Rev. Rul. 55-35

The Internal Revenue Service has been asked whether, in view of the decision of the Supreme Court of the United States in W. G. Choate v. Commissioner , 324 U.S. 1, Ct. D. 1626, C.B. 1945, 343, the principles of G.C.M. 23623, C.B. 1943, 313, are to be applied with respect to the treatment of subleases of producing oil and gas properties with retention of an overriding royalty interest where the equipment is assigned under the following circumstances:

A has a producing leasehold with an adjusted leasehold basis of zero and an adjusted equipment basis of 250 x dollars. A assigns a leasehold (or subleases) and assigns the equipment to B for a cash payment of 175 x dollars and retains an overriding royalty of one-eighth ( 1/8 ). Following the decision in the Choate case, the cash is considered as payment for the equipment to the extent of its depreciated cost and the excess of cash, if any, over the depreciated cost represents a bonus or an advance royalty subject to percentage depletion in the hands of the sublessor. Where the depreciable cost of equipment exceeds cash, the excess amount is considered an additional cost of the royalty specified in the lease. As cost of the royalty, such excess would be returnable through depletion.

This policy is based on an extension of the principles stated in G.C.M. 23623, supra , in which it was held that in transactions involving assignments of producing oil and gas leases for cash with a retention of contingent oil and gas payments no less could be allowed, but the excess of the adjusted basis of equipment over cash received represented a part of the depletable basis of the retained economic interest (the contingent oil and gas payment). G.C.M. 23623 was issued prior to the decision in the Choate case, and expressed the view that the theory of a sale of equipment would not apply on those cases in which the assignor or sublessor retained a royalty interest throughout the productive life of the property as distinguished from those cases in which the transaction effected a sale.

It is sometimes argued that depreciation of the excess of the adjusted equipment cost over the cash received should be permitted over the life of the property instead of transferring such excess to depletable cost. The fallacy of permitting the return of the remaining basis in any way other than through depletion may be illustrated by a situation where A, in the foregoing example, transfers his lease and equipment without cash or other consideration other than the retention of a one-fourth ( 1/4 ) overriding royalty. The stated argument would allow A in such a case to continue to deduct depreciation (it might be called amortization) despite the fact that he no longer owns the equipment. Furthermore, in such a case, since the overriding royalty has been increased in amount due to the fact that the property was equipped (the equipment having been assigned), and depletion is allowable on such increase, it is apparent that the allowance of depreciation in addition to depletion results in double deductions. This is less readily apparent, but nonetheless true, in the instance of a