method could be revoked. The standard for applying the anti-abuse rule
is a determination that ``a principal purpose'' of shifting income,
deductions, or credits is to avoid tax. Commentators suggested
replacing ``a principal purpose'' with ``the principal purpose.'' After
careful consideration of the comments, the Service and Treasury have
concluded that the standard contained in the proposed regulations is
appropriate. Thus, the anti-abuse rule in the proposed regulations is
finalized.
V. Requests for Clarification Under the Cumulative Method
Commentators requested certain clarifying changes under the
cumulative method relating to depletion deductions and the section 29
credit for producing fuel from a nonconventional source. First, the
rule that a taking co-producer's deduction for making a payment to a
co-producer is reduced by the amount of any depletion deduction allowed
on the related gas sales is revised to make it clear that the payment
deduction is reduced only by the taking co-producer's percentage
depletion deduction allowed on the related sales. The final regulations
are not modified to clarify the section 29 credit issues because this
project is not the appropriate one for addressing these issues.
Special Analyses
It has been determined that these regulations are not major rules
as defined in Executive Order 12291. Therefore, a Regulatory Impact
Analysis is not required. It has also been determined that section
553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the
Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these
regulations, and, therefore, a Regulatory Flexibility Analysis is not
required. Pursuant to section 7805(f) of the Code, the notice of
proposed rulemaking for the regulations was submitted to the Chief
Counsel for Advocacy of the Small Business Administration for comment
on their impact on small business.
Drafting Information
The principal author of these regulations is H. Grace Kim of the
Office of Assistant Chief Counsel (Passthroughs and Special
Industries), Internal Revenue Service. However, personnel from other
offices of the Internal Revenue Service and Treasury Department
participated in developing the regulations, both on matters of
substance and style.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
the following citation:
Authority: 26 U.S.C. 7805 * * *. Section 1.761-2 also issued
under 26 U.S.C. 446(b) and 26 U.S.C. 761(a). * * *
Par. 2. Section 1.761-2 is amended as follows:
1. The section heading for Sec. 1.761-2 is revised.
2. A sentence is added to the end of paragraph (a)(3) concluding
text.
3. Paragraph (d) is redesignated as paragraph (e).
4. New paragraph (d) is added.
5. The revised and added provisions read as follows:
Sec. 1.761-2 Exclusion of certain unincorporated organizations from
the application of all or part of subchapter K of chapter 1 of the
Internal Revenue Code.
(a) * * *
(3) * * *
* * * In addition, except as provided in paragraph (d)(2)(i) of this
section, this paragraph (a)(3) does not apply to any unincorporated
organization that produces natural gas under a joint operating
agreement, unless all members of the unincorporated organization comply
with paragraph (d) of this section.
* * * * *
(d) Rules for gas producers that produce natural gas under joint
operating agreements--(1) Joint operating agreements and gas balancing.
Co-owners of a property producing natural gas enter into a joint
operating agreement (JOA) to define the rights and obligations of each
co- producer of the gas in place. The JOA determines, among other
things, each co-producer's proportionate share of the natural gas as it
is produced from the reservoir, together with the associated production
expenses. A gas imbalance arises when a co-producer does not take its
proportionate share of current gas production under the JOA
(underproducer) and another co-producer takes more than its
proportionate share of current production (overproducer). The co-
producers often enter into a gas balancing agreement (GBA) as an
addendum to their JOA to establish their rights and obligations when a
gas imbalance arises. A GBA typically allows the overproducer to take
the amount of the gas imbalance (overproduced gas) and entitles the
underproducer to recoup the overproduced gas either from the volume of
the gas remaining in the reservoir or by a cash balancing payment.
(2) Permissible gas balancing methods--(i) General requirement. All
co-producers of natural gas operating under the same JOA must use the
cumulative gas balancing method, as described in paragraph (d)(3) of
this section, unless they use the annual gas balancing method described
in paragraph (d)(4) of this section. A co-producer's failure to comply
with the provisions of this paragraph (d)(2)(i) generally constitutes
the use of an impermissible method of accounting, requiring a change to
a permissible method under Sec. 1.4461(e)(3) with any terms and
conditions as may be imposed by the Commissioner. The co-producers'
election to be excluded from all or part of subchapter K will not be
revoked, unless the Commissioner determines that there was willful
failure to comply with the requirements of this paragraph (d)(2)(i).
(ii) Change in method of accounting; adoption of method of
accounting--(A) In general. The annual gas balancing method and the
cumulative gas balancing method are methods of accounting. Accordingly,
a change to or from either of these methods is a change in method of
accounting that requires the consent of the Commissioner. See section
446(e) and Sec. 1.446-1(e). For purposes of this section, each JOA is
treated as a separate trade or business. Paragraph (d)(2)(ii)(B) of
this section provides rules for adopting either permissible method of
accounting. Paragraph (d)(2)(ii)(C) of this section provides rules on
the timing of required changes to either permissible method during the
transitional period, and paragraph (d)(5) of this section contains the
procedural provisions for making a change in method of accounting
required in paragraph (d)(2)(ii)(C) of this section.
(B) Adoption of method of accounting. A co-producer must adopt a
permissible method for each JOA entered into on or after the start of
the co-producer's first taxable year beginning after December 31, 1994
(or, in the case of the use of the annual gas balancing method by co-
producers not having the same taxable year, the start of the first
taxable year beginning after December 31, 1994, of the co-producer
whose taxable year begins latest in the calendar year). If a co-
producer is adopting the cumulative method, the co-producer may adopt
the method by using the method on its timely filed return for the
taxable year of adoption. A co-producer may adopt the annual gas
balancing method with the permission of the Commissioner under
guidelines set forth in paragraph (d)(4)(ii) of this section.
(C) Required change in method of accounting for certain joint
operating agreements. This paragraph (d)(2)(ii)(C) applies to certain
JOAs entered into prior to 1996. Except in the case of a part-year
change in method of accounting or in the case of the cessation of a JOA
(both of which are described in this paragraph (d)(2)(ii)(C)), for each
JOA entered into prior to a co-producer's first taxable year beginning
after December 31, 1994, and in effect as of the beginning of that
year, the co-producer must change its method of accounting for sales of
gas and its treatment of certain related deductions and credits to a
permissible method as of the start of its first taxable year beginning
after December 31, 1994. In the case of a JOA of co-producers that do
not all have the same taxable year and that choose the annual gas
balancing method, if the JOA is entered into prior to the first taxable
year beginning after December 31, 1994 of the co-producer whose taxable
year begins latest in the calendar year and the JOA is in effect as of
January 1, 1996, a change to the annual gas balancing method by each
co-producer under that JOA is made as of January 1, 1996 (part-year
change in method of accounting). If the co-producers would have made a
part-year change to the annual gas balancing method but for the fact
that their JOA ceased to be in effect before January 1, 1996 (cessation
of a JOA), the co-producers do not change their method of accounting
with respect to the JOA. Rather, for their taxable years in which the
JOA ceases to be in effect, the co-producers use their current method
of accounting with respect to that JOA.
(3) Cumulative gas balancing method--(i) In general. The cumulative
gas balancing method (cumulative method), solely for purposes of
reporting income from gas sales and certain related deductions and
credits, treats each co-producer under the same JOA as the sole owner
of its percentage share of the total gas in the reservoir and
disregards the ownership arrangement described in the JOA for gas as it
is produced from the reservoir. Each co-producer is considered to be
taking only its share of the total gas in the reservoir as long as the
gas remaining in the reservoir is sufficient to satisfy the ownership
rights of the co-producers in their percentage shares of the total gas
in the reservoir. After a co-producer has taken its entire share of the
total gas in the reservoir, any additional gas taken by that co-
producer (taking co-producer) is treated as having been taken from its
other co-producers' shares of the total gas in the reservoir. The
effect of being treated as a taking co-producer under the cumulative
method is that the taking co-producer generally may not claim an
allowance for depletion and a production credit on its sales of its
other co-producers' percentage shares of the total gas in the
reservoir.
(ii) Requirements--(A) Reporting of income from sales of gas. Under
the cumulative method, each co-producer must include in gross income
under its overall method of accounting the amount of its sales from all
gas produced from the reservoir, including sales of gas taken from
another co-producer's share of the gas in the reservoir.
(B) Reporting of deduction of taking co-producer. A taking co-
producer deducts the amount of a payment (in cash or property, other
than gas produced under the JOA) made to another co-producer for sales
of that co-producer's gas, but only for the taxable year in which the
payment is made. Thus, an accrual method taking co-producer is not
permitted a deduction for any obligation it has to pay another co-
producer for sales of that co-producer's gas until a payment is made.
See paragraph (d)(3)(iii)(B) of this section for a rule requiring a
reduction of the amount of the deduction described in this paragraph
(d)(3)(ii)(B) if the taking co-producer had mistakenly claimed a
depletion deduction relating to those sales.
(C) Reporting of income by other co-producers. Any co-producer that
is entitled to receive a payment from a taking co-producer must include
the amount of the payment in gross income as proceeds from the sale of
its gas only for the taxable year that the payment is actually
received, regardless of its overall method of accounting.
(D) Reporting of production expenses. Each co-producer deducts its
proportionate share of production expenses, as provided in the JOA,
under its regular method of accounting for the expenses.
(iii) Special rules for production credits and depletion deductions
under the cumulative method--(A) In general. Under the cumulative
method, a co-producer's depletion allowance and production credit for a
taxable year are based on its income from gas sales and production of
gas from its percentage share of the total gas in the reservoir, and
are not based on its current proportionate share of income and
production as determined under the JOA. Thus, in general, a taking co-
producer is not allowed a production credit or an allowance for
depletion on its sales of gas in excess of its percentage share of the
total gas in the reservoir. However, the Service will not disallow
depletion deductions or production credits claimed by a taking co-
producer on the gas of other co-producers if the taking co-producer had
a reasonable but mistaken belief that the deductions or credits were
claimed with respect to the taking co-producer's percentage share of
total gas in the reservoir and the taking co-producer makes the
appropriate reductions and additions to tax required in paragraphs
(d)(3)(iii)(B) and (d)(3)(iii)(C) of this section. The reasonableness
of the mistaken belief is determined at the time of filing the return
claiming the deductions or credits. A co-producer receiving a payment
for sales of its gas from a taking co-producer claims a production
credit and an allowance for depletion relating to those sales only for
the taxable year in which the amount of the payment is included in its
gross income.
(B) Reduction of taking co-producer's payment deduction for
depletion claimed on another co-producer's gas. If a taking co-producer
claims an allowance for depletion on another co-producer's gas, the
taking co-producer must reduce its deduction claimed in a later year
for making a payment to the other co-producer for sales of that co-
producer's gas by the amount of any percentage depletion deduction
allowed on the gas sales to which the payment relates. If the
percentage limitation of section 613A(d)(1) applied to disallow a
depletion deduction for a previous year, the taking co-producer must
reduce the amount of any carried over depletion deduction allowable in
the year of the payment or in a future year by the portion of the
carried over depletion deduction, if any, that relates to another co-
producer's gas.
(C) Addition to tax of taking co-producer for production credit
claimed on another co-producer's gas. If a taking co-producer claims a
production credit on another co-producer's gas, the taking co-producer
must add to its tax for the taxable year that it makes a payment to the
other co-producer for sales of that co-producer's gas any production
credit allowed in an earlier taxable year on the gas sales to which the
payment relates, but only to the extent the credit allowed actually
reduced the taking co- producer's tax in any earlier year. The taking
co-producer also must reduce the amount of its minimum tax credit
allowable by reason of section 53(d)(1)(B)(iii) in the year of the
payment or in a future year by the portion of the credit, if any, that
relates to another co-producer's gas.
(iv) Anti-abuse rule. If the Commissioner determines that co-
producers using the cumulative method have arranged or altered their
taking of production for a taxable year with a principal purpose of
shifting the income, deductions, or credits relating to that production
to avoid tax, the co- producers' election to be excluded from all or
part of subchapter K will be revoked for that year and for subsequent
years. In determining that a principal purpose was to avoid tax, the
Commissioner will examine all the facts and circumstances surrounding
the use of the cumulative method by the co-producers. See Examples 3
and 4 of paragraph (d)(6) of this section.
(4) Annual gas balancing method--(i) In general. The annual gas
balancing method (annual method) takes into account each co-producer's
ownership rights and obligations, as described in the JOA, with respect
to the co-producer's current proportionate share of gas as it is
produced from the reservoir. Under the annual method, gas imbalances
relating to a JOA must be eliminated annually through a balancing
payment, which may be in the form of cash, gas produced under the same
JOA, or other property. If all the co-producers under a JOA have the
same taxable year, any gas imbalance remaining at the end of a taxable
year must be eliminated by a balancing payment from the overproducer to
the underproducer by the due date of the overproducer's tax return for
that taxable year (including extensions). If all the co-producers under
a JOA do not have the same taxable year, any gas imbalance remaining at
the end of a calendar year must be eliminated by a balancing payment
from the overproducer to the underproducer by September 15 of the
following calendar year. The annual method may be used only if the
Commissioner's permission is obtained. Paragraph (d)(4)(ii) of this
section provides guidelines for applying for this permission. The
annual method is not available for a JOA with respect to which any co-
producer made an election under paragraph (d)(5)(i)(B)(3) of this
section (to take an aggregate section 481(a) adjustment for all JOAs of
a co-producer into account in the year of change).
(ii) Obtaining the Commissioner's permission to use the annual
method. A request for the Commissioner's permission to adopt the annual
method for a new JOA must be in writing and must set forth the names of
all the co-producers under the JOA and the respective taxable year of
adoption. See paragraphs (d)(2)(ii) and (d)(5)(ii) of this section for
the rules for a change in method of accounting to the annual method. In
addition, the request must contain an explanation of how the co-
producers will report income from gas sales, the making or receiving of
a balancing payment, production expenses, depletion deductions, and
production credits. Permission will be granted under appropriate
conditions, including, but not limited to, an agreement in writing by
all co-producers to use the annual method and to eliminate any gas
imbalances annually in accordance with paragraph (d)(4)(i) of this
section.
(5) Transitional rules for making a change in method of accounting
required in paragraph (d)(2)(ii)(C) of this section--(i) Change in
method of accounting to the cumulative method--(A) Automatic consent to
change in method of accounting to the cumulative method. A co-producer
changing to the cumulative method for any JOA entered into prior to its
first taxable year beginning after December 31, 1994, and in effect as
of the beginning of that year is granted the consent of the
Commissioner to change its method of accounting with respect to each
JOA to the cumulative method, provided the co-producer--
(1) Makes the change on its timely filed return for its first
taxable year beginning after December 31, 1994;
(2) Attaches a completed and signed Form 3115 to the co-producer's
tax return for the year of change, stating that, pursuant to
Sec. 1.761-2(d)(2)(ii) of the regulations, the co-producer is changing
its method of accounting for sales of gas and its treatment of certain
related deductions and credits under each JOA to the cumulative method;
(3) In the case of a co-producer making an election under paragraph
(d)(5)(i)(B)(3) of this section to take the aggregate section 481(a)
adjustment into account in the year of change, attaches the statement
described in paragraph (d)(5)(i)(B)(3)(ii) of this section; and
(4) In the case of a co-producer not making an election under
paragraph (d)(5)(i)(B)(3) of this section, attaches a list of each JOA
with respect to which there is a section 481(a) adjustment computed in
accordance with paragraph (d)(5)(i)(B)(2)(i) of this section.
(B) Section 481(a) adjustment--(1) Application of section 481(a). A
change in method of accounting to the cumulative method under the
automatic consent procedure in paragraph (d)(5)(i)(A) of this section
is a change in method of accounting to which the provisions of section
481(a) apply. Thus, a section 481(a) adjustment must be taken into
account in the manner provided by this paragraph (d)(5)(i)(B) to
prevent the omission or duplication of income. Paragraph
(d)(5)(i)(B)(2) of this section provides the general rules for
computing the amount of the section 481(a) adjustment of a co-producer
relating to a particular JOA and for taking the section 481(a)
adjustment into account. Paragraph (d)(5)(i)(B)(3) of this section
provides rules for electing to take a co-producer's section 481(a)
adjustment computed on an aggregate basis for all JOAs into account in
the year of change. Paragraph (d)(5)(i)(C) of this section provides
rules to coordinate the taking of a depletion deduction or a production
credit with the inclusion of a section 481(a) adjustment arising from a
change in method of accounting to the cumulative method under this
paragraph (d)(5)(i).
(2) Computation of the section 481(a) adjustment relating to a
joint operating agreement--(i) In general. The section 481(a)
adjustment of a co-producer relating to a JOA is computed as of the
first day of the co-producer's year of change and is equal to the
difference between the amount of income reported under the co-
producer's former method of accounting for all taxable years prior to
the year of change and the amount of income that would have been
reported if the co-producer's new method had been used in all those
taxable years.
(ii) Section 481(a) adjustment period. Except to the extent that
paragraph (d)(5)(i)(B)(3) of this section applies, a co-producer's
section 481(a) adjustment relating to a JOA, whether positive or
negative, is taken into account in computing taxable income ratably
over the 6-taxable-year period beginning with the year of change (the
section 481(a) adjustment period). If the co-producer has been in
existence less than 6 taxable years, the adjustment is taken into
account over the number of years the co-producer has been in existence.
If the co-producer ceases to engage in the trade or business that gave
rise to the section 481(a) adjustment at any time during the section
481(a) adjustment period, the entire remaining balance of the section
481(a) adjustment relating to that trade or business must be taken into
account in the year of the cessation. For purposes of this paragraph
(d)(5)(i)(B)(2)(ii), production under each JOA is treated as a separate
trade or business. The determination as to whether the co-producer
ceases to engage in its trade or business is to be made under the
principles of Sec. 1.446--1(e)(3)(ii) and its underlying administrative
procedures. For example, the permanent cessation of production under a
co-producer's JOA constitutes the cessation of a trade or business of
the co-producer. Accordingly, for the year that production under a JOA
permanently ceases, the remaining balance of the section 481(a)
adjustment relating to the JOA must be taken into account.
(3) Election to take aggregate section 481(a) adjustment for all
joint operating agreements into account in the year of change--(i) In
general. A co-producer may elect to take into account its section
481(a) adjustment, computed on an aggregate basis for all of its JOAs,
whether negative or positive, in the year of change, provided the co-
producer uses the cumulative method for all of its JOAs entered into
prior to its first taxable year beginning after December 31, 1994, and
in effect as of the beginning of that year. The aggregate section
481(a) adjustment of a co-producer is equal to the difference between
the amount of income reported under the co-producer's former method of
accounting for all taxable years prior to the year of change and the
amount of income that would have been reported if the co-producer's new
method had been used in all of those taxable years for all JOAs for
which the co-producer changes its method of accounting. An election
made under this paragraph (d)(5)(i)(B)(3) is irrevocable. If any person
who, together with another person, would be treated as a single
taxpayer under section 41(f)(1) (A) or (B) makes an election under this
paragraph (d)(5)(i)(B)(3), all persons within that single taxpayer
group will be treated as if they had made an election under this
paragraph (d)(5)(i)(B)(3) and, as such, will be irrevocably bound by
that election. If a co-producer does not make an election under this
paragraph, each JOA entered into prior to the start of its first
taxable year beginning after December 31, 1994, and in effect as of the
beginning of that year must be accounted for separately in computing
the section 481(a) adjustment and taxable income of the co-producer for
any year to which this paragraph (d) applies.
(ii) Time and manner for making the election. An election under
this paragraph (d)(5)(i)(B)(3) is made by attaching a statement to the
co-producer's timely filed return for its year of change indicating
that the co- producer is electing under Sec. 1.761-2(d)(5)(i)(B)(3) to
take its aggregate section 481(a) adjustment into account in the year
of change.
(C) Treatment of section 481(a) adjustment as a sale for purposes
of computing a production credit and as gross income from the property
for purposes of depletion deductions. Any positive section 481(a)
adjustment arising as a result of a change in method of accounting for
gas imbalances under this paragraph (d)(5)(i) and taken into account in
computing taxable income under paragraph (d)(5)(i)(B) of this section
is considered a sale by the taxpayer for purposes of computing any
production credit in the year that the adjustment is taken into
account. Similarly, the positive section 481(a) adjustment is
considered gross income from the property and taxable income from the
property for purposes of computing depletion deductions in the year the
adjustment is taken into account. Sales amounts used in computing any
production credit in any year in which a negative section 481(a)
adjustment is taken into account in computing taxable income under
paragraph (d)(5)(i)(B) of this section must be reduced by the amount of
the negative section 481(a) adjustment taken into account in that year.
Similarly, gross income from the property and taxable income from the
property used in computing any depletion deduction in any year in which
the negative section 481(a) adjustment is taken into account must be
reduced by the amount of the negative adjustment. For these purposes,
any taxpayer that makes an aggregate section 481(a) adjustment election
under paragraph (d)(5)(i)(B)(3) of this section must allocate the
adjustment among its properties in any reasonable manner that prevents
a duplication or omission of depletion deductions.
(ii) Change in method of accounting to the annual method--(A) In
general. A co-producer changing to the annual method in accordance with
paragraph (d)(2)(ii) of this section must request a change under
Sec. 1.446-1(e)(3) and will be subject to any terms and conditions as
may be imposed by the Commissioner.
(B) Section 481(a) adjustment. A change in method of accounting to
the annual method is a change in method of accounting to which the
provisions of section 481(a) apply. Thus, a section 481(a) adjustment
must be taken into account to prevent the omission or duplication of
income. If all the co-producers under a JOA have the same taxable year,
the section 481(a) adjustment involved in a change to the annual method
by a co-producer relating to the JOA is computed as of the first day of
the co-producer's year of change. If the co-producers under a JOA do
not all have the same taxable year (that is, in the case of a part-year
change described in paragraph (d)(2)(ii)(C) of this section), the
change in method of accounting occurs on January 1, 1996, and the
section 481(a) adjustment is computed on that date.
(iii) Untimely change in method of accounting to comply with this
section. Unless a co-producer required by this section to change its
method of accounting complies with the provisions of this paragraph
(d)(5) for its first applicable taxable year within the time prescribed
by this paragraph (d)(5), the co-producer must take the section 481(a)
adjustment into account under the provisions of any applicable
administrative procedure that is prescribed by the Commissioner
specifically for purposes of complying with this section. Absent such
an administrative procedure, a co-producer must request a change under
Sec. 1.446-1(e)(3) and will be subject to any terms and conditions as
may be imposed by the Commissioner.
(6) Examples. The following examples illustrate the application of
the cumulative method described in paragraph (d)(3) of this section.
Example 1. Operation of the cumulative method. (i) L, a
corporation using the cash receipts and disbursements method of
accounting, and M, a corporation using an accrual method, file
returns on a calendar year basis. On January 1, 1995, L and M enter
into a JOA to produce natural gas as an unincorporated organization
from a reservoir located in State Y. The JOA allocates reservoir
production 60 percent to L and 40 percent to M. L and M enter into a
GBA as an addendum to the JOA. L and M agree to use the cumulative
method to account for gas sales from the reservoir and elect under
section 761(a) and this section to exclude the organization from the
application of subchapter K. Production from the reservoir is
eligible for the section 29 credit for producing fuel from a
nonconventional source. L and M produce and sell the following
amounts of natural gas (in mmcf) until 2000 during which year
production from the reservoir ceases:
------------------------------------------------------------------------
1995 1996 1997 1998 1999 2000
------------------------------------------------------------------------
L............................. 720 480 600 -0- -0- -0-
M............................. 240 60 120 160 80 40
------------------------------------------------------------------------
(ii) By the end of 1996, neither L nor M has fully produced its
percentage share of the total gas in the reservoir. In 1997, L
produces a total of 600 mmcf of gas at the rate of 50 mmcf per
month. Prior to filing its return for 1997, L determines that it
fully produced its percentage share of gas in the reservoir as of
June 30, 1997. Pursuant to the GBA executed by L and M, L pays M at
the end of 2000 for the 300 mmcf of M's gas (as determined under the
cumulative method) that L sold in the last half of 1997.
(iii) For 1995, L and M must include in their gross income the
amounts relating to gas sales of 720 mmcf and 240 mmcf,
respectively. For 1996, L and M must include the amounts relating to
gas sales of 480 mmcf and 60 mmcf, respectively. For both 1995 and
1996, L and M compute an allowance for depletion and a section 29
credit based upon gas taken and sold by each from the reservoir for
each taxable year.
(iv) For 1997, L and M must include in gross income the amounts
relating to their gas sales of 600 mmcf and 120 mmcf, respectively.
Under paragraph (d)(3)(iii)(A) of this section, L computes an
allowance for depletion and the section 29 credit based only on
production from L's proportionate share of gas in the reservoir
(that is, based on L's production through June 30, 1997).
Accordingly, for 1997, L claims depletion and the section 29 credit
only with respect to 300 mmcf of gas (50 mmcf per month x 6 months).
For 1997, because M has not fully produced from its percentage share
of the total gas in the reservoir as of the end of 1997, M claims
depletion and the section 29 credit on the 120 mmcf that M produced
in 1997.
(v) In 1998 and 1999, M must include in gross income the amounts
relating to M's sales of gas, that is, 160 mmcf for 1998 and 80 mmcf
for 1999. For 2000, M must include in gross income the amount
relating to sales of 340 mmcf of gas, which consists of its own
sales of 40 mmcf plus the payment for 300 mmcf of gas that L made to
M for having sold from M's share of the total gas in the reservoir
during the last half of 1997. Because M produced from its percentage
share of the total gas in the reservoir during 1998, 1999, and 2000,
M claims a depletion deduction and a section 29 credit on its income
and production for those years, that is, 160 mmcf for 1998, 80 mmcf
for 1999, and 40 mmcf for 2000. Additionally, for 2000, M claims
depletion and the section 29 credit relating to the payment that M
received from L for the 300 mmcf of M's gas that L sold in the last
half of 1997. Under paragraph (d)(3)(ii)(B) of this section, L's
deduction for its payment to M for the 300 mmcf of M's gas that L
sold in 1997 is allowable only for 2000.
Example 2. Adjustments under the cumulative method for depletion
deductions and production credits that were claimed for sales in
excess of a co-producer's percentage share of total gas in the
reservoir. (i) L, a corporation using the cash receipts and
disbursements method of accounting, and M, a corporation using an
accrual method, file returns on a calendar year basis. On January 1,
1995, L and M enter into a JOA to produce natural gas as an
unincorporated organization from a reservoir located in State Y. The
JOA allocates reservoir production 60 percent to L and 40 percent to
M. L and M enter into a GBA as an addendum to the JOA. L and M agree
to use the cumulative method to account for gas sales from the
reservoir and elect under section 761(a) and this section to exclude
the organization from the application of subchapter K. Production
from the reservoir is eligible for the section 29 credit for
producing fuel from a nonconventional source. L and M produce and
sell the following amounts of natural gas (in mmcf) until 2000
during which year production from the reservoir ceases:
------------------------------------------------------------------------
1995 1996 1997 1998 1999 2000
------------------------------------------------------------------------
L............................. 720 480 600 60 60 -0-
M............................. 240 60 120 60 60 40
------------------------------------------------------------------------
(ii) In addition, L does not realize until December 31, 1999,
that L fully produced its percentage share of the total gas in the
reservoir as of June 30, 1997. At the time of filing its returns for
1997 and 1998, L reasonably believes that during 1997 and 1998,
respectively, it did not fully produce its percentage share of the
total gas in the reservoir. Thus, L claims depletion and the section
29 credit for its total sales of 600 mmcf in 1997 and 60 mmcf in
1998. Pursuant to the GBA executed by L and M, L pays M at the end
of 2000 for the 420 mmcf of M's gas (as determined under the
cumulative method) that L sold (300 mmcf in the last half of 1997
(assuming that production was at a rate of 50 mmcf per month), 60
mmcf in 1998, and 60 mmcf in 1999).
(iii) In 1997 and 1998, L and M include in gross income the
amounts relating to their respective sales of gas, that is, for L
600 mmcf for 1997 and 60 mmcf for 1998, and for M 120 mmcf for 1997
and 60 mmcf for 1998.
(iv) For 1999, L must include in gross income the amount of its
sales of 60 mmcf, but may not claim depletion or the section 29
credit on those sales. For 1999, M must include in gross income the
amount of its sales of 60 mmcf and claims depletion and the section
29 credit with respect to those 60 mmcf.
(v) For 2000, M must include in gross income the amount relating
to gas sales of 460 mmcf, that is, the amount of M's own gas sales
of 40 mmcf and the amount of the payment received from L for the 420
mmcf of M's gas that L sold (consisting of 300 mmcf in 1997, 60 mmcf
in 1998, and 60 mmcf in 1999). Under paragraph (d)(3)(iii)(A) of
this section, M computes a depletion deduction and a production
credit relating to the amount of M's actual gas sales for 2000 and
the payment received from L, that is, relating to a total of 460
mmcf of gas (M's sales of 40 mmcf for 2000, plus L's payment for 420
mmcf of gas). Under paragraph (d)(3)(ii)(B) of this section, L's
deduction for making its payment to M for 420 mmcf of gas is
allowable only for 2000. Under paragraph (d)(3)(iii)(B) of this
section, L must reduce its deduction by the amount of any percentage
depletion deductions allowed on its sales of M's gas, that is,
relating to 360 mmcf of gas (300 mmcf for 1997 and 60 mmcf for
1998). In addition, under paragraph (d)(3)(iii)(C) of this section,
L must increase its tax for 2000 by the amount of any section 29
credit L claimed on its sales of M's gas, but only to the extent
that the credit claimed actually reduced L's tax in any earlier
year.
Example 3. Non-abusive altering of the taking of production for
a taxable year. (i) C and D enter into a JOA and a GBA on December
1, 1994, for gas production from a reservoir. The JOA allocates
production at 50 percent to C and 50 percent to D. C and D agree in
writing to use the cumulative method to account for gas sales.
Additionally, C and D elect under section 761(a) and this section to
exclude their organization from the application of subchapter K. C
and D arrange to sell all their production under annually renewable
contracts. In 1995, C and D each sell 480 mmcf of gas from the
reservoir.
(ii) In November 1995, D is notified that its contract with its
purchaser will not be renewed for 1996. D is unable to find a new
purchaser for its gas for 1996. In December 1995, D notifies C that
it will not be taking production from the reservoir in 1996.
Pursuant to the GBA, C then contracts with its current gas purchaser
to sell an additional 20 mmcf per month in 1996. Accordingly, C
sells 720 mmcf in 1996 (60 mmcf per month x 12 months). Under the
facts described in this example, a principal purpose of altering the
taking of production is not to avoid tax. Accordingly, the co-
producers' election under section 761(a) will not be revoked by
reason of altering the taking of production.
Example 4. Abusive altering of the taking of production for a
taxable year. The facts are the same as in Example 3(i). For 1996, C
anticipates that C's regular tax (reduced by the credits allowable
under sections 27 and 28) will not exceed C's tentative minimum tax.
Accordingly, under section 29(b)(6), C's credit allowed under
section 29(a) for sales of its gas will be zero. For 1997, C
anticipates that its credit allowed under section 29(a) will not be
limited by section 29(b)(6). On the other hand, D anticipates that
any credit it may claim under section 29(a) for 1996, even including
a credit based on sales of C's share of current production under the
JOA, will not be limited by section 29(b)(6). However, for 1997, D
anticipates that its credit under section 29(a) will be limited by
section 29(b)(6). On January 1, 1996, C and D agree that D will
contract with its purchaser to sell the entire 960 mmcf produced
from the reservoir in 1996 and that C will contract with its
purchaser to sell the entire 960 mmcf produced from the reservoir in
1997. Under these facts, a principal purpose of altering the taking
of production is to avoid tax. Accordingly, the co-producers'
election under section 761(a) will be revoked for 1996 and for
subsequent years.
(7) Effective date. Except in the case of a part-year change to the
annual method or the cessation of a JOA, both of which are described in
paragraph (d)(2)(ii)(C) of this section, the provisions of this
paragraph (d) apply to all taxable years beginning after December 31,
1994, of any producer that is a member of an unincorporated
organization that produces natural gas under a JOA in effect on or
after the start of the producer's first taxable year beginning after
December 31, 1994. In the case of a part-year change, the provisions of
this paragraph (d) apply on and after January 1, 1996. In the case of
the cessation of a JOA, the co-producers use their current method of
accounting with respect to that JOA until the JOA ceases to be in
effect.
* * * * *
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 3. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Sec. 602.101 [Amended]
Par. 4. In Sec. 602.101, paragraph (c) is amended by removing the
existing entry for 1.761-2 and by adding the entry ``1.761-2 * * *
1545-1338'' in numerical order to the table.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: December 12, 1994.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-31291 Filed 12-22-94; 8:45 am]
BILLING CODE 4830-01-U
