P.G. Lake, Inc. v. Comm'r of Internal Revenue, Docket No. 48684.

• Decision Date: 20 September 1955
• Docket Number: Docket No. 48684.
• Citation: 24 T.C. 1016
• Parties: P. G. LAKE, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: U.S. Tax Court

24 T.C. 1016

P. G. LAKE, INC., PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket No. 48684.

Tax Court of the United States.

Filed September 20, 1955.

1. CAPITAL GAIN— OIL AND GAS— UNDIVIDED INTEREST IN MINERALS IN PLACE UNTIL PRODUCTION EQUALED A STATED AMOUNT.— The petitioner realized long-term capital gain and not ordinary income when in 1950, in consideration of the cancellation of an indebtedness of $600,000, it transferred 25 per cent of seven-eights of all oil and gas upon two leases owned by it to its creditor until such time as the payments received by the latter equaled the amount of the debt plus interest thereon.

2. DEPLETION ALLOWANCE— OIL AND GAS— SUBSTITUTE ROYALTIES TRANSFERRED ALLOWABLES.— The gross income derived by the petitioner from the operation of two oil leases was not subject, for the purpose of determining the depletion allowance under section 114(b)(3) of the Internal Revenue Code of 1939, to the exclusion of amounts paid by petitioner in 1949, 1950, and 1951 to another oil company for transferred allowables and to royalty owners of a third lease owned by petitioner as substitute royalties, as a result of which the petitioner was permitted by the Railroad Commission of Texas to produce additional oil from the first two leases. Harry C. Weeks, Esq., for the petitioner.

Paul M. Newton, Esq., for the respondent.

OPINION.

MURDOCK, Judge:

The Commissioner determined deficiencies in income tax of $9,060.79 for 1949, $47,459.09 for 1950, and $12,026.24 for 1951 and a deficiency in excess profits tax for 1950 of $65,044.07. Two issues are presented for decision. One is whether the petitioner realized a long-term capital gain from the sale in 1950 of a portion of an interest in two oil and gas leases. The facts relating to this issue have been fully stipulated and the stipulation on this and the other issue is adopted, together with all exhibits as findings of fact in this case.

The petitioner is a Delaware corporation which filed its returns for the taxable years with the collector of internal revenue for the second district of Texas. It was engaged in developing oil and gas properties and producing oil and gas.

The petitioner was indebted to P. G. Lake, in the amount of $600,000 on December 29, 1950, and on that date, in consideration of the cancellation of that indebtedness, sold and transferred to him 25 per cent of seven-eights of all oil and gas upon two leases, entitling him to receive that portion of all production from the leases beginning at 7 a.m., January 1, 1951, until he had received $600,000 net to him, plus an amount equal to 3 per cent per annum payable monthly on the unpaid balance of the $600,000. The petitioner had owned the leases for several years prior to December 29, 1950, and had always held them for productive use in its business and not for sale. The petitioner reported the entire consideration of $600,000 as long-term capital gain on its return for 1950, but the Commissioner, in determining the deficiency, held that the $600,000, less the cost of documentary stamps affixed to the conveyance, was ordinary income subject to the allowance for depletion.

It is held that the petitioner correctly reported its gain from this transaction upon authority of the following cases which the Commissioner concedes are adverse to his contention: Lester A. Nordan, 22 T.C. 1132, in which the appeal of the Commissioner to the Court of Appeals for the Fifth Circuit was dismissed on June 8, 1955; John David Hawn, 23 T.C. 516, in which the Commissioner's appeal is not pending on in the Fifth Circuit was dismissed on June 8, 1955; John David Hawn, 23 T.C. 516, in which the Commissioner's appeal is now pending in the Court of Appeals for the Fifth Circuit; and Caldwell v. Campbell, 218 F.2d 567. See also Wm. Fleming, 24 T.C. 818.

The other question for decision is whether amounts paid by the petitioner to another oil company for ‘transferred allowables' and as ‘shut-in royalty’ to royalty owners under a lease owned by the petitioner, as the result of which the petitioner was allowed by the Railroad Commission of Texas to produce additional amounts of oil from other portions of its properties, are to be subtracted as royalties paid with respect to the leases from which the oil was produced in determining the gross income from those properties for the purpose of the depletion allowance under section 114(b)(3).

The Railroad Commission of Texas, hereafter called the Commission, at all times material hereto, had and exercised authority over oil and gas drilling and producing within the State, including the field known as the East Texas Oil Field in which all the properties involved herein were located. The Commission fixed the amount of oil which could be produced from wells and leases, and the amount so fixed is referred to as ‘allowable.’ Excessive salt water was produced along with oil in some instances, and the Commission permitted those operators whose properties were producing excessive amounts of salt water to shut in the wells, that is, to discontinue their operation and to produce from other wells or properties substantially the same amount of oil which they would have been allowed to produce from the shut-in wells. That is, they were allowed to transfer their allowable from a shut-in well to a producing well so that there could be produced from the latter not only its own allowable but the additional allowable transferred. The Commission permitted the transfer of the allowables from one operator to another or from one property to another where both were operated by the same person. An operator desiring to transfer an allowable from one of his leases which was shut in usually agreed with the royalty owners of that lease to continue in force the lease on the shut-in property by paying them amounts called substitute royalties based upon the amount of the allowable transferred.

DeMontrond Oil Corporation, a corporation related in no way to the petitioner, entitled in 1949 to transfer allowables on its lease of 25 acres of land known as...