Spalding v. Commissioner

CAROLINE C. SPALDING, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Spalding v. Commissioner Docket Nos. 76262, 77218. United States Board of Tax Appeals 35 B.T.A. 132; 1936 BTA LEXIS 556; Dec. 4, 1936, Promulgated *556 1. Income from an oil and gas lease obtained by petitioner from the State of California is not exempt from tax. Bankline Oil Co.,33 B.T.A. 910, followed. 2. Petitioner, after obtaining the above mentioned lease, entered into an agreement with an oil company whereby it was to develop and operate the lease at its own expense and to receive therefor two-thirds of the proceeds from the sale of oil and gas. Held, that the development and operation of the lease was the enterprise of the oil company and that petitioner may not include in her gross income for the purpose of computing her depletion allowance any portion of the proceeds received by the oil company in accordance with the agreement. Joseph D. Peeler, Esq., for the petitioner. John H. Pigg, Esq., and Arthur Clark, Esq., for the respondent. TURNER *132 These proceedings involve deficiencies in income tax for the years 1931 and 1932 in the amounts of $7,027.16 and $37,168.95, respectively. Two questions are raised by the allegations of error contained in the petitions - first, whether or not income received by the petitioner under a certain oil and gas lease*557 granted to her by the State of California is exempt from tax, and, second, if the income from the lease is taxable, whether the respondent erred in computing the depletion deduction on the basis of one-third of the production from the lease instead of total production. By amended answer the respondent raises an alternative issue, alleging that in the event the first issue raised in the petition is decided favorably to him and the second issue is decided adversely, the income of the petitioner should be increased by the amounts of certain expenditures made on the leased *133 property by the Pacific Western Oil Co., which at its own expense developed and operated the lease for two-thirds of the total sales, less selling costs of all oil, gas, and casinghead gasoline produced therefrom. FINDINGS OF FACT. The petitioner, an individual, maintains an office at 824 Richfield Building, Los Angeles, California. On March 21, 1929, the State of California, under the provisions of chapter 303, Statutes of California, 1921, entitled "An act to reserve all minerals in state lands, etc.", granted to petitioner a permit to prospect for oil and gas upon certain tide and submerged lands*558 in the Pacific Ocean, Santa Barbara County, California. On November 22, 1929, petitioner entered into a lease agreement, known as lease No. 93, with the State of California for the production of oil and gas from the lands covered by the permit just mentioned. The lease was for a term of 20 years, with a preferential right in the petitioner to renew it for successive periods of 10 years each. The lease prescribed the terms and conditions for drilling and producing oil on the premises, including a provision for the completion to production or a depth of 4,000 feet, of a well then being drilled, and provided for payment in advance to the State of California of an annual specified rental per acre, the rental to be credited against royalties for that year. It also provided for the payment of a royalty of 5 percent of the value of oil and gas produced from the land, except such as might be lost or used for production purposes, or on demand of the state, to deliver 5 percent of the oil and gas in kind. Petitioner further agreed to observe the provisions of the statute designated to prevent excess holdings under such leases and further agreed not to assign the lease or any interest*559 therein, nor to sublet any portion of the leased premises, except with the consent of the state. In case of forfeiture or termination of the lease, the petitioner was to return the premises with all permanent improvements thereon, but, at the option of the state, might remove all derricks, buildings, machinery, fixtures, and such other things as might have been placed thereon. By the terms of the lease the obligations and benefits extended and inured to the heirs, executors, administrators, successors, and assigns of the parties thereto. On December 19, 1929, the petitioner and the Pacific Western Oil Co., a Delaware corporation, hereinafter referred to as the Oil Co., entered into an agreement designated as a "Drilling Agreement", whereby the Oil Co. agreed to drill "at the times and in the manner specified, all of the wells required to be drilled * * * under the terms and conditions of the lease, to do all work of development and *134 operation required by the lease, and not to do any act in connection therewith which might be violative of any provisions of the lease." Various provisions of the agreement prescribed in detail that the Oil Co. was at its own expense to*560 drill all wells, furnish all equipment, and provide all facilities for the production, storage, and delivery to pipe lines and other transportation agencies of all oil and gas produced and saved. It was also required to pay to the State of California royalties provided by the lease and to save the petitioner harmless for and on account of any and all claims, demands, rights, suits, or judgments. The agreement contained provisions dealing with title to and possession of oil and gas and with the disposition of the proceeds from the sale thereof, as follows: TITLE XIII. PAYMENT TO STATE AND CONTRACTOR. * * * (b) Payment to Contractor. The compensation which the Owner [petitioner] agrees to pay to the Contractor [the oil company] and which the Contractor agrees to accept for all labor and materials to be furnished, all services to be rendered, all covenants and agreements to be performed by the Contractor under the terms hereof, shall be an amount equal to sixty-six and two-thirds per cent of the net sums received by the Owner for and on account of the sale of all oil, gas and casinghead gasoline produced under and during the life of this agreement and in addition*561 the Owner shall pay to the Contractor as a part of such compensation one-third of the cost of extracting such casinghead gasoline, which compensation the Owner shall pay to the Contractor as and when the proceeds of such sales are received by the Owner. In order to determine the net sums received from said sales there shall be deducted from the gross sums so received the actual, direct, reasonable costs of marketing and any sales tax levied under any existing or future law, and the remainder shall be the net sums referred to above. The Owner may provide for payment of such amounts by the purchaser directly to the Contractor by proper division orders. Whenever royalty is paid to the State in kind the Contractor shall not be chargeable with the amount thereof, but the compensation of the Contractor, instead of being an amount equal to sixty-six and two-thirds per cent of said sums received by the Owner from sales, shall be an amount equal to sixty-one and two-thirds per cent of the amount whichu the Owner would have received from such sales after making the deductions above provided for, had the State elected to take its royalty in cash and the royalty oil, gas and casinghead gasoline*562 been sold in addition to the oil, gas and casinghead gasoline actually sold and at the same rate, plus one-third of the cost of extraction of said casinghead gasoline. (c) Payment to Contractor if Oil Not Sold. It is the expectation of the parties hereto that the Owner will sell for a money consideration all oil, casinghead gasoline and dry gas produced and saved or manufactured by the Contractor under the terms of this agreement. If at any time the Owner, instead of so selling any such oil casinghead gasoline and/or dry gas, use the same or any part thereof, exchange it or any part thereof for a consideration other than a money consideration to acquire other property or rights, or sell it or any *135 part thereof to any buyer in which the Owner owns, or holds, directly or indirectly, the majority interest, for less than the then current posted or market price therefor in the Elwood Oil Field, then, for the purpose of determining the amount to be paid to the Contractor under the preceding paragraphs of this Title, all oil, casinghead gasoline and/or dry gas so used or disposed of shall be deemed to have been sold by the Owner at the then current posted or market price*563 therefor in the Elwood Oil Field, and the amount so ascertained shall be the amount on which the payments to the Contractor shall be based. TITLE XIV. TITLE AND POSSESSION OF OIL, GAS AND CASINGHEAD GASOLINE. It is particularly understood and agreed that all oil, gas and casinghead gasoline produced and saved from said leased lands shall immediately upon said production and saving, belong absolutely to the Owner, but that the Contractor shall have the duty of caring for such oil and casinghead gasoline while in storage. The Contractor shall not be liable to the Owner for its failure or inability to save any oil or other substance or for shrinkage or loss of oil at any time placed in containers unless such failure, inability, loss or shrinkage be due to the negligence of Contractor. * * * The Oil Co. was required to pay all taxes and assessments levied, assessed, or imposed against the leased lands, the production therefrom, and the machinery and other equipment thereon, but it was to be reimbursed therefor by the petitioner to the extent of one-third of the amounts so paid. Royalties payable to the state were not to be considered as such taxes or assessments. The*564 petitioner owned certain littoral land adjacent to the leased premises, and it was provided that the Oil Co. should have the use of these lands for the purpose of its operations not only upon the lands covered by lease No. 93, but for its operations on lands covered by a similar lease, No. 92, which the Oil Co. owned. The littoral lands in question were at that time under lease to the Oil Co. The agreement was to be effective as long as the lands were held under lease No. 93 or under an extension or renewal thereof. It contained provisions for its termination on 60 days written notice by either party at any time after 15 years, if production should fall below a certain specified minimum. Either party, in case of default of the other, could terminate the agreement on notice. It was also provided that the Oil Co. might terminate the agreement at any time upon 60 days notice, provided it was not in default. Upon termination of the agreement, the Oil Co. was required to remove all buildings, equipment, and other property constructed or deposited by it upon the littoral lands. It might not, however, remove similar property or structures from lands covered by lease No. 93 unless*565 permission was given in writing by the petitioner; provided, however, that if the agreement should be terminated by *136 reason of defect in petitioner's title to the littoral lands, or at the option of the Oil Co., all tanks, structures, machinery, buildings, equipment, and other property erected or deposited by it upon the leased lands might be removed. On the same day the above agreement was executed, a supplemental agreement was entered into between the petitioner and the Oil Co. wherein it was recited that the Oil Co. had expended the sum of $256,874.39, as shown in a schedule attached, in effecting compromises and settlements with adverse claimants, in the drilling of a well known as Blue Goose No. 2, and in the construction of certain buildings, tanks, and facilities for development of the property. The schedule designated these expenditures as investment expenditures and by the terms of the agreement, the petitioner was released from any obligation to reimburse the Oil Co. for any part of the sums so expended. In paragraph 3 it was stated that the petitioner had expended in the acquisition of the lease and the permit upon which the lease was issued, for legal and*566 engineering fees and other items, the sum of $176,043.84. Subsequent paragraphs provided for repayment of the said amount to the petitioner by the Oil Co. During the year 1931 the proceeds from the sale of oil and gas produced from lease No. 93 amounted to $839,309.44. The royalties paid to the State of California amounted to $41,965.47. The Oil Co. received under the terms of the agreement of December 19, 1929, the sum of $517,574.15. Expenses paid directly by the petitioner amounted to $42,980.38, leaving $236,789.44 as the net proceeds to her from the lease before making any allowance for depletion. Included in the total proceeds from the lease, as above stated, was the amount of $51,515.27 received from the sale of casinghead gasoline, of which 40 percent was allocable to production and 60 percent to manufacturing processes. Exclusive of oil and gas products from lease No. 93 and exclusive of any deduction for contributions, petitioner, during the taxable year 1931, had a net loss of $62,360.29. During the same year she made contributions to various charitable, educational, and scientific corporations amounting to $11,710, all of which sum has been allowed as a deduction*567 by the respondent. On March 14, 1932, petitioner filed a tentative return for the taxable year 1931 showing an estimated total tax of $25,000, of which amount $6,250 was paid at the time of the filing of the return and $6,250 on June 10, 1932. On September 14, 1932, she filed her income tax return for 1931, showing a net income of $58,716.32 and a total tax of $5,945.86. On February 21, 1934, she filed with the collector of internal revenue a claim for refund in the amount of $6,554.14, representing the excess of the amount paid under the tentative return over the amount reported on the return filed on September 14, 1932. *137 On March 15, 1934, she filed a further claim for refund for the remainder of the tax paid, in the amount of $5,945.86. During the year 1932 proceeds from the sale of oil and gas produced under lease No. 93 amounted to $834,086.90. Royalties paid to the State of California amounted to $41,704.36. The Oil Co. received under the agreement of December 19, 1929, the sum of $514,353.61. Expenses paid directly by the petitioner amounted to $54,935.88, leaving $223,093.05 as the net proceeds to her from the lease before making any allowance for depletion. *568 Included in the total proceeds from the lease during 1932, as above stated, was the amount of $109,161.49 from the sale of casinghead gasoline, of which 40 percent was allocable to production and 60 percent to manufacturing processes. During the taxable year 1932 petitioner had a net loss of $33,449.92, exclusive of income from the oil and gas produced from lease No. 93 and exclusive of any deduction for contributions. During the same year she made contributions to various charitable, educational, and scientific corporations totaling $4,898.34, all of which sum has been allowed as a deduction by the respondent. The royalties received by the State of California in accordance with the terms of lease No. 93 have been paid into the general fund of the State of California. During the years 1931 and 1932 the Oil Co. expended certain amounts in connection with the development of lease No. 93. These amounts were capitalized on its books as follows: Account [1932] Oil Wells: Tangibles $71,999.27 Intangibles $238.00 21,955.25 The "tangibles" account on said books represented the costs of the actual materials in the structures constructed*569 in the wells and on the property, and the cost of drilling tools, pipe, casing, tubing, tanks, engines, boilers, and machines. The "intangibles" account on said books represented the expenditures for wages, fuel, repairs, hauling, and supplies incident to the drilling of wells and the preparation of wells for the production of oil. None of said amounts were capitalized on the books of the petitioner. OPINION. TURNER: The first issue raised by the petitioner has previously been considered by the Board, in . In that case, as in this, the petitioner relied on , to sustain the proposition that income derived from the development and operation of an oil lease obtained from the State of California was exempt. The lease in that case was *138 made under authority of the same California statute and the lands covered by the lease were located in the same county as in this case. We held, under authority of , that the income was taxable. The first issue is accordingly determined for the respondent, and it*570 becomes necessary to consider the petitioner's alternative contention. In determining the deficiencies herein, the respondent computed the depletion deduction by eliminating from petitioner's gross income the amounts received by the Oil Co. under the agreement of December 19, 1929. The petitioner contends that this was error. It is her position that she was the sole owner of lease No. 93 and is entitled, under section 114(b)(3) of the Revenue Act of 1928, 1 to a depletion deduction computed on the total gross income from the lease. She insists that under the agreement the Oil Co. acquired no interest in the lease or the production therefrom, and that the amounts received by it were received not as income from any operation of the property on its own account, but from her as compensation for services performed in her behalf. *571 In support of her contention that the development and operation of the lease was her individual enterprise and that the Oil Co. was employed for a cash compensation and had no interest in the production from the lease, the petitioner places great reliance in recurrent recitals in the agreement designating her as the "Owner" and the Oil Co. as the "Contractor", and the further provision to the effect that all of the oil and gas, when produced, belonged to her. Mere assertion, however, that the legal effect of a contract is thus and so is not sufficient to make it so, where the provisions of the contract itself show it to be otherwise. Here the Oil Co. by the terms of the agreement relieved the petitioner of all risks and burdens connected with the development and operation of the lease. For a right to two-thirds of the proceeds from the sale of oil and gas, it agreed to do and perform all acts required of her under lease No. 93, which she had received from the state, while the petitioner, for merely holding title to the lease in her name and without financial outlay on her part, was to receive and retain one-third of the proceeds, subject only to payment of one-third of the taxes*572 on the property and production and one-third of the cost of manufacturing casinghead gasoline. There is some reference to an obligation on her part to stand the cost of selling and marketing the production *139 of the lease, but a closer inspection of the contract and the stipulation of facts filed herein discloses that these expenditures were to be made out of proceeds from such sales before division thereof between the parties. It does not even appear that the petitioner actively took any part in the marketing of the production, and, as a matter of fact, we might well be justified, on the record before us, in concluding that this function was also performed by the Oil Co. Any doubt that the development and operation of the lease was the enterprise of the Oil Co. and not of the petitioner is removed by the supplemental contract between the parties, also executed on December 19, 1929. That contract discloses that the only cash investment in the venture was made by the Oil Co. and by that contract the Oil Co. released the petitioner from any obligation to reimburse it for any part of the sums previously expended and carried on its books as investment expenses. The schedule*573 of these expenditures shows that a substantial portion thereof was used in effecting compromises and settlements with adverse claimants to the title, which was held in the name of the petitioner. In a subsequent paragraph, the Oil Co. agreed to reimburse the petitioner for all amounts expended by her in the acquisition of the lease. These expenditures amounted to $176,043.84 and covered, among other things, legal and engineering fees. The California statute very likely supplies the reasons for the repeated assertions by the parties that the petitioner retained ownership of the lease and that the Oil Co., the "Contractor", was receiving a cash compensation from her for services rendered in her behalf. In one clause of the lease granted by the state the petitioner specifically agreed to observe the provisions of section 12 of the act under which the lease was granted. That section provides in part that "no person, association or corporation, shall take or hold, under the terms of this Act, more than one oil or gas permit or lease." It further provides that any interest held in violation of the act shall be forfeited by appropriate proceedings in the superior court for the county*574 in which the property is located. The agreement between the parties discloses that the Oil Co. was already the holder of lease No. 92, and, under the section just referred to, could not have obtained or held in its own name the lease involved in this case. Under the circumstances and facts of this case, it might well be argued that, while the petitioner obtained and held the legal title to the lease, she at all times was acting for the Oil Co. It is apparent from the supplemental agreement that the Oil Co. and not the petitioner, prior to the contract of December 19, 1929, had expended $256,874.39 in prospecting and proving the property, in drilling the first well and in settling adverse claims to the title. It also agreed *140 to reimburse the petitioner in full for all expenditures made by her in obtaining the lease. We are further of the opinion that if it be conceded that the petitioner obtained the lease from the state for her own account, a very strong argument could be made that the contract of December 19, 1929, was in effect a sublease of her interest in the property, under which she retained for herself only a right to share in the proceeds from the sale of*575 the oil and gas produced. We are not here concerned, however, with a particular designation of the respective interests of the petitioner and the Oil Co. in the property in question, nor with any question as to whether or not the agreement between the parties is within or without the spirit and letter of the lease and the California statute, but with a determination of the depletion deduction allowable to the petitioner in respect of the interest, whatever it may be called, of the petitioner in the lease. In , the Supreme Court, in considering the interest necessary as the basis for a depletion deduction, said: "The language of the statute is broad enough to provide, at least, for each case in which the taxpayer has acquired, by investment, any interest in the oil in place, and secures, by any form of legal relationship, income derived from the extraction of oil, to which he must look for a return of his capital." See also , and *576 . In , the Supreme Court, although dealing there with apportionment of the depletion allowance between lessor and lessee, clearly indicated that the total depletion allowance of all parties who own interests in any oil property may not exceed 27 1/2 percent of the gross income from the property, and that the deduction permitted to any one party is limited to a proportionate part of the total allowance based on his interest in the total production. In our opinion, it is definite and clear that the petitioner and the Oil Co., under the contracts between them, provided for the development and operation of lease No. 93 and for definite interests to each in the production therefrom. These interests were to be one-third and two-thirds, respectively, with certain minor adjustments prescribed by the terms of the agreement. We accordingly hold that the petitioner may not include in her gross income, for the purpose of computing her depletion deduction in respect of lease No. 93, any amounts received by the Oil Co. as its share in the proceeds from the sale of oil, gas, and casinghead*577 gasoline in accordance with the terms of the agreement of December 19, 1929. Since the second issue has been determined for the respondent, the alternative issue raised by his answer need not be considered. Reviewed by the Board. Decision will be entered under Rule 50. Footnotes 1. SEC. 114. (b) Basis for depletion. - * * * (3) PERCENTAGE DEPLETION FOR OIL AND GAS WELLS. - 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. ↩