UNITED STATES TAX COURT

138 T.C. No. 2

UNITED STATES TAX COURT

CALTEX OIL VENTURE, CALTEX MANAGEMENT CORPORATION,

TAX MATTERS PARTNER, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 3793-08.

Filed Jar uary 12, 2012.

C, an accrual-basis partnership, entered into a turnkey contract

under which it paid $5,172,666 by cash and note in December 1999

for the drilling of two oil and gas wells. Although some site

preparation required under the contract occurred in 1999, no drill

penetrated the ground for purposes of drilling a well by or on behalf

of C within 90 days after the end of 1999. C claimed à full deduction

for the $5,172,666 as intangible drilling costs (IDCs) on its 1999

Federal tax return. R issued a notice of final partnersliip

administrative adjustment to P, C's tax matters partner, determining,

inter alia, that C was not entitled to deduct the IDCs b cause the

economic performance requirement of I.R.C. sec. 461(h) was not

satisfied.

-2Held: For purposes of I.R.C. sec. 461(i)(2)(A), "drilling of the

well commences" when there is actual penetration of the ground

surface in the act of drilling for purposes of spudding a well. Mere

site preparation is insufficient. Under this special timing rule, C did

not satisfy the economic performance requirement of I.R.C.

sec. 461(h).

Held, further, the 3-1/2-month rule of sec. 1.461-4(d)(6)(ii),

Income Tax Regs., does not enable C to treat any of the services due

under the contract as having been economically performed in 1999,

because, in the case of an undifferentiated, non-severable contract,

the 3-1/2-month rule contemplates that all of the services called for

must be provided within 3-1/2 months of payment.

Held, further, in the alternative, if C is able to invoke the

3-1/2-month rule and treat some of the services due under the contract

as having been economically performed in 1999, then deductions

under the 3-1/2-month rule are limited to payments of cash or cash

equivalents and do not include payments made by notes.

Bernard Stephen Mark and Richard Stephen Kestenbaum, for petitioner.

Halvor N. Adams III, for respondent.

OPINION

GUSTAFSON, Judge: On November 13, 2007, the Internal Revenue

Service (IRS) issued a notice of f'mal partnership administrative adjustment

(FPAA) for taxable year ending December 31, 1999, to Caltex Management Corp.,

the tax matters partner (TMP) of Caltex Oil Venture. (It is the latter entity--Caltex

Oil Venture--to which we refer herein as "Caltex".) This case is a

partnership-level action based on a petition filed by the TlSIP pursuant to section

6226.1 The matter is currently before the Court on the IRS's motion for partial

summary judgment filed pursuant to Rule 121, which asks us to hold that Caltex is

not entitled to deduct the $5,172,666 that it reported in 19 9 as nonproductive

intangible drilling costs (IDCs).2 As explained below, we will grant partial

summary judgment in the IRS's favor as to most of the issues addressed in its

motion, but we find that other issues-e.g., under the general rule of section

461(h), the amount, if any, of IDCs that was incurred in 1999--may remain for

trial.

Unless otherwise indicated, all section references are to the Internal

Revenue Code of 1986 as in effect for the year in issue (codified in 26 U.S.C., and

referred to herein as "the Code"), and all Rule references are to the Tax Court

Rules of Practice and Procedure.

2IDCs are drilling cost outlays associated with oil and gas drilling

operations. IDCs range from amounts paid for the clearing öf ground, draining,

road-making, and surveying work to all amounts paid for labor, fuel, repairs,

hauling, and supplies (e.g., drilling muds, chemicals and cendent) incident to and

necessary in the drilling and preparation of wells for the production of oil and gas.

See 26 C.F.R. sec. 1.612-4, Income Tax Regs.

-4Backaround

The following facts are not in dispute and are derived from the pleadings,

stipulations of fact, the parties' motion papers, and the supporting exhibits

attached thereto.

Caltex was organized in 1999. For Federal income tax purposes, Caltex is a

partnership that uses the accrual method of accounting and has a taxable year

ending December 31. On December 31, 1999, Caltex entered into a turnkey

contract with Red River Exploration, Inc. Under the contract, Red River assigned

to Caltex a 74.33-percent interest in a well in Louisiana designated "J.O. Kimbrell

2-8#1" and a 90-percent interest in a well in Oklahoma designated "NW Sulphur

#2". Red River agreed to "commence or cause to be commenced" the drilling of

wells at the two sites "[a]s soon as practicable after the execution of * * * [the

contract] but in no event later than March 31, 2000". "[T]hereafter * * * [Red

River would] continue or cause to be continued the drilling [of the wells] with due

diligence and in a workmanlike manner to a depth to adequately test the objective

formation." For purposes of the IRS's motion for partial summary judgment, we

assume (as Caltex asserts) that "a typical well will take two years to grow from

concept to commencement to production for the purpose of selling

hydrocarbons."3

The contract called for Caltex to pay to Red River by the close of business

on December 31, 1999, $4,123,333 in cash and note "as Túrnkey Drilling Costs"

and "$1,049,333 for the Intangible Completion Costs", for a total of $5,172,666.

Caltex paid Red River with two checks dated December 27, 1999, in the amounts

of $308,293.50 for "drilling" and $1.19,892 for "completion",4 totaling

$428,185.50, and executed a note in favor of Red River for approximately $4.8

million

3Steps in this process may overlap, but they include: (i) collecting data,

acquiring leases, securing access roads, staking and permitting the well (one to

two years); (ii) designing the procedures and getting estimajes from various

service companies (three to four months); (iii) negotiating contracts for

subcontract services, equipment, rigs, and specialists, as appropriate (three to four

months); (iv) location work, including site operations, equipment delivery, and

installation (four weeks); (v) actual drilling operations (fou to eight weeks); (vi)

completion and testing operations (four weeks); (vii) buyin , and building surface

facilities (four weeks); and (viii) negotiating gas sales, saltvlater disposal, and

field supervision.

4The record also reflects that on December 27, 1999, Caltex paid Red River

an additional $30,481 for "Int", presumably interest.

5The record does not include,any note executed by Caltex in favor of Red

River, but for purposes of the IRS's motion we assume (in Caltex's favor) that

Caltex satisfied its payment obligations under the contract by executing a note in

favor of Red River on or before December 31, 1999.

-6By December 31, 1999, drilling permits were secured for the two well sites

identified in the contract, and we assume that in early 2000 Red River engaged in

activities to prepare to drill the wells. However, the parties have stipulated that

"[n]o drill penetrated the ground for purposes of drilling a well by or on behalf of

Caltex Oil Venture during 1999 or 2000."

Caltex timely filed, for 1999,:a Form 1065, "U.S. Partnership Return of

Income". On the Form 1065, Caltex claimed a deduction of $5,172,666 for

nonproductive IDCs.

In November 2007 the IRS issued its FPAA determining that Caltex was not

entitled to deduct any portion of the IDCs because, among other things, the

economic performance requirement of section 461(h) was not satisfied. The IRS

also disallowed $744,241 in other deductions claimed by Caltex on its 1999 return

and determined that Caltex was liable for accuracy-related penalties under section

6662(a) and (b)(1) and (2).

On February 12, 2008, Caltex, through its TMP, timely filed a petition

pursuant to section 6226 seeking a readjustment of the IRS's determinations in the

FPAA. Caltex asserted, among other things, that the IRS erred in determining (i)

"that the deduction for non-productive intangible drilling costs in the amount of

$5,172,666.00 is improper"; (ii) that economic performance was not met by Caltex

under Section 461(h)"; and (iii) that they "are subject to penalties under Section

6662(a), 6662(b)(1) and in 6662(b)(2)." In doing so, Caltex asks us to find that

there "are no adjustments to Partnership items for the yea in question" and that

"no penalties are properly asserted against any investor of Caltex". At the time the

petition was filed, the principal place of business for both Caltex and its TMP was

Pennsylvania.

.

On September 18, 2009, the IRS moved for partial summary judgment on

the issue of whether the economic performance requirement of section 461(h) was

satisfied with respect to the $5,172,666 deduction claimed by Caltex in 1999 for

IDCs. In particular, the IRS asks us to narrow the issues of the case by holding

that the economic performance requirement of section 461( ), if satisfied at all,

limits Caltex's maximum potential deduction for 1999 for IDCs to amounts paid in

1999 for work actually performed in 1999.6 Caltex opposes the IRS's motion.

For purposes of deciding this motion, we will consider to what extent, if

any, the services attributable to the $5,172,666 in IDCs were economically

6On the basis of a stipulation agreed to by Caltex, the RS asserts that this

maximum potential deduction is $7,072.80. We hold that s mmary judgment is

not appropriate as to the precise amount (s_ee section V of the argument below),

but we hold in favor of the IRS on the interpretation and application of the

economic performance requirement.

-8performed during 1999 or within a time that the Code and regulations allow the

services to be treated as if performed in 1999.

Discussion

I.

Standard for summary judgment

Under Rule 121 (the Tax Court's analog to Rule 56 of the Federal Rules of

Civil Procedure) the Court may grant full or partial summary judgment where

there is no genuine issue of any material fact and a decision may be rendered as a

matter of law. The moving party bears the burden of showing that no genuine

issue of material fact exists, and the Court will view any factual material and

inferences in the light most favorable to the nonmoving party. Dahlstrom v.

Commissioner, 85 T.C. 812, 821 (1985); cf. Anderson v. Liberty Lobby, Inc., 477

U.S. 242, 255 (1986) (same standard under Fed. R. Civ. P. 56). "The opposing

party is to be afforded the benefit of all reasonable doubt, and any inference to be

drawn from the underlying facts contained in the record must be viewed in a light

most favorable to the party opposing the motion for summary judgment."

Espinoza v. Commissioner, 78 T.C. 412, 416 (1982).

The issue presented in the IRS's motion--i.e., whether the economic

performance requirement of section 461(h) is satisfied with respect to the

$5,172,666 deduction claimed by Caltex in 1999 for IDCs--can be largely resolved

on the basis of the undisputed facts. As a result, we will grant the IRS's motion in

part.

II.

Statutory and regulatory framework

The issue before us is an accounting question: What is the proper year for

claiming deductions for costs that are related to the drillinþ, of oil wells?7 As we

will show, Caltex is allowed deductions for 1999 only to the extent that the

performance of the drilling-related services was timely under one of several

alternative rules.

A.

"All events test"

Section 461 of the Code and its accompanying regul tions provide general

rules that govern the timing of deductions. For a taxpayer (like Caltex) that uses

7Apart from the special allowances of the Code, IDC would be capital

expenditures. Since they benefit future periods, they would have to be capitalized

and recovered over those periods for income tax purposes, rather than being

expensed for the period the costs are incurred. See, e.g., 26 C.F.R. sec. 1.4611(a)(2)(i), Income Tax Regs. Notwithstanding this general ï·ule, section 263(c)

grants taxpayers the option to currently expense IDCs. See Keller v.

Commissioner, 725 F.2d 1173, 1178 (8th Cir. 1984), a_fff'g 79 T.C. 7 (1982).

However, "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." 26 C.F.R. sec. 1.6124(a), Income Tax Regs.

- 10 the accrual method of accounting, an expense is generally allowed as a deduction

for the year the taxpayer incurred the expense, irrespective of the date of payment.

Whether a business expense has been "incurred" is determined by the "all events

test" as set forth in 26 C.F.R. section 1.461-1(a)(2)(i), Income Tax Regs., which

provides:

Under an accrual method * * * a liability * * * is incurred, and

generally is taken into account for Federal income tax purposes, in the

taxable year in which all the events have occurred that establish the

fact of the liability, the amount of the liability can be determined with

reasonable accuracy, and economic performance has occurred with

respect to the liability. * * * [Emphasis added.]

See United States v. Gen. Dynamics Corp., 481 U.S. 239, 242-243 (1987). The

IRS does not dispute that Caltex satisfied the first two requirements of the "all

events test" (i.e., (1) that all the events occurred to establish the liability; and

(2) that the amount of the liability was determinable with reasonable accuracy).

Rather, the IRS contends that Caltex failed to satisfy the third "all events"

requirement, namely, "economic performance".

B.

Economic performance with respect to services provided to a

taxpayer

1.

General rule: provision of services

Before the enactment of section 461(h) in the Deficit Reduction Act of 1984

(DEFRA), Pub. L. No. 98-369, sec. 91(a), 98 Stat. at 598, economic performance

-11was not required. With its enactment, section 461(h) expanded the "all events

test" by providing that "in determining whether an amount has been incurred with

respect to any item during any taxable year, the all events est shall not be treated

as met any earlier than when economic performance with r spect to such item

occurs." Sec. 461(h). Section 461(h) applies to any item allowable as a cost,

expense, or deduction, unless specifically exempted by an alternative timing rule

in the Code. Sec. 461(h)(2).

Generally, if the liability of the taxpayer arises from third person's

providing services to the taxpayer, economic performance òccurs as the services

are provided. Sec. 461(h)(2)(A)(i); 26 C.F.R. sec. 1.461-4(d)(2), Income Tax

Regs. This general rule is applicable in cases of IDCs under a turnkey contract for

the drilling of an oil or gas well. See 26 C.F.R. sec. 1.461-4(d)(7), Example (_4).

Before the enactment of section 461(h), when an accrual-basis oil or gas

enterprise entered into a contract to receive drilling services under which the

taxpayer was to incur IDCs, it was proper under the "all events test" for the

taxpayer to claim a deduction in the year in which the oblig tion for the IDCs

became fixed under the contract, whether or not there was iii that year any

economic performance of services called for by the contract. As compared to a

cash-basis taxpayer, this rule placed an accrual-basis taxpay r in a superior

- 12 position with regard to IDCs, because the cash-basis taxpayer actually had to

prepay its IDCs to be allowed the deduction while an accrual-basis taxpayer only

had to become obligated to pay in order to be allowed a deduction. However,

since the enactment of section 461(h), the Code has not allowed accrual-basis

taxpayers to claim a deduction for IDCs until economic performance of the

services under the contract has occurred. Thus, even though the old "all events

test" might be met for one tax year because the taxpayer's liability for payment

became fixed and determined in that year, under the rules now applicable to

accrual-basis taxpayers, a deduction is allowed for that year only if the economic

performance test of section 461(h) is satisfied as well.

As a result, unless an exception to this general rule applies, the IDCs at

issue here satisfy the economic performance requirement of section 461(h) for

1999 only to the extent the corresponding services were actually performed in

1999.

- 13 2.

The two pertinent exceptions in dispu e8

Caltex does not contend that Red River performed inore than $5 million in

services on the last day of 1999 (i.e., the day the contract

as executed).' Rather,

Caltex claims its deduction is warranted under two possible exceptions to the

general rule:

a.

The 90-day rule

The 90-day rule of section 461(i)(2)(A) allows a taxpayer to deduct IDCs in

full prior to economic performance if "drilling of the well commences" within 90

days after the close of the tax year in which the taxpayer p epaid the IDCs and for

which the taxpayer is seeking to claim the deduction. The IRS maintains that

8A third exception is the recurring item exception of section

461(h)(3)(A)(iii), which allows a taxpayer to claim a deduc)ion in advance of

economic performance if certain requirement are met. In its motion the IRS

argues that Caltex is not entitled to the recurring item exception because, inter alia,

the liability under the contract is not recurring in nature. Caltex does not counter

the IRS's argument or explicitly argue that it is entitled to i¼voke the recurring

item exception of section 461(h)(3)(A)(iii). We therefore irifer that Caltex

concedes this issue and does not invoke the recurring item (xception.

Caltex does contend that, even if all its other argumeþts fail, it is still

entitled to a deduction for the cost of any services that Red R.iver actually

performed in 1999 under the terms of the contract. The IRS!acknowledges that

entitlement but argues that Caltex's maximum possible ded etion under that

theory should be $7,072.80 because Caltex stipulated that "it incurred $7,072.80

of intangible drilling costs relating to Exhibit 5-J (the docun ent entitled 'Turnkey

Contract' between Caltex Oil Venture and Red River Exploration, Inc.) during

1999." We address this issue briefly in section V below.

- 14 Caltex is not entitled to the special timing provision of the 90-day rule because no

drill penetrated the ground for the purpose of beginning Caltex's wells before the

close of the 90th day after the close of 1999 (i.e., by March 30, 2000). In so

arguing, the IRS contends that the phrase "drilling of the well commences" as used

in section 461(i)(2)(A) requires actual penetration of the ground by a drill bit for

purposes of starting the well.

In contrast, Caltex contends that it is entitled to a full deduction for the

IDCs for 1999 because it commenced drilling operations, i.e., by securing drilling

permits and beginning site preparation, within 90 days of the close of 1999 in

satisfaction of section 461(i)(2)(A). Caltex challenges the IRS's interpretation

that the 90-day rule requires that a drill bit actually penetrate the ground. Caltex

argues that actual drilling is not necessary and that acts normally required to be

done before the commencement of actual drilling are sufficient to constitute the

commencement of a well or drilling operations.

b.

The 3-1/2-month rule

In the alternative, Caltex argues that, even if it is not entitled to a full

deduction under the 90-day rule, it is entitled, at least, to a partial deduction of

IDCs for 1999 under the 3-1/2-month rule of 26 C.F.R. section 1.461-4(d)(6)(ii),

Income Tax Regs., which allows a taxpayer to treat a liability as having been

- 15 economically performed at the time of payment if that taxpayer "reasonably

expect[ed] the * * * [provider of services] to provide the services * * * within 3

1/2 months after the date of payment". The IRS maintain¼ that Caltex may not

invoke this special timing rule because the 3-1/2-month rule contemplates that,

under a non-severable contract, all of the services called for must reasonably be

expected to be performed within the required time. Calte disputes the IRS's

interpretation of the regulation and contends that it is entitled to a deduction for

the portion of the contracted services that it reasonably ex1sected to be performed

within 3-1/2 months of payment.

We now address these disputed issues.

III.

The special 90-day rule for oil and gas tax shelters under section

461(i)(2)(A): "if drilling of the well commences"

Section 461(i)(2)(A) provides a special rule for econömic performance as it

relates to the drilling of oil and gas wells. This special rule is limited to "tax

shelters" as defined in section 461(i)(3). For purposes of tl is motion, we will

assume (favorably to Caltex) that Caltex is such a tax shelter so that it may invoke

section 461(i)(2)(A), which provides:

In the case of a tax shelter, economic performance with respect to

amounts paid during the taxable year for drilling an oil or gas well

shall be treated as having occurred within a taxable year if drilling of

- 16 the well commences before the close of the 90th day after the close of

the taxable year. [Emphasis added.]

Thus, accrual-basis oil and gas tax shelters (such as Caltex) may deduct their IDCs

in advance of drilling as long as the "drilling of the well commences" within 90

days after the close of the tax year for which the taxpayer is seeking to claim the

deduction.

The question that this provision prompts is: When does the "drilling" of a

well "commence"?

The IRS maintains that the drilling of a well commences when the well is

"spudded", meaning at the beginning of surface drilling (i.e., when the drill bit

penetrates the ground), while Caltex argues that drilling is commenced when

activities such as site preparation begin.

A.

The plain language of the statute: "drilling * * * commences"

To construe a statute, we consult first the ordinary meaning of its language,

see Perrin v. United States, 444 U.S. 37, 42 (1979), and we apply the plain

meaning of the words used in a statute unless we find that those words are

ambiguous, United States v. James, 478 U.S. 597, 606 (1986). Since the 90-day

rule was added to the Code in 1984, see DEFRA sec. 91(a), and has remained

relatively unchanged, these are not antiquated words or terms that would need

- 17 special interpretation. According to Webster's Third New International Dictionary

690 (2002), to "drill" means "to make (a rounded hole or havity in a solid) by

removing bits with a rotating drill", while to "commence" means "to begin". Id. at

456. Giving effect to the plain meaning of these words, we find it unambiguous

that "drilling of the well commences" when the boring of a hole for the well

begins. Therefore, we find that the plain language of sectipn 461(i)(2)(A) dictates

that, as a matter of law, "drilling of the well commences" when the drill bit

penetrates the ground to start the hole for the well. Our interpretive task could

stop there, with our conclusion based on the plain language of section

461(i)(2)(A).

B.

The title of section 461(i)(2): "spudding"

However, we need not look far to see strong corroboration of this

interpretation--or, if the language were thought ambiguotis, resoliition of that

ambiguity. The title of section 461(i)(2)--"Special rule for spudding of oil or gas

wells" (emphasis added)--shows the intended meaning of tlie term "drilling of the

well commences". .While the title of an act will not limit the plain meaning of the

text, see Strathearn S.S. Co. v. Dillon, 252 U.S. 348, 354 (1920); Caminetti v.

United States, 242 U.S. 470, 490 (1917), it may be of aid in resolving an

ambiguity, Fla. Dept. of Revenue v. Piccadilly Cafeterias, I c., 554 U.S. 33, 47

- 18 (2008).1° In the case of section 461(i), the heading is not at any variance with the

text. This is an instance in which the heading is "of some use for interpretative

purposes"," Wallace v. Commissioner, 128 T.C. 132, 140-141 (2007), and it

confirms our reading of the text of the statute:

To "spud" means "to begin to drill (an oil well) by alternately raising and

releasing a spudding bit with the drilling rig". Webster's Third New International

1°See also Graves v. Commissioner, 89 T.C. 49, 51 (1987); Keeble v.

Commissioner, 2 T.C. 1249, 1252-1253 (1943)). The Court of Appeals for the

Third Circuit, to which an appeal of this case would lie, follows this principle:

"'[T]he title of a statute and the heading of a section are tools available for the

resolution of a doubt about the meaning of a statute.'" Gay v. CreditInform, 511

F.3d 369, 385 (3d Cir. 2007) (quoting Almendarez-Torres v. United States, 523

U.S. 224, 234 (1998)); see also United States v. Thayer, 201 F.3d 214, 221 (3d

Cir. 1999)("the title of a [statutory] section can assist in resolving ambiguities").

"The word "spudding" was used not only in the title of the statute but

several times in the legislative history. See S. Rept. No. 100-445, at 100-101

(1988), 1988 U.S.C.C.A.N. 4515, 4618 ("When the special spudding rule for

economic performance was adopted by Congress * * * economic performance was

deemed to occur at the time of spudding of an oil or gas well where the taxpayer

had paid for the drilling costs prior to the close of the taxpayer's year. * * * the

special spudding rule * * * in order for spudding to be considered as economic

performance" (emphasis added)); H.R. Conf. Rept. No. 98-861, at 884-885 (1984),

1984-3 C.B. (Vol. 2) 1, 138 ("economic performance is deemed to occur with

respect to all intangible drilling expenses of a well when the well is 'spudded.'

* * * [If] the spudding of the well commenced within 90 days after the close of the

taxable year, the entire amount of the prepaid intangible drilling expense would be

deductible"). Thus, if there were any doubt, the legislative history could be cited

to confirm the interpretation we have found.

-19Dictionary 2212 (2002)." As a result, we find that a well is "spudded" when the

drill bit penetrates the ground for purposes of drilling an oil or gas well. That

being the case, the title that Congress gave to this subparagraph--"Special rule for

spudding"--indicates that when Congress said that the special rule would apply "if

drilling of the well commences" it meant that the rule would apply if a spudding

bit had been raised and released to begin the actual drillinj,.

"If "spudding", as a specialized term, should be defi ed by reference to oil

and gas sources, then such sources only confirm the dictior ary meaning. See

Marathon Oil Co. v. FERC, 68 F.3d 1376, 1377 (D.C. Cir. 1995) (spudding occurs

"where surface drilling had commenced"); American Petroleum Institute, Glossary

of Oilfield Production Terminology (1988) (citing API Bulletin D11, "Glossary of

Drilling-Fluid and Associated Terms" (2d ed. 1979) (defining "spudding in" as

"[t]he starting of the drilling operations of a new hole")) (atailable at

http://www.occeweb.com/og/api-glossary.pdf);Howard R. 040Nilliams

& Charles J.

Meyers, Manual of Oil and Gas Terms 1084 (12th ed. 2003) (defiming "spudding

in" as "[t]he first boring of the hole in the drilling of an oil well"). In addition, an

abridged version of the Dictionary of Petroleum Terms pro ided by Petex and the

University of Texas Austin (c) Petex 2001 (provided on the Department of Labor's

website at http://www.osha.gov/SLTC/etools/oilandgas/glossary of_terms/

glossary_of_terms_a.html) defines "spud" as "1. to begin dr lling a well; such as,

to spud in. 2. to force a wireline tool or tubing down the hole by using a

reciprocating motion", where "spud in" means "to begin drilling; to start the hole."

Caltex does not dispute that "spudding" has this specific me ning, nor does Caltex

cite any sources that give a different definition of "spudding '.

- 20 C.

Giving effect to every word in the statute

In support of its contrary position, Caltex cites several State court opinions

that interpret similar language in oil and gas leases but hold that actual drilling is

not required. However, in most of the cases Caltex cites, the language and the

contexts are different from section 461." Caltex cites one case with language

sufficiently close to section 461 to warrant discussion: Jones v. Moore, 338 P.2d

872 (Okla. 1959), which interprets a contract term that required a lessee to

"commence to drill a well" and holds that the contract was satisfied even without

actual drilling.'4 In Jones the Supreme Court of Oklahoma held that the "well was

"See Allen v. Cont'l Oil Co., 255 So.2d 842 (La. App. 1971) (interpreting

contract term that required "operations for drilling" to have commenced); Walton

v. Zatkoff, 127 N.W.2d 365 (Mich. 1964) (interpreting contract term requiring

commencement of "operations for the drilling of a well" or "the commencement of

drilling operations"); Henderson v. Ferrell, 38 A. 1018 (Pa. 1898) (interpreting

contract term that required lessee "to commence operations on the premises within

30 days"); Pemco Gas, Inc. v. Bernardi, 5 Pa. D & C.3d 85 (1977) (interpreting

lease term that required "commencement of operations" by a certain date);

Petersen v. Robinson Oil & Gas Co., 356 S.W.2d 217 (Tex. Civ. App. 1962)

(interpreting contract term requiring the commencement of "operations for

drilling"); Edgar v. Bost, 14 S.W.2d 364 (Tex. Civ. App. 1929) (interpreting

contract term that "well be commenced"); Fast v. Whitney, 187 P. 192 (Wyo.

1920) (interpreting contract term that "well be commenced"). None of these sheds

any light on the meaning of "if drilling of the well commences" (emphasis added)

in section 461.

14Caltex also cites, to the same effect, 2 Walter Lee Summers, Oil and Gas,

sec. 349 (1959), cited in Anderson v. Hess Corp., 733 F. Supp. 2d 1100, 1108

(continued...)

- 21 commenced" by certain preparatory acts, e.g., staking the location, digging a slush

pit preparatory to drilling, and ordering a machine out to drill the well. El at 874876. In doing so, the court seems to have ascribed no sig ificance to the presence

of the word "drill" in the lease term at issue ("commence to drill a well" (emphasis

added)), and Caltex would evidently have us do the same here. However, we do

not face the question whether, under Oklahoma law, lease terms of this nature are

understood not to require actual penetration of the ground, despite language

literally calling for "drill[ing]". Instead, we interpret a statute (not a lease), and we

construe it as a provision of Federal law (not under State 1 w).

In so doing, we follow the "'elementary rule of construction that effect must

be given, if possible, to every word, clause and sentence of[a statute.'" Vetco Inc.

& Subs. v. Commissioner, 95 T.C. 579, 592 (1990) (quoting 2A Sutherland

Statutory Construction sec. 46.06 (1986)). As a result, we 7vill not ignore or

minimize the word "drilling" in section 461(i)(2)(A). To do so would be at odds

with the heading of the section (discussed above at III.B.) and its intended purpose

(see supra note 11). Therefore, we do not find the cases cit d by Caltex to be

persuasive in aiding our interpretation of section 461.

(...continued)

(D. N.D. 2010), aff'd, 649 F.3d 891 (8th Cir. 2011).

- 22 D.

Application to Caltex

Caltex has stipulated that "[n]o drill penetrated the ground for purposes of

drilling a well by or on behalf of Caltex Oil Venture during 1999 or 2000." Given

that fact, Caltex is not entitled to the special timing rule of section 461(i)(2)(A).

IV.

The 3-1/2-month rule of 26 C.F.R. section 1.461-4(d)(6)(ii)

As we have shown, the general "economic performance" rule of section

461(h)(2)(A)(i) provides that economic performance occurs as services are

provided to the taxpayer; but section 461(h)(2) conferred on the Secretary the

authority to promulgate regulations that would provide alternative timing. Acting

under this authority, the Secretary promulgated 26 C.F.R. section

1.461-4(d)(6)(ii), Income Tax Regs., which provides that a taxpayer is allowed to

treat services as having been provided (i.e., thereby satisfying the economic

performance prong of the "all events test") when the taxpayer makes payment for

those services if the taxpayer can "reasonably expect the * * * [provider of

services] to provide the services * * * within 3 1/2 months after the date of

payment." This is commonly referred to as "the 3-1/2-month rule."

- 23 A.

The parties' contentions

The IRS maintains that this 3-1/2-month rule does not allow Caltex to treat

the services due under the contract as having been econonhically performed in

1999 because the rule applies only if Caltex could reasonably expect all services

due under the contract to be provided within 3-1/2 month after the date of

payment. The IRS acknowledges a distinction (and a different outcome) where the

contract provides for differentiated or severable services to be performed under a

single contract. The IRS concedes that, in the case of a divisible contract, also

known as a severable contract,*economic performance occurs (and any applicable

economic performance exception will apply) separately with regard to each

distinct service that was contracted for as that service is provided. See 26 C.F.R.

sec. 1.461-4(d)(6)(iv), Income Tax Regs. ("If different services * * * are required

to be provided to a taxpayer under a single contract or agreement, economic

"Where several things are to be done under a contract, and the money

consideration to be paid is apportioned to each of the items, the contract is

ordinarily regarded as severable. MacArthur v. Commissidner, 168 F.2d 413 (8th

Cir. 1948), aff'g 8 T.C. 279 (1947); Canister Co. v. Wood å Selick, Inc., 73 F.2d

312, 314 (3d Cir. 1934). On the other hand, if the consider¼tion to be paid is

single and entire, the contract will ordinarily be held as entire, see United States v.

U. S. Fid. & Guar. Co., 236U.S. 512, 524-525 (1915); Traiman v. Rappaport, 41

F.2d 336, 338 (3d Cir. 1930), "although the subject thereof may consist of several

distinct and wholly independent items," Fullmer v. Poust, 26 A. 543, 543 (Pa.

1893).

- 24 performance generally occurs over the time each service is provided"). However,

the IRS maintains that the same is not so if a contract--like, it points out, the

turnkey contract'' at issue here--does not specifically provide for differentiated

services.

Caltex disagrees and argues that the IRS's interpretation of the 3-1/2-month

rule must be rejected because if all the services called for under a turnkey contract

had to be performed within 3-1/2 months of payment, the rule could never be

applicable to the oil and gas industry. Our record shows that digging an oil well

usually takes over two years from conception to production and necessarily

requires, among other things, extensive data collection, lease acquisitions,

securing access roads, staking and permitting of the well site, negotiating contracts

for subcontract services, buying and building surface facilities, and the actual

drilling and production of oil or gas. Instead, Caltex maintains that the rule

permits a taxpayer to accelerate a deduction for just the allocable cost of the

services that would be provided in the 3-1/2-month period from payment. In

16"A turnkey contract has a definite meaning in the oil industry. It is a

contract where the driller undertakes to furnish everything, and to do all the work

required to complete the well, place it on production, and turn it over ready to

'turn the key' and start the oil running into the tanks." Cont'l Oil Co. v. Jones,

177 F.2d 508, 510 (10th Cir. 1949).

- 25 taking this position, Caltex does not address the IRS's distinction between a

severable and non-severable contract.

Thus, the questions before us are (i) whether the 3-1/2-month rule

contemplates that all of the services called for under a contract must be provided

within 3-1/2 months of payment, or whether the rule pernlits a taxpayer to

accelerate a deduction for just the portion of the services that would be expected to

be provided in the 3-1/2-month period from payment, and (ii) whether the

interpretation and application of the 3-1/2-month rule changes depending on

whether the contract at issue is severable or non-severable.

B.

Construing 26 C.F.R. section 1.461-4(d)(6)(ii

1.

The ambiguity of the regulation

The starting point for interpreting a regulatory provision is, as with a statute,

its plain meaning. Walker Stone Co. v. Sec'y of Labor, 156 F.3d 1076, 1080 (10th

Cir. 1998)("When the meaning of a regulatory provision is clear on its face, the

regulation must be enforced in accordance with its plam meanmg"); Intermountain

Ins. Serv. of Vail, L.L.C. v. Commissioner, 134 T.C. 211, 218 (2010), rev'd on

other grounds, 650 F.3d 691 (D.C. Cir. 2011). The 3-1/2-n onth rule inquires

whether Caltex reasonably expected Red River "to provide the services" within

the relevant time period. See 26 C.F.R. sec. 1.461-4(d)(6)(li), Income Tax Regs.

- 26 (emphasis added). The IRS argues that this rule contemplates that "the services"

called for under a contract--i.e., all of the contracted services--must be provided

within 3-1/2 months of payment, while Caltex maintains that the rule permits a

taxpayer to claim a deduction for just the portion of the services that would be

expected to be provided in the 3-1/2-month period from payment. The IRS thus

contends in effect that "the services" means "all of the services", and Caltex

contends in effect that it means "any of the services".

We think that the IRS's proffered meaning (i.e., all of the services) is the

more likely. The regulation reads:

A taxpayer is permitted to treat services or property as provided to the

taxpayer as the taxpayer makes payment to the person providing the

services or property (as defined in paragraph (g)(1)(ii) of this

section), if the taxpayer can reasonably expect the person to provide

the services or property within 3 1/2 months after the date of

payment.

26 C.F.R. sec. 1.461-4(d)(6)(ii), Income Tax Regs. The regulation thus presumes

a correlation between "the services" and "payment" therefor. Where multiple

services are provided pursuant to a contract that calls for a single payment, and the

single payment is thus not linked to fewer than all of the contracted services but is

instead paid for all ofthe contracted services, "the services" that must be provided

- 27 within 3-1/2 months would seem to be the services for which "payment" is made-i.e., all the services.

However, the regulation does not include either the phrase "all of" or the

phrase "any of". We cannot say that Caltex's interpretation is impossible. Since

the meaning of the regulation is thus ambiguous, we will look to other principles

and canons" to see whether they confirm or correct our initial reading of the

regulation.

2.

Narrow construction of deductions

It is well settled that deductions are a matter of legislative grace and should

be narrowly construed. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992);

New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Caltex asks us to

read the 3-1/2-month rule expansively--i.e., giving the taxpayer a greater

entitlement to accelerate deductions--whereas the IRS's interpretation is narrower.

This tends in favor of the IRS's interpretation, especially s nce the 3-1/2-month

rule, even narrowly construed, is already a relaxation of the general economic

"The IRS's interpretation of 26 C.F.R. sec. 1.461-4(d)(6)(ii) has not been

announced in any published guidance. Because we uphold this interpretation on

other grounds, we need not reach the question whether, as the IRS contends, this is

a circumstance in which we should defer to the agency's unpublished

interpretation of its own regulation.

- 28 performance rule of section 461(h) and expands taxpayers' entitlement to a

deduction.'8

3.

The history of the 3-1/2-month rule

It is well settled that where a statute is ambiguous, we may look to

legislative history to ascertain its meaning. Burlington N. R.R. v. Okla. Tax

Comm'n, 481 U.S. 454, 461 (1987); Griswold v. United States, 59 F.3d 1571,

1575-1576 (11th Cir. 1995). The rules of statutory construction also apply to the

construction of regulations. See Estate of Schwartz v. Commissioner, 83 T.C.

943, 952-953 (1984). Therefore, when a regulation is ambiguous, we may

likewise consult its "regulatory history"-i.e., statements made by the agency

contemporaneously with proposing and adopting the regulation--to ascertain its

meaning. See Armco, Inc. v. Commissioner, 87 T.C. 865, 868 (1986) ("A

18The Secretary showed an intention to limit the relaxation of the economic

performance rule. Some commentators on the Secretary's initial proposed

regulations encouraged the IRS to adopt final regulations with a "payment trump"

rule--i.e., treating the time of payment as full economic performance, see T.D.

8408, 1992-1 C.B. 155, 157--and others suggested that the proposed 3-1/2-month

rule be extended to six months, see id., 1992-1 C.B. at 157. Rejecting these

suggestions in the final regulations, the Secretary determined that "the policy of

section 461(h) would be frustrated" by adopting the "payment trump" rule and that

"the 3 1/2-month rule appropriately operates to relieve taxpayers of the burdens

incident to determining precisely when services and property are provided, while

assuring that economic performance occurs within a reasonable time following

payment." Id.

- 29 preamble will frequently express the intended effect of some part of a regulation

* * * [and] might be helpful in interpreting an ambiguity in a regulation"); see also

Abbott Labs. v. United States, 84 Fed. Cl. 96, 103 (2008) ("the court [is] permitted

to consult the agency's interpretations or the regulatory history to determine

meaning" if the regulation is ambiguous), aff'd, 573 F.3d 1327.(Fed. Cir. 2009).

Proposed regulations under section 461(h) were issued on June 7, 1990, and

adopted on April 9, 1992. See Notice of Proposed Rulem king, Economic

Performance Requirement, IA-258-84, 1990-2 C.B. 805; T.D. 9408, 1992-1 C.B.

155. In publishing the proposed regulations, the Secretary explained the origin of

the 3-1/2-month rule:

[I]n the case of a liability of a taxpayer arising from the provision by

another person of property or services to the taxpayer, the statute

provides that economic performance occurs as the property or

services are provided to the taxpayer. The regulatioihs provide rules

designed to lessen the burden on a taxpayer incident!to determining

when property or services are provided to the taxpayler. For example,

the regulations provide that a taxpayer may treat proþerty or services

.

as provided to the taxpayer as the taxpayer makes payment for the

property or services. However, this treatment is available only if the

taxpayer can reasonably expect the property or services to be

provided by the other person within 3 1/2 months after the payment is

made. [1990-2 C.B. 805, 806; emphasis added.]

In promulgating the f'mal regulations (in which it rejected a suggestion to lengthen

the 3-1/2-month period; see supra note 18), the Secretary reþeated--

- 30 that the 3 1/2-month rule appropriately operates to relieve taxpayers

of the burdens incident to determining precisely when services and

property are provided, while assuring that economic performance

occurs within a reasonable time following payment. [Emphasis

added.]

T.D. 8408, 1992-1 C.B. at 157.

Therefore, the history of 26 C.F.R. section 1.461-4(d)(6)(ii) is emphatic

about avoiding the burden of having to determine precisely when services were

provided. It would be somewhat at odds with such a regime--engineered to avoid

difficulties in determining when services have been provided--to allow a taxpayer

to accelerate deductions for just the portion of services expected to be provided

within 3-1/2 months of payment and, in order to do so, to make ex post facto

valuations of those services--valuations that would require fact-intensive analyses

by both the taxpayer and the IRS. This is the very difficulty that the regulation

sought to avoid. We hardly think that the Secretary intended this result when

promulgating the 3-1/2-month rule.

4.

Difficulty for the oil and gas industry

Caltex argues that the IRS's interpretation of the 3-1/2-month rule must be

rejected because if all the services called for under a turnkey contract have to be

performed within 3-1/2 months of payment, the 3-1/2-month rule could never be

- 31 applicable to the oil and gas industry because of the:imm nsity of its projects,

thereby making the rule superfluous.

It is true that, generally speaking, an interpretation that renders a statutory

provision superfluous should be avoided, since that interpretation would offend

"the well-settled rule of statutory construction that all pa s of a statute, if at all

possible, are to be given effect." Weinberger v. Hynson, Westcott & Dunning,

Inc., 412 U.S. 609, 633 (1973).

However, the 3-1/2-month rule is a general excepticn to the economic

performance rule of section 461(h). It is not an exception that is specific to the oil

and gas industry. Cf. sec. 461(i)(2)(A). As a result, even if it were true that the

3-1/2-month rule could not be used in the oil and gas indu try, that fact would not

be sufficient by itself to invalidate the IRS's proposed interpretation, because

inapplicability to one particular industry does not make a lbrovision entirely

superfluous.

Moreover, we do not find that the IRS's interpretatiön of the 3-1/2-month

rule would always make it inapplicable to the oil and gas industry. For example, if

a contract for the drilling of an oil or gas well were drafted in such a manner that

payments were allocated to specified services, the 3-1/2-month rule could apply to

such oil and gas contracts. _S_ee 26 C.F.R. sec. 1.461-4(d)(6)(iv), Income Tax

- 32 Regs. Or, if some or all of the preparatory activities were already completed at the

time the taxpayer entered into a turnkey contract and made payment and the

remaining services that were the subject of the contract could be completed in

3-1/2 months, then under such a contract all the services under the contract could

be completed within that 3-1/2-month period.

In any event, we do not reject the IRS's interpretation of the 3-1/2-month

rule simply because the rule might be used in the oil and gas industry only

infrequently.

C.

Application to Caltex

1.

Caltex is not entitled to the special timing provisions of the

3-1/2-month rule.

We hold that the 3-1/2-month rule contemplates that all of the services

called for under an undifferentiated, non-severable contract must be provided

within 3-1/2 months of payment. Therefore, a determination of Caltex's

entitlement to use the 3-1/2-month rule requires (1) a determination of whether the

contract at issue is an undifferentiated, non-severable contract (see supra note 15),

versus a severable one, and (2) a determination of whether the services called for

thereunder could have reasonably been expected to be performed within 3-1/2

- 33 months of payment; In doing so, we find that Caltex is not entitled to the special

timing provisions of the 3-1/2-month rule.

Caltex's contract with Red River fits the definition of a "turnkey contract",

(see supra note 16). It did not provide an exhaustive, itemized list of services to

be provided to Caltex by Red River (or its subcontractors with particular

payments associated with or allocated to each service. Instead, the contract

enumerated some, but not all, of the services to be provid d in order for Red River

to "commence or cause to be commenced" the drilling of vells at the two sites,

and it called for lump-sum payments of $4,123,333 for drilling costs and

$1,049,333 for completion costs without any allocation of those sums to particular

services. As a result, we hold that the contract at issue he3e is an entire, non-

severable contract, as the IRS contends.

Given that the contract is non-severable, Caltex maý use the 3-1/2-month

rule only if all the services called for in the contract with ed River could have

been reasonably expected to be performed within 3-1/2 months of payment.

Caltex has never alleged that it expected all of the services to be provided within

3-1/2 months of payment. On the contrary, Caltex conced s that it did not

reasonably expect all services to be performed within 3-1/2 months of payment,

since "turnkey contract services in the oil and gas industry could never be

- 34 completed in such a limited time frame." As a result, we find that Caltex may not

treat any of the services due under the contract as having been economically

performed in 1999 by operation of the 3-1/2-month rule of 26 C.F.R. section

1.461-4(d)(6)(ii).

2.

Deductions under the 3-1/2-month rule are limited to payments

made by cash or cash equivalents, not notes

For purposes of the regulation at issue, "payment" has the same meaning as

it has for taxpayers using the cash receipts and disbursement method of

accounting. See 26 C.F.R. sec. 1.461-4(d)(6)(ii), Income Tax Regs. (defining

"payment" by reference to 26 C.F.R. section 1.461-4(g)(1)(ii)). Pursuant to 26

C.F.R. section 1.461-4(g)(1)(ii)(A),

payment includes the furnishing of cash or cash equivalents and the

netting of offsetting accounts. Payment does not include the

furnishing of a note or other evidence of indebtedness of the taxpayer,

whether or not the evidence is guaranteed by any other instrument

(including a standby letter of credit) or by any third party (including a

government agency).

After this regulation was proposed, see Notice of Proposed Rulemaking,

Economic Performance Requirement, IA-258-84, 1990-2 C.B. 805, 814,

commentators objected to this rule and, among other things, asked that the

regulation provide that a note or other evidence of indebtedness which bears an

arm's-length rate of interest be included as "payment". T.D. 8408, 1992-1 C.B. at

- 35 159. The Secretary rejected this suggestion because they believe[d] that

consistent use of the cash method definition of payment p ovides an administrable

rule that is consistent with congressional intent." E Therefore, for purposes of

the 3-1/2-month rule, the "payments" made by Caltex would not include any notes

executed in favor of Red River, but instead would include only the two payments

made by Caltex to Red River via checks in the amounts of $308,293.50 and

$119,892. As a result, even if Caltex were able to invoke the 3-1/2-month rule, it

would be able to deduct only the amount of its actual payments (i.e., $428,185.50),

not the approximately $5.2 million it attempted to deduct.

V.

Economic performance under the general rule of section 461(h)

Even though Caltex does not qualify for the exceptions discussed above, it

may still invoke the general rule of section 461(h). That sta ute provides that "the

all events test shall not be treated as met any earlier than when economic

performance with respect to such item occurs"; and, if the liábility of the taxpayer

,

arises from a third person providing services to the taxpayer "economic

performance occurs as such person provides such services". Sec. 461(h)(1),

(2)(A)(i). Thus, Caltex remains entitled to deduct for 1999 t e payments it made

in 1999 for services actually performed in 1999.

- 36 The IRS acknowledges this principle but argues that economic performance

with respect to at least $5,165,593.20 of the claimed IDCs of $5,172,666 did not

occur in 1999, because (it says) Caltex stipulated that only $7,072.80 of the IDCs

due under the contract was incurred in 1999. The actual language of the

stipulation is: "Petitioner contends that it incurred $7,072.80 of intangible drilling

costs relating to * * * [the contract] during 1999." Therefore, reasons the IRS,

Caltex's maximum potential deduction for IDCs for 1999 under section 461(h) is

$7,072.80.

Caltex counters that while it stipulated that it contends that $7,072.80 of

IDCs was incurred in 1999, it did not stipulate that it contends that only $7,072.80

of IDCs was incurred in 1999. As a result,.Caltex maintains that the precise

amount of IDCs incurred in 1999 remains in dispute.

We think the IRS's reading of the stipulation is the more likely reading.

However, we cannot say that Caltex's reading is impossible, and we currently

address this question not after a trial but under Rule 121. In deciding the IRS's

motion for partial summary judgment, we must draw every inference in favor of

the non-moving party, Caltex. As a result, there remains a genuine issue of

material fact regarding the amount, if any, of IDCs incurred by Caltex in 1999

- 37 (and the effect, if any, of the parties' stipulation on Caltex s ability to claim

deductions in excess of $7,072.80).

Moreover, we note that the IRS does not maintain that, by way of summary

judgment on this point, we can use the stipulation to avoid a trial on the issue of

the amount of Caltex's 1999 IDC deductions under the general rule of

section 461(h). The IRS does not concede that Caltex may actually deduct

$7,072.80 in IDCs for 1999. Instead, the IRS argues that f ctual issues relating to

the deductibility even of the $7,072.80 should remain for trial and that such issues

include (i) whether the services to which the $7,072.80 relate were performed in

1999, and (ii) if so, whether the services were performed before Caltex acquired

interests in the wells. See Haass v. Commissioner, 55 T.C. 43, 50 (1970)(holders

of interests in oil and gas wells may deduct IDCs only after they have been granted

operating rights to the wells to which those costs relate). It s not worthwhile for

us to attempt resolve under "genuine issue of material fact" tandards a

controversy about the interpretation of a stipulation, only to hen have to address

in large part the issue that summary judgment should resolve. These

considerations also tilt this question in Caltex's favor, for purposes of the IRS's

I

- 38 Conclusion

The IRS is entitled to summary judgment on two issues: (1) Caltex is not

entitled to the 90-day special timing rule of section 461(i)(2)(A); and (2) Caltex is

not eligible to treat any services due under the contract as having been

economically performed in 1999 under the 3-1/2-month rule of 26 C.F.R.

section 1.461-4(d)(6)(ii), Income Tax Regs. Whether, and to what extent, Caltex

may be entitled to deduct some of its IDCs for 1999 on the basis of the general

economic performance rule of section 461(h) is still in dispute.

To reflect the foregoing,

An appropriate order will be issued.