Standard Oil Co. v. Comm'r of Internal Revenue

• Decision Date: 27 May 1970
• Docket Number: Docket No. 3613-68.
• Citation: 54 T.C. 1099
• Parties: STANDARD OIL COMPANY (INDIANA), PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

54 T.C. 1099

STANDARD OIL COMPANY (INDIANA), PETITIONER

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 3613-68.

United States Tax Court

Filed May 27, 1970.

Lee I. Park and Glenn L. Archer, Jr., for the petitioners.

J. C. Linge, for the respondent.

In 1955 T assigned gas rights in certain oil and gas leases in return for annual payments based on the volume of actual or possible gas production. Apart from a cash payment for physical equipment and facilities, T received no present consideration and looked solely to the deferred annual payments in respect of gas production or potential gas production as consideration for the gas reserves themselves. No limit was placed on the amount of such payments, and the assignee was not permitted to sell any of the assigned gas rights without the consent of T. In 1958 the parties modified the instruments under which the assignments had been made by setting a $134,619,000 limit on the amount of the deferred payments owed by the assignee and by permitting the assignee to sell the gas rights without obtaining T's consent, provided that T would be entitled to one-half of the proceeds of such sale. At the time the modifications were made, a reasonable estimate of the time required to pay the total consideration, in view of the variables involved, would have been between 50 and 100 years; the assignee was not required to pay interest on the unpaid balance. Held: As a practical matter in the circumstances of this case, T looked solely to gas production as the source of the deferred payments and consequently retained an ‘economic interest’ in the gas properties in question. Deferred payments received in 1958 and 1959 therefore represent ordinary income to T rather than the proceeds of sale of a capital asset.

The Commissioner determined deficiencies of $261,786.85 and $395,085.70 in the consolidated income tax of petitioner and its affiliated corporations for the calendar years 1958 and 1959, respectively. The only issue remaining for decision involves payments made in 1958 and 1959 by Pacific Northwest Pipeline Corp. to Pan American Petroleum Corp., one of petitioner's subsidiaries. The question presented is whether the payments represented part of the sale price of interests in certain oil and gas leases and therefore reflect long-term capital gain to Pan American, or whether, on the other hand, the payments were made in respect to Pan American's retained interest in the leases and therefore constitute ordinary income to Pan American.

FINDINGS OF FACT

The parties have stipulated certain facts, which, together with the attached exhibits, are incorporated herein by this reference.

Petitioner, Standard Oil Co. (Ind.), hereinafter referred to as Standard, is a corporation organized under the laws of the State of Indiana. Its principal place of business and principal office is located at 910 South Michigan Avenue, Chicago, Ill. Standard, as the parent corporation, and affiliated companies filed consolidated returns for the calendar years 1958 and 1959 with the district director of internal revenue, Chicago, Ill. At all times material, the books of Standard and its affiliated companies were maintained on an accrual basis.

At all times herein relevant, Standard and its affiliates were engaged in the business of acquiring, exploring, and developing oil and gas properties, and producing, refining, and marketing petroleum and petroleum products.

Pan American Petroleum Corp., formerly known as Stanolind Oil & Gas Co. and hereinafter sometimes referred to as Pan American or Stanolind, is a wholly owned subsidiary of Standard and filed consolidated returns with Standard for the taxable years 1958 and 1959. Prior to March 15, 1955, Pan American acquired certain oil and gas leases in an area in New Mexico and Colorado commonly known as the San Juan Basin. It had been generally known for some time that the Basin included a number of different formations and structures which might be productive oil and/or gas. The Basin encompassed separate subareas which were identified by their individual names. The leases were located in the subareas known as the Bondad area (La Plata County, Colo.), the Township Units area (Rio Arriba County, N. Mex.), the Rosa Unit area (Rio Arriba and San Juan Counties, N. Mex.), the Ignacio area (La Plata County, Colo.), the N.W. Cedar Hill (South Bondad) area (La Plata County, Colo.), the Huerfano area (San Juan County, N. Mex.), the North Rosa area (Rio Arriba and San Juan Counties, N. Mex.), and the Arboles area (La Plata and Archuleta Counties, Colo.). Typically, a lease remained in effect for a term of years or so long thereafter as oil or gas was, or in some cases could be, produced. Each lease ordinarily required a 12 1/2-percent royalty on the production under the lease or on the proceeds from the sale of the oil or gas produced; in some cases, a small initial cash payment or a nominal minimum annual royalty was also required.

On March 16, 1955, Pan American transferred certain interests in its San Juan Basin leases to Pacific Northwest Pipeline Corp. (Pacific). Pacific was a natural gas pipeline company, producing, transporting, and selling natural gas. It was formed sometime prior to 1955 for the purpose of obtaining a certificate from the Federal Power Commission (FPC) authorizing it to construct and operate a pipeline from the four-corners area of Colorado, New Mexico, Utah, and Arizona— where the San Juan Basin was located— to the Canadian border, north of Seattle, Wash. But before Pacific could receive authority to operate the pipeline, it had to satisfy the FPC's gas supply requirement. The proposed pipeline was to take part of its supply from the San Juan Basin, and in entering the transaction with Pan American, Pacific was interested in securing gas rights only. Although Pan American was engaged to a certain extent in the production and sale of gas in addition to its petroleum business, it was not interested in continuing to exploit the gas reserves in the San Juan Basin properties covered by the foregoing leases, notwithstanding that it had already expended $1,422,227.62 for equipment, facilities, and productive gas wells in respect of such properties. Pan American was primarily interested in oil, and the March 16, 1955, transaction was designed in such manner as to reserve to Pan American any oil of consequence that might be within the leased properties.

In order to effectuate the transaction, Pan American and Pacific entered into eight contracts specifying their rights and obligations with respect to the leases. Only six of the contracts (relating to an aggregate of some 564 leases) are involved in this proceeding; Pan American received no payments attributable to the other two contracts during the years in question. Each contract was designated as a ‘Sales Contract and Operating Agreement’ and governed the leases in one of the subareas named above. The interests assigned to Pacific were limited to certain geological formation (the Pacific formations), each of which was though to be gasbearing only. Oil and gas rights in the remaining formations were retained by Pan American. Each formation represents a different geologic layer or subsurface stratum of the earth and is identified by a characteristic name. The formations in which Pacific was assigned interests were, in descending order from the surface, the Pictured Cliffs (Fruitland-Pictured Cliffs in Colorado), the Mesa Verde, and the Dakota, all of which were above the Morrison formation. The contract numbers for the six contracts involved herein and the subareas and formations governed by each contract were as follows:

+---------------------------------------------------------+
                ¦Contract  ¦         ¦                                    ¦
                +----------+---------+------------------------------------¦
                ¦No.       ¦Subarea  ¦Formations                          ¦
                +----------+---------+------------------------------------¦
                ¦27836     ¦Bondad   ¦All formations above the base of the¦
                +---------------------------------------------------------+
                

                     Morrison formation
                27834 Township Units All formations above the base of the Mesa
                

                Verde formation
                27833 Rosa Unit All formations above the base of the Mesa
                

              Verde formation
                27832 Ignacio All formations below the base of the Pictured
                

                           Cliffs formation and above the base of the
                                           Morrison formation
                27831 Northwest Cedar Hill All formations above the base of the Mesa
                      (South Bondad)       Verde formation
                27829 Huerfano             All formations above the base of the Pictured
                

  Cliffs formation
                

After reciting that Pan American (Stanolind) had ‘conveyed and assigned’ certain oil and gas leases to Pacific, each contract went on to state that such conveyances and assignments were subject, inter alia, to the terms of such contract, which governed the ‘interdependent rights and obligations of the parties with respect to the maintenance, development, operation, payment for the rights conveyed, and release or reassignment of the leases.’

Relevant provisions of the contract which followed may be summarized as follows: Pan American agreed to transfer to Pacific, in return for an amount equal to its cost, its interest in lease equipment, facilities, and productive wells on the property covered by the assigned leases; payment for such physical equipment, facilities, and productive wells was to be made in full contemporaneously with the execution of the contract by certified or cashier's check. Pacific agreed to develop the assigned oil and gas rights at least as rapidly as it developed other properties in the area which had been assigned to it by other parties. (Pacific acquired substantial gas reserves in the San Juan Basin from parties other than Pan American.) In any event, Pacific was required to develop at least 25 percent of the net...