Kiesau Petroleum Corp. v. Commissioner

KIESAU PETROLEUM CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Kiesau Petroleum Corp. v. Commissioner Docket No. 95760. United States Board of Tax Appeals 42 B.T.A. 69; 1940 BTA LEXIS 1057; June 13, 1940, Promulgated *1057 Petitioner entered into contracts with lessees of oil producing land whereby in return for furnishing equipment needed in exploiting such land petitioner became entitled to a certain precentage of the oil produced. Held, that petitioner's income realized pursuant to such contracts was not "derived from royalties" within the meaning of section 351(b)(1) of the Revenue Acts of 1934 and 1936, and petitioner was not "a personal holding company" within the meaning of those acts; held, further, that petitioner is entitled to depletion calculated upon such income. Jonah Jones, Jr., Esq., for the petitioner. John H. Pigg, Esq., for the respondent. KERN *70 In this proceeding respondent determined a deficiency in the sum of $1,169.09 against petitioner for the years 1935 and 1936 because of petitioner's alleged liability for surtax as a personal holding company for those years. Respondent also imposed a delinquency penalty of $292.27. This deficiency and penalty arise by reason of respondent's determination that petitioner during the taxable years derived more than 80 percent of its gross income from royalties within the meaning of section*1058 351(b)(1) of the Revenue Acts of 1934 and 1936, and was, therefore, a personal holding company. At the time of the hearing respondent filed an amended answer alleging that in event the Board should find that the income derived by petitioner pursuant to a certain contract does not constitute income from royalties within the meaning of section 351(b)(1), then respondent erred in allowing petitioner depletion deductions for the taxable years, and in that event there would be deficiencies in petitioner's income tax and excess profits tax liability for the taxable years in the sums of $1,747.60 and $832.17, respectively. FINDINGS OF FACT. Petitioner was incorporated on April 17, 1930, under the laws of the State of California, and its principal place of business is at Long Beach, California. More than 64 percent of its capital stock was owned at all times here material by three members of the Kiesau family. Its income for 1935 and 1936 was derived entirely from the operation of nine separate oil wells, only one of which, known as the Paige well, was drilled upon land owned by petitioner. The income from the other eight of said wells, which constituted over 80 percent of*1059 its gross income, was derived from contracts similar to exhibits No. 1 and No. 2, the pertinent parts of which are set out as follows: AGREEMENT THIS AGREEMENT, made and entered into this 28th day of August, 1933, by and between EQUITABLE OIL COMPANY, a corporation, First Party, and KIESAU PETROLEUM CORPORATION, a corporation, Second Party, both of the County of Los Angeles, State of California; WITNESSETH: That First Party is the owner of and in possession of a recorded oil and gas lease covering the following described real property. [Description omitted.] WHEREAS, First Party is desirous of Second Party's furnishing certain equipment to be used in the drilling and completion of an oil well on the above described property, known as Fowler Number One. NOW, THEREFORE, it is agreed, in consideration of the mutual promises and benefits to be derived by both parties hereto, that Second Party will furnish to *71 First Party, to be used in the drilling and completion of the said oil and/or gas well, the following property: To furnish water string casing, shoe and guide to the value of $5,000.00 and if the same does not total $5,000.00 to furnish tubing or other*1060 equipment as agreed upon so that the total shall equal $5,000.00. All of the above equipment shall be of the value of $5,000.00 which First Party agrees to take and use in the drilling of said oil well, and in payment thereof agrees to and does hereby give the Second Party 15% of 100% of the received from the sale of all oil, gas and/or other hydrocarbon substances produced and saved from the well situated upon the above described real property, until such time as Second Party has been reimbursed from the income of said 15% for the actual cost to it of the above listed equipment. After said Second Party has been reimbursed as aforesaid, its interest shall be a permanent 7 1/2% of 100% of the said production from said well. The royalty interests herein provided for shall not be subject to any drilling cost, but are to bear an operating charge due and payable only from production of oil and gas produced, saved and sold from the above mentioned property, at the rate of $5.00 per each one per cent. per month. * * * In no event shall the additional 7 1/2% royalty interest herein assigned to repay the cost of equipment furnished by the Second Party be chargeable with any operating*1061 expense whatsoever, and it shall only be liable for its pro-rata share of mineral rights taxes assessed against production from the above referred to well. * * * It is further agreed that if for any reason, First Party abandon the drilling of same before said well is completed, Second Party, at its option, may complete the said well, in which event said Second Party shall reimburse itself for said completion out of the available royalty owned by both parties, after which it shall reimburse First Party for its actual expense. The First Party warrants that the consent of the landowner to permit a completion of said well by Second Party shall have been obtained in writing prior to the execution of this agreement. It is further agreed that in the event of the bankruptcy or insolvency of First Party, or in the event that a receiver in equity be appointed, or a receiver be appointed otherwise, or in the event of attachment or levy of execution, that in such event, Second Party may complete said well and reimburse itself therefor out of the available royalty owned by both parties, and it is further warranted that the consent of the landowner to this proviso shall have been obtained*1062 in writing prior to the execution of this agreement. In the event of the bankruptcy, insolvency, appointment of a receiver in equity, or the appointment of a receiver otherwise, the title to the equipment aforementioned shall be deemed to have been retained by the Second Party. * * * It is further agreed that in case of production being obtained on said property, First Party shall have the right to contract for the sale of the Second Party's oil, at a price per barrel posted and freely offered by the Standard Oil Company, Shell, Union and General Petroleum Corporation. In case a different price is posted by these companies, then the average of these prices shall be the price for which First Party shall settle with Second Party, and settlement for same to be made in money not later than the 25th day of the following month in which any oil shall have been sold. First Party agrees *72 to order the payment of oil to be made direct by purchasing company to Second Party. * * * It is further agreed that in no event is it the intention of the parties hereto to enter into a partnership agreement of any kind or nature whatsoever. * * * It is understood that it is proposed*1063 to drill said Fowler Well No. 1 to the Ashton Zone, found at a depth of less than 5,000 feet in the Huntington Beach Oil Field. Should First Party hereafter drill additional wells to the Ashton Zone, Second Party is to have the option of purchasing a like interest for the same price and upon the same terms as hereinbefore set forth. A thirty day notice to be given to Second Party prior to commencing additional wells, and Second Party, within fifteen days after receipt of such notice, to exercise or reject such option. Should a well be drilled to a zone deeper than the Ashton Zone in an attempt to obtain production from such deeper zone, then and in that event, Second Party shall have the option of purchasing 7 1/2% participating interest in such well by paying therefor the proportionate part of such costs of such deeper well. Such part of the costs to be in the proportion that 7 1/2 bears to 81. * * * IN WITNESS WHEREOF, the parties hereto have set their hands and seals the day and year in this agreement first above written. KIESAU PETROLEUM CORPORATION, By A. H. KIESAU By R. M. Kiesau EQUITABLE OIL COMPANY, By H. S. KOHLBUSH, President By D. M. WAITE, *1064 Secretary AGREEMENT THIS AGREEMENT, made and entered into this 24th day of August, 1931, by and between WEST AMERICAN OIL COMPANY, a Calif corp., FIRST PARTY, and KIESAU PETROLEUM CORPORATION, a corp., SECOND PARTY, both of the City of Long Beach, County of Los Angeles, State of California. WITNESSETH: That FIRST PARTY is the owner of, and in possession of a recorded oil and gas lease covering the following described real property; [Description omitted.] Whereas, FIRST PARTY is desirous of SECOND PARTY's furnishing certain equipment to be used in the drilling and completion of an oil well on the above described property: NOW, THEREFORE, it is agreed, in consideration of the mutual promises and benefits to be derived by both parties, hereto, that SECOND PARTY, will furnish FIRST PARTY, to be used in the drilling and completion of the said oil and/or gas well, the following property: [Description omitted.] *73 All of the approximate value of Seven Thousand Six hundred Dollars ($7,600.00), which FIRST PARTY agrees to take and use in the drilling of said oil well, and in payment thereof, agrees to, and hereby does, give the SECOND PARTY, twenty-five*1065 per cent (25%) per cent of one hundred per cent (100%) of the oil, gas and other hydro-carbon substances produced from the said premises previously described, until such time as said SECOND PARTY has been reimbursed from the income of said twenty-five per cent (25%) for the actual cost to them of the above listed equipment. After said SECOND PARTY has been so reimbursed, its interest shall be ten per cent (10%) of one hundred per cent (100%) of the said production from the said well. The twenty-five per cent (25%) and the ten per cent (10%) referred to is not to be subject to any drilling cost, but is to bear an operating charge, due and payable only from production of oil and gas produced, saved, and sold from the above mentioned property, as follows: * * * In no event shall the fifteen per cent (15%) additional royalty assigned to repay the cost of equipment furnished by the SECOND PARTY, be chargeable with any operating expense whatsoever, and shall only be liable for its pro rata share of mineral rights, taxes assessed against production from above referred to well. In the event the amount spent by said SECOND PARTY for the above referred to equipment is more than Seven*1066 Thousand Six Hundred Dollars ($7,600.00), or in the event that the cost thereof shall be less than that sum, the difference will be adjusted in cash between the parties in question at the earliest possible time, following completion of said well. It is further agreed that if for any reason FIRST PARTY abandon the drilling of same before said well is completed, that second party, at its option, may complete the said well, in which event, said SECOND PARTY shall reimburse itself for said completion out of the available royalty owned by both parties, after which it shall reimburse FIRST PARTY for its actual expense. The FIRST PARTY warrants that the consent of the landowner to permit a completion of said well by SECOND PARTY shall have been obtained in writing prior to the execution of this agreement. It is further agreed that in the event of the bankruptcy, insolvency of FIRST PARTY or in the event that a receiver in equity be appointed, or a receiver be appointed otherwise, or in the event of attachement or levy of execution, that in such event SECOND PARTY may complete said well and reimburse itself therefor out of the available royalty owned by both parties, and it is further*1067 warranted that the consent of the landowner to this proviso shall have been obtained in writing prior to the execution of this agreement. It is further agreed that in case of production being obtained on said property, that FIRST PARTY shall have the right to contract for the sale of the SECOND PARTY'S oil, at a price per barrel posted and freely offered by the Standard Oil Company, Shell, Union and General Petroleum Corporation. In case a different price is posted by these Companies, then the average of these prices shall be the price for which FIRST PARTY shall settle with SECOND PARTY, and settlement for same to be made in money not later than the 25th day of the following month in which any oil shall have been sold. FIRST PARTY agrees to order the payment of oil to be made direct by purchasing company to SECOND PARTY. FIRST PARTY shall also have the right to contract for the sale of gas and other hydro-carbon substances, produced, saved, or sold from the above described premises, and to remit in money to said SECOND PARTY for its share, as provided above. *74 It is further agreed that in no event is it the intention of the parties to enter into a partnership agreement*1068 of any kind or nature whatsoever. It is further agreed that FIRST PARTY will, at all times, carry ample and complete workmen's compensation insurance. IN WITNESS WHEREOF, the parties hereto have set their hands and seals the day and year in this agreement first above written. WEST AMERICAN OIL COMPANY, By H. S. KOHLBUSH, President By H. S. GIMBAL, Secretary First Party KIESAU PETROLEUM CORPORATION By A. H. KIESAU, President By R. M. KIESAU, Secretary Second Party. Petitioner during the taxable years had an economic interest in oil in place by virtue of said contracts and was entitled to deduct depletion calculated on the income therefrom. The income derived by petitioner during the taxable years from the eight wells pursuant to the contracts above described was not income derived from royalties within the meaning of section 351 of the Revenue Acts of 1934 and 1936. Petitioner was not a personal holding company during said years. Petitioner failed and refused to file a return for either of the years 1935 or 1936 on Form 1120-H. Petitioner is not liable for the 25 percent penalty for failure to file said returns. OPINION. *1069 KERN: The primary question before us is whether 80 per centum of petitioner's gross income for the taxable years was derived from "royalties" as the word is used in section 351(b)(1) of the Revenue Acts of 1934 and 1936, set out in the margin. 1 If it was so derived, then petitioner must be considered as a personal holding company within the meaning of those acts. Petitioner concedes that the income derived from the oil well which it owns "is derived from royalties", but contends that its interests in the other eight oil wells were merely participating interests*1070 and the income which petitioner derived from them pursuant to the contracts described in our findings, and constituting more than 80 per centum of its gross income, can not be considered as being derived from royalties. *75 These contracts were executed between petitioner and the owners of various oil leases, and provided that, in consideration of certain equipment furnished by petitioner, the owner of the lease would give petitioner a certain percentage of the proceeds received from the sale of oil produced from the well situated on the property. Is the interest in the oil thus acquired by petitioner a "royalty" within the meaning of the revenue acts? In construing the words contained in a statute our first resort should be to the natural, ordinary, and familiar meaning of the words used, unless Congress has definitely indicated an intention that the words should be construed otherwise. We, therefore, turn to the definitions of the word "royalty" as found in the following dictionaries: Webster's New International Dictionary defines the word "royalty" as "(a) A share of the product or profit (as of a mine, forest, etc.) reserved by the owner for permitting another to*1071 use the property. (b) A duty or compensation paid to the owner of a patent or a copy-right for the use of it or the right to act under it, usually at a certain rate for each article manufactured, used, sold, or the like; also, a percentage, as an output, paid to the owner of an article, especially a machine, by one who hires the use of it." In Black's Law Dictionary, 3d ed., the word "royalty" is defined as "A payment reserved by the grantor of a patent, lease of a mine, or similar right, and payable proportionately to the use made of the right by the grantee." Ballentine's Law Dictionary defines the word "royalty" as "Rent based upon the amount of mineral or oil taken from the ground; * * * As applied to oil and gas leases the term signifies the compensation provided in such a lease for the privilege of drilling on the premises for oil and gas, and consists of a share in the oil and gas produced under the lease. The royalty interest does not consist of a perpetual interest in the oil or gas as they lie in the ground, but, on the expiration of the lease, the right of the owner of the royalty expires." It is apparent from these definitions that the word "royalty" refers to an*1072 interest reserved by the owner in return for permission to use the property owned. To take examples from the oil industry, the interest reserved by the owner of the fee to be paid by the lessee out of oil produced would be a royalty, as would also be the interest reserved by the owner of the leasehold to be paid by a sublessee from the oil produced. In , we referred to "royalty" in the following language: * * * The word "royalty" as used in a gas lease generally refers to "a share of the product or profit reserved by the owner for permitting another to use the property." ; . It is compensation for the privilege of drilling and producing oil and gas and consists of a share in the product. . In the instant case the petitioner, by the contracts referred to, did not reserve an interest in the oil producing properties; it acquired such an interest for the first time. It acquired a percentage of the interest of the lessees and was to share with them in the*1073 oil produced from the leased properties. Certainly the interests of the lessees in the oil produced from the properties held by them on lease could not be considered royalties. We conclude that the ordinary meaning of the word "royalties" does not embrace the interest held by petitioner under the various contracts with lessees of oil producing properties. Does the word "royalties" have a technical meaning peculiar to the oil industry which would embrace petitioner's interests? If it does, it may be that Congress was using the word in this special sense. The record in this case contains uncontradicted testimony to the effect that according to the terms used in the oil industry, petitioner's interest was known as a "participating interest" and not as a "royalty," and that the word "royalty" was only used to describe the interest of the owner of the fee of oil producing land reserved upon lease ("a landowner's royalty") and the interest of a lessee in cases of sublease ("an overriding royalty"). Therefore, we must conclude that the word "royalties" has no technical or commercial meaning different from its ordinary and normal meaning. Nor is there anything in the revenue acts*1074 which would indicate that Congress intended this word to have any meaning other than ordinary and normal. Petitioner here acquired by contract for a consideration an interest in the natural resources of oil producing property. This was not a royalty. Respondent lays great stress on the fact that the contracts refer to petitioner's interest as a "royalty interest." However, if petitioner's interest was not in fact a "royalty" in the sense that that term was used by Congress, it matters not what label is given it by a contract between individuals. We are concerned with the rights created by the contract, and with the labels used only to the extent that they may be helpful in a construction of the contract. Here the contract is unambiguous, and, therefore, the label attached by the scrivener to petitioner's interest is immaterial. For the reasons above stated, we conclude that 80 per centum of petitioner's income was not derived from royalties within the meaning of section 351(b)(1), and petitioner is not a personal holding company. *77 Respondent argues in the alternative that no depletion is allowable to petitioner in the event that we conclude, as we have concluded, *1075 that petitioner's income is not derived from royalties. He says in his brief: "To place the income received by petitioner beyond the bounds of royalty income must of necessity remove it from its classification of income subject to depletion." For this proposition of law he cites no authority. With it we can not agree. The right of a lessee of oil producing property to a depletion deduction can not be based upon any concept of royalty. The right to depletion depends upon an economic interest in oil in place acquired as a capital investment. See ; ; ; . From an examination of the contracts introduced in evidence in this proceeding we are of the opinion that petitioner had such an interest and is entitled to depletion. Certain provisions present in the contracts persuade us to this result. Among them are the following: "After said Second Party [petitioner] has been reimbursed as aforesaid, its interest shall be a permanent 7 1/2% of 100% of the said production*1076 from said well"; "* * * First Party shall have the right to contract for the sale of the Second Party's oil * * *"; "* * * First Party * * * hereby does give the Second Party twenty-five percent (25%) of one hundred percent (100%) of the oil * * * produced from the said premises * * *"; and "After said Second Party has been so reimbursed, its interest shall be ten percent (10%) of one hundred percent (100%) of the said production of the said well." These provisions indicating the acquisition by petitioner of oil in place as a capital investment being present in the contracts before us, the decision of , is not applicable to the facts of the instant proceeding. Since we have concluded that petitioner is not a personal holding company, it follows of course that it was not obliged to file a return as such, and is not liable for the payment of any penalty for failure to do so. Reviewed by the Board. Decision of no deficiency will be entered. MELLOTT and ARNOLD dissent. MURDOCK MURDOCK, dissenting: I dissent from the holding of the majority that the petitioner is not a personal holding company. Footnotes 1. SEC. 351. SURTAX ON PERSONAL HOLDING COMPANIES. * * * (b) Definitions. - As used in this title - (1) The term "personal holding company" means any corporation * * * if - (A) at least 80 per centum of its gross income for the taxable year is derived from royalties, dividends, interest, annuities, and (except in the case of regular dealers in stock or securities) gains from the sale of stock or securities, and (B) at any time during the last half of the taxable year more than 50 per centum in value of its outstanding stock is owned, directly or indirectly, by or for not more than five individuals, * * * ↩