West Production Co. v. Commissioner

WEST PRODUCTION COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. West Production Co. v. Commissioner Docket No. 88997. United States Board of Tax Appeals 41 B.T.A. 1043; 1940 BTA LEXIS 1107; May 3, 1940, Promulgated *1107 1. In the taxable year petitioner purchased certain collaterally secured notes at a substantial discount. It sold a portion of the collateral with the consent of the maker of the notes and thereafter acquired the remaining collateral at a foreclosure sale. Held, that petitioner's profit should be determined by considering the entire transaction, and not by the situation that existed at the end of each intermediate step. 2. Petitioner assigned an undivided interest in a block of leases for a cash payment, additional payments to be made out of a portion of the oil to be produced, overriding royalties on all leases except three, and certain other rights as to all leases. Respondent allocated the cash payment equally among the acres transferred, denied depletion on that portion of the cash payment attributed to the three leases, but allowed depletion on the remainder, on the oil payments and on oil royalties. Held, petitioner is entitled to deplete the entire cash payment since the transfer was in the nature of a sublease and respondent's allocation upon the basis of equal acreage valuation is not justified by the facts. Robert Ash, Esq., and J. A. Platt,*1108 Esq., for the petitioner. R. P. Hertzog, Esq., for the respondent. ARNOLD *1044 This proceeding involves a deficiency in income tax for 1932 in the amount of $93,413.41. Petitioner admits liability as to $6,853.45, but denies liability as to the remainder of the deficiency. The several erros alleged present two principal issues - (1) the gain, if any, resulting from petitioner's purchase at a discount of certain secured notes which were foreclosed and a portion of the collateral sold and a portion retained, and (2) the amount of depletion to which petitioner is entitled in connection with the disposition of an undivided interest in certain oil properties. One issue was disposed of by the parties' stipulation that "depletion is allowable on the $5,841.09 income from the Luscher lease oil payment." Effect will be given to this stipulation upon recomputation of the deficiency under Rule 50. The parties filed a written stipulation of facts, which was supplemented by oral testimony and documentary evidence. FINDINGS OF FACT. The stipulated facts are adopted as a part of our findings of fact, and we include herein the portions thereof deemed necessary*1109 to understand the issues presented. The petitioner is a corporation, organized and existing by virtue of the laws of Texas, with its principal office in Houston, Texas. Its income tax return for 1932 was filed with the collector of internal revenue at Austin, Texas. The return showed net income of $941,829.93 and a tax of $129,501.62. Respondent's adjustments increased petitioner's net income to $1,621,200.23, and its tax liability to $222,915.03. The principal adjustments were a $177,691.43 increase in petitioner's income as a result of the Sterling note transactions, and a $435,566.73 reduction in the amount of depletion allowed petitioner. On October 27, 1931, R. S. Sterling obtained a loan in the amount of $800,000 secured by various properties pledged under a deed of trust, in which the National Bank of Commerce of Houston was named as trustee. The loan was evidenced by notes due on or before January 1, 1934, and bearing 6 percent interest. One of the properties pledged was Sterling's undivided interest in the "Moss Bluff Oil Field." Prior to June 20, 1932, Sterling asked J. M. West, chairman of petitioner's board of directors, to buy up the notes at a discount. *1110 West was not interested until he found that the Humble Oil & Refining Co., hereinafter referred to as Humble, wanted to acquire the Moss Bluff properties. After securing this information J. M. West conferred with Humble officials and ascertained the price they would pay for the Moss Bluff properties. He then negotiated with the National Bank of Commerce for the purchase of the notes. The matter *1045 was discussed with R. S. Sterling prior to the purchase of his notes,, and he agreed to the sale of the Moss Bluff properties to Humble. On June 20, 1932, the petitioner purchased the notes (face value $800,000) for $320,000, and paid legal expenses of $4,039 in connection therewith, making a total of $324,039. At the time the notes were purchased, petitioner received cash which had previously been paid thereon in the amount of $118,891.98. On July 18, 1932, the substitute trustee, West Securities Co., which succeeded the National Bank of Commerce as trustee, conveyed an undivided three-fourths interest in the Moss Bluff properties to Humble, except for the royalties reserved. The owners of the other one-fourth interest joined with the trustee in this conveyance, and*1111 they likewise reserved certain royalties. By separate instrument of even date R. S. Sterling consented to the sale, and petitioner, the trustee, R. S. Sterling, and others agreed and acknowledged that the deed to Humble was a valid conveyance which would not thereafter be denied by any of the parties thereto. On July 21,1932, petitioner received from West Securities Co., trustee, $165,000 on account of the sale of Sterling's interest in the Moss Bluff field to Humble. On October 28, 1932, petitioner received an additional $9,534.59 from the trustee, making a total of $174,534.59, which represented $187,500 paid by Humble less expenditures by the trustee on account of the Sterling $800,000 notes. R. S. Sterling failed to pay taxes and other charges on the property covered by the deed of trust, and, on September 12, 1932, the petitioner declared the unpaid principal of the collateral notes to be due and immediately payable, and directed the trustee to sell the real and personal property and to apply the proceeds toward the payment of the notes. The trustee, in accordance with the trust agreement, gave notice, as required by law for judicial sales, that on October 4, 1932, it*1112 would "sell to the highest bidder or bidders for cash at public auction * * * all of said real and personal property, together with all of the rights, appurtenances, privileges and franchises thereunto belonging or in any wise appertaining * * *." On October 4, 1932, the property was sold at public sale on the steps of the Harris County, Texas, courthouse. The personal property was sold separately from the real property to the petitioner, which paid $1,500 for the personal property and $17,300 for the real property. The personal property was sold first, then the city real property, and then the acreage property. The people at the sale were given the opportunity to bid on any separate item of personal or real property. No persons, other than petitioner, bid for either the real or personal property. The sterling notes were not canceled *1046 and are still in the possession of petitioner, and no further attempt has been made to collect thereon. On October 10, 1932, R. S. Sterling gave a quitclaim deed to petitioner covering the real properties and a bill of sale covering the personal properties. The petitioner allocated the purchase price ($18,800) on its books with*1113 respect to each property. The respondent determined that the real and personal properties acquired at the foreclosure sale had a value in excess of the bid price, namely, $183,087.44 for the realty and $22,326.56 for the personalty. In addition the petitioner received certain other securities which were not included in the foreclosure proceedings nor were they included in the trustee's bill of sale. These securities were entered on petitioner's books by a credit to surplus of $3 but their value was determined by respondent to be $13,910. Respondent reduced the values so determined by certain expenditures made by petitioner in connection therewith to arrive at a net value of the assets acquired in the Sterling foreclosure of $213,802.45. The parties have stipulated that the fair market value of the properties, as of October 4, 1932, was $101,522.77, which includes $9,534.59 in cash. In determining the deficiency the respondent broke down the $165,000 payment received from the sale of the Moss Bluff properties into "realized discount", $115,302.66, and return of capital, $49,697.34. He capitalized the $4,039 expense in connection with the purchase of the notes and computed*1114 a profit of $58,349.77 on the foreclosure sale by taking the difference between the net value of the cash and property received ($213,802.45) and the basis of the notes in petitioner's hands, $155,449.68 ($324,039 less $118,891.98 less $49,697.34), less the $3 reported as profit. The parties have stipulated the following facts with respect to the depletion issue: Prior to March 9, 1932, H. R. Cullen, an individual and the petitioner acquired a group of oil and gas leases with the Gulf Production Company near Thompson in Fort Bend County, Texas. The Gulf Production Company was the owner of the one-half interest in the leases and Cullen and the petitioner each owned a one-fourth interest. Copies of the said leases are attached hereto, marked Exhibits B-1 to B-12 inclusive, and made a part of this stipulation by reference. On March 23, 1932, Cullen and the petitioner entered into an agreement with the Humble Oil & Refining Company with respect to the above leases, under which they received $3,000,000.00 in cash and retained an oil payment of $17,000,000.00 to be paid out of production from all the leases. In addition they retained a royalty interest in all of said leases, except*1115 the A. P. George et al. 200 acre lease (Exhibit B-3), the R. A. Wolters et al. 800 acre lease (Exhibit B-1), and the R. A. Wolters et al. 100 acre lease (Exhibit B-2). *1047 Copies of the instruments executed in connection with the Humble transaction are attached hereto, marked Exhibits C and D, and made a part of this stipulation by reference. In its income tax return the petitioner claimed depletion on its one-half of the $3,000,000.00 cash received on the deal, as well as on the money received on account of the oil payment and the royalty interest. Respondent, in the Notice of deficiency, did not allow depletion on petitioner's one-half part of the $3,000,000.00 cash received from the Humble Company and also did not allow depletion on $43,402.60 which represented income from production from the Thompson leases on which only an oil payment but no royalty interest was retained. Also respondent did not allow depletion on $5,841.09, which represented income from production from the Luscher lease, on which only an oil payment but no royalty interest was retained. The Luscher lease was not included in and had no connection with the Thompson deal with the Humble Company referred*1116 to above. Subsequent to the filing of the appeal in this case, the respondent ruled that so much of the cash payment of $3,000,000.00 in the Thompson deal as was allocable to the leases on which a royalty interest was retained was subject to depletion. Depletion was also allowed on the $43,402.60 income from the Thompson leases on which only an oil payment was retained, and it is now agreed that depletion is allowable on the $5,841.09 income from the Luscher lease oil payment. No change was made in the respondent's position with respect to depletion on that portion of the cash payment allocable to the Thompson leases on which no royalty interest was retained. The respondent thereupon made an allocation of the cash payment between the Thompson leases upon which a royalty interest was retained and those upon which no royalty interest was retained. The said allocation was on acreage basis, and is as follows: Portion of cash payment subject to depletion $2,557,836.86 Portion of cash payment not subject to depletion 442,163.14 $3,000,000.00 Under the terms of the agreement, Exhibits C and D, mentioned in the stipulated facts, petitioner and Cullen "GRANTED, *1117 BARGAINED, SOLD AND CONVEYED" to Humble all of their one-half undivided interest in leases covering approximately 7,467 acres of land for the consideration, terms, conditions and stipulations set forth in the supplemental agreement which was incorporated in and made a part of the formal assignment. The consideration for the properties was "the sum of Twenty Million ($20,000,000.00) Dollars, of which amount Three Million Dollars ($3,000,000.00) has been paid in cash by Assignee, simultaneously with the execution and delivery of such assignment and of this instrument to Assignee, one-half of which has been paid to H. R. Cullen and the remaining one-half to West Production Company, and the remaining consideration of Seventeen Million ($17,000,000.00) Dollars the Assignee agrees to pay monthly to said H. R. Cullen and West Production Company, the Assignors, in equal portions, from production, after deducting royalties, and outstanding overriding royalties and the overriding royalties hereinafter provided for * * *." Payment *1048 of the $17,000,000 was to be made from fractional portions of the oil produced and saved, plus specified amounts from gas, sulphur, and other minerals*1118 produced, if any. No obligation to pay the $17,000,000 existed save from the value of oil, gas, and other minerals actually produced and saved, but the obligation followed the ownership of the interest whenever conveyed. In addition, the assignors specifically reserved overriding royalties of an equal 1/48 part of all oil produced, and overriding royalties on gas, sulphur, and other minerals, in amounts not here material, except as to the three leases mentioned in the stipulated facts hereinabove set forth. The remaining paragraphs of the supplemental agreement provide that the assignee shall be under no implied obligation to preserve said leases or to develop and operate said premises to a greater extent than is required under the provisions of the respective leases and the supplemental agreement; that the assignee agrees to perform the obligations contained in the several lease contracts affected by the assignment and the supplemental agreement so long as it retains said leases; that the assignee may reassign all leases to its assignors and thereupon relieve itself of all liability under the contract; tha the assignee may surrender one or more leases or any acreage under conditions*1119 not here material; and that the assignee will, within 120 days, so develop and operate the leases that the production therefrom will amount to at least 15,000 barrels of oil per day and will maintain production from the leases to at least 15,000 barrels of oil per day until the assignors have received in full their $17,000,000 out of oil produced, or in lieu of such production, regularly and currently pay to assignors the equivalent of 15,000 barrels of oil per day, unless, after reasonable development, production from the leases under efficient operation is less than 15,000 barrels per day, in which event the assignee shall pay on the basis of actual production. The assignors were to have access to the records and books of account relating to production, were to be furnished with logs of the wells drilled or being drilled and samples of cores and cuttings from the wells and to have a representative present at all times to witness gauges of production. Petitioner was represented in the negotiations which preceded the transfer of the "Thompson leases" by J. W. West. Humble was represented in these negotiations by Wallace E. Pratt, one of its directors. In negotiating for the transfer*1120 of the Thompson leases J. M. West relied upon a geological report, dated January 15, 1932, which had been made for petitioner by a petroleum engineer named Cashin. During the negotiations Cashin was called in by West to elaborate upon the potentialities of the Thompson leases. Cashin estimated the probable productive area to be 2,010 acres of which the proven productive area was 230 acres, as demonstrated by the *1049 existing wells. Pratt relied upon information available within the Humble organization and checked this information against the Cashin estimate. Pratt negotiated for and acquired the leases upon the hope and theory that the entire acreage was potential oil producing property. The negotiations were concluded by the transfer of the entire block of leases for the consideration stated in the agreement. No segregation or allocation of the consideration as between the several leases transferred was ever discussed or considered. OPINION. ARNOLD: The first issue involves the gain, if any, realized by petitioner on the Sterling note transaction. Respondent determined that petitioner first realized income upon the sale of the Moss Bluff property, and thereafter*1121 upon the purchase at foreclosure of the remaining collateral. Petitioner has advanced several theories with respect to the transaction, none of which are decisive of the question presented. There is no dispute between the parties as to the amounts involved or the values used by each party in arriving at the various gains computed from the Sterling transaction. In arriving at the item of "realized discount" of $115,302.66 respondent treated the sale of the initial portion of the collateral as a separate transaction from the foreclosure within the taxable year on the remainder of the collateral by petitioner. In our opinion this was the initial error in respondent's determination. The entire transaction, i.e., the purchase of the notes, the sale of a portion of the collateral, and the acquisition of the remainder, all occurred within the taxable year 1932, and, as it was obviously a transaction entered into for profit by the petitioner, the gain or loss that finally materialized should govern the tax liability of the petitioner. Ignoring the intermediate steps, which merely serve to cloud the issue, the essential factors may be summarized as follows: Petitioner purchased property*1122 (collaterally secured notes) for $324,039; it realized cash of $118,891.98 with the purchase; it sold a portion of the collateral (Moss Bluff properties) with the consent of the mortgagor, and received $165,000 of the sale price; and it reduced to possession by purchase at foreclosure sale the remaining collateral. It is agreed that the fair market value of the remaining collateral at the date of foreclosure sale was $101,522.77, which includes $9,534.59 balance realized from the sale of the Moss Bluff properties. The total cash and property received from the transaction by petitioner was $385,414.75; its cost basis was $324,039. Thus it appears that petitioner realized a gain on the transaction of $61,375.75. In this view of the tax significance of the Sterling note transaction, it is immaterial whether J. M. W.est or petitioner was acting as agent *1050 for Humble in the acquisition of the Moss Bluff Oil Field. In any event the net result of the entire transaction would be a $61,375.75 profit to petitioner. This result is forecast in petitioner's first theory, wherein it arrives at a net cost of the Sterling notes of $40,147.02 ($324,039 less $118,891.98, less $165,000). *1123 If petitioner had then taken into account the stipulated fair market value of the property acquired by the foreclosure sale on October 4, 1932, it would have arrived at the ultimate profit of $61,375.75. One other contention of the petitioner merits comment, namely, that the foreclosure sale price represents the fair market value of the property. The Supreme Court's decision in , is cited in support of this contention. We can not agree. We have held, in , that the doctrine announced by the Supreme Court in the Midland case did not prohibit an independent inquiry as to the fair market value of the property at the time of the foreclosure sale. See also . Obviously, we need make no independent inquiry here, as the parties themselves have stipulated the fair market value of the various properties. The decision in *1124 , turned upon its own facts, and may be further distinguished by the absence of any evidence of fair market value other than the bid price at the foreclosure sale. The second issue involves petitioner's right to a depletion deduction by virtue of the cash payment received from the transaction of March 23, 1932. (As used herein the term "cash payment" refers to petitioner's one-half interest.) In its return for the taxable year petitioner claimed a depletion deduction on the entire cash payment, which the respondent disallowed. Subsequently, however, respondent reversed his determination and ruled that $2,557,836.86 of the cash payment was subject to depletion, and $442,163.14 thereof was not subject to depletion. Respondent's change in position grows out of his application of the principle announced in , to a part of the leases transferred, and the application of the principle announced in , to the remainder of the leases transferred. He apparently justifies his breakdown of the transfer into two separate*1125 transactions by the fact that the assignors retained different interests and rights of ownership in three of the leases from that retained in the other leases. Having broken the transaction down to the individual leases, respondent then allocated the cash payment among the leases upon the basis of the acreage involved. In , the lessee of an oil and gas lease had explored and discovered oil on leased premises, which were then transferred *1051 by an assignment to a third party in consideration of a cash payment, a further payment to be made out of one-half of the first oil produced and saved, and a one-eighth overriding royalty. The Supreme Court allowed depletion upon each type of consideration, i.e., the cash payment or bonus, the oil payment or oil bonus, and the royalty payments. In its opinion the court pointed out that a taxpayer is entitled to a depletion allowance if by virtue of the leasing transaction he has retained a right to share in the oil produced. If he has such a right, he has an economic interest in the oil in place which is depleted by production. More specifically the Court stated that "When the two lessees*1126 transferred their operating rights to the two oil companies, whether they became technical sublessors or not, they retained, by their stipulations for royalties, an economic interest in the oil, in place, identical with that of a lessor." The facts in the Fleming case, supra, are that Fleming owned an undivided interest in two oil and gas leases which he assigned for cash plus certain amounts payable out of a fractional part of the oil produced. The court denied depletion as to the cash payment but allowed depletion as to the payments from oil produced, upon the theory that part of the income resulted from a sale of a capital asset and part of it arose from the operation of the producing property in which Fleming had retained an economic interest. In a more recent decision, , the Supreme Court pointed out that a conveyance of oil and gas properties for cash and deferred payments aggregating $2,000,000 was an absolute sale, even though under certain conditions the vendor would be entitled to receive one-third of the net profits resulting from production and operation. *1127 The Court pointed out that gross income from the property us used in the statute governing the allowance of depletion meant gross income received from the operation of the oil and gas wells by one who has a capital investment therein, and accordingly it denied percentage depletion to the vendor then before the Court because it had retained no investment in the properties assigned. A similar lack of investment in the mineral deposit caused the Supreme Court to deny depletion deductions to a processor who had contracted for casinghead gas, ; and to a stockholder of a corporation that owned oil and gas in place, . See also . Factually, the Fleming case, supra, represents a hybrid of the situations that existed in , and Helvering v. Elbe Oil Land Development Co., case, supra, in that Fleming sold a part of his interest and retained a part. The decided cases hold that where this situation exists the assignor has retained such an *1052 *1128 economic interest in the mineral deposit that production will deplete his investment, and accordingly the assignor has been allowed depletion on the gross income from the part retained, but has been denied depletion on the cash payment. , affirming ; ; . Cf. , which involved the depletion allowable to the assignee. The facts in this proceeding are both like and unlike the Fleming case. The leases here were disposed of as a unit or block, and there is no suggestion in the testimony or the documentary evidence that any segregation of leases was contemplated by the parties to the transaction. The transfer subjected all the leases equally to the charge of $17,000,000 to be paid out of production and the reservation by the assignors as to this payment applied to all leases equally. By the trade a five-sixths interest in the undivided half was transferred to Humble in all the leases. Petitioner and Cullen retained for themselves*1129 an undivided 1/48 in all leases except three, namely, the two Wolters' leases and the A. P. George 200-acre lease. The 1/48 interest in these leases had been disposed of by the assignors prior to the transfer to Humble, or had been reserved by the transferor of the assignors. In this situation one of the questions which we are asked to decide is whether the interest in the $17,000,000 oil payment is sufficient to entitle petitioner to deplete the portion of the cash payment attributable to the three leases. Another question which the issue suggests is whether the cash payment should be considered as applicable to the entire property, disposed of as a unit, and the separate nature of the leases ignored. If the property by treated as a unit rather than as separate leases making up the unit, then there would be a clear, decisive parallel with the facts in the Palmer case, supra, and petitioner would be entitled to deplete the entire cash payment. If the property can be broken down, and the separate leases individually considered, then the Fleming case, supra, is parallel with respect to three of the leases. In the last analysis, therefore, we must decide whether*1130 one property was transferred, or several properties were grouped and transferred as a unit. Our examination of the agreement of March 23, 1932, together with the other documentary evidence of record, and the testimony of the several witnesses, convinces us that to subdivide this agreement into as many separate agreements as there were leases forming the Thompson field is without justification. The transaction with Humble and the negotiations leading up to the transfer were all premised upon the assignment of five-sixths of petitioner's interest in a producing oil field. Such an assignment in our opinion, should *1053 be viewed broadly, and not narrowly or technically. When so viewed the transfer is comparable to , in that the petitioner assigned five-sixths of its interest in a producing oil field for cash, future payments to be made out of production, and retained royalties. That the transfer here was a "leasing transaction" is demonstrated by the various limitations placed upon the assignee's use of the property. Humble had no right to release or reassign the leases to the original lessors without the consent of its assignors. *1131 Humble did have the right, however, at any time, to reassign all the leases to its assignors, and thereupon relieve itself of any further obligation or liability to its assignors with respect to said leases and under the contract. Humble likewise had the right at any time to surrender any one or more of said leases, or any portion of the acreage included therein, provided, however, it gave written notice to its assignors of its intention and if so requested it was to execute and deliver the said lease or leases or acreage to its assignors, in which event Humble would be relieved from any liability with respect to the lease, leases, or acreage surrendered. The leasing character of the transaction is further shown by the obligation imposed upon Humble to produce a minimum of 15,000 barrels of oil daily, a provision solely for the benefit of its assignors, which was no part of the original leases, and also by the assignors' right to inspect Humble's books and records relating to production in the Thompson field, by the assignor's right to witness gauges of production, and by their right to receive logs of all wells drilled or drilling and samples of cores and cuttings from wells drilled*1132 or drilling by the assignee. Each of these provisions connotes a lease rather than a sale. However we view the situation, we fail to see any sound basis for subdividing the assignment into the separate leases composing the Thompson field and an attempt to make an allocation based on average acre value, as the Commissioner has done. The Commissioner in his allocation treats each acre included in the transfer as of equal value. Some of the acreage was shown by wells drilled to be very productive, with much greater thickness of producing sand than others. Some of the more remote wells produced water and showed the producing sand to be thinning out and much less productive, while the greater portion of the acreage was untested and its value was then more or less speculative and could not be determined with a sufficient degree of accuracy on which to make a valuation allocation. Necessarily producing acreage is more valuable than acreage without production and remote from producing wells. Under these circumstances we would not be justified in approving any allocation based on equal valuation of the acreage included in the transfer. Decision will be rendered under Rule 50.*1133