Mesa Petroleum Co.  v. Comm'r of Internal Revenue

• Decision Date: 25 May 1972
• Docket Number: Docket No. 5139-69.
• Citation: 58 T.C. 374
• Parties: MESA PETROLEUM CO. (AS CORPORATE SUCCESSOR TO HUGOTON PRODUCTION COMPANY), PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

58 T.C. 374

MESA PETROLEUM CO. (AS CORPORATE SUCCESSOR TO HUGOTON PRODUCTION COMPANY), PETITIONER

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 5139-69.

United States Tax Court

Filed May 25, 1972.

O. Don Chapoton and Richard R. Cruse, for the petitioner.

Robert Liken and Leslie A. Plattner, for the respondent.

Petitioner operated gas properties under leases calling for it to pay its lessors one-eighth of the proceeds from the actual sale of the gas and its products, reduced by an aliquot share of the costs of transporting, processing, and marketing the gas. The parties have stipulated the representative market or field price for the gas at the wellhead. Held, petitioner must compute its percentage depletion allowance under sec. 613, I.R.C. 1954, on the basis of the amount remaining after the gross income from the property, calculated under the representative market or field price method, has been reduced by the royalties actually paid the lessors.

FEATHERSTON, Judge:

Respondent determined a deficiency in petitioner's Federal income tax for 1965 in the amount of $208,506.63. Most of the issues have been settled; the only issue remaining for decision is the proper amount of petitioner's percentage depletion deduction under section 613.¹

FINDINGS OF FACT

Mesa Petroleum Co., a corporation chartered under the laws of Delaware, has its principal office at Amarillo, Tex. It is the surviving corporation of a merger, on April 30, 1969, with Hugoton Production Co. (hereinafter referred to as Hugoton). Hugoton was also chartered under the laws of Delaware; it maintained its executive offices in New York, N.Y., and its operating offices in Garden City, Kans. It filed its Federal income tax return for 1965 with the district director of internal revenue, Wichita, Kans.

During 1965, Hugoton was engaged in the production and sale of natural gas from wells in which it owned a working interest. The wells involved in this case were all located in the Grant and Stevens County portions of the Hugoton Gas Field of Kansas, known as the Hugoton Lease Block— an area of approximately 97,000 acres. All these wells were connected to a gathering system which ultimately converged at a central point.

Gas which was not sold in the immediate vicinity of a well was moved through the gathering system to a natural gasoline plant centrally located on the Hugoton Lease Block. In this plant, the liquefiable hydrocarbons were removed from the gas and separated into the marketable products of natural gasoline, and propane. Hugoton owned and operated both the gathering system and the natural gasoline plant.

Of the 37,289,531 MCF (at a pressure base of 14.65 p.s.i.a.) of gas produced from the wells during 1965, all but 4,631,320 MCF was transported to the natural gasoline plant for processing. After processing, the dry gas and the liquefiable hydrocarbons extracted during the processing were sold.

Hugoton obtained the right to extract the gas from the land under oil and gas leases. A royalty clause in one of the leases was construed by the Supreme Court of Kansas² to provide that the lessors were to receive one-eighth of the proceeds from the actual sale of the gas and its products, reduced by an aliquot share of the costs of transporting, processing, and marketing such gas and its products. This so-called Matzen formula was used during 1965 by Hugoton, pursuant to agreements with the landowners, to compute the royalty payments for all the lessors. Under this formula, the proceeds at the wellhead were 19.27 cents per MCF. The royalty payments, therefore, were 2.40875 cents per MCF (one-eighth of 19.27 cents), and the total royalties paid were $905,076.

The representative market or field price for gas at the wellhead during 1965 was 14 cents per MCF.

In the notice of deficiency, respondent computed the gross income from the property by reference to the representative market or field price and then reduced that amount by the $905,076 paid as royalties to the lessors. The remainder was determined to be the gross income from the property on which petitioner was entitled to compute its percentage depletion.

OPINION

Section 611(a) provides that ‘there shall be allowed as a deduction in computing taxable income a reasonable allowance for depletion.’ This deduction is designed to permit every person who has an economic interest in the minerals in place to recover his investment tax-free. Kirby Petroleum Co. v. Commissioner, 326 U.S. 599, 602-603(1946). Only a single allowance is available for any mineral deposit, and it is to be apportioned between all persons having economic interests in the minerals in place. Commissioner v. Southwest Expl. Co., 350 U.S. 308, 313(1956); Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25, 32-34(1946); Helvering v. Twin Bell Syndicate, 293 U.S. 312, 321(1934).

In the case of a lease, both a lessor, whose interest stems from his ownership of the minerals in place, and a lessee, whose interest stems from his acquired right to extract such minerals, have depletable interests. Palmer v. Bender, 287 U.S. 551, 558(1933). In recognition of these interests, section 611(b)(1) expressly provides that the depletion deduction ‘shall be equitably apportioned between the lessor and lessee.’ The apportionment gives the lessor a deduction computed with reference to the royalties he receives and the lessee a deduction calculated with reference to the share of the production which he is entitled to retain. Helvering v. Twin Bell Syndicate, supra at 320-321.

The formulae for computing the deduction allowed by section 611 are set forth in part in section 612, which refers to the taxpayer's cost basis, and in section 613, which authorizes ‘percentage’ depletion. See Helvering v. Twin Bell Syndicate, supra at 318. Under this latter section, the lessee's allowance is a specified percentage (27 1/2 percent for gas in 1965) of the ‘gross income from the property excluding from such gross income an amount equal to any rents or royalties paid or incurred by the taxpayer in respect to the property.’ Whichever method is chosen— cost or percentage— ‘the deduction must be apportioned between lessor and lessee.’ Helvering v. Twin Bell Syndicate, supra at 320.

The computation of the amount of the ‘gross income from the property’ under section 613 creates no problem where gas is sold in the immediate vicinity of the well. Such gross income is the amount for which the gas is actually sold. Shamrock Oil & Gas Corp., 35 T.C. 979, 1029(1961), affd. 246 F.2d 377 (C.A. 5, 1965), certiorari denied 382 U.S. 892(1965).

Where the gas is not sold at the well but is manufactured or converted into a refined product or is transported from the premises of the well prior to sale, an artificial price must be established. The gross income from the property in such situations, according to the regulations, ‘shall be assumed to be equivalent to the representative market or field price of the oil or gas before conversion or transportation.’ Sec. 1.613-3(a), Income Tax Regs. This means that a calculation must be made of the weighted-average price received at the well on all sales of comparable gas within the competitive market area. This weighted-average price per MCF is then applied to the total number of MCF produced in computing the total ‘gross income from the property.’ See Panhandle Eastern Pipe Line Co. v. United States, 408 F.2d 690, 701 (Ct.Cl. 1969); Shamrock Oil & Gas Corp., supra at 1034. The lessee's gross income from the property for depletion purposes is the amount which he has remaining after he has paid the royalties to the lessor. Sec. 613(a).

In computing the disputed deficiency, respondent followed the formula prescribed in the representative price regulation. See sec. 1.613-3(a), Income Tax Regs. He multiplied a determined market or field price by the number of MCF produced from the wells and thus arrived at the total gross income from production. The payments to the lessors as royalties, computed under the Matzen formula, were then subtracted from the total production income, and petitioner's depletion deduction was calculated by applying 27 1/2 percent to the remainder.³

Petitioner contends that this determination does not reflect an equitable apportionment of the depletion deduction between the lessors and petitioner, the lessee, as contemplated by section 611(b). He argues that, under the leases, the lessors were entitled to only one-eighth (12.5 percent) of the depletable income; yet, under respondent's method, the lessors would receive 17.2 percent of the depletion allowance. The discrepancy between the 12.5 percent and the 17.2 percent is due to the use of the Matzen formula in computing the lessors' royalties and, in contrast, the use of the representative market or field price in computing the total gross income from the property.

Petitioner contends that this ‘inequity’ can be corrected only by allowing it to compute its depletion deduction on the basis of (1) seven-eighths of the total gross income from the property computed under the representative market or field price, regardless of the amounts paid the lessors as royalties, or alternatively, (2) seven-eighths of the total gross income from the property computed under the Matzen formula.

The fault in petitioner's argument is in its major premise: that the leases entitled the lessors to royalties equal to only one-eighth (12.5 percent) of the production income computed under the representative market or field price. The meaning of the lease provisions here in question was litigated in Matzen v. Hugoton Production Co., 182 Kan. 456, 321 P.2d 576(1958), and the Supreme Court of Kansas held that the royalty-owners were entitled to one-eighth of the proceeds of the actual sale of the gas and its products, reduced by an aliquot share of the costs of transporting, processing, and marketing the gas and its products. The words of the court were, in part, as follows (...