Commissioner of Int. Rev. v. Southwest Exploration Co.

• Decision Date: 07 March 1955
• Docket Number: No. 13875.,13875.
• Citation: 220 F.2d 58
• Parties: COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. SOUTHWEST EXPLORATION COMPANY, a corporation, Respondent.
• Court: U.S. Court of Appeals — Ninth Circuit

220 F.2d 58 (1955)

COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. SOUTHWEST EXPLORATION COMPANY, a corporation, Respondent.

No. 13875.

United States Court of Appeals, Ninth Circuit.

March 7, 1955.

H. Brian Holland, Asst. Atty. Gen., Hilbert P. Zarky, Ellis N. Slack, Cecilia H. Goetz, Sp. Assts. to Atty. Gen., Charles W. Davis, Chief Counsel, Internal Revenue Service, Washington, D. C., for petitioner.

Melvin D. Wilson, Los Angeles, Cal., for respondent.

Pillsbury, Madison & Sutro, W. J. McFarland, Harry R. Harry R. Horrow, Sigvald Nielson, San Francisco, Cal., amici curiae.

Before STEPHENS and CHAMBERS, Circuit Judges, and HARRISON, District Judge.

PER CURIAM.

In this appeal, the only question brought to us from the Tax Court is who is entitled to depletion for oil that is extracted from beneath the ocean. The Tax Court held that upland owners from whose lands the slant wells were drilled into the pool of oil, under the ocean, are not entitled to participate in the depletion for oil thus extracted. The Commissioner of Internal Revenue appeals asserting that the upland owners, comprising the Huntington Beach Co., Pacific Electric Ry. Co., Pacific Electric Land Co., The Bolsa Land Co., the Bolsa Chica Gun Club, and the Standard Oil Co., upon whose lands the wells were drilled and through whose property the rights of way and easements were granted for the drilling of such wells are entitled to a portion of the depletion for oil extracted under the permit granted by the State to the taxpayer.

We are in accord with the ruling of the Tax Court 18 T.C. 961 and adopt that part of the Tax Court's opinion reading as follows:

"The second question involves petitioner\'s right to a depletion deduction on the 24½ per cent of its net profits which it paid to certain upland owners. It was on and through the property of these owners that petitioner had located various `whipstock\' wells for the production of gas and oil from the submerged lands located adjacent thereto.

"As pointed out above, petitioner acquired the sole right to exploit the oil property in question by virtue of its 1938 agreement with the State of California. The terms of this agreement provided that any development of, or drilling into, the submerged lands covered thereby must be conducted from littoral or upland sites. This provision required as a condition precedent to the agreement that the requisite easements be procured from the owners of the adjacent uplands and that certification as to such action then be made in the form of an endorsement by the upland owners attached to the agreement as finally executed. In consideration of the necessary easement and certification petitioner agreed to pay to the upland owners involved an amount equal to 24½ per cent of its net profits.

"Petitioner seeks to include the foregoing amount within its gross income subject to a deduction for depletion in accordance with sections 23(m)² and 114(b) (3),³ Internal Revenue Code 26 U.S.C.A. §§ 23(m), 114(b) (3).

"In order to determine whether petitioner is entitled to include the above amount within its gross income and then be allowed the depletion claimed, we would briefly recall the purpose and intent of the statutory allowance. Because of their inherent nature, oil and gas reserves, together with other mineral deposits, have been recognized and designated as wasting assets. Anderson v. Helvering, 310 U.S. 404 60 S.Ct. 952, 84 L.Ed. 1277. By this designation it is meant that a portion of the capital assets is consumed in the production of income through exploitation thereof. Helvering v. Bankline Oil Company, 303 U.S. 362 58 S.Ct. 616, 82 L.Ed. 897. Hence, Congress has granted the deduction in question as an equitable means of allowing a tax free return of the capital so consumed in the process of production. Anderson v. Helvering, supra. It follows that the depletion deduction is allowable only to those who have a capital investment or economic interest in the oil or other mineral in place from which income is received by reason thereof. Kirby Petroleum Company v. Commissioner, 326 U.S. 599 66 S.Ct. 409, 90 L.Ed. 343; Burton-Sutton Oil Co., Inc., v. Commissioner, 328 U.S. 25 66 S.Ct. 861, 90 L.Ed. 1062; Helvering v. Bankline Oil Company, supra; United States v. Spalding 9 Cir., 97 F. 2d 701. In determining whether a taxpayer has such an investment or interest no significance attaches to the particular legal form of the transaction creating the rights. Burton-Sutton Oil Co., Inc., v. Commissioner, supra; Palmer v. Bender, 287 U.S. 551 53 S.Ct. 225, 77 L.Ed. 489; Lynch v. Alsworth-Stephens Co., 267 U.S. 364 45 S.Ct. 274, 69 L.Ed. 660. It is enough that the taxpayer has acquired through any form of legal relationship the right to share in the oil produced. Palmer v. Bender, supra. And a right to share in the profits from the sale of the oil following extraction is analogous to a right to share in the mineral itself. Helvering v. Twin Bell Oil Syndicate, 293 U.S. 312 55 S.Ct. 174, 79 L.Ed. 383; Anderson v. Helvering, supra; Kirby Petroleum Company v. Commissioner, supra; Burton-Sutton Oil Co., Inc., v. Commissioner, supra. However, the term `economic interest\' does not embrace a `* * * mere economic advantage derived from production through a contractual relation to the owner by one who has no capital investment in the mineral deposit * * *.\' Helvering v. Bankline Oil Company, supra. On the contrary, it appears clearly that an allowance for depletion is warranted only where, by agreement between the parties, the taxpayer has obtained a capital interest in the oil and gas in place, to the severance and sale of which one must look for the return of capital consumed in that process. The right to share in the net receipts disassociated from an economic interest therein does not entitle the holder thereof to an allowance for depletion. Kirby Petroleum Company v. Commissioner, supra; Burton-Sutton Oil Co., Inc., v. Commissioner, supra; Anderson v. Helvering, supra; Helvering v. O\'Donnell, 303 U.S. 370 58 S.Ct. 619, 82 L.Ed. 903.

"In the instant case, it cannot be gainsaid that petitioner possessed an economic interest in the oil involved. The dispute arises as to whether petitioner was the sole owner of such an interest during the taxable years. Petitioner contends that it acquired and has retained the entire economic interest conveyed under the Agreement for State Easement No. 392. Respondent, on the other hand, rejects petitioner\'s contention and argues on brief that the upland owners, by their endorsement of the Agreement for State Easement No. 392, became parties thereto; that such owners thereby acquired an economic interest in the oil and gas in place directly from the State; that the income received therefrom by the upland owners is includible in their gross income, rather than that of petitioner, subject to the depletion deduction here in dispute.

"We have no desire or purpose to enter into the dispute as to the claims to rights in the submerged coastal areas (see U. S. v. California, 332 U.S. 19 67 S.Ct. 1658, 91 L.Ed. 1889 1947) and what we say herein is not intended in any way to pass upon the competing interests asserted in that litigation or growing out of the cited decision.⁴

"Prior to 1938 the State allowed such oil property as is here involved to be developed and operated from piers, islands or barges. In that year

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