Gibson Products Co. v. U.S.

• Decision Date: 23 February 1981
• Docket Number: No. 79-2374,79-2374
• Citation: 637 F.2d 1041
• Parties: 81-1 USTC P 9213 GIBSON PRODUCTS CO. Kell Blvd., Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee. . Unit A
• Court: U.S. Court of Appeals — Fifth Circuit

Page 1041

637 F.2d 1041

81-1 USTC P 9213

GIBSON PRODUCTS CO. Kell Blvd., Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.

No. 79-2374.

United States Court of Appeals, Fifth Circuit.

Unit A

Feb. 23, 1981.

Robert I. White, Houston, Tex., for plaintiff-appellant.

M. Carr Ferguson, Asst. Atty. Gen., Gilbert E. Andrews, Chief, Appellate Sec., Ann Belanger Durney, Karl P. Fryzel, Tax Div., Dept. of Justice, Washington, D. C., Kenneth J. Mighell, U.S. Atty., Fort Worth, Tex., for defendant-appellee.

Appeal from the United States District Court for the Northern District of Texas.

Before WISDOM, GARZA and REAVLEY, Circuit Judges.

REAVLEY, Circuit Judge:

This is a taxpayer's refund suit under 28 U.S.C. § 1346(1). Gibson Products Company, an accrual basis taxpayer, appeals from a judgment denying it recovery of $25,414.48 in taxes and interest which it alleges were erroneously assessed and collected by the Government for the 1972 tax year. Gibson Products contends that the district court erred in sustaining the disallowance by the Commissioner of Internal Revenue for the deduction, as an intangible drilling expense in 1972, of taxpayer's pro rata share of liability on a nonrecourse note given in that year by a limited partnership, in which it was a limited partner, in exchange for a "no-out" turnkey drilling contract on some oil and gas prospects owned by the partnership. We affirm the judgment of the district court.

I. Background

The factual details are fully set out in the district court's opinion. Gibson Products Co. v. United States, 460 F.Supp. 1109 (N.D.Tex.1978). The following facts are significant for purposes of this appeal.

In 1972 Gibson Products, a Texas corporation, invested in a limited partnership known as the "McNeil Street Drilling Venture 72." McNeil Street consisted of two general partners, Robert Pace and Harold Rogers, and thirteen limited partners including Gibson Products. Gibson Products' cash contribution to the McNeil Street partnership was $25,000, equaling 8.06% of the total capitalization.

McNeil Street subsequently entered into a joint venture with the Midwest Drilling Venture to acquire certain oil and gas leases. McNeil possessed a 59% participating interest in the joint venture, and Midwest had a 41% interest. On December 29, 1972, the McNeil/Midwest joint venture entered into an agreement with Galaxy Oil Company to purchase five oil and gas leases. The leases were purchased for $63,500, of which $25,400 was paid in cash with the balance of $38,100 being satisfied by a nonrecourse promissory note.

As part of the purchase of these oil and gas leases, McNeil/Midwest entered into a "no-out" turnkey drilling contract ¹ with Galaxy Oil, whereby Galaxy agreed to drill an exploratory test well on each of the five leases commencing on or before January 31, 1973. The consideration for the drilling contract equalled $1,036,500, of which $414,600 was paid in cash and the balance of $621,900 was included in the nonrecourse note. Consequently, the McNeil/Midwest joint venture paid a total of $1,100,000 for the five oil and gas leases plus the drilling contract, of which $440,000 or 40% was paid in cash and the remaining $660,000 or 60% was paid by the nonrecourse note.

The promissory note in the amount of $660,000, dated December 29, 1972, was payable on January 1, 1977 with 6 1/2% interest per annum. Galaxy's sole recourse for nonpayment was determined by the terms of the mortgage and security agreement entered into by the parties on the same date. According to that agreement, the collateral securing the $660,000 note consisted of the five oil and gas leases, any operating equipment on the leases owned by McNeil/Midwest, and 80% of any future oil and gas production from wells completed on the leases. Part of the mortgage agreement consisted of an assignment by the McNeil/Midwest joint venture to Galaxy Oil of 80% of all oil and gas produced from the lease prospects. The agreement provided that the proceeds from any oil and gas production would be applied as follows: (1) to satisfy any expenses incurred by Galaxy in connection with collection, (2) to payment of accrued interest on the nonrecourse note, and (3) to payment of the principal on the note. Moreover, under the terms of the loan agreement entered into on the same date, Galaxy was given the option, once drilling had been completed to the agreed depth and if McNeil/Midwest elected to complete any of the wells thus drilled, to enter into a joint venture arrangement with McNeil/Midwest for completion of any particular well and to share in the well's ownership, development and operation with a 20% participating interest.

McNeil Street's pro rata contribution (51%) to the consideration given to Galaxy Oil for the leases and drilling contract consisted of $244,614 in cash and.$366,921 on the nonrecourse note. McNeil Street, an accrual basis partnership, claimed $611,535 ($244,614 plus.$366,921) on its 1972 partnership return as intangible drilling and development costs, ² which it elected to deduct as expenses under I.R.C. § 263(c) (26 U.S.C. § 263(c)) and Treas.Reg. § 1.612-4(a). On its 1972 tax return, McNeil Street claimed a total loss of $661,760, including the $611,535 in intangible drilling anddevelopment costs. Gibson Products' pro rata share (8.06%) of the partnership's losses attributable to intangible drilling costs figured out to be $49,317.34, ³ which it in turn claimed as a deduction on its 1972 tax return. Although a partner cannot deduct partnership losses that exceed his basis in the partnership, I.R.C. § 704(d) (26 U.S.C. § 704(d)), a partner's basis includes not only the money contributed to capitalization, but also his pro rata share of nonrecourse liabilities incurred by the partnership. Treas.Reg. § 1.752-1(e). Taxpayer argues that since McNeil Street was a comaker on the nonrecourse note to Galaxy Oil, it was entitled to an increase of its partnership basis by a proportionate amount, i. e. by 8.06% of 59% of $660,000 equaling $31,403.23. By adding this figure to its cash contribution of $25,000, Gibson Products concludes that its basis in the partnership was $56,403.23. Therefore, taxpayer contends it was entitled to deduct its full pro rata share of McNeil Street's losses, including its share of the partnership's intangible drilling and development costs ($49,317.34).

After examining the McNeil Street partnership return for 1972, the Internal Revenue Service disallowed the deduction of $611,535 as intangible drilling costs. Accordingly, taxpayer's deduction of $49,317.34 as intangible drilling costs attributable to McNeil Street's operations was also disallowed. As a result of this disallowance, the IRS assessed and collected from Gibson Products $25,414.48 in additional taxes for 1972, the major portion of which was credited to the disallowance of the deduction of $49,317.34 for intangible drilling costs.

At trial, the Government made two arguments in support of the disallowance of taxpayer's deduction. First, it asserted that the nonrecourse liability of McNeil/Midwest to Galaxy Oil was contingent upon oil and gas production and was, therefore, not accruable as a debt to McNeil Street in 1972 under the "all-events" test. ⁴ Second, the Government contended that taxpayer's basis in McNeil Street could not be increased by its proportionate share of the partnership's nonrecourse liability to Galaxy under the Crane doctrine. ⁵

The district court held first that taxpayer was entitled to deduct its proportionate share of McNeil Street's loss attributable to the cash payment made to Galaxy for the drilling obligations, but that the amount of the deduction would be limited to taxpayer's basis in the partnership. ⁶ Then after examining the substance of the transaction, as opposed to its form, the district court made a factual determination that McNeil Street's liability to Galaxy on the nonrecourse note was contingent upon future production of oil and gas from the five leases. Based on that factual determination, the district court drew the legal conclusion that the requirements of the "all-events" test for accrual basis accounting, which would allow taxpayer to deduct its pro rata share of the note attributable to the drilling contract as an intangible drilling cost, had not been met. Finally, the court held that taxpayer could not increase its basis in McNeil Street by an amount equal to its prorata share of the nonrecourse note to Galaxy because: (1) liability on the note was contingent, and/or (2) taxpayer had failed to prove in accordance with I.R.C. § 752(c) (26 U.S.C. § 752(c)) and Treas.Reg. § 1.752-1(e) that the value of the collateral securing the debt equalled the amount of the note. ⁷

While this case was pending on appeal, the Tax Court rendered its decision in Brountas v. Commissioner of Internal Revenue, 73 T.C. 491 (1980). In Brountas, the Tax Court held, under facts identical to those sub judice in every relevant respect, see 73 T.C. at 534-38, that nonrecourse notes payable to the drilling contractor/lender, from whom the mineral leases were purchased, constituted production payments or the substantial economic equivalent thereto under I.R.C. § 636 (26 U.S.C. § 636) and Treas.Reg. § 1.636-3(a)(2). Since § 636 provides that a production payment be treated as a loan, the Tax Court concluded that the nonrecourse notes given in exchange for turnkey drilling contracts and secured by future mineral production could be deducted as intangible drilling and development costs, irrespective of the highly contingent nature of liability thereon and without regard to whether such liability accrued in the year of deduction under the "all-events" test. Taxpayer urges us to follow the reasoning of the Tax Court in Brountas and hold that the nonrecourse note to Galaxy is a production payment, which § 636 requires to be treated as a loan, and that as such it is deductible as an intangible...