IRS RULES ON DEPRECIATING 'LINE PACK GAS' AND 'CUSHION GAS'.

Rev. Rul. 97-54

[1] ISSUES

(1) Is the cost of "line pack gas" or "cushion gas" a capital expenditure under section 263 of the Internal Revenue Code or an amount that is included in inventory under section 471?

(2) If the cost of "line pack gas" or "cushion gas" is a capital expenditure under section 263, is that cost depreciable under sections 167 and 168?

FACTS

[2] "Line pack gas" is the minimum volume of natural gas necessary to provide the pressure to facilitate the flow of gas through a pipeline. "Cushion gas" is the minimum volume of natural gas necessary to provide the pressure to facilitate the flow of gas from a storage reservoir to a pipeline. Recoverable line pack gas and recoverable cushion gas will be available for sale or other use upon the abandonment of the pipeline or storage reservoir, respectively. Unrecoverable line pack gas and unrecoverable cushion gas will not be available for sale or other use upon the abandonment of the pipeline or storage reservoir, but will become obsolete with that abandoment.

LAW AND ANALYSIS

[3] Section 263(a) provides that no deduction shall be allowed for amounts paid out for permanent improvements or betterments made to increase the value of any property or estate.

[4] Section 1.263(a)-2 of the Income Tax Regulations provides that a "capital expenditure" includes the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the tax year.

[5] Section 167(a) provides that there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) of property used in a trade or business or held for the production of income.

[6] Generally, for tangible property, the depreciation deduction under section 167(a) is determined under section 168 by using the applicable depreciation method, the applicable recovery period, and the applicable convention.

[7] Section 471 provides that whenever, in the opinion of the Secretary, the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by that taxpayer, on the basis the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting income.

[8] Section 1.471-1 provides that in order to reflect income correctly, inventories at the beginning and end of each tax year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor. Inventories should include all finished and partly finished goods and, in the case of raw materials and supplies, only those that have been acquired for sale or that will physically become a part of merchandise intended for sale.

[9] Rev. Rul. 68-620, 1968-2 C.B. 199, amplified by Rev. Rul. 78-352, 1978-2 C.B. 168, holds that line pack gas is merchandise in transit that is intended to be sold to customers and therefore must be included in the inventory of the taxpayer.

[10] Rev. Rul. 75-233, 1975-1 C.B. 95, holds that the cost of unrecoverable cushion gas is a capital expenditure under section 263, which is recoverable through an annual depreciation deduction under section 167.

[11] With respect to both line pack gas and cushion gas, several court decisions have considered the capital expenditure versus-inventory issue, as well as the depreciation issue. In Pacific Enterprises v. Commissioner, 101 T.C. 1 (1993), the United States Tax Court held that the costs of line pack gas and cushion gas are capital expenditures. Accord Transwestern Pipeline Co. v. United States, 639 F.2d 679 (Ct.Cl. 1980), regarding line pack gas; Arkla, Inc. v. United States, 765 F.2d 487 (5th Cir. 1985), regarding cushion gas. The United States Court of Appeals for the Fifth Circuit in Arkla further held that recoverable cushion gas was not subject to depreciation because it was not subject to exhaustion, wear, tear, or obsolescence. Accord Washington Energy Co. v. United States, 94 F.3d 1557 (Fed. Cir. 1996). The Fifth Circuit in Arkla distinguished unrecoverable cushion gas as being subject to depreciation because that gas will become obsolete along with the storage facility. Accord Rev. Rul. 75-233. Finally, in Arkla, Inc. v. United States, 37 F.3d 621 (Fed. Cir. 1994), the United States Court of Appeals for the Federal Circuit held that line pack gas and cushion gas are treated the same for purposes of depreciation. Accord Washington Energy Co. v. United States, 94 F.3d 1557.

[12] Line pack gas or cushion gas is recoverable if it will be available for sale or other use upon abandonment of a pipeline of storage reservoir. See Arkla, Inc. v. United States, 765 F.2d at 490. The Service will treat line pack gas or cushion gas as being available for sale or other use to the extent that such gas will be recovered from an abandoned pipeline or storage reservoir pursuant to a plan, a requirement of law, or economic feasibility, whichever method projects the greatest actual recovery of such gas.

[13] The Service will follow the court decisions cited in this revenue ruling to the extent they hold that the cost of line pack gas or cushion gas is a capital expenditure, the cost of recoverable line pack gas or recoverable cushion gas is not depreciable, and the cost of unrecoverable line pack gas or unrecoverable cushion gas is depreciable.

[14] HOLDINGS

(1) The cost of line pack gas or cushion gas is a capital expenditure under section 263.

(2) The cost of recoverable line pack gas or recoverable cushion gas is not depreciable, but the cost of unrecoverable line pack gas or unrecoverable cushion gas is depreciable under sections 167 and 168. The Service will treat line pack gas or cushion gas as recoverable to the extent that such gas will be recovered from an abandoned pipeline or storage reservoir pursuant to a plan, a requirement of law, or economic feasibility, whichever method projects the greatest actual recovered of such gas.

APPLICATION

[15] Any change in a taxpayer's treatment of the costs of line pack gas or cushion gas to conform with this revenue ruling is a change in method of accounting to which the provisions of sections 446 and 481 and the regulations thereunder apply. A taxpayer wanting to change the method of accounting for the cost of line pack gas or cushion gas to conform with this revenue ruling must follow the automatic change in accounting method provisions of Rev. Proc. 97-37, 1997-33 I.R.B. 18.

EFFECT ON OTHER DOCUMENTS

[16] Rev. Rul. 68-620 and Rev. Rul. 78-352 are revoked. Rev. Rul. 75-233 is superseded. Rev. Proc. 97-37 is amplified to include this change in the Appendix.

PROSPECTIVE APPLICATION

[17] The Service will not require a taxpayer to change its method of accounting to comply with the holding that the cost of line pack gas or recoverable cushion gas to a capital expenditure for any taxable year beginning before December 29, 1997. In addition, the Service will not require a taxpayer to change its method of accounting to comply with the holding for determining the amount of recoverable line pack gas or recoverable cushion gas for any taxable year beginning before December 29, 1997, provided the method used by the taxpayer projects recoverable line pack gas or recoverable cushion gas in an amount equal to or greater than an amount that would be projected using an economic feasibility of recovery standard.

DRAFTING INFORMATION

[18] The principal author of this revenue ruling is Jennifer L. Nuding of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information concerning this revenue ruling, contact Ms. Nuding at (202) 622-4970 (not a toll-free call).