Oil Co v. Commissioner of Internal Revenue 25 8212 28, 1946

• Decision Date: 22 April 1946
• Docket Number: BURTON-SUTTON,No. 361,361
• Citation: 66 S.Ct. 861,328 U.S. 25,162 A.L.R. 827,90 L.Ed. 1062
• Parties: OIL CO., Inc., v. COMMISSIONER OF INTERNAL REVENUE. Argued and Submitted March 25—28, 1946
• Court: U.S. Supreme Court

328 U.S. 25

66 S.Ct. 861

90 L.Ed. 1062

BURTON-SUTTON OIL CO., Inc.,

v COMMISSIONER OF INTERNAL REVENUE.

No. 361.

Argued and Submitted March 25—28, 1946.

Decided April 22, 1946.

Mr. Norman F. Anderson, of Lake Charles, La., for petitioner.

Mr. J. Howard McGrath, Sol. Gen., of Washington, D.C., and Sewall Key, Acting Asst. Atty. Gen., and Miss Helen R. Carloss and Mr. Hilbert P. Zarky, both of Washington, D.C., for respondent.

Mr. Justice REED delivered the opinion of the Court.

The taxpayer, the petitioner here, is the operating company for the production of oil from Louisiana lands. The taxpayer acquired a contract from J. G. Sutton, grantee in the contract, that imposed upon the grantee the obligation to develop the oil land. For that purpose the contract transfe red to the grantee all oil rights previously obtained by S. W. Sweeney by a lease from the owners of the land, the Cameron Parish School Board. Through another transaction the grantor in the Sutton contract, the Gulf Refining Company of Louisiana, acquired these rights from Sweeney. An underlying oil royalty was retained by the School Board and an overriding oil royalty by Sweeney. The contract between Gulf and Sutton required the grantee-operator, who is now this taxpayer, to pay to the grantor, Gulf, 50% of the proceeds of the oil produced and sold from the land, deducting from the proceeds certain itemized expenses of the producer. Those expenses are so general in character that it may be said fairly that Gulf was to receive 50% of the net from operations.

The issue here is the correctness of the taxpayer's manner of handling this 50% net from operations, paid to Gulf, in its return for federal income tax for its fiscal years ending during 1936, 1937 and 1938 under the Revenue Acts of 1934 and 1936. The taxpayer deducted these payments of 50% of net income from its income for each of the years from the oil sold from the property. It claimed that Gulf retained an economic interest in the oil in place to the extent of this 50% payment. The Tax Court upheld the Commissioner's inclusion of an amount equal to these 50% payments in the taxpayer's gross income. They were included by the Commissioner in the income on the theory that the 50% payments represented capital investment by the taxpayer. That is, they were a part of the cost of the lease. 3 T.C. 1187. If this theory is correct, it is proper to add an equivalent sum, as the Commissioner did, to the taxpayer's gross income.¹ The Circuit Court of Appeals affirmed the Tax Court. Burton-Sutton Oil Co. v. Commissioner, 5 Cir., 150 F.2d 621, 160 A.L.R. 961.

A decision on the category of expenditures to which these 50% disbursements belong affects both the operators who make them and the owners, lessors, vendors, grantors, however they may be classed, who receive them. If they are capital investments to one, they are capital sales to the other. If they are rents or royalties paid out to one, they are rents or royalties received by the other.² The decision below conflicts in principle with Commissioner v. Felix Oil Co., 9 Cir., 144 F.2d 276. Kirby Petroleum Co. v. Commissioner, 326 U.S. 599, 66 S.Ct. 409, involved payments of a share of net income by a producer but differs from this case because the lessor there was a landowner who reserved a royalty as well as a share in the net profits. Consequently, we granted certiorari, 327 U.S. 771, 66 S.Ct. 526.

The applicable provisions in the Revenue Acts for 1934 and 1936 and the Regulations thereunder are substan- tially the same for the two Acts. We insert below those that seem pertinent.³ The issue of the character of these 50% payments is not settled, however, by the statutes or regulations. These prescribe the federal income tax accounting procedure after a determination that an expendi- ture of an operator is or is not a rent, a royalty or an ordinary business expense, but throw little light on what is a rent or royalty.

In the Kirby case, we held that a payment of a share of the net profits from oil production by the operator to the owner of the land was a rent or royalty and taxable to the landowner as income from the oil property. Therefore the owner could take from the payment the 27 1/2 per centum allowance for depletion provided by Section 114(b)(3). The reason given in the Kirby case for holding that the payment of a part of the net return from the property to the landowner was a royalty or rent,⁴ was that the owner had a capital investment—an economic interest—in the oil with a possibility of profit from that interest or investment solely from the extraction of the oil. As hereinbefore indicated, the landowner in the Kirby case had retained also a one-sixth oil royalty and had received a bonus. It was conceded that as both the bonus and the royalty represented a return for the sale in part of the lessor's investment in the oil in place, the lessor was entitled to depletion on both. ⁵

The respondent urges that in the Kirby case it was the lessor's economic interest in some of the oil itself, or its proceeds, because of the bonus and royalty rights, which made the net profit payments subject to depletion in the lessor's hands; that net profits received are not depletable unless the recipient is entitled also to oil royalties.⁶ Consequently, the Government contends that in this case where there is only a share in profits due to the assignor, Gulf, the Kirby case conclusion on the right to depletion should not be extended but that the judgment below should be affirmed on the ground that the profit payment was a part of the purchase price. In dealing with the operator's exclusion from gross income of agreed payments to lessors or assignors of leases out of net profits and with the lessor's or a signor's rights to depletion, the Tax Court has not followed consistently the principle that a reserved royalty is necessary to make a net profit payment depletable to the lessor and deductible from gross income from the property by the operator. ⁷ A number of the Tax Court cases on depletion and deduction cited in the preceding note did involve reserved royalties as well as payments of net profits. The Felix Oil Company and A. B Innis did not. 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.

To let the character of the net profit payments turn wholly on the ownership of a royalty of some sort by the one who received the net profit would make the right to depletion a form of words. No such mechanical application of a national tax act is desirable. Compare Burnet v. Harmel, 287 U.S. 103, 110, 111, 53 S.Ct. 74, 77, 77 L.Ed. 199. This taxpayer's acquisition of Sutton's contract with Gulf places the taxpayer in Sutton's situation as operator of the School Board lease. The School Board and Sweeney, the original parties to the lease, unquestionably have royalties which would compel a determination that net income payments would be subject to depletion if paid to them in addition to their royalties. It does not logically follow, it seems to us, that the mere receipt of the net income payments by different lessors or assignors can change the character of the taxpayer's arrangements from leases to purchases.

It seems generally accepted that it is the owner of a capital investment or economic interest in the oil in place who is entitled to the depletion. Anderson v. Helvering, 310 U.S. 404, 407, 60 S.Ct. 952, 953, 84 L.Ed. 1277; Euleon Jock Gracey, 5 T.C. 296, 302; Kirby Petroleum Co. v. Commissioner, supra. Whether the instrument creating the rights is a lease, a sublease or an assignment has not been deemed significant from the federal tax viewpoint in determining whether or not the taxpayer had an economic interest in the oil in place. Palmer v. Bender, 287 U.S. 551, 557, 558, 53 S.Ct. 225, 227, 77 L.Ed. 489. Nor has the title to the oil in place been considered by this Court as decisive of the capital investment of the taxpayer in the oil.⁸ Technical title to the property depleted would ordinarily be required for the application of depletion or depreciation. It is not material whether the payment to the assignor is in oil or in cash which is the proceeds of the oil, Helvering v. Twin Bell Syndicate, 293 U.S. 312, 321, 55 S.Ct. 174, 178 79 L.Ed. 383, nor that some of the payments were in the form of a bonus for the contract. Burnet v. Harmel, 287 U.S. 103, 111, 53 S.Ct. 74, 77, 77 L.Ed. 199; Murphy Oil Co. v. Burnet, 287 U.S. 299, 302, 53 S.Ct. 161, 162, 77 L.Ed. 318. Congress, however, has recognized the peculiar character of the business of extracting natural resources.⁹ Leases are a method of exploitation of the land for oil and payments under leases are 'income to the lessor, like payments of rent.'¹⁰ Receipts from oil sales are gross income to the operator and subject to statutory deductions. Since lessors as well as lessees and other transferees of the right to exploit the land for oil may retain for themselves through their control over the exploitation of the land valuable benefits arising from and dependent upon the extraction of the oil,¹¹ Congress provided as early as the Revenue Act of 1918¹² for equitable apportionment of the depletion allowance between them to correct what was said to be an existing inequality in the law or its administration.¹³

In the present case, the assignor of the petitioner before assignment had an economic interest in the oil in place through its control over extraction. Under the contract with petitioner, its assignor retained a part of this interest—fifty per cent of net. Like the other holders of such economic interest through royalties, the petitioner looked to the special depletion allowances of Section 114(b)(3) to return whatever capital investment...