Murphy Oil Co. v. Burnet

• Decision Date: 23 February 1932
• Docket Number: No. 6388,6459.,6388
• Parties: MURPHY OIL CO. v. BURNET, Com'r of Internal Revenue. COMMISSIONER OF INTERNAL REVENUE v. MURPHY OIL CO.
• Court: U.S. Court of Appeals — Ninth Circuit

55 F.2d 17 (1932)

MURPHY OIL CO. v. BURNET, Com'r of Internal Revenue.

COMMISSIONER OF INTERNAL REVENUE v. MURPHY OIL CO.

Nos. 6388, 6459.

Circuit Court of Appeals, Ninth Circuit.

January 11, 1932.

Rehearing Denied February 23, 1932.

Randolph E. Paul, of New York City (Thomas R. Dempsey, A. Calder Mackay, Kenyon F. Lee, and Bradner W. Lee, all of Los Angeles, Cal., of counsel), for petitioner and cross-respondent.

G. A. Youngquist, Asst. Atty. Gen., and Sewall Key, J. L. Monarch, John G. Remey, and J. P. Jackson, Sp. Assts. to Atty. Gen. (C. M. Charest, Gen. Counsel, R. N. McMillan and J. K. Polk, Sp. Attys., Bureau of Internal Revenue, all of Washington, D. C., of counsel), for respondent and cross-petitioner.

Raymond Benjamin, of Washington, D. C., amicus curiæ.

Before WILBUR and SAWTELLE, Circuit JJ., and JAMES, District J.

WILBUR, Circuit Judge.

Two petitions have been presented to review a determination of the Board of Tax Appeals. That by the commissioner claims that by the order of the board with reference to bonus, payments by the lessee, aggregating $5,173,595.18, were improperly applied by the board in estimating the depletion, properly deductible, from the income for the years 1919 and 1920. That by the taxpayer claims an error in regard to the application of the cost and expense of a law suit and of money paid in settlement of the same, amounting in the aggregate to $1,370,877.24 ($1,200,000 being the amount paid in settlement and $170,877.24 being the cost and expenses of the litigation). This suit involved only the Coyote property belonging to petitioner. The net income of the taxpayer for these years subject to depletion deductions was respectively $2,636,882.78 and $2,988,550.51.

The facts involved were determined by the Board of Tax Appeals and also appear in part from the computation of tax made by the Commissioner of Internal Revenue by order of the board in pursuance of their rule 50. This computation of the depletion which is in effect the decision of the board is to be found in the margin.¹ The facts are undisputed.

In 1903 Simon J. Murphy, petitioner's predecessor, obtained an oil lease of 2,240 acres of land owned by Domingo Bastanchury and in 1904 assigned and transferred this lease to petitioner, Murphy Oil Company. An oil well was drilled on the land under this lease, but it was capped. The widow of Domingo Bastanchury, as the administratrix of his estate, later claimed in the litigation involved herein that this well was represented to him to be a dry hole when in fact oil was discovered therein and that he sold the land with that belief. In December, 1904, E. W. Bacon, then secretary of the Murphy Oil Company, purchased the fee in the land from Domingo Bastanchury at $35 an acre, for $78,400, and leased the surface rights to Bastanchury. In January, 1905, Bacon and his wife granted and conveyed the said land to the petitioner, the Murphy Oil Company. Thereafter oil development on the property proceeded and oil was produced in paying quantities. On December 1, 1913, the petitioner leased the land, which was thereafter known as the Coyote project, to the Standard Oil Company of California, together with land thereafter known as the Whittier property. A bonus of $5,173,595.18 was paid for the lease on these two oil properties, which bonus was apportioned by the commissioner to these properties in the sum of $4,517,402.70 and $656,192.48, respectively. Hereinafter only the depletion of the Coyote property as affected by the portion of the bonus allocated to that property will be considered in detail, but the same principles are also applicable to the depletion of the Whittier property.

The Commissioner of Internal Revenue fixed the value of the land, referred to as "Coyote," on March 1, 1913, at $15,710,899.52 and the recoverable oil content of the land on that date at 41,191,605 barrels, and thus fixed the value of the recoverable oil in the ground at 38.141 cents per barrel. The commissioner fixed the value of the land at the time of the execution of the lease to the Standard Oil Company on December 1, 1913, the terms of which are involved in this proceeding, as $15,547,522.17. This value was that fixed for the land on March 1, 1913, less the value of the oil produced therefrom at 38.141 cents per barrel up to December 1, 1913, the date of the lease; that is, less $163,377.35. Under the direction of the Board of Tax Appeals in its decision and in opposition to the views entertained by the commissioner on the subject as determined by the deficiency tax, the commissioner also fixed this amount ($15,547,522.17) as the value of the land in December, 1913, after the execution of the lease and subject to the lease. Thus, upon the execution of the lease, the commissioner, in compliance with the order of the board, raised the value of the recoverable oil belonging to, or payable as royalty to, the petitioner to $1.52564 per barrel; that is, four times $0.38141. This figure was arrived at by subtracting from the total recoverable mineral content of 41,191,605 barrels, less 428,351 barrels already recovered, three-fourths thereof, to wit, 30,572,440 barrels, and leaving as the recoverable portion belonging to the petitioner, as royalty oil, 10,190,814 barrels. The value of this royalty oil was taken as equal to the value of the land prior to the execution of the lease, thus giving as the value of each barrel of royalty oil $1.52564. It seems absurd on its face to estimate the value of the royalty oil in the ground at the time of the execution of the lease at 38.141 cents, and immediately thereafter at $1,52564, but the absurdity disappears when it is observed that the $1.52564 represents oil brought to the surface, and that the difference between the 38.141 cents and the $1.52564 represents the cost to the petitioner of bringing the oil to the surface; that is, it cost petitioner three barrels of oil at 38.141 cents to bring a barrel of oil to the surface which was worth 38.141 cents in the ground, and $1.52564 at the surface. "Worth" in this connection meaning capital investment. But the actual depletion of the value of the land as of March 1, 1913, by the recovery of oil therefrom was nevertheless four barrels of oil at 38.141 cents for each barrel of royalty oil recovered for the petitioner. In these statements we are ignoring for the present the added cost of extraction due to the consumption of oil by the lessee in its work of development and production which was known as "free oil." In considering the reasonableness of this figure of $1.52564 as representing the portion of petitioner's capital investment in the oil recovered as royalty to be deducted from the total receipts actually derived from the royalty oil in determining the proportion thereof which was petitioner's income and assuming, as the commissioner and the Board of Tax Appeals held, that the market value of the property on November 30, 1913, was $15,547,522.17, it should be observed that the owner of the land had several methods of reducing its capital to money. This it could do by selling the property for its market value, which was the same as March 1, 1913, less depletion, in which event the purchase price would not be subject to income tax because it would merely represent a change in form of capital, or it could continue the operations it was already engaged in for the bringing of the oil to the surface. Instead of doing either, it could enter into a lease or contract with a third party by which the third party undertook to bring the oil to the surface and sell it or turn it over to the petitioner. This would reduce the amount of oil which the owner would be entitled to sell at market prices, but, depending upon the market price of oil, might or might not increase his income. The effect of the lease as determined by the Board of Tax Appeals (ignoring the question of bonus for the moment) was that the owner paid from the oil content of the soil 30,572,440 barrels of oil, plus the free oil allowed to the tenant under the lease, as the expense of bringing to the surface the remaining recoverable oil it was to receive. Under these circumstances it no doubt would be a reasonable adjustment of the relationship of the landlord and tenant with reference to depletion to fix $1.52564 as the capital investment on March 1, 1913, in each barrel of royalty oil brought to the surface and to allow this whole amount to the landlord as his depletion, the tenant having no capital investment at this time (March 1, 1913), and on this hypothesis it would be entitled to no depletion allowance.

We are here met with the difficulty in the case arising from the payment of a bonus of $4,517,402.70 which was determined by the commissioner in one way and by the Board of Tax Appeals in the other. The lessee agreed to pay this money in installments extending over a period of five years aggregating $4,517,402.70, regardless of whether or not any oil was produced from the property during that period. This amount the Board of Tax Appeals determined to be income to the landlord taxable as such during the years in which it was paid, but the commissioner had determined the entire bonus to be a return of capital investment to the landlord (with certain minor deductions hereinafter referred to); that is to say, the commissioner in effect held that the petitioner did not pay 30,572,440 barrels of oil in the ground valued at 38.141 cents per barrel to the lessee for bringing petitioner's royalty oil to the surface (that is, $11,660,634.34 worth of oil for that purpose), but paid that amount less the bonus of $4,517,402.70, to wit, $7,143,231.64. By this process of reasoning the commissioner came to the conclusion that the amount of petitioner's capital invested in its royalty oil in the ground was about $1.08236 per barrel. Consequently, the point involved here resolves itself into the question whether or not $1.52564 or $1.08236 should be...