OIL & GAS INVESTMENT:

Taxation & Securities Laws

Copyright © 1996 by Lewis G. Mosburg, Jr.

BROOKSTONE RESOURCES, INC.

Oil and Gas Tax Bits

Volume 1 - November 1, 1996

By: Patrick R. Sughroue, Esq.

President, Brookstone Resources, Inc.

Copyright, 1996; Brookstone Resources, Inc., All rights reserved.

Don't Let the Sun Go Down On Your Section 29 Tax Credits

Owners of certain oil and gas production may be elifible for a federal tax credit adding dollar value to the sale price of qualifying production sold prior to January 1, 2003

In this article we discuss the existence and computation of, as well as certain limitations upon, an extremely valuable tax benefit - The Nonconventional Fuel Source Tax Credit available under Section 29 of the Internal Revenue Code. The Section 29 tax credit can significantly reduce or eliminate federal income tax liability generated from producing and profitable qualifying oil and gas properties. The credit is transferable with ownership of an economic interest in qualifying production. However the credit's complexity and numerous limitations provide a trap for the unwary.

General. Section 29 of the Internal Revenue Code (the "Code") provides a nonrefundable tax credit against regular federal tax liability (but not alternative minimum tax) for the production and sale of energy from so-called alternative sources.

 Computation of the Section 29 Tax Credit.

 Amount of the Credit. The amount of the Section 29 tax credit is, subject to certain limitations and adjustments , equal to $3.00 (subject to adjustment for inflation - except in the case of gas produced from tight formations) multiplied by the number of barrel-of-oil equivalent of qualified fuels produced and sold during the taxable year. A barrel-of-oil equivalent is an amount of fuel which has the energy equivalent of 42 U.S. gallons of oil. The energy equivalence is based on the Btu (British thermal unit) content of the fuels. As a result, the Section 29 credit produces a $3.00 tax credit for the production of 5.8 million Btus of energy from qualified sources. Any Btus attributable to sources other that the qualified sources are excluded from computation of the credit.

Timing of Claiming the Credit. The IRS has ruled that a cash basis taxpayer should claim the Section 29 credit in the year in which the revenue from the sale of the qualifying fuel is recognized for federal income tax purposes. However, the actual amount of the credit must be based on the year in which the sale was made. The Section 29 credit which is disallowed for any reason (with the exception of the disallowance solely as a result of the alternative minimum tax, discussed below) cannot be carried forward or back to another taxable year.

Alternative Minimum Tax Carryover. In the event Section 29 is disallowed in any year solely by reason of the limitation based on the taxpayer's alternative minimum tax liability, the taxpayer's minimum tax credit allowable under Code Section 53 in future years against regular tax liability is increased by the amount of the Section 29 credit so disallowed.

Credit Allocation among Co-Owners. When more than one taxpayer has an interest in a property or facility, there is some uncertainty concerning the allocation of the production for purposes of the credit. The Code provides that, in general, production should be allocated in proportion to the owners' respective interests in the gross sales from such property of facility. The Treasury Department has been authorized and directed to provide regulations regarding allocation of the credits, but as yet has not done so. Generally, taxpayers would be entitled to the credit in proportion to their ownership in the qualifying production or facility. In the case of production from shale, geopressurized brine, coal seams, Devonian shale, and tar sands, the credit would be based on the taxpayer's economic interest in the property (within the meaning of Code Section 613(a)). The production attributable to any taxpayer for any year would be equal to an amount which bears the same ratio to total production from the property for that year as the amount of the taxpayer's gross income from the property on account of that production bears to the aggregate gross income from the property of all persons having an economic interest in the property. In the case of energy production from biomass, coal liquefaction and gasification, the credit would be based on the taxpayer's interest in the facility.

Qualifying Fuels. Qualified fuels eligible for the Section 29 credit include the following:

* Oil Produced from Shale or Tar Sands. More specifically, shale oil is defined as the liquid oil from shale rock after the retorting (heating) process but before hydrogenation, refining, or any other process subsequent to retorting.

 * Gas Produced from Geopressurized Brine, Devonian Shale, Coal Seams and Tight Formations. The determination of whether gas is produced from these sources is judged by the standards of the Federal Energy Regulatory Commission (FERC) in accordance with section 503 of the Natural Gas Policy Act of 1978 (NGPA). It is not necessary that the producer must have received a determination by FERC under the NGPA that the qualifying gas was produced from Devonian shale or a tight formation, as long as that is in fact the case. In order to qualify for the Section 29 credit, this gas must have been sold at a lawful price which is determined without regard to the provisions of section 107 of the NGPA and subtitle B of title I of such Act (generally providing for price incentives for certain natural gas). In the case of tight formation gas, the gas must be (1) produced from a well drilled after November 5, 1990; or (2) which, as of April 20, 1977, was committed or dedicated to interstate commerce.

* Gas from Biomass. The term "biomass" means any organic material other than oil, natural gas or coal or any product thereof. Biomass includes organic waste, municipal and industrial waste, sewage, sludge, and oceanic and terrestrial crops.

* Synthetic Fuels Produced from Coal. Synthetic fuels derived from coal include solid fuel produced from coal liquefaction or gasification including solvent-refined coal, as well as gaseous synthetic fuel products produced by a coal gasification process, and liquid and solid synthetic fuel produced from coal by a mild pyrolysis process.

Limitations on Eligible Production.

Domestic Production. To be eligible for the credit, the production of a qualified fuel must occur within the United States or a possession of the United States.

 Sales must be to Unrelated Persons. Only production that is sold to an unrelated person qualifies for the credit. Reference is made to Code Section 52(b) to determine whether a seller and purchaser are related. As a result, a sale of production within certain parent-subsidiary, brother-sister, or other controlled groups, may not qualify as a sale to an unrelated person. However, the IRS has held in a number of rulings that a partnership in which a person directly or indirectly owns no more than a 50% interest can qualify as an unrelated person for purposes of this rule.

 Time Constraints. The Section 29 tax credit is subject to certain time constraints. Qualifying fuels generally must be produced from wells drilled after December 31, 1979 and before January 1, 1993; or produced in a facility placed in service after December 31, 1979 and before January 1, 1993. Furthermore, The qualifying fuel must generally be sold after December 31, 1979 and before January 1, 2003, to qualify for the credit.

 For purposes of these rules, the IRS has ruled that a well will be considered to have been drilled when it is "spudded in" if there is continual drilling to the productive horizon qualifying as an alternative source. The suspension of drilling operations just above the production horizon (a so-called open-hole completion) will not be considered a termination of continual drilling. Delays caused by factors beyond the control of the taxpayer will not interrupt the continuity of drilling for purposes of the credit. Such factors include severe weather conditions, need for mechanical repairs, operation of federal or state laws, but do not include the unavailability of drilling rigs or the financial condition of the taxpayer or the operator.

Interpreting the "spudding in" continuos drilling concepts, the IRS has ruled that qualifying production from a well recompleted after 1992 is eligible for the Section 29 credit if the recompletion does not involve additional drilling to deepen or expand the well. Recompletions to repair formation damage are not new wells completed after 1992 to the extent the recompletions produce from the same formations.

Gas from geopressurized brine, Devonian shale, coal seams, or a tight formation does not qualify for the Section 29 credit if it is produced from a property that had produced the same type of such gas in marketable quantities before January 1, 1980.

 Reduction of Credit.

General. The Section 29 credit is generally available only in calendar years for which the annual average wellhead price of a barrel of uncontrolled domestic crude oil (the "Reference Price") is below $29.50, as adjusted for inflation. The IRS is to publish an estimate of the Reference Price and an inflation adjustment factor. The $3.00 credit (adjusted for inflation - except in the case of gas produced from tight formations) is reduced proportionately as the Reference Price increases from $23.50 to $29.50, adjusted for inflation.

Inflation Adjustment Factor and Reference Prices. The inflation adjustment factor and Reference Price for the Section 29 credit for the years 1990 - 1994 were as follows:

 Further Limitations on the Credit.

Other Credits Must be Applied First. The Section 29 credit is nonrefundable. It cannot exceed the taxpayer's tax liability as first reduced by any other allowable credits of the taxpayer.

Reduction For Subsidies. After application of the rules phasing out the Section 29 credit based on inflation-adjusted Reference Prices is subject to further reduction if the funds used in connection with the project were derived from governmental grants, tax-exempt obligations, or government-subsidized energy financing. The proportion of such funds to the project's total capital contributions determined at the end of the taxable year is the percentage used to compute the reduction of the Section 29 credit.

Incentive Price Restriction. Natural gas that is eligible for incentive prices under the NGPA and sold at such incentive prices is not is not eligible for the Section 29 credit.

 Reduction for Enhanced Oil Recovery Credit. The Section 29 credit with respect to any project must be reduced by the amount of any enhanced oil recovery credit allowed under Code Sections 38 and 43 for the project. Any enhanced oil recovery credit allowed but subsequently recaptured will not reduce the Section 29 credit.

Reduction for Energy Credit. The Section 29 credit must be reduced by any energy investment credit under Code Section 38 allowed in the current and prior years with respect to a property. Any energy investment credit allowed but subsequently recaptured will not reduce the Section 29 credit.

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Brookstone Resources, Inc. is presently advising clients on transactions involving the acquisition of oil and gas properties with Section 29 tax credits. Because of the complexities of the Section 29 credit, these transactions can be very involved and, at times, subject to uncertainties. The prospect of reducing tax liability through the year 2003, however, makes the transactions worthwhile.

Coming Next Month

Why Pay Income Taxes Now When You Can Pay Later:

An Introduction to Like-Kind Exchanges Under Section 1031 of the Code

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Brookstone Resources, Inc. is a capital formation advisory firm providing specialized advisory services to new and emerging companies, market intermediaries and individuals primarily in the areas of oil and gas, real estate and technology development.

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For further information contact:

Patrick R. Sughroue

at

Brookstone Resources, Inc.

3777 Sparks Drive, SE

Suite 130

Grand Rapids, MI 49546

(616) 940-3389

(616) 940-3592 fax

E-Mail: prspc@aol.com

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