In computing alternative minimum taxable income (AMTI), taxpayers must add back the amount by which"excess intangible drilling costs " exceed 65 percent of net income from oil and gas properties. However, IRC section 57(a)(2)(E) provides that for taxpayers other than integrated oil companies (so called "independent producers" ) the excess intangible drilling cost preference for oil and gas has been repealed for tax years beginning after December 31, 1992.

IRC section 907 provides a limitation on the amount of foreign taxes available as a credit under IRC section 901 that were paid or accrued on foreign oil and gas extraction income (FOGEI) and foreign oil related income (FORI). These limitations must be computed separately from the limitations for taxes on other foreign income.

This provision of the law can be quite complex and consideration should be given to consulting with an international examiner when FOGEI or FORI generates foreign tax credits. Refer to IRM 4.60.6.1 for referral criteria and procedures.

An S corporation that was a C-corporation at one time may have accumulated earnings and profits. In general, the earnings and profits of an electing Subchapter S-corporation are computed in the same manner as any other corporation. In the computation of earnings and profits of an S-corporation, the earnings are reduced by the taxable income, because the shareholders are required to include in their gross income. The results of this computation and other adjustments required by IRC section 1368 may cause distributions in excess of the undistributed taxable income to be treated as ordinary dividends in the hands of the shareholder.

If corporate distributions made in the current year are in excess of current undistributed taxable income, the earnings and profits for the current and prior years should be verified to ensure that the excess depletion is being properly accounted for. The adjustments section on Schedule M–2 of Form 1120–S should be inspected for such excess depletion adjustments.

Section 1375 imposes a corporate level tax on excess net passive income if an S-corporation has C-corporation accumulated Earnings & Profit. Excess net passive income is passive income in excess of 25% of the S-corporation's gross receipts, reduced by allowable deductions. For these purposes, passive income is similar to portfolio income as defined under the passive activity rules, which includes the royalties from oil and gas production payments, royalties, and overriding royalties. This would not include those production payments which do not retain economic interest status and are characterized as loans. Also does not include mineral, oil and gas royalties if the income from those royalties would not be treated as personal holding company income under IRC sections 543(a)(3) & (4) if the taxpayer was a C-corporation. Some oil and gas lease bonuses are also considered "passive investment income." If an S-corporation has more than three consecutive years of passive investment income in excess of 25% of its gross income, the S election is terminated as of first day of the fourth year. See Treas. Reg. 1.1362-2(c)(5)(ii)(A)

The examiner should be alert to the types of oil and gas income of electing Subchapter S corporations. The passive investment income relating to the oil and gas business when added to other types of passive investment income could result in an entity level tax or in a termination of the S-corporation election.

Originally petroleum refining was a rather simple process of separating crude oil into its component parts by distillation. The fractional distillation of an average crude oil yields a relatively small gasoline fraction, with larger amounts of kerosene and gas oil. Exhibit 4.41.1 - 12 provides an illustration of the distillation fractions of a typical crude oil. While the temperature range for indicated fractions remains relatively constant, the percentage distilled will vary based on the specific type crude involved.

Conversion of the higher-boiling materials into more valuable products (gasoline or petrochemical feedstocks) became essential. Conversion is partially accomplished in the cracking process by which the large paraffins are broken down to yield a mixture of smaller paraffins, olefins, etc. Such conversion enables the refiner to convert as much as 80 percent of some crude oils into gasoline (if desired) whereas, only about 20 percent could be attained by fractional distillation. In addition, the cracking and other processes not only increase the quantity of gasoline, but also increase the quality.

While the cracking process conversion of the heavier hydrocarbons to gasoline range hydrocarbons increases the quantity of gasoline products, the process also reflects an overall volumetric gain or increased yield. The total products produced, as a percent of feed to the unit, will reflect a 15–25 percent gain in volume (115–125 percent yield) due to the changes in gravities after cracking or hydrocracking. If refinery measurements were by weight, the yield would be approximately 100 percent.

The cracking process produces both saturated and unsaturated hydrocarbons. Other processes are used for recombining the resulting hydrocarbons to produce finished refinery products or for separating individual products as specialty feedstocks for the petrochemical industry. Separation of component streams is accomplished by additional fractionation, absorption, or solvent extraction. Precise separation/extraction of a particular product by fractionation is not always possible due to the small difference in boiling points. While some refineries may have a "super fractionation" area producing finely defined cuts, particular product extraction is often accomplished by absorption or solvent extraction.

In addition to the cracking and recombining of the hydrocarbons, other processes are available for the rearrangement of straight-chain hydrocarbons into ring or cyclic structures, the conversion of straight-chain hydrocarbons to branched-chain hydrocarbons, the removal of hydrogen to produce highly reactive hydrocarbons with double or triple bonds and/or aromatics, and the production of complex branched molecules of the paraffinic series. Some of these processes involve shrinkage (due to changes in gravities) with volumetric yields of 75–90 percent. See Exhibit 4.41.1-11 for illustrations of the various hydrocarbon arrangements. The relationship or arrangement of the hydrogen and carbon can be altered in many ways, and the resulting products have distinct characteristics.

Exhibit 4.41.1-13 provides a simplified flow diagram for a modern refinery. A specific refinery may or may not have all of the indicated processing units, or it may have additional units (isomerization, coking, asphalt, etc.). However, the flow diagram is illustrative of possible product flows between some processing units.

The engineering design of a refinery is based on the type(s) of crude to be processed and optimum production of products. Actual production of the amounts of specific products will fluctuate, within limited parameters, based on seasonal demands or economic market conditions (i.e., a refinery designed to produce up to 60 percent gasoline may at times produce a lesser amount of gasoline with increased fuel oil production to satisfy seasonal demands, etc.).

Refinery operational flexibility is controlled by changes in individual processing unit operating conditions or by diversion of streams between units.

In addition to the above design and operational flexibility in producing normal refinery products, the feasibility of producing petrochemical feedstocks creates other variables. The light gases from a catalytic cracker contain hydrogen, ethylene, propylene, and butylene. Separation of these components provides a design/operational stream for either alkylation or petrochemical feedstock. Catalytic reforming is a source of aromatic hydrocarbons (benzene, toluene, and xylene). Solvent extraction of aromatics from the reformate can provide a valuable petrochemical feedstock.

Refiners have historically used Asset Class 13.3, Petroleum Refining, for depreciation purposes. Some refiners are seeking to change their method of depreciation for certain assets used in petroleum refineries to Asset Class 28.0, Manufacture of chemicals and Allied Products. On April 2, 2002, the Industry Director for Natural Resources and Construction issued a Field Directive on this issue. The primary recommendation was that all processing assets involved in the activity of petroleum refining are to be included in MACRS Asset Class 13.3. This would include any incidental manufacturing or waste removal processes, which are integral parts of petroleum refining. See www.irs.gov/pub/irs-utl/field_directive_refinery_assets.pdf.

The importance/interaction of the petrochemical industry cannot be ignored when considering refining operations. The inter-relationship in research, licensing/royalty fees, disposition of intermediate products, etc., must be analyzed through contractual arrangements, joint ownerships, trade-offs, etc.

The potential utilization of petroleum based (hydrocarbon) building blocks is tremendous. Available byproducts of cracking (ethylene and propylene) provide the principal building blocks of the petrochemical industry. Methane can be converted to ammonia and ammonia to nitric acid. Anhydrous ammonia can be commercially sold in the liquid form as a fertilizer, or the ammonia and nitric acid can be combined to provide a solid fertilizer of high nitrogen content. Another example involves the production of synthetic rubbers. Successive dehydrogenation of n-butane produces 1,3–butadiene (plus hydrogen to be used in other processes). Polymerization or copolymerization of this product provides our Buna rubbers for automobile tires, etc.

The integrated oil and gas operator may have its own petrochemical plants and/or may be involved in petrochemicals through arrangements with third-parties.

Fully integrated oil and gas operators with in-house divisions/companies for production, shipping, refining, petrochemicals, marketing, research and development, etc., provide a challenge in determining proper accounting for cross division/company operations. Research and development operations provide benefits and services to the other divisions/companies as well as development of patents, etc., available for lease or sale to third-parties. Intermediate streams or product streams from one plant provide feedstock for another plant.

Refining/petrochemical arrangements with third-parties may involve actual partnerships or be joint ventures with individual variable percentage ownership in the feed preparation plant(s) and the petrochemical plant(s) involved. In such integrated joint ventures, frequently an operating committee is responsible for daily operations, but has no ownership, etc.

Particular problems encountered in such joint operations are further discussed in IRM 4.41.1.6.8, Joint Operations.

In refining/petrochemical plant processes, catalysts are frequently Catalysts employed. By definition, a catalyst is a substance which hastens or retards a chemical reaction without undergoing a chemical change itself during the process. Such processes involve many substances as catalysts: acids, minerals, metals, mixed metals, metallic oxides or halides, etc. Metallic catalysts may be utilized in the free state (i.e., gauze or sponge form, etc.) or bonded to a base material to facilitate handling or usage.

While the catalyst does not undergo any chemical change in the process, it may become inactive or ineffective after a time, due to physical abuse or buildup of impurities. Some processes include ongoing provisions for regeneration (i.e., burning off of carbon buildup) of physically stable catalysts. Where precious metals are involved (platinum, gold, silver, rhenium, etc.), reclamation of any physically deteriorated catalyst is standard operating procedure. Such reclamation usually involves returning the material to the manufacturer for reprocessing with credit for the precious metal (normally, practically no operational or reclamation loss of the precious metal is experienced).

The cost of catalysts is handled in different ways according to the types of catalyst involved and the taxpayer's accounting method(s). Some taxpayers may charge the catalyst to expense when it is placed in use. Others may capitalize the initial cost and claim depreciation. In some cases the catalyst may be rented or leased under a standard supply contract. The correct tax accounting method for handling catalysts depends on the contractual arrangements, the type of catalyst involved, and operational factors (operational life, recoverability, reclamation, etc.). See IRM 4.41.1.6.8.2 for further discussion of catalysts.

There is no standard system of accounting employed by oil refineries, nor are there any prescribed examination guidelines within the industry.

In some situations, the refinery may operate as a self-contained entity preparing its own tax return or, in the case of a multinational conglomerate, feed its operational results back to corporate headquarters for consolidation.

Since refinery managers need various types of data to evaluate and control their operations, numerous types of reports and analysis are prepared using complex cost accounting techniques.

The examining agent should obtain a complete working knowledge of the accounting system prior to beginning his examination and should be cautious not to devote time to internal allocations having no tax significance.

An example of an information document request which could be used in a review of the accounting system is shown in Exhibit 4.41.1-14. Exhibit 4.41.1-15 provides a list of some terms which might be of use when reviewing the cost accounting system.

A prime area of examination concern should be the proper treatment of various types of overhead/indirect expenses.

Consideration should also be given to the form of business entity under which the refinery operates. Joint operations are discussed in IRM 4.41.1.6.8.

A major element in the cost of production at a refinery, and a significant source of examination potential, is the use of foreign crude oil.

This area is a controlled issue under the responsibility of the Office of Pre-Filing & Technical Guidance (PFTG) - Petroleum. IRM 4.41.1.1.3 and IRM 4.40.4 discuss this area.

In addition to the examination potential to be found in crude oil pricing, International assistance from an international examiner may be required if issues are present.

The use of a CAS is discussed in IRM 4.41.1.1.3.2. It is essential that the CAS be requested as early in the examination as his need can be established. Consultations should also be held during the course of the examination concerning updating existing record retention agreements in view of current experiences.

Examples of possible applications which may be helpful are to be found in Exhibit 4.41.1-17. A more detailed explanation can be found in the Computer Audit Specialist Handbook.

In addition to the skills of a petroleum engineer, the assistance of a general/industrial engineer may be required in the event the refinery has been involved in a major expansion or repair program. IRM 4.41.1.6.3 , IRM 4.41.1.6.6 and IRM 4.41.1.6.7 discuss potential examination areas.

Potential issues present in oil refineries are often common to both the chemical and petroleum industry since many refineries are part of an integrated petrochemical processing chain.

The Industry Specialization Program Handbook discusses the purpose and scope of the program. IRM 4.41.1.1.4 , discusses PIP and its responsibilities.

An excise tax examination may be conducted as a separate examination, as part of the "package audit" requirements for an Industry case. It is mandatory for the Coordinated Industry Case (CIC) Program.

A review of the taxpayer's retained copies of Forms 720 (Quarterly Federal Excise Tax Return) in conjunction with a "transcript" of taxpayer's account (and in light of the examination of the taxpayer's income and deductions per books and the income tax returns under examination) may indicate that an excise tax examination is warranted. This decision should be made as early as possible in each case so the examination work can be coordinated to the maximum extent desirable.

Review of the quarterly federal excise tax returns, Form 720 with attachments, is an important part of the examination of a taxpayer that owns or operates a refinery. The operator of the refinery may be liable for certain excise taxes.

IRC section 4081(a)(1) imposes a tax on certain removals, entries and sales of gasoline, diesel fuel), and kerosene. These three fuels are collectively referred to as "taxable fuel." Section 4041(a) imposes a tax on liquids other than gasoline (usually diesel fuel and kerosene used or sold for use in a diesel-powered highway vehicle or diesel powered train. Section 4041(a)(1)(B) provides an exemption if these fuels were previously taxed as taxable fuels. section 4041(a)(2) imposes a tax on alternative fuels (excluding gas oil, fuel oil, and taxable fuel) used or sold for use in a motor vehicle or motorboat. Alternative fuels include those fuels referred to a "special fuels" prior to 10/01/2006. Common alternative fuels are liquified petroleum gas (such as propane, butane, pentane, or mixture of these fuels). boat. IRC section 4042 imposes a tax on any liquid used by any person as a fuel in commercial waterway transportation (Inland Waterway tax).

The oil spill liability tax is an environmental tax. This $.05 per barrel tax generally applies to crude oil received at a U. S. refinery and to petroleum products entered into the U. S. for consumption, use, or warehousing. The tax also applies to certain uses and the exportation of domestic crude oil.

The tax imposed on ozone-depleting chemicals (ODCs) is also an environmental tax. This tax is imposed on an ODC when it is first used or sold by its manufacturer or importer. The manufacturer or importer is liable for the tax. The instructions for Form 6627 (Environmental Taxes) lists the taxable ODCs and tax rates.

Verification of the environmental taxes reported on the Form 6627 attached to the Form 720 (Excise Tax Return) may include the following items for Ozone-Depleting Chemicals or Imported Products (IRC sections 4661 & 4671):

The environmental taxes deduction ledger account(s) should be analyzed and traced to source documents for a representative period. The examiner should determine that the taxable chemicals were properly classified for the appropriate tax rate, and that none of the taxable chemicals and none of the petroleum liquids were omitted from the amounts reported on Form 6627.

In any transaction where different properties or assets are acquired, there is the problem of allocation of the basis to the various properties or assets. In some contracts, the amounts involved for each separate property or asset is stated. When stated at realistic values, the allocation problem may be eliminated. The acquisition of a refinery, refinery facilities, patents, processes, and know-how involve complex allocations of the purchase price.

The costs incurred incidental to the acquisition of a capital asset should be capitalized to the cost of the asset. Expenditures to be capitalized include items such as commissions, consulting fees, feasibility studies, environmental impact studies, legal fees, salaries, travel, and "new image " costs incidental to the acquisition of assets or expansion of the business. These incidental costs may include expenditures involved in forming a coownership for joint operations such as a joint venture or a partnership. See IRM 4.41.1.6.8 , Joint Operations.

Any costs incidental to the acquisition of a capital asset and having a benefit to the taxpayer beyond the current year should be capitalized, as part of the cost of the asset acquired or constructed. It is noted that the cost of such environmental studies should be distinguished from expenditures deductible under the provisions of IRC section 174. Rev. Rul. 80–245, 1980-2 C.B. 72, and the potential problems involving environmental impact studies are discussed in IRM 4.41.1.6.3.4.

When examining acquisition costs, verify the total purchase price (including the adjusted cost basis of any property given in exchange), the incidental costs of the acquisition, etc.

Verify the allocation of the total acquisition cost to the respective assets acquired in ratio to their relative fair market values at the date of acquisition. Acquisition costs should be allocated to items such as:

Some of the documents that should be examined for verification of acquisition costs include:

Construction costs, in general, fall into three categories; initial refinery construction, expansion of refining capacity, and other improvements. In each category construction costs may include outside contractors self construction, or a combination of both.

Contracts with outside contractors should be reviewed to ensure that all costs called for in the contract have been properly considered as capital expense. The agent should also verify that the items included in the construction contract are properly classified or allocated for depreciation, etc. Engineering assistance may be required where a lump sum construction contract calls for items to be constructed which will fall into more than one category for depreciation, etc.

The agent should verify that appropriate self-construction costs have been properly capitalized. A good examination technique, when reviewing outside contractor costs, is to inquire if the taxpayer was furnishing personnel or equipment to supervise or assist in the construction process.

When self-construction costs are encountered, the agent should ensure that the capitalized costs include the direct costs, as well as the indirect costs such as insurance, benefits, and overhead.

In the oil and gas business, as well as in other industries construction/activities such as building pipelines, roads, canals, refineries, and industrial plants can have an adverse effect on the natural environment. Sometimes the company will spend a great deal of money making studies of the effect the proposed business expansion will have on the environment. Should these costs be deductible as ordinary operating expenses or should they be capital expenses? Any cost incidental to the acquisition of a capital asset and having a benefit to the taxpayer beyond the current year should be capitalized as part of the cost of the asset acquired or constructed. However, if the study results in the abandonment of the project, the cost would be deductible under IRC section 165 in the taxable year the taxpayer decides to abandon the undertaking.

In the examination of taxpayers that have had large expansions, or have constructed plants that might have an environmental effect, the agent should be alert for such costs that might not have been capitalized.

Expenditures to conduct environmental impact studies to support its application to expand its facilities are not research and experimental expenditures, within the meaning of IRC section 174. Whether such expenses are capital expenditures will depend upon the facts of the particular case. The expenses, if not chargeable to a capital account, are ordinary and necessary business expenses deductible under IRC section 162(a). Rev. Rul. 80–245, 1980–2 C.B. 72, holds that the costs of environmental impact studies paid by a public utility company in connection with its application to expand its generating facilities are not research and experimental expenditures within the meaning of IRC section 174.

The operation of refineries and petrochemical plants often involves the utilization of numerous patents, exclusive processes, and trade secrets. During the examination of these operations, the agent should be alert for acquisitions of these types of assets. These items are capital assets and may be amortized over their useful life.

The purchase of these types of assets frequently will occur when other items of plant, property, or equipment are being purchased. When other items are purchased, the agent should inquire if the purchase includes any patents, exclusive processes or know-how.

Know-how may be defined as an aggregation of data or information that is employed in a business endeavor and has the effect of providing the user with a competitive advantage over others who do not have access to, or use of, such data or information.

Finished or saleable refinery products are a blend of various refinery streams and sometimes include purchased blending stocks. The prime example is gasoline.

The refiner's unfinished products inventory will normally include all produced or purchased basic stocks available for further processing or blending into finished products. The unfinished products inventory may be subcategorized to include:

The refiner's finished products inventory will include all saleable products resulting from further processing and blending of unfinished stocks. While individual refineries produce different products, and taxpayer's categorization and sub-categorization will vary. Exhibit 4.41.1-18 provides an indication of the types of goods found in product inventories.

To avoid unplanned shutdowns and to assist in performing routine maintenance, refineries normally maintain an inventory of spare parts and equipment.

The agent should examine those spare parts and equipment items that should be or are being inventoried. Items not held for resale are not inventory, and LIFO cannot be used to account for such items (Treas. Reg. 1.472–1). For non-inventory treatment of expendable, rotatable, or standby emergency spare parts, see Rev. Rul. 81–185, 1981–2 C.B. 59.

With respect to equipment, the agent should determine that proper consideration is given to investment credit and recapture of investment credit for items being placed in service or removed from service.

Due to rapidly increasing prices for oil and oil products, many companies have elected the LIFO method of valuation of inventory. For assistance, please contact PIP and/or the Inventory Technical Advisor.

The refining/petrochemical products are ready for marketing at various points of the manufacturing process: distilling, cracking, treating, etc. The various "split off" points in the manufacturing process are noted, in general terms, in the discussion in IRM 4.41.1.6.1.1 , Refinery Processes.

Finished refinery products, fuel, lubricating oil, etc., are the principal products sold. The accounting for amounts reported in gross sales of these products should be reconciled to the sales journal/ledger. Potential issues include transfers, exchanges, or sales at less than "arm's-length " value. The main line of petroleum finished products are illustrated in Exhibit 4.41.1 - 18.

Unfinished products in the manufacturing process are sometimes saleable for various uses, such as raw material for further refinery processing, blending, or as feedstock for many different manufacturing processes. The best known market for these "intermediate stream products" is their use in the manufacture of fertilizers, synthetic rubber, plastics, etc.

The petrochemical manufacturing plant may be nearby or contiguous to the refinery to take advantage of the convenient source of raw material. The plant may be an intracompany or related company owned facility. The list of divisions and/or related companies and their business operations should be ascertained from the annual report to stockholders and/or SEC reports. The areas of interest for examination will include the "arm's-length " pricing and the "timing" of the transactions reported in the return.

As technology progresses, substantially all of the byproducts from the refining process are in demand; therefore, most products are considered major products. The sale of byproducts should be identified in the sales reported per return. Some such items may be reported in the cost of sales rather than in the gross receipts.

The operator of the refinery may realize revenue from miscellaneous sources such as:

Research and development has created technology that is a vital commodity for the refining and petrochemical industries. The demand for proven processes and the utilization of patent rights is an important source of revenue. Investments in these intangible assets and a listing of the in-house developed know-how, patents, and processes should be analyzed:

The income from rents, royalties, etc., received for the use of these intangible assets should include the value of any items or services received in exchange. Consideration should be given to the impact of the transactions involving these intangible assets on the taxable income.

It is the position of some taxpayers that long term gain under the provisions of IRC section 1231 is recognized upon the sale or exchange of these intangible assets. Alternatively, some have proposed that no ordinary income may be attributed to the sale or exchange when no "tax benefit" was realized for the "section 174 expenditures" made and deducted for the creation of the subject intangible asset (IRC section 111). See also Rev. Rul 85–186.

It should be noted that IRC section 1235 provides that patents disposed of by the "holder," as defined in the provisions of IRC section 1235(b), qualify as the sale or exchange of a capital asset held for more than one year. This special provision excludes the employer of the creator of the patent.

Foreign crude oil is a major source of supply for the operation of the refining complex. The agent should be alert to the fact that foreign crude oil, as a part of the raw material for the refining operations, can be from related producers and from unrelated suppliers. The acquisition of foreign crude can pose a problem for the agent in his/her examination. Foreign crude oil imports are subject to price adjustment by PIP, as discussed in IRM 4.41.1.6.2.1. Should the agent discover purchases from foreign sources in the course of his/her examination, he/she should obtain the assistance of an international examiner for coordination with PIP.

Most large refineries distribute utility costs in their internal cost accounting systems. Their controls may involve a distribution to the various processing units as well as between utilities (fuel for steam generation). Many of the smaller refineries do not distribute or allocate utility expenses, and they control their utility operations through operational reviews and budgetary analysis.

Filtering materials are used in the production of petroleum products to remove impurities. The agent should verify that unconsumed filtering materials are inventoried at yearend. Refer to IRM 4.41.1.6.4.4.1 , Consumable Supplies, concerning the treatment of this item in inventory.

Among the other direct costs to be attributed to the finished product, as throughput of the refinery, are the labor and applicable benefits of the employees directly related to the manufacturing operations of the refining industry. The entity being examined will normally maintain cost accounting records that accumulate all factors of costs that are component cost factors of the finished product. The agent should obtain these workpapers for utilization in his examination and verification of inclusion of all direct cost factors of the finished product.

Taxpayers may not use the applicable percentage stated in IRC section 168(b) for recovery property used predominantly outside the United States. The determination that a property is used predominantly outside the United States shall be made by following the rules under former IRC section 48(a)(2). The rules are provided in Treas. Reg. 1.48-1(g).

Are the classes of property correctly designated, including recovery property used predominantly outside the United States?

Is the applicable percentage for the recovery deduction consistent with the alternative depreciation system?

Overhead items are those costs necessary for production which cannot be conveniently traced to a specific unit of finished product.

The cost accounting system groups all such individual items together or applies them to products through the use of some allocation method and base.

An improper choice of the method or base may distort income through an erroneous inventory valuation.

Examiners should carefully review overhead allocations to insure that the taxpayer is complying with the uniform capitalization rules of section 263A. Treas. Regs. 1.263A–1 through 1.263A-3 set forth the guidelines and should be reviewed.

Consideration also should be given to the impact of Treas. Reg. 1.861–8 on overhead allocations.

Exhibit 4.41.1 - 15 provides commonly accepted accounting terminology which may be of use in analyzing overhead.

A good source of examination leads might be cost of production reports. An example of the contents of a cost of production report is shown in Exhibit 4.41.1 - 20.

Refinery repairs are normally very substantial due to the nature of refining processes. The agent should consider giving major emphasis in his/her examination of this area to items which are substantial in amount.

Refinery repair accounts normally have a large volume of activity. Due to this large volume, it is often an area well suited for the use of statistical sampling methods to detect items misclassified.

The term "turnaround" in the context of refining refers to a period of time that the refinery is shutdown to perform preventive maintenance. The agent should expect to see a large portion of the yearly repair expense incurred during this brief interval of time.

During turnarounds, the taxpayer may be also making some capital improvements, i.e., changing out old equipment for new equipment, adding new units, etc. Even though the purpose of the turnaround is primarily to do preventative maintenance, capital expenditures may be incurred simultaneously.

When the agent encounters capital expenditures, he/she should determine that all related costs have been properly included in the amount capitalized. This may include removal costs of old equipment or other modifications to the plant which are necessary in order to enable the new equipment to be installed and used. The agent should ascertain that labor and indirect costs associated with the capital item have been capitalized.

The task of successfully operating refineries and petrochemical plants necessitates the use of various royalty/licensing arrangements. During the examination, the agent should be alert to the payment of these fees. Such payments may be to related entities and if so, the contracts requiring their payment should be analyzed for arm's-length pricing. The contracted arrangements for the payment of these fees are usually related to units of throughput or units of production.

The payment of royalty/licensing fees become obvious and are more likely to occur when acquisition, construction, and/or expansion of plant facilities are undertaken. The agent should be alert to any advance payments of these fees that would be payable on future production as through put in the manufacturing processes of the refining and petrochemical plants.