Transcalifornia Oil Co. v. Commissioner

TRANSCALIFORNIA OIL COMPANY, LIMITED, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Transcalifornia Oil Co. v. Commissioner Docket No. 73111. United States Board of Tax Appeals 37 B.T.A. 119; 1938 BTA LEXIS 1085; January 20, 1938, Promulgated *1085 1. The petitioner was the owner of an oil and gas lease and in order to raise the funds needed to drill a well thereon it sold certificates which entitled purchasers to percentage interests in proceeds to be derived from the well's production. All amounts derived from the sale of certificates were entirely consumed in drilling the well. Held, that the funds derived from the sale of certificates did not, on the facts here, constitute income to the petitioner; held, further, that petitioner may not include in its gross income, for the purpose of computing its percentage depletion, any part of the proceeds thus received by the certificate holders. 2. The petitioner is entitled to depletion deduction computed on the cost basis if it amounts to more than depletion computed on the percentage basis, but in computing its cost petitioner is not entitled to include that part of its intangible expenditures which was supplied by the certificate holders. 3. Where taxpayer is on the accrual basis, amounts representing landowners' royalties incurred and accrued on its books at the end of the tax year, but of which, through arrangement with the landowners, payment is deferred until*1086 after more pressing debts of the taxpayer are paid, and deductible from its gross income for the year incurred. Melvin D. Wilson, Esq., and George H. Rudd, C.P.A., for the petitioner. J. C. Maddox, Esq., for the respondent. TURNER *120 These proceedings were brought to redetermine deficiencies in income tax for the years 1930 and 1931, in the amounts of $294.29 and $4,504.07, respectively. The principal issue to be determined is whether money and property received by petitioner from its sales of percentage interests in future recoveries from an oil well, which was to be drilled with such money and property, constitute income. Two other issues to be determined are whether the respondent erred (1) in computing petitioner's depletion allowance, and (2) in disallowing deductions for accrued but unpaid landowners' royalties. FINDINGS OF FACT. The petitioner is a California corporation, with its principal office in Los Angeles, California. It has an authorized capital of 1,000 shares of common stock of no par value. It was organized on October 14, 1930, for the purpose of acquiring and developing a certain oil and gas lease covering*1087 a tract in the Venice oil fields at Venice, California. On October 20, 1930, petitioner's incorporators held a meeting and elected Joseph Saylin as president, Arthur C. Verge, vice president, and David Saylin, secretary and treasurer. Those three officers constituted the board of directors of the new corporation. At this first meeting Joseph and David Saylin, assignees of Isaac and Emma Saylin, the original lessees, submitted a written offer to assign to petitioner, for considerations hereafter disclosed, all their right, title, and interest in the above mentioned oil and gas lease. Petitioner's board of directors adopted a resolution authorizing the acceptance of their offer to assign the lease, and agreed to assume all obligations imposed thereunder, one of which was to pay landowners' royalties of 22 percent of all oil and gas recovered from the property. The board agreed at this meeting to begin at once the drilling of an *121 oil well, to be known as "Saylin-Verge Well No. 1." Joseph Saylin agreed to procure, on his personal credit, all funds and materials necessary for the spudding in of the first well. Petitioner agreed to repay Saylin in full for any and all*1088 such advances as soon thereafter after as funds were available to its use. With respect to the problem of financing the drilling of the well, the board agreed that the necessary funds would be raised by selling percentage interests in the proceeds to be derived from the future production of the well. On October 24, 1930, petitioner, in accordance with resolutions adopted by its board of directors, filed an application with the California State Corporation Commission requesting that it be permitted: (1) to issue and assign 700 shares of its common stock to Joseph Saylin and David Saylin in consideration for the assignment of the aforementioned oil and gas lease; (2) to issue and sell 300 shares of its common stock to Arthur C. Verge for a cash consideration of $1 per share; (3) to issue and assign five "one per cent" percentage interests in proceeds to be derived from the sale of oil and gas produced from Saylin-Verge Well No. 1, as follows: (a) one each to Joseph Saylin and David Saylin as further consideration for the assignment of the oil and gas lease; (b) one each to Arthur C. Verge and Harold F. Collins in consideration for legal services already performed and to*1089 be performed in connection with the drilling of the oil well; (c) one to C. P. Dellinger as further consideration for his services as field superintendent; and (4) to issue and sell fifty "one per cent" percentage interests for a cash consideration of $1500 each. The petitioner attached to its application a proposed form for the assignment of percentage interests. The following is an exemplification: TRANSCALIFORNIA OIL COMPANY, LTD. ASSIGNMENT OF ROYALTY INTEREST For and in consideration of the sum of Ten Dollars ($10.00) and other valuable considerations, receipt of which are hereby acknowledged, the TRANSCALIFORNIA OIL COMPANY, LTD. does hereby sell, assign, transfer and set over to an undivided per cent ( %) interest in and to the entire proceeds derived from the sale of all gas, oil and other hydrocarbon substances produced, saved and sold from that certain oil well known as SAYLIN-VERGE WELL No. 1, located on the following described premises: Lot 13, Block 3, Del Rey Beach, as per Map recorded in Book 6, Page 186 of Maps, Records in the office of the County Recorder of Los Angeles County, California; Said interest in subject to (a) The terms and amendments of*1090 the lease under and by virtue of which TRANSCALIFORNIA OIL COMPANY, LTD. now owns the oil and gas rights in and to said premises; (b) a pro-rata monthly deduction at the rate of Ten Dollars ($10.00) a month for each one per cent (1%) *122 interest to apply on the cost of maintaining and operating said well; (c) a pro-rata share of all taxes. All of said charges shall be deductible and payable out of oil and gas and the TRANSCALIFORNIA OIL COMPANY, LTD. reserves the amounts thereof to itself for said purposes. All proceeds derived from the sale of oil and gas and payable hereunder shall be payable on the 20th day of each month for the period covered by the preceding calendar month. The TRANSCALIFORNIA OIL COMPANY, LTD. reserves the right to sell and market the entire production of said well at such times, and under such conditions as in its judgment appears to be most beneficial for all concerned; and also reserves the right to designate any reputable depository to receive the proceeds from the sale of said products and to distribute the same to the several interest holders in their proportionate shares. IN WITNESS WHEREOF the TRANSCALIFORNIA OIL COMPANY, LTD. has caused*1091 this assignment to be executed on its behalf by its duly authorized officers this day of , 1930. TRANSCALIFORNIA OIL COMPANY, LTD. By President The application contained the following explanation with respect to the intended uses of the funds to be derived from the sale of its stock and the percentage interests: That the money derived from the proposed stock issue will be used specifically for the purposes enumerated and outlined in the Articles of Incorporation and for the purpose of paying the expenses of incorporating, and the money derived from the proposed issue of royalty interests will be used for the purpose of purchasing oil well equipment and financing drilling operations, the total expense of which is estimated at $62,300.00, as set forth in the budget hereto annexed and marked Exhibit "J." On November 1, 1930, the California State Division of Corporations issued to the petitioner a permit authorizing it to issue and sell its stock and percentage interests in accordance with its request as above set forth. Respecting the percentage interests to be sold for cash, the permit recitals were as follows: To sell and issue an aggregate of not to exceed 50 "one*1092 per cent" participating interests in its Saylin-Verge Well No. 1, in the form described in the application, at and for the price of $1,500.00 for each One Per Cent interest, cash, lawful money of the United States, for the uses and purposes recited in the application, subject to a selling commission, payable only to a duly licensed broker or agent, of not to exceed 20 per cent of the amount received in cash on account of the selling price. On November 21, 1930, Joseph and David Saylin assigned to petitioner the oil and gas lease, and petitioner in consideration therefor issued and assigned to each of them 350 shares of its common stock. The record does not disclose whether petitioner sold its remaining 300 shares to Arthur C. Verge, as provided for in its application and permit. On April 25, 1931, the petitioner's president directed a letter to the California Commissioner of Corporations, requested that the *123 time limit in its permit be extended 60 days from May 1, 1931. In this letter the president stated that due to economic depression they had been unable to sell all of the interests authorized in the permit; that the well was then down approximately 5,720 feet; *1093 that they expected to resume drilling within a few days; and that the well was expected to be on production within 45 days. On April 30, 1931, the Commissioner of Corporations of California extended petitioner's permit by amendment to October 30, 1931. The amended permit made specific mention of the reasons for granting the extension in a clause which we quote in part: * * * This well is reported to be at an approximate depth of 5,715 feet. In order to complete financing of its well, the applicant is herein permitted to sell and issue participating interests for a selling price of $1,000.00 for each One Per Cent participating interest. The petitioner brought in "Saylin-Verge Well No. 1" in June of 1931, with a recoverable oil content of 142,500 barrels. Its recovery in 1931 amounted to 20,517.69 barrels. During the year 1930 petitioner sold percentage certificates for which it received $7,050 in cash. During 1931 it received from the same source the sum of $40,879.04 in cash, property and services, which included the four "one per cent" percentage certificates assigned to Joseph Saylin, David Saylin, Arthur C. Verge, and Harold F. Collins. During both years petitioner*1094 sold and assigned in the aggregate 35.4124 "one per cent" percentage certificates in the future recoveries of oil and gas. The total cost of the well amounted to $81,848.39, apportioned between intangible and tangible expenditures in the amounts of $29,027.46 and $52,820.93, respectively. The cash and property received from its sales of percentage certificates during both years, and the above mentioned expenditures, were capitalized on petitioner's books. The respondent has determined that the proceeds from the sale of such certificates constituted income to the petitioner for the year received. The respondent has allowed a depletion deduction in the amount of $2,010.77, representing "50 per cent of the net income from Saylin-Verge Well No. 1", as against petitioner's claim for a deduction based upon cost of the well. During the summer of 1931 the petitioner became involved in financial difficulties and its affairs were placed in the hands of a creditors' committee. Included in its debts was an item of $1,895.78, representing unpaid landowners' royalties, which was due and accrued on its books as of December 31, 1931. By agreement with the owners of these claims, the committee*1095 was permitted to defer payment of them until after the more pressing debts were paid. In dealing with such accounts the committee first issued its checks as payment in full to *124 their owners. The owners, in turn, endorsed the checks back to the committee, which deposited them to its bank account. The funds which these checks represented were thus commingled with the committee's general funds and used in payment of petitioner's other debts. The petitioner kept its books and made its income tax return upon the accrual basis, and it claimed a deduction from gross income in 1931 for these unpaid royalty accounts. The respondent has disallowed such deduction. OPINION. TURNER: The respondent's contention that petitioner's transactions in royalty interests resulted in receipt of income is based on the proposition of barter and sale. He argues that the transactions constituted absolute sales of property, and that since the lease was assigned to the petitioner without consideration, the total amounts received from such sales should be included in its gross income. The petitioner, on the other hand, contends that its development scheme was a joint venture, prosecuted*1096 by it and its coinvestors, and that payments received in exchange for interests in production, whether in cash, property, or services, constituted contributions of capital. It is argued that under the California law appertaining to such projects its status was that of a trustee charged with the duty of applying such capital contributions to the uses and purposes specified in its application to, and the permit issued by, the state corporation commission. In that connection petitioner cited the case of ; , wherein the District Court of Appeals, Fourth District, State of California, held that "a voluntary trust with the production owners as beneficiaries * * * was created by the payment of the various sums of money by the production owners, with an implied covenant on the part of the trustees to use the money to develop oil production on the leased property if it was oil bearing." Assuming but not conceding or deciding that a lessee might be the trustee or agent of the certificate holders, the Circuit Court of Appeals for the Ninth Circuit, in *1097 , referring to , stated that it was "equally conceivable that the lessee could realize a profit in creating such agency or trust, which profit would be personal to the lessee." Referring later to a situation where a lessee sold percentage interests, contemplating the sinking of a new and particular well, the court said that in such a case "there is no obligation to return to the certificate holder the excess of moneys received by the lessee as consideration for the contract, above the cost of the well. Such excess constitutes income to the lessee." In that *125 case the court held that all of the proceeds from the sale of percentage interests constituted income to the lessee, since it had failed to show how much, if any, of the proceeds were actually used in drilling the well designated. In the instant case there is no such failure of proof. The record shows that the sales were made for the specified purpose of obtaining funds to be used in drilling Saylin-Verge Well No. 1, and further, that the entire amount received by the petitioner from*1098 the sale of certificates was actually expended in the drilling of that well. We are of the opinion that the sums received by the petitioner from the certificate holders were received subject to an implied trust to use those funds in the sinking of the well, , and, since in this case the petitioner received nothing from the sale of percentage certificates in excess of the amount necessary to sink the well or in excess of the amount actually expended therein, it never at any time received any such sums without restriction as to their use and disposition. There was no excess which the petitioner might have appropriated to its own use, and under such circumstances it can not be said that any part of the sums received by it from the certificate holders in the production of Saylin-Verge Well No. 1 constituted income to it. This issue must be decided for the petitioner. Cf. ;; and *1099 The respondent has allowed petitioner a depletion deduction for the year 1931 in the amount of $2,010.77, which, according to the stipulation of facts, represents "50 per cent of the net income from the Saylin-Verge Well No. 1." Section 114(b)(3) of the Revenue Act of 1928 1 provides that 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. It is further provided, however, that the 27 1/2 per centum allowance shall not exceed 50 per centum of the net income of the taxpayer from the property and that in no case shall the depletion allowance be less than it would be if computed without reference to the section mentioned. *1100 The petitioner contends that the depletion allowance computed on the cost basis amounts to $4,179.47 and, since that amount is *126 greater than the amount allowed by the respondent, under section 114(b)(3), supra, it is entitled to the larger deduction. In computing the deduction claimed, the petitioner first ascertained the unit cost per barrel of oil by dividing the total intangible expenditures on the well, amounting to $29,027.46, by the well's oil content of 142,500 barrels, and then, by multiplying the unit cost so determined by the number of barrels produced in 1931, arrived at the depletion figure of $4,179.47. If the petitioner's depletion deduction is to be computed on the basis of cost rather than by one of the methods prescribed by section 114(b)(3), supra, the basis for that computation must be limited to petitioner's actual depletable cost and may not include the cost to others. Clearly the facts of record do not support the claim of a depletable cost to the petitioner in the amount of $29,027.46. The total cost of the well, tangible and intangible, amounted to $81,848.39, of which amount $47,929.04 was supplied by the purchasers of percentage interests*1101 in production, leaving $33,919.35 as the amount furnished by the petitioner. We have previously pointed out that the sums received by the petitioner from the purchasers of percentage interests did not constitute income to the petitioner, but represented sums held subject to an implied trust for use in drilling the well for the benefit of the certificate holders. It follows that no part of the $47,929.04 received from the sale of certificates and expended in sinking the well may be said to be cost of the well to the petitioner. The inconsistency of the petitioner's position is that it contends that such receipts did not belong to it, for the purpose of computing its taxable income for the years 1930 and 1931, but at the same time seeks to include such part thereof as its cost in drilling the well. The petitioner is, of course, entitled to include only its actual depletable cost in computing the depletion deduction on a cost basis and is not entitled to include that portion of the depletable cost of the well representing expenditures by the certificate holders. Cf. *1102 ; affirming in part, . On the facts before us, the petitioner's depletable cost should be determined by allocating the actual amount expended by it and from its own funds between tangibles and intangibles. The amount thus allocated to intangible expenditures represents the amount recoverable by the petitioner through depletion if computed on the cost basis. If the depletion allowance computed on that basis is less than the allowance computed on the percentage basis, the petitioner is entitled to the larger deduction. It is also apparent that the petitioner is not entitled to deduct the full amount of the depletion on Saylin-Verge Well No. 1 computed under section 114(b)(3), supra. If a taxpayer has acquired or retained the right to share in the oil produced from a certain property, *127 "he has an economic interest in the oil in place, which is depleted by production" and entitles him to a depletion allowance thereon. ; *1103 ; ; ; and . The statute provides for a single depletion allowance in respect of any given property, however, and this allowance is to be apportioned among the parties entitled to depletion on the basis of the economic interest of each party. . The deduction permitted to any one party is limited therefore to his proportionate share of the total allowance to all parties. . In this case the petitioner sold and exchanged percentage interest certificates covering 35.4124 percent of the entire proceeds to be derived from the well's production, thereby reducing its depletable interest in the well's recoverable reserve to 64.5876 percent. Accordingly, the petitioner is entitled, under section 114(b)(3), supra, only to its proportionate share, or 64.5876 percent, of the total depletion allowance to all parties who owned*1104 depletable interests in the property. The depletion deduction will be computed under section 114(b)(3), supra, on the percentages above indicated, and on the basis of cost as previously outlined, and allowed in whichever amount is greater. At the end of 1931 the petitioner had accrued on its books $1,895.78 representing unpaid landowners' royalties. By agreement with the landowners, the petitioner was allowed to defer payment of such claims until after its more pressing debts were paid. The respondent does not question the petitioner's right to deduct all accruable debts from its gross income, but argues in his brief that "Because the royalty was waived until creditors were paid * * * the payment of the amount by petitioner was uncertain and could not be an accrued liability until the condition of the corporation was such that there was at least some certainty that the amount would be paid." There is no merit to this argument. The accruability test of a debt is not certainty of payment, but rather certainty of its liability, and a taxpayer on the accrual basis can not defer deductions for a debt which becomes fixed in a given year to a subsequent year. Art. 342, Regulations*1105 74; ; ; ; . The record supports the petitioner's contentions on this item and they are accordingly sustained. Decision will be entered under Rule 50. Footnotes 1. SEC. 114. BASIS FOR DEPRECIATION AND DEPLETION. * * * (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. ↩