Rev. Rul. 75-233

Advice has been requested as to the deductibility for Federal income tax purposes of the cost of natural gas injected into a subsurface aquifer reservoir and determined to be unrecoverable.

The taxpayer is a corporation engaged in the purchase, transportation, and sale of natural gas through a pipeline transportation system. The fluctuating seasonal demand for gas made it necessary for the taxpayer to provide an underground storage reservoir in order to meet its customers' peak demands. To accomplish this, the taxpayer acquired the rights to store natural gas in a subsurface aquifer reservoir, a reservoir which in its natural state contains water.

To adapt the reservoir to gas storage, the taxpayer drilled a number of wells for the purpose of observation, injection, and withdrawal of natural gas. During the summer months, when the taxpayer's transmission line had "excess" capacity, gas was injected into the subsurface aquifer reservoir for storage. During the winter months, gas was withdrawn from the storage reservoir to supplement the gas deliveries of the pipeline.

The gas to be injected during the useful life of the storage reservoir consists of unrecoverable gas and recoverable gas. The unrecoverable gas is the volume of injected gas which it is established will remain permanently in place in the reservoir pore space at conditions of reservoir pressure and saturation initially projected for reservoir abandonment. The excess of total injected gas over unrecoverable gas is deemed to be recoverable gas.

The taxpayer has taken core drill samples from the aquifer reservoir, performed extensive laboratory tests on the cores to determine the reservoir's physical characteristics, and compiled engineering studies on the feasibility of storing gas in the formation. In addition, the taxpayer has compiled a performance history of the reservoir that included the seasonal gas injection and withdrawal rates, the water production, and the continuous record of reservoir pressure. From these operations the taxpayer has developed data from which the amount of unrecoverable gas in the reservoir was reasonably determined.

Section 263(a) of the Internal Revenue Code of 1954 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. Section 1.263(a)-1 of the Income Tax Regulations provides, in part, that, except as otherwise provided in chapter 1 of the Code, no deduction will be allowed for amounts paid or incurred to adapt property to a new and different use.

Section 167(a) of the Code 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 the trade or business, or held for the production of income.

Section 1.167(a)-2 of the regulations provides, in part, that the depreciation allowance does not apply to land apart from the improvements or physical developments added to the land. When an expenditure relates to an improvement or physical development added to the land, it may be subject to a depreciation allowance if the property meets all the requirements necessary for the application of the depreciation deduction.

The unrecoverable gas in the instant case is tangible property in the nature of a permanent improvement or betterment made to adapt the reservoir to the storage of gas. See Rev. Rul. 72-403, 1972-2 C.B. 102, which holds that the cost of acquiring an easement for electric transmission lines is an intangible asset but the cost of clearing and grading is a tangible asset.

Accordingly in the instant case the cost of the natural gas injected into the underground reservoir and determined to be unrecoverable is a capital expenditure pursuant to section 1.263(a)-1 of the regulations and is recoverable through allowances for depreciation provided by section 167 of the Code and the regulations thereunder.