United States v. Oil Co

Decision Date13 March 1933
Docket NumberNo. 434,DAKOTA-MONTANA,434
CourtU.S. Supreme Court

The Attorney General and Mr. G. A.Youngquist, Asst. Atty. Gen., for the United States.

Mr. Herman J. Galloway, of Washington, D.C., for respondent.

Mr. Justice STONE delivered the opinion of the Court.

Respondent, a North Dakota corporation, in making its tax return of income derived from its operation of oil wells in 1926, claimed a deduction from gross income of a depreciation allowance on account of the capitalized costs of preliminary development and drilling. The Commissioner refused to allow the deduction claimed, ruling that it was for depletion, not depreciation, and was therefore included in the statutory depletion allowance of 27 1/2 per cent. of the gross income, which the respondent had also deducted. Sections 204(c), 234(a)(8), Revenue Act of 1926, c. 27, 44 Stat. 9, 14, 16, 41, 26 USCA §§ 935(c), 986(a)(8). Having paid the correspondingly increased tax, respondent brought this suit in the Court of Claims to recover the excess. The court gave judgment for respondent, holding that the development and drilling costs were the proper subjects of a depreciation allowance which should have been made in addition to that for depletion. 59 F.(2d) 853. This Court granted certiorari (287 U.S. 591, 53 S.Ct. 120, 77 L.Ed. —-) to resolve a conflict of the decision below with that of the Circuit Court of Appeals for the Fourth Circuit in Burnet v. Petroleum Exploration, 61 F.(2d) 273.

The Revenue Act of 1926, like earlier acts,1 provided generally that 'in the case of * * * oil and gas wells,' taxpayers should be allowed, as a deduction from gross income, 'a reasonable allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each case'; such allowance 'in all cases to be made under rules and regulations to be prescribed by the commissioner with the approval of the Secretary.' Section 234(a)(8). The earlier acts provided that depletion should be allowed on the basis of cost unless the taxpayer was the discoverer of the well upon an unproven tract, in which case the basis was the 'value of the property' at the time of the discovery or within 30 days thereafter.2 See Palmer v. Bender, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489, decided January 9, 1933. But the 'discovery value' provision was eliminated from the act of 1926, which is applicable here, and the taxpayer was permitted to calculate depletion on the basis of cost alone, section 204(c), 26 USCA § 935(c), or else to deduct an arbitrary allowance, fixed by the statute, without reference to cost or discovery value, at 27 1/2 per cent. of gross income from the well.3

Articles 223 and 225 of Treasury Regulations 69, under the Revenue Act of 1926, were followed by the Commissioner in assessing the present tax. Article 223 purports to permit the taxpayer to choose whether to deduct costs of development and drilling as a development expense in the year in which they occur or else to charge them 'to capital account returnable through depletion.' In the latter event, which is the case here, 'in so far as such expense is represented by physical property, it may be taken into account in determining a reasonable allowance for depreciation,' which, if the arbitrary deduction for depletion were claimed, would constitute an additional allowance. Article 225 limits the depreciation for which an allowance may be made to that of 'physical property, such as machinery, tools, equipment, pipes,' etc. We do not doubt that the effect of this language is to require the taxpayer to look to the depletion allowance, in this case 27 1/2 per cent. of gross income, for a return of the costs of developing and drilling the well, which are involved here.

Respondent challenges the validity of the regulations thus applied as in conflict with section 234(a)(8), 26 USCA § 986(a)(8), which allows the deduction of a reasonable allowance 'for depreciation of improvements' in addition to the deduction for depletion. It is urged that the drill hole is an 'improvement' of the taxpayer's oil land, and that no logical distinction in accounting practice can be made between the cost of this improvement and the cost of buildings and machinery placed on the property for the operation of the well, for which depreciation should admittedly be allowed.

The government argues that the well itself is not tangible physical property which wears out with use so as properly to be the subject of depreciation, and that in any event the regulations are based upon the practices of the oil industry, and are within the requirements of section 234(a)(8) that a reasonable allowance for depletion and depreciation of improvements be made in all cases under rules and regulations to be prescribed by the Treasury Department.

We do not stop to inquire whether, under correct accounting practice, an anticipated loss of a part of the capitalized cost of developing and drilling an oil well because of decreased utility of the well would be described or treated differently than wear and tear of the machinery used in production, or whether an allowance for the former serves a purpose logically distinguishable from one for the latter. For the issue before us, whether the statute requires the former to be treated as depletion, is resolved by the history of the legislation and the administrative practice under it.

The Revenue Act of 1916 permitted the deduction of a reasonable allowance for the 'exhaustion, wear and tear of property' used in a business or trade and in the case of oil and gas wells 'a reasonable allowance for actual reduction in flow and production.' Section 12(b) Second (39 Stat. 767). The regulations authorized the deduction of an annual allowance for 'depreciation,' and, in the case of oil and gas wells, for 'depletion' (Treasury Regulations 33, arts. 159, 160, 162, 170), but ruled that no annual deduction for 'obsolescence' was authorized by the statute in any case; such a loss it was provided might only be deducted in the year when it became complete by abandonment of the property as no longer useful. See articles 162, 178, 179 of Treasury Regulations 33; Gambrinus Brewery Co. v. Anderson, 282 U.S. 638, 643, 51 S.Ct. 260, 75 L.Ed. 588. In defining these terms, therefore, the Department was apparently faced with the practical consequence that no annual deduction could be made in anticipation of those losses which it regarded as attributable to obsolescence, while such a deduction might be made for those which it attributed to depreciation or depletion. Depreciation was defined generally to include the wear and tear and exhaustion of property by use, and obsolescence, the loss in value of property due to the fact that because of changing conditions it has ceased to be useful.

Plainly, under these definitions the loss in value of the drill hole for an oil well, because of the approaching exhaustion of the oil in the ground, was not to be treated as depreciation. Article 170 of Regulations 33 neces sarily ruled that it was not to be treated as obsolescence by declaring that the purpose of the statutory provision relative to oil wells was to return, through the aggregate of annual depletion deductions, the taxpayer's capital investment in the oil, including 'the cost of development (other than the cost of physical property incident to such development).' Article 170 thus contemplated that an annual deduction should be made for costs of development by including them in the cost of the oil in the ground for which a depletion allowance was authorized by section 12(b), Second, 'for actual reduction in flow and production.'

While the Revenue Acts which followed that of 1916 provided that taxpayers generally might deduct 'a reasonable allowance for obsolescence' in addition to that 'for the exhaustion, wear and tear of property used in the trade or business,'4 in each of them the section expressly applicable to oil and gas wells,5 omitted the word obsolescence and provided, in terms, only for the deduction of an allowance for depletion and for depreciation of improvements. Whatever doubts this omission may have suggested as to the propriety of an allowance for obsolescence in the case of oil and gas wells, raising the same problem as that under the act of 1916, the question whether an allowance should be made for development and drilling costs was set at rest, where cost was the basis of depletion and depreciation of improvements, by the express language of the acts of 1918 and 1921, that the cost basis should include 'costs of development not otherwise deducted.' But the questions remained whether the allowance was to be treated as for depreciation or depletion, and, more important, whether any allowance could be made for development costs when the basis of depletion was discovery value rather than cost.6 In answering these questions, the Department adhered to and made explicit the position taken by it under the 1916 act that development costs other than the cost of physical property incident to the development must be returned through the depletion allowance, but the regulations also provided expressly that...

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