Engle v. C. I. R., 81-2463

• Decision Date: 07 May 1982
• Docket Number: No. 81-2463,81-2463
• Citation: 677 F.2d 594
• Parties: 82-1 USTC P 9367 Fred L. and Mary A. ENGLE, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 594

677 F.2d 594

82-1 USTC P 9367

Fred L. and Mary A. ENGLE, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 81-2463.

United States Court of Appeals, Seventh Circuit.

Argued Feb. 16, 1982.

Decided May 7, 1982.

Michael J. Conlan, Quarles & Brady, Milwaukee, Wis., for petitioners-appellants.

Mary Lou Fahey, Dept. of Justice, Tax Div., Washington, D. C., for respondent-appellee.

Before PELL, Circuit Judge, FAIRCHILD, Senior Circuit Judge, and BAUER, Circuit Judge.

PELL, Circuit Judge.

Taxpayers Fred and Mary Engle appeal from a decision of the United States Tax Court upholding a determination by the Commissioner that they were not entitled to a percentage depletion allowance on two oil and gas leases for the year 1975. The Engles had received advance royalties as a result of their assigning the leases during the taxable year. No physical extraction of oil or gas from the depletable properties had occurred during 1975. The Tax Court held that 26 U.S.C. § 613A(c) (1976) ¹ permits the percentage depletion deduction only if there is some physical extraction of oil or gas during the taxable year.

The sole issue on appeal is whether the Tax Court correctly interpreted section 613A(c) to preclude a taxpayer otherwise entitled to the percentage depletion allowance from claiming the deduction if there was no physical extraction of oil or gas from the depletable properties during the year for which the percentage depletion allowance is claimed.

I. FACTS

The facts are undisputed. Fred and Mary Engle are husband and wife. They filed a joint federal income tax return for 1975. During that year, Fred Engle acquired two oil and gas leases covering a total of 240 acres of land in Wyoming. Both leases were assigned by Engle to different parties in October, 1975. Engle received advance royalties of $7,600 from the two assignments. This $7,600 was the only taxable income received from the properties during 1975. No discovery or exploratory work was done on the properties covered by the leases during the taxable year; no gas or oil was extracted from the properties that year.

The Engles claimed a 22% depletion deduction, pursuant to section 613A. The Commissioner determined that the Engles were not entitled to the deduction because there was no "average daily production." § 613A(c), of domestic crude oil or natural gas and no average daily secondary or tertiary production of domestic crude oil or natural gas during 1975. The Commissioner assessed a deficiency of $4,957.55. ² A majority of the Tax Court upheld the Commissioner's interpretation in a majority and concurring opinion that together span forty-six pages. ³ Judge Fay strongly dissented from the conclusion that the "average daily production" language of section 613A(c) makes actual physical extraction of gas or oil a prerequisite to the percentage depletion deduction.

II. DISCUSSION

We note at the outset that the pertinent language of section 613A(c) has not previously been interpreted by a court of appeals. We must consider the statutory language, pertinent legislative history, and the judicial interpretation of the percentage depletion allowance as it existed prior to enactment of section 613A ⁴ in construing the challenged provision. We begin by setting forth the statutory scheme for percentage

depletion allowances as it existed prior to enactment of the Tax Reduction Act of 1975, Pub.L. No. 94-12, 89 Stat. 26 (1975) (1975 Act).

A. Sections 611 and 613 of Title 26.

Prior to promulgation of the 1975 Act, percentage depletion allowances were governed solely by sections 611 and 613. Section 611(a) states, in relevant part, that "there shall be allowed as a deduction in computing taxable income a reasonable allowance for depletion ...." § 611(a). Section 613, entitled "Percentage Depletion," states in part: "In the case of the mines, wells, and other natural deposits listed in subsection (b), the allowance for depletion under section 611 shall be the percentage, specified in subsection (b), of the gross income from the property ...." § 613(a) (emphasis added).

The Supreme Court made clear that if the depletable properties resulted in gross income to the taxpayer, the percentage depletion allowance was applicable whether or not any physical extraction occurred during the taxable year. E.g., Herring v. Commissioner, 293 U.S. 322, 55 S.Ct. 179, 79 L.Ed. 389 (1934). The ruling in Herring was in response to the Commissioner's conclusion that section 214(a)(9) of the Revenue Act of 1926 contemplated actual production as a prerequisite to the percentage depletion allowance. The Commissioner had reasoned that no oil or gas well existed absent production and the statutory language permitted the "reasonable allowance for depletion" only "(i)n the case of mines, oil and gas wells ...." It is clear, therefore, that the Engles would have been entitled to the percentage depletion allowance on the basis of their advance royalties had this case arisen prior to promulgation of the 1975 Act.

It was also established, prior to the 1975 Act, that if no production of oil or gas occurred prior to cancellation of the lease, the taxpayer was required to restore the previously deducted depletion to income. Douglas v. Commissioner, 322 U.S. 275, 285, 64 S.Ct. 988, 994, 88 L.Ed. 1271 (1944); 26 C.F.R. §§ 1.612.3(a)(2) and (b)(2) (1981). As the Tax Court noted in the instant case, this rule constituted at least an implicit requirement of actual production of oil or gas at some point in time.

B. The 1975 Act.

The 1975 Act essentially eliminated the percentage depletion allowance in the case of oil and gas wells except as to certain domestic gas wells and independent producers and royalty owners. See §§ 613A(a), (b), and (c). The latter exception is the one relevant to this appeal. That subsection provides in part:

(c) Exemption for Independent Producers and Royalty Owners-

(1) In general.-Except as provided in subsection (d), the allowance for depletion under section 611 shall be computed in accordance with section 613 with respect to-

(A) so much of the taxpayer's average daily production of domestic crude oil as does not exceed the taxpayer's depletable oil quantity; and

(B) so much of the taxpayer's average daily production of natural gas as does not exceed the taxpayer's depletable natural gas quantity;

and the applicable percentage (determined in accordance with the table contained in paragraph (5)) shall be deemed to be specified in subsection (b) of section 613 for purposes of subsection (a) of that section.

§ 613A(c)(1).

A majority of the Tax Court reasoned that physical extraction during the taxable year is a prerequisite if the percentage depletion allowance is to be determined "with respect to ... average daily production." The Tax Court also relied on language in two subsections which specify the tentative number of barrels in a taxpayer's "depletable oil quantity" and the applicable percentage to be used in computing the percentage depletion deduction. Each of these tables refers to "production during the calendar year." §§ 613A(c)(3) and (5). Because of this language, the Tax Court concluded that "the express language of section 613A(c) In his brief before this court, the Commissioner argues that the term "production" means marketable oil or gas and, therefore, Congress clearly contemplated physical extraction in using that term. The Commissioner reasons that only if this extraction prerequisite is satisfied, should one refer to section 613(a). He concludes, as did the Tax Court, that the reference in section 613A(c) to "comput(ation) in accordance with section 613" was intended by Congress to incorporate into section 613A the numerous Regulations, Revenue Rulings and court opinions that had interpreted how the "gross income from the property" and the "taxable income from the property" were to be computed pursuant to section 613.

limiting the percentage depletion deduction to stated quantities of production is so clear that it permits no other reasonable interpretation" than that urged by the Commissioner.

The appellants maintain, by contrast, that one must first look to section 613 and determine whether there is gross income from the depletable property. If there is, the percentage depletion allowance is available to the taxpayer regardless of whether physical extraction occurred during the year for which the deduction is claimed. The reference to "average daily production" in section 613A constitutes a limitation on the amount of deduction that a taxpayer may claim rather than a prerequisite. ⁵

We will analyze this statutory language in Section II(D), infra, of this opinion. We do note at this time that, contrary to the conclusion stated by the Tax Court, we find the statutory language to be ambiguous. We therefore turn to the legislative history of the statute.

C. Legislative History.

An understanding of legislation before Congress in both 1974 and 1975 is necessary to determine the relevance of portions of the legislative history relied on by the parties.

During 1974, the House Committee on Ways and Means considered H.R. 17488. 93d Cong., 2d Sess. (1974). That bill generally repealed percentage depletion. It allowed three exemptions from the repeal including one for small producers. ⁶ The bill was reported out of Committee but no further action was taken on it. It was never reviewed by the Senate, the Finance Committee of the Senate, or the Joint Committee.

In 1975, H.R. 2166, 94th Cong., 1st Sess. (1975), was ordered reported to the House. There was no provision in the Committee version of that bill eliminating percentage depletion on income from oil and gas wells. ⁷ A House floor amendment introduced repeal of percentage depletion into H.R. 2166. 121 Cong.Rec. 4651-4652 (1975). That amendment contained none of the exceptions that had been part of H.R. 17488.

H.R. 2166 then went to the Senate where an...