Southwest Exploration Company v. Riddell

• Decision Date: 22 July 1964
• Docket Number: No. 63-852.,63-852.
• Citation: 232 F. Supp. 13
• Court: U.S. District Court — Southern District of California
• Parties: SOUTHWEST EXPLORATION COMPANY, by Signal Oil & Gas Company, Successor through Liquidation, Plaintiff, v. Robert A. RIDDELL, District Director of Internal Revenue, Los Angeles, California, Defendant.

232 F. Supp. 13

SOUTHWEST EXPLORATION COMPANY, by Signal Oil & Gas Company, Successor through Liquidation, Plaintiff, v. Robert A. RIDDELL, District Director of Internal Revenue, Los Angeles, California, Defendant.

No. 63-852.

United States District Court S. D. California, Central Division.

July 22, 1964.

COPYRIGHT MATERIAL OMITTED

Musick, Peeler & Garrett, Melvin D. Wilson, Peter C. Bradford, Los Angeles, Cal., for plaintiff.

Francis C. Whelan, U. S. Atty., Loyal E. Keir, Thomas H. McPeters, Asst. U. S. Attys., Los Angeles, Cal., for defendant.

BYRNE, District Judge.

On July 19, 1963, Southwest Exploration Company,¹ plaintiff, having duly complied with all conditions precedent, brought this action against Robert A. Riddell, District Director of Internal Revenue, Los Angeles, California, defendant. Plaintiff seeks to recover a portion of the Federal income taxes paid by it for the calendar year 1955.

A full understanding of what is involved in this action requires consideration of disputes rooted in events extending back to 1938.

In 1938 the State of California passed legislation designed to prevent the despoiling of beaches and interference with fishing by those who were developing undersea oil deposits belonging to the State. Plaintiff submitted a bid to the State wherein it sought the right to extract oil from those deposits. It proposed to comply with the State legislation by reaching the deposits by means of slant drilling from upland shore sites. Since the plaintiff did not own the land from and through which it proposed to drill, it entered into certain agreements with the owners of the property. After defining "net profits" the agreements provided that the land owners would receive a certain percentage of plaintiff's net profits from extraction and sale of the oil. The State of California accepted plaintiff's bid and it began operation under the agreements.

A dispute over who was entitled to depletion on the percentage share of the net profits arose almost immediately. Plaintiff declared that it was entitled to depletion on that portion of the profits, and treated the payments to the land owners as mere expenses. On the other hand, the land owners declared that they were entitled to depletion on the percentage share. Actions involving the disputed taxes for the calendar years 1939 through 1945 were commenced. In Southwest Exploration Co. v. Commissioner, 18 T.C. 961 (1952), affirmed 220 F.2d 58 (9th Cir. 1955) it was held that plaintiff was entitled to take depletion of the percentage of profits, for the land owners had no economic interest in the oil. However, in Huntington Beach Co. v. United States, 132 Ct.Cl. 427, 132 F. Supp. 718 (1955) it was held that one of the land owners was entitled to a depletion allowance on its share of the net income. Since it was clear that both were not entitled to depletion, the Supreme Court granted certiorari in both cases. On February 27, 1956, the Court decided that plaintiff was not entitled to depletion on the percentage of net profits and that the land owners were. Commissioner v. Southwest Exploration Co., 350 U.S. 308, 76 S.Ct. 395, 100 L.Ed. 347 (1956). In reaching its decision the Court analyzed the agreements between the parties and decided that as a question of "economic realities" the land owners had an interest in the oil. Thus, the proper treatment of the percentage of net profits for tax purposes became crystal clear. On mandate of the Ninth Circuit Court of Appeals the Tax Court of the United States entered final judgment against plaintiff on August 7, 1956.

During the years when the disputes over the 1939-45 taxes were pending, the plaintiff continued to take the position that it was entitled to depletion on all of the oil profits, including the percentage of net profits which was paid to the land owners. Therefore, on its Federal income tax returns for the calendar years 1950 through 1954 plaintiff took the position that it was entitled to a total depletion deduction greatly in excess of the amount ultimately determined to be proper by application of the 1956 decision of the Supreme Court. The excess amount was $3,817,949.98. On March 19, 1957, defendant issued his Revenue Agent's Report containing the proper computation of plaintiff's depletion allowance. The corrected computation was made by simply deducting the amount paid to the land owners from the gross income per plaintiff's returns, rather than treating it as a mere expense of operation. Interest was owed on the deficiency, and both the deficiency and the interest were paid during the year 1957.

In the Revenue Agent's Report of March 19, 1957, the defendant also told plaintiff for the first time that it was not entitled to deduct, as a current expense of its Oklahoma operations, a certain amount of intangible drilling costs $224,755.57, which plaintiff had deducted in its tax return for the calendar year 1954. This asserted deficiency was unrelated to the depletion question, and was simply another item uncovered by the defendant's agents while they were auditing the plaintiff's 1954 return. Interest was assessed on this asserted deficiency also, and plaintiff paid both the deficiency and the interest during the year 1957.

Of course, during the years that plaintiff was asserting its view as to the proper depletion allowance for Federal income tax purposes, it was taking a similar view regarding the proper allowance for State of California franchise tax purposes. Thus, plaintiff's State franchise tax returns for the calendar years 1950 through 1954 included a depletion deduction which was $3,994,633.72 greater than the amount which was finally allowed. On June 28, 1957, the State Franchise Tax Board (the Board) issued notices of proposed additional tax, based upon an audit of plaintiff's returns, which was commenced some time after January 1, 1957. The Board followed the decision of the United States Supreme Court, and it was this that caused the depletion allowance deficiency. Plaintiff paid this State tax and the interest thereon in 1957. The Board also determined that plaintiff had taken an excessive deduction for Oklahoma drilling costs on its 1954 return, and found that a deficiency arose out of that error. The excess amount was $465,001.38. This deficiency was first called to plaintiff's attention in 1957, and the additional tax and interest due thereon were paid in that year.

During the year 1956 another matter was being negotiated between plaintiff and defendant's agents. This negotiation concerned a reduction in plaintiff's excess profits taxes for the calendar years 1940 through 1945 and a deficiency proposed by defendant's agents for the years 1941 through 1945. The litigation over the proper depletion allowance for the years 1939-1945, which finally culminated in the Supreme Court decision of February 27, 1956, was indirectly related to the matters involved in this negotiation. However, it was only one of several factors utilized to establish the excess profits tax liability for the years 1941 through 1945. On November 26, 1956, plaintiff executed defendant's form No. 870-AD. This form was entitled "Offer of Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and of Acceptance of Overassessment." The form itself made it perfectly clear that it was merely an offer, and that it would not be accepted until the Joint Committee on Internal Revenue Taxation gave its approval thereto. The plaintiff thereby agreed to waive restrictions on assessment and collection of Federal income and excess profits tax deficiencies of $815,275.96 in return for allowance by defendant of a corresponding overassessment of excess profits taxes in the amount of $820,311.43. On or about August 6, 1957, plaintiff was notified that the Joint Committee had accepted the offer after considering it since about June 20, 1957. Interest was due on both the overassessment and on the deficiencies.

One further item of interest became due in 1957. That was the amount of $1,928.46, which accrued on the 1939-1945 deficiency during 1957, before the deficiency was paid.

On or about June 15, 1956, plaintiff filed its Federal income tax return for the calendar year 1955. The depletion allowance taken on this return was computed in accordance with the Supreme Court's decision of February 26, 1956. The income tax liability for 1955 was duly paid.

During the calendar year 1957 plaintiff sustained a net operating loss, which it sought to carry-back to the calendar year 1955, pursuant to 26 U.S.C. § 172. Plaintiff asserts that the operating loss is composed of the following items: (1) an undisputed net loss item $87,674.53; (2) the aforementioned interest on the 1950-1954 Federal income tax deficiencies; (3) the aforementioned additional California franchise taxes and interest thereon; (4) the aforementioned interest on Federal tax deficiencies from 1941 through 1945 less interest on the overassessments from 1940 through 1945; and, finally, (5) the aforementioned interest on the 1939-1945 Federal income tax deficiency. Defendant, for the most part, disallowed these items, with the exception of the first. However, pursuant to a stipulation of the parties, defendant now agrees that the fifth item should have been allowed also. Thus, only items (2) through (4) remain in controversy.

Defendant does not dispute the amount of the items involved. Nor does he claim that they are not proper deductions under 26 U.S.C. §§ 163 and 164. His sole contention is that each of these items accrued in 1956 rather than 1957. Since plaintiff uses a calendar year accounting period and the accrual method of accounting, defendant asserts that the deductions must be taken in 1956 rather than in 1957. Therefore, he argues, the amounts of tax and interest involved cannot be carried back from 1957 to 1955 pursuant to the provisions of 26 U.S.C. § 172.

The general principles applied to accrual method taxpayers are...