Commissioner of Internal Revenue v. Engle Farmar v. United States

Decision Date10 January 1984
Docket NumberNos. 82-599,82-774,s. 82-599
Citation104 S.Ct. 597,464 U.S. 206,78 L.Ed.2d 420
PartiesCOMMISSIONER OF INTERNAL REVENUE, Petitioner v. Fred L. ENGLE et ux. Philip D. FARMAR, et al., Petitioners v. UNITED STATES
CourtU.S. Supreme Court

In response both to the public outcry concerning the United States' growing dependence on foreign energy and to the alleged excessive profits that major integrated oil companies were earning, the Tax Reduction Act of 1975 repealed, as applied to the major integrated oil companies, the percentage depletion allowance authorized as a deduction from taxable income, but exempted independent producers and royalty owners from the repeal so as to encourage domestic production of oil and gas. The Act added § 613A to the Internal Revenue Code (Code). That section provides that a percentage depletion allowance under § 611 for such independent producers and royalty owners shall be computed in accordance with § 613 "with respect to . . . so much of the taxpayer's average daily production of domestic crude oil as does not exceed the taxpayer's oil quantity" and "depletable natural gas quantity." During 1975, respondents (husband and wife) in No. 82-599 assigned their oil and gas leases to third parties, while retaining overriding royalties. As partial consideration for these assignments, respondents received $7,600 in advance royalties. This constituted the entire income received from the property in 1975 since there was no oil and gas production that year. On their joint federal income tax return for 1975, respondents claimed a percentage depletion deduction equal to 22% of the advance royalties. The Commissioner of Internal Revenue (Commissioner) disallowed the deduction because the advance royalties were not received "with respect to" any "average daily production" of oil or gas. The Tax Court upheld this determination, but the Court of Appeals reversed. In No. 82-774, petitioner joint owners leased their oil and gas interests in 1975 to various lessees. Under the leases petitioners were to receive both royalties from oil and gas produced and annual cash bonuses even if no oil or gas was produced. In 1976, oil and gas was discovered on the property and was produced in substantial amounts. Petitioners claimed depletion deductions on both the bonuses and the royalties received in that year. The Commissioner disallowed the deduction on the bonuses, again because they were not received "with respect to" any "average daily production." After paying the resulting deficiencies, petitioners filed a suit for refund in the Court of Claims, which held for the Commissioner.

Held: Section 613A was not intended to deny the allowance for percentage depletion on advance royalty or lease bonus income altogether; rather, §§ 611-613A entitled taxpayers to such an allowance at some time during the productive life of the lease. Pp. 214-227.

(a) Any reasonable interpretation of § 613A must harmonize with the section's goal of subsidizing the combined efforts of small producers and royalty owners in the exploration and production of the Nation's oil and gas resources. The Commissioner's interpretation—under which taxpayers would receive percentage depletion on income derived from oil and gas interests only if the payment associated with that income could be attributed directly to specific units of production, and which anomalously suggests that a Congress intent on increasing domestic production by small producers included substantial economic disincentives in the same legislation—does not comport with this goal. By contrast, allowing percentage depletion on all qualified income makes available the maximum public subsidy that Congress was willing to provide. Pp. 217-220.

(b) The legislative history of § 613A discloses a clear congressional intent to retain the percentage depletion rules that existed in 1975, and under which taxpayers leasing their interests in mineral deposits were entitled to a percentage depletion on any bonus or advance royalty whether there was production of the underlying mineral or not. Pp. 220-223.

(c) When § 613A is considered together with related Code sections and in light of the legislative history, it is clear that Congress did not mean to withdraw the percentage depletion on lease bonuses or advance royalty income arising from oil and gas properties. Section 613A clearly provides that income attributable to production over a certain level will not be eligible for percentage depletion, but nothing in the statute bars such a depletion on income received prior to actual production. To the contrary, so long as the income can be attributed to production below the established ceilings, lease bonuses and royalty income come within the four corners of the percentage depletion provisions. Pp. 223-224.

(d) Since the Commissioner's interpretation is unreasonable, this Court will not defer to it. The Commissioner has not shown any "insurmountable" practical problems that would render his position more tenable. While § 613A's various production requirements and limitations make accurate percentage depletion allowances difficult in the absence of production figures, these problems can be resolved in a number of reasonable ways, as, for example, by requiring lessors to defer depletion deductions to years of actual production or to adjust deductions taken with amended returns. The Commissioner cannot resolve the practical problems by eliminating the allowances altogether. Pp. 224-227.

No. 82-599, 677 F.2d 594 (7th Cir.1982), affirmed; No. 82-774, 231 Ct.Cl. 642, 689 F.2d 1017 (1982), reversed and remanded.

Carter G. Phillips, Washington, D.C., for C.I.R. and U.S.

Thomas J. Donnelly, Pittsburgh, Pa., for Fred L. Engle, et ux.

Marvin K. Collie, Houston, Tex., for Philip D. Farmar, et al.

Justice O'CONNOR delivered the opinion of the Court:

These consolidated cases present the question whether §§ 611-613A of the Internal Revenue Code (Code), 26 U.S.C. §§ 611-613A, entitle taxpayers to an allowance for percentage depletion on lease bonus or advance royalty income received from lessees of their oil and gas mineral interests.


Ever since enacting the earliest income tax laws, Congress has subsidized the development of our nation's natural resources. Toward this end, Congress has allowed holders of economic interests in mineral deposits, including oil and gas wells, to deduct from their taxable incomes the larger of two depletion allowances: cost or percentage.1 Under cost depletion, taxpayers amortize the cost of their wells over their total productive lives.2 Under percentage depletion, taxpayers deduct a statutorily specified percentage of the "gross income" generated from the property, irrespective of actual costs incurred.3 Through these depletion provisions, Congress has permitted taxpayers to recover the investments they have made in mineral deposits and to generate additional capital for further exploration and production of the nation's mineral resources.

Taxpayers have historically preferred the allowance for percentage, as opposed to cost, depletion on wells that are good producers because the tax benefits are significantly greater. Prior to 1975, it was well-settled that taxpayers leasing their interests in mineral deposits to others were entitled to percentage depletion on any bonus 4 or advance royalty 5 received, whether there was production of the underlying mineral or not. The bonus was regarded as "payment in advance for oil and gas to be extracted," Herring v. Commissioner, 293 U.S. 322, 324, 55 S.Ct. 179, 180, 79 L.Ed. 389 (1934), and the advance royalty was considered a "return pro tanto of [the lessor's] capital investment in the oil in anticipation of its extraction . . . ." Palmer v. Bender, 287 U.S. 551, 559, 53 S.Ct. 225, 227, 77 L.Ed. 489 (1933). Though the Commissioner of the Internal Revenue had once argued that the allowance should not apply to such income,6 this Court determined that both lease bonuses and advance royalties constituted "gross income from property" and accordingly were subject to percentage depletion. See Herring v. Commissioner, supra, 293 U.S., at 327-328, 55 S.Ct., at 181. The depletion was based on the income received from the property, and not, at least in the short run, on the production of the substance itself. 293 U.S., at 327-328, 55 S.Ct., at 181.

Even under pre-1975 law, however, depletion deductions eventually had to be attributed to actual production. Lessors receiving bonus or advance royalty income without oil or gas being produced during the life of the lease have been required to recapture their depletion deductions and restore the previously deducted amounts to income. See Douglas v. Commissioner, 322 U.S. 275, 285, 64 S.Ct. 988, 994, 88 L.Ed. 1271 (1944). Furthermore since only one percentage depletion allowance is statutorily authorized for each dollar of oil and gas income, lessees have always been required to reduce their allowances by any bonuses or advance royalties paid to lessors. See Helvering v. Twin Bell Oil Syndicate, 293 U.S. 312, 55 S.Ct. 174, 79 L.Ed. 383 (1934). Thus, prior to 1975, those who held economic interests in mineral deposits, large or small, were entitled to a single percentage depletion deduction for all income from the property, including lease bonus and advance royalty income, so long as oil or gas was eventually extracted from the land.

The 1970s, however, brought about an abrupt redirection in the nation's energy policy. Escalating energy prices and the Arab oil embargo awakened the public to the nation's growing reliance on foreign energy sources. Some thought the major integrated oil companies were reaping excessive oil and gas profits at the public's expense, while reinvesting little of their concomitant tax depletion subsidies in domestic energy production.7 Congress responded to this public outcry by repealing the percentage depletion allowance as applied to the major...

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