Commissioner of Internal Revenue v. Southwest Exploration Co United States v. Huntington Beach Co

• Decision Date: 27 February 1956
• Docket Number: Nos. 286,287,s. 286
• Parties: COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. SOUTHWEST EXPLORATION CO. UNITED STATES of America, Petitioner, v. HUNTINGTON BEACH CO
• Court: U.S. Supreme Court

350 U.S. 308

76 S.Ct. 395

100 L.Ed. 347

COMMISSIONER OF INTERNAL REVENUE, Petitioner,

v SOUTHWEST EXPLORATION CO.

UNITED STATES of America, Petitioner,

v. HUNTINGTON BEACH CO.

Nos. 286, 287.

Argued Jan. 23, 24, 1956.

Decided Feb. 27, 1956.

Mr. Hilbert P. Zarky, Washington, D.C., for petitioners.

Mr. Melvin D. Wilson, Los Angeles, Cal., for respondent Southwest Exploration Co.

Mr. Harry R. Horrow, San Francisco, Cal., for respondent Huntington Beach Co.

Mr. Justice CLARK delivered the opinion of the Court.

The Southwest Exploration Co., respondent in No. 286, contracted to develop certain oil deposits lying off the coast of California by whipstock drilling from sites located on the property of adjacent upland owners. Southwest agreed to pay to such owners 24 1/2% of the net profits for the use of their land. Both Southwest and the upland owners sought to take the statutory depletion allowance of 27 1/2% on this share of the profits. The Tax Court decided that Southwest was entitled to the depletion allowance, 18 T.C. 961, and the Ninth Circuit affirmed, 220 F.2d 58. In the other case, the Court of Claims held that one of the upland owners, Huntington Beach Co., respondent in No. 287, was entitled to the depletion allowance on its share of the net income, 132 F.Supp. 718, 132 Ct.Cl. 427. We granted certiorari in both cases, 350 U.S. 818, 76 S.Ct. 83, because both the drilling company and the upland owners cannot be entitled to depletion on the same income. We agree with the Court of Claims. ¹

The California State Lands Act of 1938 provided that the State's offshore oil might be extracted only from wells drilled on filled lands or slant drilled from upland drill sites to the submerged oil deposits.² Other provisions of the same statute required that 'derricks, machinery, and any and all other surface structures, equipment and appliances' be located only on filled lands or uplands. It was further provided that the state commission might require each prospective bidder for such a state lease to furnish, as a condition precedent to consideration of his bid, satisfactory evidence of 'present ability to furnish all necessary sites and rights of way for all operations contemplated under the provisions of the proposed leased.'³

In 1938 California published notice of its intention to receive bids for the lease of certain oil lands pursuant to this statute. At the time Southwest—a corporation organized in 1933 but completely inactive until the transaction at issue here—did not own, lease, operate or control any of the uplands adjacent to the area of oil deposits. It is agreed that there were no filled lands available. Southwest entered into three agreements with the upland owners, and was granted the right of ingress to and egress from the designated uplands and the right to construct, use and maintain all equipment necessary for drilling on the same lands. The upland owners reserved to themselves the right to give easements or subsurface well crossings in the uplands, except that they would not allow such easements for the purpose of drilling into the off-shore oil deposits while Southwest retained an interest granted to it by state easement. Southwest's rights were expressly subject to all rights previously granted by the upland owners. The agreements defined 'net profits' and provided that Southwest would pay a total of 24 1/2% of its net profits from extraction and sale of oil to the upland owners.⁴ It was also provided that the upland owners did not acquire a share in the lease or oil deposit by virtue of the last agreement and that it was not the intention of the parties to create a partnership relationship.

As a result of these agreements, the upland owners endorsed Southwest's bid for a lease submitted to the State of California. Southwest, as the only bidder, was granted 'Easement No. 392' by the State in consideration of the 'royalty to be paid, the covenants to be performed, and the conditions to be observed by the Grantee.' One such condition was that set out in paragraph (1):

'That each well drilled pursuant to the terms of this agreement shall be slant drilled from the uplands to and into the subsurface of the State lands. Derricks, machinery, and any and all other surface structures, equipment and appliances shall be located only upon the uplands and all surface operations shall be conducted therefrom.'

The agreement further provided that if Southwest should 'default in the performance or observance of any of the terms, covenants and stipulations hereof', the State might re-enter, cancel the agreement or close down wells not being operated according to the agreement.

The wells drilled pursuant to this lease have produced oil continuously since 1939. In No. 286, Southwest Exploration Co., the tax years 1939 through 1945 are involved. If Southwest may claim the depletion allow- ance on the upland owner's share of the profits during this period, its tax liability is reduced by approximately $175,000. In No. 287, Huntington Beach Co., the upland owner is claiming a tax refund of $135,000 for the year 1948 alone.⁵

An allowance for depletion has been recognized in our revenue laws since 1913. It is based on the theory that the extraction of minerals gradually exhausts the capital investment in the mineral deposit. Presently, the depletion allowance is a fixed percentage of gross income which Congress allows to be excluded; this exclusion is designed to permit a recoupment of the owner's capital investment in the minerals so that when the minerals are exhausted, the owner's capital is unimpaired. The present allowance, however, bears little relationship to the capital investment, and the taxpayer is not limited to a recoupment of his original investment. The allowance continues so long as minerals are extracted, and even though no money was actually invested in the deposit. The depletion allowance in the Internal Revenue Code of 1939 is solely a matter of congressional grace; it is limited to 27 1/2% of gross income from the property after excluding from gross income 'any rents or royalties' paid by the taxpayr with respect to the property.⁶

The complexities of oil operations and risks incident to prospecting have led to intricate, multiparty transactions, so that it is often difficult to determine which parties are entitled to a part of the allowance. The statute merely provides in § 23(m) that in the case of leases the depletion allowance should be 'equitably apportioned between the lessor and lessee.'

In determining which parties are entitled to depletion on oil and gas income, this Court has relied on two interrelated concepts which were first formulated in Palmer v. Bender, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489. There, the taxpayer, a lessee of certain oil and gas properties, had transferred his interest in these properties to two oil companies in return for a cash bonus, a future payment to be made 'out of one-half of the first oil produced and saved', and an additional royalty of one-eight of the oil produced and saved. In upholding the taxpayer's right to depletion on all such income, the Court based its decision on the grounds that a taxpayer is entitled to depletion where he has: (1) 'acquired, by investment, any interest in the oil in place,' and (2) secured by legal relationship 'income derived from the extraction of the oil, to which he must look for a return of his capital.' 287 U.S. at page 557, 53 S.Ct. at page 226, 77 L.Ed. 489.

These two factors, usually considered together, constitute the requirement of 'an economic interest.' This Court has found the requisite interest in the oil in place to have been retained by the assignor of an oil lease, Thomas v. Perkins, 301 U.S. 655, 57 S.Ct. 911, 81 L.Ed. 1324, the lessor of oil properties for a share of net profits, Kirby Petroleum Co. v. Commissioner, 326 U.S. 599, 66 S.Ct. 409, 90 L.Ed. 343, and the grantor of oil lands considered as an assignor of drilling rights, Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25, 66 S.Ct. 861, 90 L.Ed. 1062. The Court found no such interest in the case of a processor of natural gas who had only contracted to buy gas after extraction, Helvering v. Bankline Oil Co., 303 U.S. 362, 58 S.Ct. 616, 82 L.Ed. 897, and in the case of a former stockholder who had traded his shares in a corporation which owned oil leases for a share of net income from production of the leased wells, Helvering v. O'Donnell, 303 U.S. 370, 58 S.Ct. 619, 82 L.Ed. 903.

The second factor has been interpreted to mean that the taxpayer must look solely to the extraction of oil or gas for a return of his capital, and depletion has been denied where the payments were not dependent on production, Helvering v. Elbe Oil Land Co., 303 U.S. 372, 58 S.Ct. 621, 82 L.Ed. 904, or where payments might have been made from a sale of any part of the fee interest as well as from production. Anderson v. Helvering, 310 U.S. 404, 60 S.Ct. 952, 84 L.Ed. 1277. It is not seriously disputed here that this...