Southland Royalty Co. v. US

• Decision Date: 14 July 1978
• Docket Number: No. 12-75.,12-75.
• Citation: 582 F.2d 604
• Parties: SOUTHLAND ROYALTY COMPANY v. The UNITED STATES.
• Court: U.S. Claims Court

582 F.2d 604

SOUTHLAND ROYALTY COMPANY v. The UNITED STATES.

No. 12-75.

United States Court of Claims.

July 14, 1978.

R. Gordon Appleman, Fort Worth, Tex., attorney of record for plaintiff. Bird & Appleman, Fort Worth, Tex., of counsel.

Donald H. Olson, Washington, D.C., with whom was Asst. Atty. Gen. M. Carr Ferguson, Washington, D.C., for defendant. Theodore D. Peyser, Jr., Washington, D.C., of counsel.

Before COWEN, Senior Judge, and DAVIS and KUNZIG, Judges.

OPINION

DAVIS, Judge.

This is a corporate income tax dispute whether certain business expenditures should be deducted as ordinary and necessary expenses or should be capitalized. Taxpayer Southland Royalty Company ("Southland") is engaged in the oil and gas business. It keeps its books and reports its income and expenses for federal income tax purposes on the calendar year and accrual bases. The controversy resolves around the deductibility of legal expenses which Southland accrued during 1966, 1967, and 1968 in connection with litigation, and of expenses which it accrued during 1968 for a study of petroleum reserves. Senior Trial Judge White concluded that the plaintiff was entitled to take a current deduction for (1) the litigation costs incurred in 1966 in connection with the collection of royalties; (2) unrelated legal expenses incurred in 1967 and 1968 in a separate suit concerning the timing of the reversion of a leasehold; and (3) the costs of preparing the oil reserve survey incurred in 1968 as ordinary and necessary business expenses under I.R.C. § 162(a). In so deciding, the trial judge held that plaintiff was not required to capitalize the various costs pursuant to I.R.C. § 263, as contended by the defendant. We concur with this disposition of the first and third issues, but rule for the defendant on the second.¹

I.

Southland contends that each of the three items of expense involved in this suit was deductible for income tax purposes under I.R.C. § 162(a),² which provides that:

(a) In general. — There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business ....

I.R.C. § 263(a)(1), on the other hand, declares that:

(a) General Rule. — No deduction shall be allowed for —

(1) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate....

It is familiar law that I.R.C. § 263 (if applicable) takes precedence over I.R.C. § 162. I.R.C. §§ 161, 261.³ See Commissioner of Internal Revenue v. Idaho Power Co., 418 U.S. 1, 17, 94 S.Ct. 2757, 41 L.Ed.2d 535 (1974). Also, I.R.C. § 263 does not provide a complete list of nondeductible expenditures.⁴ Commissioner of Internal Revenue v. Lincoln Savings & Loan Assn., 403 U.S. 345, 358, 91 S.Ct. 1893, 29 L.Ed.2d 519 (1971). Expenditures incurred in the acquisition of a capital asset must generally be capitalized. Woodward v. Commissioner of Internal Revenue, 397 U.S. 572, 575, 90 S.Ct. 1302, 25 L.Ed.2d 577 (1970). "Ordinary," as used in I.R.C. § 162, differentiates between those expenses currently deductible versus those which must be capitalized and amortized over the life of the asset, if they are deductible at all. Commissioner of Internal Revenue v. Tellier, 383 U.S. 687, 689-90, 86 S.Ct. 1118, 16 L.Ed.2d 185 (1966). An expense satisfies the requirement of being "necessary" within the statute if it is "appropriate and helpful" to "the development of the taxpayer's business." Tellier, supra, 383 U.S. at 689, 86 S.Ct. 1118; Welch v. Helvering, 290 U.S. 111, 113, 54 S.Ct. 8, 78 L.Ed. 212 (1933).

For each of the items in controversy, defendant argues on the basis of the regulations that the expenditure must be capitalized because it was incurred: (1) in defending or perfecting title to property (Treas. Reg. § 1.263(a)-2(c)); (2) in the acquisition of property having a useful life substantially beyond the end of the taxable year (Treas. Reg. § 1.263(a)-2(a)); and/or (3) in adding to the value of, or substantially prolonging the life of, property owned by the taxpayer (Treas.Reg. § 1.263(a)-1(a)(1)-1(b)).⁵ We test the three claimed deductions by these general standards.

II. The 1966 Litigation Expenses

At the times pertinent to this litigation, Southland owned a fraction of the royalty interest in a certain 480-acre parcel of land located in Winkler County, Texas; two other companies, Avoca Corporation ("Avoca") and Socony Mobil Oil Company ("Mobil"), owned the remaining fractions of the royalty interest in the 480 acres; and Pan American Petroleum Corporation ("Pan Am") and Westbrook-Thompson Holding Corporation ("Westbrook") were the holders of a mineral lease on the land, authorizing them to mine and operate for oil, gas, potash, and other minerals.

The mineral lease referred to in the preceding paragraph contained three numbered royalty provisions, as follows:

(1) The first royalty provision required the lessee to deliver to the credit of the lessor (i. e., to Southland, Avoca, and Mobil, as successors to the original lessor insofar as the royalty interest was concerned), free of cost, "the equal one-eighth part of all oil produced and saved from the leased premises and 1/8 of the net proceeds of potash and other minerals at the mine."

(2) The second royalty provision required the lessee to pay the lessor $100 per year "for the gas from each well where gas only is found, while the same is being used off the premises * * *."

(3) The third royalty provision required the lessee to pay the lessor $50 per year "for gas produced from any oil well and used off the premises * * *."

In 1956, Pan Am and Westbrook drilled a deep well on the 480-acre parcel, and this well produced only gas. They began selling gas from this well in 1958. Two other deep gas wells were completed on the 480-acre parcel, one in 1958 and one in early 1959; and Pan Am and Westbrook began selling gas from these wells. Sales of gas from the three deep wells were running at the rate of more than a million dollars per year in 1959, after the completion of the third well.

As of 1959, Pan Am and Westbrook were paying Southland and the other royalty owners, in connection with the production and sale of gas from the three deep wells referred to in the preceding paragraph, at the rate of $100 per well per year, under the second royalty provision previously mentioned.

In 1959, Southland, Avoca, and Mobil filed suit against Pan Am and Westbrook in a Texas district court, seeking additional royalty payments on the gas produced and sold from the three wells mentioned in the two immediately preceding paragraphs of this opinion. Southland et al. contended in the litigation that they had the right to have their payments calculated on the basis of one-eighth of the net proceeds from the sale of the gas, under the phrase in the first royalty provision of the mineral lease requiring the payment of "1/8 of the net proceeds of potash and other minerals at the mine" (emphasis supplied); and that the second and third royalty provisions relative to lump-sum payments per well per year in connection with gas were applicable only to gas used by Pan Am and Westbrook off the leased land.⁶ On the other hand, Pan Am and Westbrook contended that the second and third royalty provisions, requiring the lessee to pay the lessor a flat sum per well per year relative to gas "while the same is being used off the premises," were applicable both to the use and to the sale of gas by the lessor; and that the first royalty provision was inapplicable to gas.

On motions for summary judgment by all parties (there being no dispute as to any material fact), the state district court sustained the position of Pan Am and Westbrook; and this judgment was later affirmed by the Texas Court of Civil Appeals.

The case was then taken to the Texas Supreme Court by Southland et al. The Texas Supreme Court first decided the case in favor of Pan Am and Westbrook on June 26, 1963. On motion for rehearing, however, the Texas Supreme Court on January 29, 1964, withdrew its prior opinions of June 26, 1963, substituted new opinions which construed the royalty provisions of the lease in favor of Southland et al., reversed the judgments of the district court and of the Texas Court of Civil Appeals, and remanded the cause to the district court for further proceedings in accordance with the new opinions. The Texas Supreme Court held (378 S.W.2d 50) that the first royalty provision was applicable to gas sold by Pan Am and Westbrook, and that the second and third royalty provisions were applicable only to gas used by Pan Am and Westbrook off the leased land. Further motions for rehearing were denied by the Texas Supreme Court.

The district court, on remand, entered a final judgment on June 29, 1964, determining the respective amounts due Southland et al. in accordance with the Texas Supreme Court's decision of January 29, 1964. Pan Am and Westbrook took an appeal; and on October 27, 1965, the Texas Court of Civil Appeals affirmed the district court's decision of June 29, 1964.

After Pan Am and Westbrook filed with the Texas Supreme Court an application for writ of error to review the Texas Court of Civil Appeals' decision of October 27, 1965, but before any action was taken by the Texas Supreme Court on the application, the parties entered into a settlement agreement which concluded the litigation. Under the settlement agreement, Southland on or about March 30, 1966, collected a lump sum of $168,990.78 representing royalties that had accrued to Southland's account through December 31, 1965, plus interest thereon in the amount of $26,247.81. In addition, the settlement provided for Southland to receive, from and after January 1, 1966, its proportionate share of royalty payments calculated on the basis of one-eighth of the net proceeds received by Pan Am and Westbrook from the sale of gas, as provided for in the...