Huntington Beach Company v. United States

• Decision Date: 12 July 1955
• Docket Number: No. 18-55.,18-55.
• Citation: 132 F. Supp. 718,132 Ct. Cl. 427
• Parties: HUNTINGTON BEACH COMPANY, a Corporation, v. The UNITED STATES.
• Court: U.S. Claims Court

132 F. Supp. 718

132 Ct. Cl. 427

HUNTINGTON BEACH COMPANY, a Corporation, v. The UNITED STATES.

No. 18-55.

United States Court of Claims.

July 12, 1955.

W. J. McFarland, Beverly Hills, Cal., Sigvald Nielson and Harry R. Horrow, and Pillsbury, Madison & Sutro, San Francisco, Cal., on the brief, for plaintiff.

Hilbert P. Zarky, Washington, D. C., H. Brian Holland, Asst. Atty. Gen., Andrew D. Sharpe, Ellis N. Slack, and Kenneth E. Levin, Washington, D. C., on the brief, for defendant.

Melvin D. Wilson, Los Angeles, Cal., filed a brief for Southwest Exploration Co. as amicus curiae.

Before JONES, Chief Judge, and LITTLETON, WHITAKER, MADDEN and LARAMORE, Judges.

MADDEN, Judge.

The plaintiff owned land near the seashore in California. It granted to Southwest Exploration Company the right to come on its land and drill wells slantwise to reach oil deposits which were beneath the adjoining submerged lands owned by the State. As compensation, Southwest agreed to pay the plaintiff 17.75% of Southwest's net profits from the sale of the oil taken from the wells. During the year 1948 the plaintiff received large sums of money from Southwest under this arrangement. It claimed, but the Commissioner of Internal Revenue denied to it, the right to a depletion deduction on those receipts, under sections 23(m), 53 Stat. 14, and 114(b), 53 Stat. 45, of the Internal Revenue Code of 1939, 26 U.S.C.A. §§ 23(m), 114(b). It paid its corporate income taxes without the benefit of the deduction, and here sues for the refund of $182,802.98 of taxes and interest which it paid, and for interest on that sum as provided by law.

When the owner of solid minerals or of oil and gas deposits receives money as a result of the mining or production of these commodities, what he receives is treated, for tax purposes, as income, and not as a return upon the sale of a capital asset. But the income is different from interest or rent in that the production of the income depletes the source from which the income is derived. For this reason the tax statutes permit the receiver of such income to deduct, in his tax return, 27½% of his gross income from the production of oil.

When the oil produced or the income from its production is by the arrangements of the parties, to be divided among two or more persons, the basic reason for the depletion allowance is applicable to each of them in his proper proportion. In the usual arrangement whereby the landowner is to have one-eighth of the oil and the operator is to have seven-eighths, the prospect of each for future receipts is diminished as present receipts are obtained. Section 23(m) of the Internal Revenue Code says that in the case of leases the depletion deductions shall be equitably apportioned between lessor and lessee.

Transactions looking to the production of oil and gas have taken a great variety of forms. The landowner leases, reserving a royalty. The lessee may sublease, reserving a royalty. Or he may "assign" his lease, the assignee promising to pay a consideration only out of oil produced, and measured by the amount of production. These are only simple illustrations of the various forms which such transactions take. The statutes do not specifically provide for the application of the depletion allowance to these various forms of transactions. But the Supreme Court of the United States has decided many cases involving the depletion allowance, and has thereby developed principles helpful in the solution of other cases not covered by that Court's decisions.

Southwest Exploration Company, the operator which produced the oil from wells on the plaintiff's land, claimed the depletion deduction on all of the oil income. The plaintiff, at the same time, claimed the deduction on its 17¾% of Southwest's net profits. In order to protect the revenue against the loss which would result if these competing claims to the same deduction were both successful, the Commissioner of Internal Revenue took inconsistent positions and denied the disputed portion of the deduction to both parties. Southwest contested the Commissioner's denial in the Tax Court, and that court held in Southwest Exploration Co. v. Commissioner, 18 T.C. 961, that the plaintiff did not possess a depletable interest and that Southwest was entitled to the deduction on all its gross income from the oil wells during the years 1939 through 1945. The United States Court of Appeals for the Ninth Circuit, in a per curiam opinion affirmed, on the basis of the Tax Court's opinion. Commissioner v. Southwest Exploration Co., 220 F.2d 58. If that decision is correct, the plaintiff cannot prevail in this case. It is not legally permissible for both companies to have the same deduction.

The fact that in the instant situation the plaintiff received a share in the net profits from the production of oil, rather than a share of the oil produced regardless of the expense of production, is not a reason to deny the plaintiff a depletion deduction. In Kirby Petroleum Co. v. Commissioner, 326 U.S. 599, 66 S.Ct. 409, 90 L.Ed. 343, a landowner leased his land for the production of oil and gas in return for a cash bonus a fractional royalty and 20% of the net profits realized from the production. The Court held that the lessor was entitled to a depletion deduction on the percentage of net profits payment, as well as on the bonus and the royalty. The Court held that the net profits provision gave the taxpayer an additional economic interest in the oil. The Court, 326 U.S. at page 603, 66 S.Ct. at page 411, said:

"By this is meant only that under his contract he must look to the oil in place as the source of the return of his capital investment. * * * The test of the right to depletion is whether the taxpayer has a capital investment in the oil in place which is necessarily reduced as the oil is extracted."

The Court, 326 U.S. at page 604, 66 S.Ct. at page 411, further said, in explaining why no distinction was to be made between a retained royalty interest in gross production, and in the operator's net profits:

"In both situations the lessors' possibility of return depends upon oil extraction and ends with the exhaustion of the supply. Economic interest does not mean title to the oil in place but the possibility of profit from that economic interest dependent solely upon the extraction and sale of the oil."

In the language from the Kirby Petroleum case first quoted above, the reference to the taxpayer's "capital investment" in the oil in place should be noted. It surely cannot mean that it would make any difference that the land had been bought by the lessor for a song as practically worthless desert land, and with no thought of the possibility that it might be a source of oil. In Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25, 34, 66 S.Ct. 861, 867, 90 L.Ed. 1062, the Court said:

"The cost of that investment to the beneficiary of the depletion under Section 114(b) (3) is unimportant. * * * Through retention of certain rights to payments from oil or its proceeds in himself, each of these assignors of partial exploitation rights in oil lands has maintained a capital investment or economic interest in the oil or its proceeds."

It is apparent that in the Supreme Court's view, the economic interest is the essential thing, regardless of what, if anything, it cost to acquire it.

In the Burton-Sutton case, supra, the question was whether one G, who was in a chain of title from the original lessor, but who had in turn transferred his rights to another, who had transferred his rights to an operator under a contract requiring the operator to pay 50% of the profits of the operation to G, was entitled to the depletion deduction. The Government, in arguing against the deduction, urged that the decision in the Kirby Petroleum case, supra, was based on the fact that the taxpayer there had, in addition to his right to a percentage of profits, a right to an oil royalty and a bonus. The Government urged that a right to a percentage of profits, standing alone, should not entitle the taxpayer to the depletion deduction. The Court rejected that argument and said in 328 U.S. at page 32, 66 S.Ct. at page 865:

"We do not agree with the Government that ownership of a royalty or other economic interest in addition to the right to net profits is essential to make the possessor of a right to a share of the net profit the owner of an economic interest in the oil in place. The decision in Kirby did not rest on that point."

We must, then, determine the nature and extent of the plaintiff's economic interest in the oil from which it derived the income here in question. Under the California law, the oil under the State's submerged lands could not be recovered except by drilling in the upland. As a condition precedent to obtaining a lease from the State to drill for oil, an operator had to obtain the consent of the owner of the upland to such drilling. The plaintiff owned the upland. The Government says in its brief, "The plaintiff, is, from a pure legal viewpoint, a stranger to the oil which is being extracted from the submerged lands." From a legal viewpoint, the plaintiff, because of its ownership of the strategic upland, had a legal right to say to the prospective operator, "You cannot produce oil from these lands of the State unless you pay me 17¾% of your net profits." That would seem to mean that the plaintiff, far from being a stranger, was almost as intimately related to the oil as is the ordinary landowner on whose land vertical drilling may be done. An oil operator does not give strangers a percentage, large or small, of his net profits. In this case the plaintiff was in such a legal and geographical position of control with regard to the oil under the State's submerged lands that it could, and did, in exchange for its consent to the recovery of the oil, require that it be paid 17¾% of the operator's net profits, which, in the single year 1948, brought a payment to the...