Ambassador Petroleum Co. v. Commissioner

AMBASSADOR PETROLEUM COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Ambassador Petroleum Co. v. Commissioner Docket No. 40039. United States Board of Tax Appeals 28 B.T.A. 868; 1933 BTA LEXIS 1058; August 8, 1933, Promulgated *1058 1. BASIS FOR GAIN OR LOSS - COST OF PROPERTY ACQUIRED FOR STOCK AND CASH. - Where a corporation issues its capital stock for property plus some cash, the cost of the property to the corporation is the fair market value of the stock plus the cash paid. Seymour Mfg. Co.,19 B.T.A. 1280, followed. 2. BASIC DATE FOR VALUING STOCK. - Where a corporation agrees in 1920 to issue its capital stock in part payment for property but does not actually issue the stock until 1923, the basic date for valuing the stock to determine the cost of the property is in 1920 when the obligation to issue the stock was incurred. 3. DEPLETION - OIL AND GAS WELLS - PERCENTAGE BASIS - MEANING OF "NET INCOME OF TAXPAYER FROM THE PROPERTY" AS USED IN SECTION 204(c)(2), REVENUE ACT OF 1926. - Under section 204(c)(2) of the Revenue Act of 1926, if a taxpayer elects to treat development expenditures as ordinary and necessary business expenses deductible in computing taxable net income, such expenditures must also be deducted in determining the "net income from the property", which amount is used as a limitation in the computation of the percentage depletion allowance based on gross income. *1059 George Bouchard, Esq., and Joseph D. Brady, Esq., for the petitioner. J. M. Leinenkugel, Esq., R. W. Wilson, Esq., and Charles R. Vorck, Esq., for the respondent. BLACK *868 This proceeding is for a redetermination of a deficiency in income tax for the calendar year 1925 in the amount of $19,238.76. The amended petition alleges that the respondent erred (1) in disallowing as a deduction in computing petitioner's net income for the year 1925 the entire net loss claimed by petitioner for the year 1924 in the amount of $111,878.21; (2) in failing to determine that petitioner sustained a net loss for the year 1924 in an amount of not less than $150,000, by reason of the abandonment during the year 1924 of an oil and gas lease, the cost of which petitioner contends was the amount of $181,666.66 instead of $15,000 as determined by the respondent; and (3) in determining that petitioner's allowance for depletion for the year 1925 with respect to its own wells *869 was the amount of $73,745.41 instead of $119,687.05 (referred to in the record as $119,187.05). FINDINGS OF FACT. Petitioner is a corporation organized and existing*1060 under and by virtue of the laws of the State of California. It was incorporated on April 22, 1920, for the purpose of engaging in the business of producing oil, gas and other hydrocarbon substances from properties located in the Santa Fe Springs Oil Field of southern California. It had an authorized capital stock of $1,000,000 divided into 1,000,000 shares of the par value of $1 each. During the year 1919 the Wilshire Oil Co. acquired from the fee owners a leasehold interest in and to about 55 acres of land situated in Los Angeles County, State of California, and hereinafter referred to as parcel A. During the year 1919 S. S. Wold acquired from the fee owners a leasehold interest in and to about 55 acres of land situated adjacent to and immediately to the north of parcel A, and hereinafter referred to as parcel B. During the year 1919 H. O. Jones acquired from the fee owners a leasehold interest in and to about 55 acres of land situated adjacent to and immediately to the north of parcel A, and hereinafter referred to as parcel C. Each of the three above mentioned leases was for a term of 20 years and for so long thereafter as oil and gas were produced in paying quantities. *1061 On or prior to May 18, 1920, the Wilshire Oil Co. offered to assign to petitioner its leasehold interest in parcel A in consideration of 105,000 shares of petitioner's authorized capital stock as being fully paid, and the agreement of petitioner to pay the Wilshire Oil Co. $15,000 out of the first $45,000 received by petitioner over and above the first $100,000 which petitioner might receive from the sale of its stock or from the development of, or sale or other disposition of any portion of its interest in parcels A, B or C. Simultaneous offers to petitioner, identical to the one from the Wilshire Oil Co., were made by Wold and Jones, respectively, in connection with parcels B and C. Pursuant to a resolution of petitioner's board of directors adopted at a meeting held on May 18, 1920, all of the above mentioned offers were accepted by petitioner as made subject to the approval of the Corporation Commissioner of California as to the issuance of petitioner's stock; and the said leasehold interests in parcels A, B and C were, on May 25, 1920, assigned to petitioner by the respective owners. *870 On June 11, 1920, the Commissioner of Corporations of the State of California, *1062 pursuant to application of petitioner dated May 18, 1920, issued a permit authorizing petitioner to issue 105,000 shares of its capital stock of the par value of $1 per share to each of the three above mentioned owners. The permit also authorized petitioner to issue 315,000 shares at par for cash, but stipulated that the total commission, compensation and all other expense connected with the sale thereof should not exceed 20 percent of the selling price. At the time petitioner was organized in April 1920, seven persons subscribed for a total of 700 shares of petitioner's authorized capital stock. During the period between June 1920 and December 1922, the leasehold rentals and overhead of petitioner were paid by moneys advanced by Wilshire Oil Co. and other stockholders of petitioner. During the month of December 1922, petitioner offered for sale to its stockholders pro rata 105,000 shares of its capital stock of the par value of $1 and petitioner received, in installments paid during December 1922, and the months of January, February, March, and April 1923, the sum of $105,000 in cash, net to petitioner, for the said 105,000 shares. On August 14, 1923, petitioner issued*1063 the 105,000 shares that had been sold for cash during December 1922, the 315,000 shares to which the three lease owners had become entitled, and the 700 shares subscribed for by the seven original subscribers in April 1920. The aforesaid 165 acres consisting of parcels A, B and C, and hereinafter collectively described as parcel ABC, are located in what is known as the Santa Fe Springs Oil Field. During October 1919, Union Oil Co. brought in its well called No. "Meyer" 3. This was the discovery well of the Santa Fe Springs Oil Field. The initial production was reported to be at the rate of approximately 3,000 barrels per day. This lasted for but a few hours, when water broke in and killed the production, which thereafter was only about 150 barrels per day. This well was 2,725 feet due east of a point about 200 feet south of the northeast corner of Parcel C. At the time petitioned acquired its leasehold interests in parcel ABC, the Union Oil Co. was also drilling a well for the development of oil and gas about 2,000 feet east of the easterly line of parcel ABC which, on or about May 18, 1920, had attained a depth of about 3,000 feet; the Amalgamated Oil Co. was then drilling*1064 a well about 1,800 feet east of petitioner's easterly line which had attained a depth of about 2,900 feet; and the Wilshire Oil Co. was then drilling a well about 725 feet east of petitioner's easterly line which had attained a depth of about 2,500 feet. *871 During November 1921, Union Oil Co. brought in its well called No. "Bell" 1. This well was about 1 1/3 miles northwest of No. "Meyer" 3, and about 1,825 feet northeast of the northeast corner of parcel C. This well had a production of about 2,500 barrels of 30 gravity oil and was the cause of the activity which immediately took place in the Santa Fe Springs Oil Field. The western portion of parcel C was developed and operated by petitioner as lessee and the eastern portion was sublet by petitioner to the Buckeye Union Oil Co., the petitioner retaining an overriding royalty of one third. The first well on parcel C was completed by the Buckeye Union Oil Co. on March 21, 1923, with an initial production of 3,600 barrels per day of 34 gravity oil. By December 5, 1923, the Buckeye Union Oil Co. had completed five other producing wells on its portion of Parcel C. The first well completed by petitioner on parcel*1065 C was brought in on May 14, 1923, with an initial production of 9,000 barrels per day of 33 gravity oil. By December 9, 1923, petitioner had completed four other wells on the westerly portion of parcel C. During the month of February 1924, it became apparent to petitioner's officers and directors that the expenditure of substantial sums of money in drilling and developing parcel A would probably not prove sufficiently profitable to justify such expenditures. At a meeting of the board of directors of petitioner held on February 27, 1924, it was decided to abandon petitioner's interest in parcel A; and two days later petitioner delivered a quitclaim deed to the fee owners by which petitioner remised, released and forever quitclaimed unto the fee owners all of the right, title and interest which petitioner had in said parcel A. Petitioner, in filing its income tax return for the year 1925, deducted, under section 206(e) of the Revenue Act of 1926, a net loss for the year 1924 of $111,878.21. In arriving at the alleged net loss petitioner deducted from other income which it had for 1924 an amount of $120,000 as the alleged cost (capital stock $105,000; cash $15,000) to it of its*1066 leasehold interest in parcel A which it had abandoned as set forth above. The respondent determined that the cost to petitioner of its abandoned leasehold interest in parcel A was only the amount of the cash paid for the lease, namely $15,000, and that the 105,000 shares of capital stock issued for the lease had no fair market value. The fair market value of the 105,000 shares of petitioner's capital stock which in 1920 it agreed to issue in payment for a leasehold on parcel A, was $105,000. This was also the par value of the stock. *872 In interpreting section 204(c)(2) of the Revenue Act of 1926, the respondent determined that petitioner's deduction for percentage depletion from its wells on parcel C was limited to the amount of $73,745.41, computed as follows (Note: The stipulation which we incorporate herein by reference shows this computation in greater detail than stated below): Gross sales of oil and gas $499,956.95 Less: Royalties paid 83,326.15 "Gross income from the property" $416,630.80 Deductions: Operating expenses: Production $98,333.42 Warehouse 1,112.08 Administration 18,528.38 Production repairs 19,869.66 Warehouse repairs 86.23 Taxes 8,187.33 Depreciation 27,411.82 Bad debts 7.15 Miscellaneous 3,720.63 $177,256.70 Development expenses: Repairs 10,569.70 Depreciation 67,171.93 Expense No. 6 14,141.65 91,883.28 269,139.98 "Net income of the taxpayer 147,490.82 (computed without allowance for depletion) from the property Percentage depletion limited 73,745.41 to 50% *1067 Petitioner has always, including the taxable year in question, elected under the option permitted in the respondent's regulations to treat development expenditures as ordinary and necessary business expenses deductible from gross income in determining net income rather than as chargeable to the capital account returnable through depletion and depreciation. OPINION. BLACK: We are asked to determine the amount of petitioner's net loss, if any, for the taxable year 1924 which petitioner seeks to deduct from its net income for the year 1925, and the amount of depletion deductible from petitioner's gross income for the year 1925. These are the only two issues in this proceeding. The parties have stipulated that if petitioner sustained a loss on the abandonment of its leasehold interest in parcel A in excess of $23,817.11, then and in that event it sustained a net loss within the *873 meaning of section 206 of the Revenue Act of 1924, in the amount of such excess. In his deficiency notice the respondent determined that petitioner sustained a loss on the abandonment of its leasehold interest in parcel A in the amount of $15,000, and stated in part: Lease was acquired*1068 * * * for $15,000.00 cash and an issuance of 105,000 of its own capital stock. The stock, having no market value and not having been issued until August 14, 1923, the only amount allowable as a deduction from gross income on the abandonment of the lease is the cash paid for same * * *. Petitioner contends that the 105,000 shares of its capital stock given in part payment for the leasehold interest had a fair market value of at least $166,666.66 and that its loss due to the abandonment of the lease was $181,666.66 instead of $15,000 determined by the respondent. Under section 204(a) of the Revenue Act of 1924, the basis for determining the loss here claimed is the cost of the property abandoned. In Seymour Mfg. Co.,19 B.T.A. 1280, we said: "The cost of property acquired for stock is the 'fair market value' of the stock." What was the fair market value in 1920, at the time parcel A was acquired, of the 105,000 shares which petitioner obligated itself to issue to the Wilshire Oil Co.? Respondent makes the point that the stock was not actually issued until August 14, 1923, but we see nothing important about that. In this connection see *1069 Anita Owens Hoffer,24 B.T.A. 22, 27. As far as the record shows, the only assets acquired by petitioner at the time of organization were the three leasehold interests in parcels A, B and C. There were no sales of petitioner's stock at or about the basic date, other than petitioner's agreement to issue 315,000 shares for the three leases, and the 700 shares originally subscribed and sold for $1 per share. Under such circumstances it is proper to consider evidence tending to prove the fair market value, if any, of the leases on the date acquired by petitioner. Commissioner v. Swenson, 56 Fed.(2d) 544; Melville Hanscom et al., Executors,24 B.T.A. 173; Herman Adaskin,8 B.T.A. 460. Cf. also Walls v. Commissioner, 60 Fed.(2d) 347; Mount v. Commissioner, 48 Fed.(2d) 550; Patterson v. Commissioner, 42 Fed.(2d) 148; O'Meara v. Commissioner, 34 Fed.(2d) 390; and Mead Realty Co.,21 B.T.A. 1062. We have examined the evidence carefully and, on the basis of the fair market value of the lease (parcel A) on the date acquired, *1070 we find the fair market value of the stock contracted to be issued for the lease was $1 per share, which was its par value. This makes the cost of the lease in question $105,000 paid in stock plus $15,000 which was paid the seller in cash. *874 This corresponds with the way petitioner returned the transaction for taxation purposes in 1924 and we think is well supported by the facts. At the hearing petitioner introduced the testimony of two witnesses to show that the lease on all three tracts, A, B and C, 165 acres in all, had a fair market value of $500,000 at the time they were transferred to petitioner and that one third of this amount, or $166,666.67, was properly allocable to tract A, abandoned in 1924. We are not convinced by this testimony. We are convinced that, considering the location of tract A with reference to the original discovery well in the Santa Fe Springs Oil Field and the other wells which were being drilled at that time in nearby outlying territory, the demand for oil leases and all other relevant circumstances, the lease in question was worth what was paid for it; viz., $15,000 in cash and 105,000 shares of stock of petitioner, of a par value of*1071 $1 per share, which we hold had an actual value of $1 per share. The Corporation Commission of the State of California authorized petitioner to issue 105,000 shares of its stock of the par value of $1 per share for the lease in question plus the $15,000 which was to be paid in cash, and we are satisfied that this estimate by the Corporation Commission of the valuation was reasonably correct at the time. Subsequent events proved that the three leases taken together had a value greatly in excess of the $500,000 claimed by petitioner as of the basic date, but it is not subsequent events from which we are to determine value at the basic date. If that were true, then we should find that tract A had no value because it ultimately proved to be worthless and was entirely abandoned in 1924, whereas tract C, on which the producing wells were subsequently brought in, proved to be of great value. It is by the conditions and known facts which existed in 1920 that we must judge to find our valuation in 1920, and, applying that test, we are of the opinion that petitioner treated the cost of parcel A correctly in its income tax return for 1924, viz., a cost of $120,000. Petitioner's net loss*1072 for 1924 should be determined accordingly. The second issue is whether the respondent erred in determining that petitioner's deduction for percentage depletion was limited under section 204(c)(2) of the Revenue Act of 1926 (quoted in the margin 1) to the amount of $73,745.41. The respondent's computation is set out in our findings. *875 Petitioner does not contend that the depletion allowance determined by the respondent is "less than it would be if computed without reference to" section 204(c)(2), supra, and that it should, therefore, be determined under section 234(a)(8) of the same act. Both parties agree that petitioner's depletion allowance should be determined under section 204(c)(2), supra, but it is petitioner's*1073 contention that in determining the "net income of the taxpayer (computed without allowance for depletion) from the property," the respondent erred in deducting development expenses in the amount of $91,883.28. The Revenue Act of 1926 eliminated so called discovery depletion entirely as far as oil and gas wells were concerned and substituted in its place the percentage depletion of 27 1/2 percent subject to the limitation already stated. The regulations promulgated under the 1926 Act continued the provisions granting an election to either capitalize or deduct as a development expense all expenditures in connection with the exploration and development of properties, 2 and defined 3 the phrase "net income" as used in section 204(c)(2), as follows: * * * The phrase "net income of the taxpayer (computed without allowance for depletion)" means the gross income from the sale of all mineral products from the mining property and any other income incidental to the operation of the property for the production of mineral products, less the deductions in respect to the property upon which the discovery is made, including operating expenses, depreciation, taxes, losses sustained, etc.*1074 , but excluding any allowance for depletion. * * * [Italics supplied.] On September 26, 1927, the respondent published an opinion by the General Counsel of the Bureau of Internal Revenue, known as G.C.M. 2315 (VI-2 C.B. 21), the material portion of which as set out in the margin. 4 *1075 Section 114(b)(3) of the Revenue Acts of 1928 and 1932 is identically the same as section 204(c)(2) of the Revenue Act of 1926 *876 (see footnote No. 1), except that the Revenue Act of 1932 added at the close of the first sentence the phrase "excluding from such gross income an amount equal to any rents or royalties paid or incurred by the taxpayer in respect of the property." It has been the consistent practice of petitioner since its organization to elect to deduct from its statutory gross income in determining its statutory net income all "development expenses" as ordinary and necessary business expenses. It is petitioner's contention that the administrative practice of the respondent in construing the provisos limiting discovery depletion in the Revenue Acts of 1921 and 1924 to mean that the "net income from the property" should be computed without regard to development expenditures regardless of whether the taxpayer elected to treat such expenditures as ordinary and necessary business expenses or to charge them to capital, must be deemed as having received legislative approval by Congress in the reenactment by Congress of a similar proviso limiting percentage depletion*1076 in the Revenue Act of 1926; and that, therefore, the ruling in G.C.M. 2315, supra, is in error in so far as it holds that in determining the "net income of the taxpayer (computed without allowance for depletion) from the property" under section 204(c)(2) of the 1926 Act, development expenditures must be deducted in those cases where the taxpayer has elected to treat such development expenditures as ordinary and necessary business expenses deductible from statutory gross income in determining statutory net income under other sections of the act. See Brewster v. Gage,280 U.S. 327; Murphy Oil Co. v. Burnet,287 U.S. 299; and United States v. Dakota-Montana Oil Co.,288 U.S. 459. Petitioner further contends that in any event the respondent's construction of the earlier acts is the correct construction for the reason that Congress could never have intended the "net income * * * from the property" to have one meaning *877 for taxpayers who elect to capitalize development expenditures and an entirely different meaning for taxpayers who elected to deduct from statutory gross income such expenditures as*1077 ordinary and necessary business expenses. We do not feel that we are called upon in this proceeding to decide whether or not the Commissioner's regulations dealing with discovery depletion under the 1921 and 1924 Acts and his consistent practice with reference thereto, were correctly interpretative of the law as written in these acts. The act we have here for interpretation is the 1926 Act, which abandoned discovery depletion so far as oil and gas wells are concerned and substituted a flat percentage basis of depletion, subject to a limitation. This limitation was that the percentage allowance for depletion should in no case exceed 50 per centum of the net income of the taxpayer (computed without allowance for depletion) from the property, etc. This section 204(c)(2), although it contained some of the same language used in prior acts in defining discovery depletion, was an entirely new provision and naturally called for new interpretative regulations on the part of the Commissioner of Internal Revenue. The Commissioner has construed the words "The net income of the taxpayer from the property" contained in section 204(c)(2), Revenue Act of 1926, to mean that if a taxpayer elects*1078 to treat development expenditures as ordinary and necessary business expenses deductible under section 214(a)(1) or section 234(a)(1) of the same act in computing taxable income from the property, such expenditures must be deducted in determining the net income from the property, which amount is used as a limitation in the computation of the depletion allowance based on income. As we have already pointed out, the provisions as to percentage depletion deductions granted in the case of income from oil and gas wells are substantially the same in the 1928 and 1932 Acts as in the 1926 Act, and the Commissioner in his regulations applicable to the 1928 and 1932 Acts gives the same construction to the words "net income of the taxpayer from the property" as he has given in applying the provisions of the 1926 Act to the instant case. For example, article 221(i), Regulations 74, 1928 Act, reads in part: The phrase "net income of the taxpayer (computed without allowance for depletion)" means the gross income from the sale of oil and gas less the deductions in respect to the property upon which depletion is claimed, including overhead and operating expenses, development expenses (if the*1079 taxpayer has elected to deduct development expenses), depreciation, taxes, losses sustained, etc., but excluding any allowance for depletion. [Italics supplied.] To the same effect is article 221(h) of Regulations 77, Revenue Act of 1932. *878 We think this construction by the Commissioner of the meaning of "net income" of the taxpayer from the property is correctly interpretative of the meaning of the words as used in the revenue act now under consideration, section 204(c)(2), Revenue Act of 1926. We therefore hold that respondent committed no error when he reduced petitioner's gross income from the property in question by the sum of $91,883.28 for the taxable year 1925, in which year petitioner incurred that amount in the development of the property from which the income was received and claimed such amounts as allowable deductions in determining its net income for 1925, which deductions were allowed by respondent. Reviewed by the Board. Decision will be entered under Rule 50. Footnotes 1. Sec. 204(c)(2). In the case of oil and gas wells the allowance for depletion shall be 27 1/2 per centum of the gross income from the property during the taxable year. Such allowance shall not exceed 50 per centum of the net income of the taxpayer (computed without allowance for depletion) from the property, except that in no case shall the depletion allowance be less than it would be if computed without reference to this paragraph. ↩ 2. See art. 223, Regulations 69, and I.T. 2338, VI-1 C.B. 74↩. 3. Art. 201(h), Regulations 69. See also art. 1602, Regulations 69. ↩ 4. Shortly after the enactment of the Revenue Act of 1921, the construction of the proviso inserted in section 234(a) 9 of the Act that the "depletion allowance based on discovery value shall not exceed the net income, computed without allowance for depletion, from the property upon which the discovery is made" was given consideration by the Bureau, and the decision was reached that the "net income from the property" referred to in the proviso should be computed without regard to development expenditures; that is, that development expenditures should not be treated as a deduction in computing the "net income from the property" regardless of whether the taxpayer corporation under article 223 of Regulations 62 elected to treat such expenditures as operating expenses deductible in computing taxable income or to charge them to capital returnable through depletion. In view of the decision made at that time, the fact that it has been uniformly followed in closing a great number of cases, and the desirability of a consistent administration of the provision in question, the conclusion is reached that in applying the limitation on discovery depletion in the case of oil and gas wells provided for in section 234(a) 9 of the Revenue Act of 1921, the gross income from a discovery property should not be reduced by development expenditures in the computation of the "net income from the property," which amount measures the maximum depletion allowance based on discovery which can be allowed in respect to such property. A like construction should be followed in applying the provisions of section 214(a) 10 of the Revenue Act of 1921 and the provisions of section 204(c) of the Revenue Act of 1924. The latter section restricts a depletion allowance based on discovery value to "50 per centum of the net income (computed without allowance for depletion) from the property upon which the discovery is made." The construction herein adopted relative to discovery depletion in the case of oil and gas wells under the 1921 and 1924 Acts should be confined to those Acts. Under section 204(c) 2 of the Revenue Act of 1926, provision is made that in the case of oil and gas wells the allowance for depletion based upon the gross income from the property "shall not exceed 50 per centum of the net income of the taxpayer (computed without allowance for depletion) from the property." The term "net income" as used in that section should be taken to mean the net income defined in sections 212 and 232 of the Act. Accordingly, if a taxpayer elects to treat development expenditures as ordinary and necessary business expenses deductible under section 214(a) 1 or 234↩(a) 1 in computing taxable net income, such expenditures must be deductible in determining the net income from the property, which amount is used as a limitation in the computation of the depletion allowance based on income.