164 Ct. Cl. 540 | Ct. Cl. | 1964
Lead Opinion
delivered tlie opinion of the court:
The plaintiff, the CBN Corporation (formerly Columbian Carbon Company), sues for an alleged overpayment of Federal income taxes which it claims were improperly collected by the defendant for the tax year 1953.
The ultimate issue is whether plaintiff had a sufficient economic interest in certain natural gas in place in Moore County, Texas, during the tax year 1953, under a contract hereafter described, to entitle it to participate in the depletion allowance for income tax purposes.
The issue is governed by sections 23 (m) and 114(b) (3) of the Internal Revenue Code of 1939 (26 U.S.C., 1952 ed.).
Treasury Regulations 118
An economic interest is possessed in every case in which the taxpayer has acquired, by investment, any interest in mineral in place or standing timber and secures, by any form of legal relationship, income derived from the severance and sale of the mineral or timber, to which he must look for a return of his capital.
The plaintiff reported an income tax liability for the year 1953 in the sum of $3,921,707.66 and paid this amount in installments during the year 1954. On March 28, 1957, the District Director, Internal Revenue Service notified plaintiff that an additional assessment for the year 1953 had been recommended in the sum of $115,574.37, plus interest. That additional amount was assessed by the Commissioner of Internal Revenue and paid by the plaintiff.
The plaintiff filed a timely claim for a refund in the amount of $46,320.60 or such larger amount as might be legally refundable, on the ground that the Commissioner had erroneously disallowed a deduction for percentage depletion on royalty payments to the plaintiff by the Shamrock Oil and Gas Corporation (hereafter referred to as “Shamrock”).
Notice of disallowance of the claim was issued in May 1959.
The claim for depletion allowance was based on a contract made in 1952, which became effective January 1, 1953, but for a clear understanding of that contract it is helpful to trace the dealings between the plaintiff and Shamrock which began in 1935.
Natural gas is ordinarily composed of hydrocarbons— hydrogen and carbon. There are a number of different com
When the natural gas reaches the surface some of the hydrocarbons are in liquid form and others are liquefiable.
Shamrock operated a plant called the McKee Plant in Moore County where the liquid or liquefiable hydrocarbons were extracted or separated from the lighter hydrocarbons. After such removal, about 95 percent of the original or raw gas remained. This remaining 95 percent is sometimes called residue gas. This remainder was not altered in individual physical or chemical characteristics by the process of extraction.
It will be noted that the statute provides that in the case of oil and gas wells the allowance for depletion “shall be 27% per centum of the gross income from the property during the taxable year,” excluding certain items of expense incurred by taxpayer. The allowance may be and frequently is divided among many different owners of economic interests in the property in question. The total allowance cannot exceed 27^4 percent of the gross income. But that amount is allowed if claimed by those entitled to such deduction.
Usually the lessee pays those having economic interests on the basis of an aggregate of one-eighth of the market price of the oil or gas. The lease usually provides that the lessee may purchase the product but must account for the market price whether sold at the mouth of the well or purchased by the lessee or sold in the open market.
The sequence of events out of which the instant issue arises began in 1935. Shamrock was then engaged, inter alia:, in the production of natural gas from lands owned or leased by that company in Moore County, Texas. The Western Carbon Company (hereafter referred to as “Western”) at that time was engaged in the manufacture of carbon black by a process which burned vast quantities of natural gas.
An agreement was made between the two companies by the terms of which Western agreed to construct a plant for the manufacture of carbon black with a capacity for utilizing a minimum of 30,000,000 cubic feet of gas per day. The agreement also provided that Shamrock (referred to in the
Pertinent terms of the agreement are set out in finding 12(b). The Buyer was given the right to cease burning the gas at any time, in which event the Buyer could resell to other purchasers. In the latter event different terms of paying Shamrock for the gas were provided. The apparent reason for the provision was the fact that in the production of carbon black the burning of more than 1,000 cubic feet of gas was required to produce a small quantity of carbon black. There was a continuing threat of legislation to prevent such tremendous use of a natural resource to produce so small an amount of carbon black, even though the latter was a valuable product.
A similar agreement was entered into on the same date, October 1, 1935, between Shamrock and the Reliance Carbon Company, Inc., the respective parties being referred to as “Seller” and “Buyer.”
A subsidiary agreement, also dated the same day, gave both Western and Reliance preferential rights in the purchase of gas made by Shamrock in 12,000 acres in Moore County. As a safeguard, the Buyer was given the “right at any time to cease burning all or any part of the gas it has been burning, and resell for other purposes said gas,” at a different specified method of payment. (Findings 12 and 15.)
On January 2, 1936, Western assigned to plaintiff all rights in the agreements described above.
An amendatory agreement was entered into in 1937 between Shamrock and plaintiff, which was then operating the carbon black plant. The agreement increased the contracted plaintiff’s minimum purchase of natural gas by 15,000,000 cubic feet per day.
The amendatory agreement further provided that “Buyer [plaintiff] shall have the first right hereunder in priority to all other uses or disposition of its natural gas made
The agreement further provided that the plaintiff would add additional units to its carbon black plant, which it later did: The prior right to purchase and to receive gas was increased in 1946 by 3,250 acres. This later agreement also provided that Seller would desulphurize all gas to be resold. It also provided for a somewhat different method of paying Shamrock for the gas. Other minor amendments were entered into in 1947, 1949, and 1951. The material change in these agreements was the following:
* * * [T]he aggregate volumes of residue gas which Buyer [plaintiff] has the prior right to purchase and which Seller [Shamrock] has the obligation to sell and deliver to Buyer * * * is the fractional part of the residue gas remaining (after being processed for the recovery of liquid hydrocarbons in either Seller’s McKee plant or its recently acquired Sunray plant’, located near Sunray, Moore County, Texas) from all of the sour gas reserves of Seller heretofore accepted by Buyer * * * represented by a fraction, the nominator [sic] of which is 12,250, and the denominator of which is 62,225 * * *. Said fractional part of said residue gas is hereinafter referred to as the “dedicated reserves” of Buyer. It is agreed, however, if there shall be available from such dedicated reserves of Buyer in excess of forty million (40,000,000) cubic feet daily, averaged monthly, Buyer shall not be obligated to purchase in excess of forty million (40,000,000) cubic feet daily, but shall be privileged to purchase, by notifying Seller in writing of its desire to so purchase, the volumes attributable to the reserves of Buyer up to forty-two million (42,000,000) cubic feet daily when such volumes are available from such sources * * *. [Finding 21.]
All of these agreements and the amendments thereto were purchase contracts. The Buyer agreed to purchase and pay in one form or another for a minimum of 30 or more million cubic feet of gas per day, and the Seller agreed to give the plaintiff the prior right to purchase the available gas produced from certain designated reserves available after re
Under all these contracts Shamrock had claimed and had been granted the full 27% percent depletion deduction for all of the gas used in the contracts and the amendatory agreements. Plaintiff did not claim at any time any depletion allowance under these purchase agreements.
After September 11, 1951, Shamrock represented to the plaintiff that it desired to be free of the dedication to the plaintiff of its gas reserves in Moore County in order that Shamrock might be free to negotiate more favorable contracts with the Northern Natural Gas Company. In October it negotiated a contract with the latter company to be effective January 1, 1953, for the sale of gas, including gas from the acreage to which the plaintiff had been given the prior right of purchase. However, as will be noted in finding 21, that dedication had been by one of the amendments limited to a fractional part approximately one-fifth of the gas from the dedicated area.
THE NEW CONTRACT
On November 19,1952, Shamrock and the plaintiff entered into a contract that superseded the prior agreements between the parties. Pertinent parts of the new agreement are set out in finding 24.
This was an entirely different contract. It terminated the previous agreements. Under the new contract the plaintiff was no longer obligated to buy and Shamrock was no longer obligated to sell any gas to the plaintiff. Thereafter Shamrock was to sell or dispose of the gas.
As compensation, Shamrock agreed to pay plaintiff 6 cents per 1,000 cubic feet (Mcf) in connection with the sales of residue gas that were within the scope of the contract. The contract covered a fraction, the numerator of which was 9,000 and the denominator 62,625, of the reserves described in
4. * * * provided that if Shamrock should cease to process through its plant or plants the gas produced from its sour gas reserves, or any part thereof, and shall make sale thereof at the well or wells where produced, then such payments shall be applicable to the proportionate part of the raw gas volumes that may be sold by Shamrock. [Finding 24.]
Paragraph 9 of the contract stipulated that plaintiff would not be required to pay any portion of gross production or severance taxes levied prior to March 1, 1950. Plaintiff, however, agreed that it should be billed by Shamrock for its proportionate part of any increases after March 1, 1950, of gross production taxes, severance taxes or other excise taxes, and other taxes that might be thereafter levied. Plaintiff thereafter paid its proportionate share of increased production taxes, severance taxes, and other excise taxes levied upon or with respect to volumes of gas as specified in paragraph 9.
After the cancellation of the old agreements and entering into of the new contract, Shamrock did not claim any depletion allowance for the portion of the gross income from the residue of gas, use or sales that had been paid to the plaintiff. Plaintiff, after the 1952 contract, which became effective January 1, 1953, claimed a depletion allowance in reporting and paying its income for the year 1953. The deduction was disallowed, additional assessments were levied and collected, and plaintiff seeks a refund.
The question is: Did the plaintiff have an economic interest in the gas in place under the new contract which became effective January 1, 1953?
The plaintiff asserts that under the statute and regulations heretofore quoted and under the decisions of the various courts, it had an economic interest in the gas in place under
We think plaintiff had such an economic interest. All of the previous agreements — the ones entered into in 1935 and all amendments thereto — were pure purchase agreements with varying terms but nevertheless the plaintiff was a buyer and Shamrock a seller of the residue gas up to a certain minimum from a designated acreage in Moore County, Texas.
Under the new contract the plaintiff was no longer a purchaser nor was it a user of natural gas. It was simply permitted to sit back and draw what was equivalent to royalty payments on its designated percentage of all gas produced, used or sold from the acreage designated in the new contract.
Under the old contracts, plaintiff purchased and used and had the privilege of reselling all of the residue gas covered by the contracts. The plaintiff was nothing more than a purchaser with certain priority rights of purchase. Under the 1952 contract it was no longer a purchaser with the right to either use or resell the gas. In this respect the plaintiff was in the position of any holder of royalty interest in the proceeds of oil or gas production. Practically all lease contracts have a provision that the royalty, holder or holders shall be paid usually one-eighth of the proceeds of the sale at the then market price of a pro rata part of any oil or gas that is produced and marketed.
Some of the royalty provisions stipulate that the owner or holder of the royalty is entitled to one-eighth of the oil or gas produced. However, the standard form provides that the lessee shall have the right to purchase the oil or gas in the pipeline or sell it in the open market, accounting to the royalty owner for his proportionate part of the sales or market price of the product. If the lessee sells or transfers the commodity to someone else for production and marketing he must account for the royalty for his proportion of the market price of the product at the time.
Likewise, if Shamrock removed and sold or used any of the gas covered by the contract it must account to the plaintiff for the payments. If it used the gas, it was required to account to plaintiff for the market price at the time. If Shamrock ceased to process the gas produced from the reserves and should make a sale at the well or wells where
Thus, Shamrock could not remove for use or resale a single cubic foot of gas without paying plaintiff its designated percentage of the proceeds. It could not even sell the product at the well without accounting to the plaintiff for its payments.
It is not necessary that the holder of an economic interest •have title to the property. This is made clear in the case of Commissioner v. Southwest Exploration Co., 350 U.S. 308, 312, 314 (1956), where it states that:
* * * a taxpayer is entitled to depletion where he has : (1) “acquired, by investment, any interest in the oil in place,” and (2) secured by legal relationship “income derived from the extraction of the oil, to which he must*551 look for a return of his capital.” 287 U.S., at 557. [p. 314]
No particular form of the legal interest of a taxpayer is required in deciding whether the taxpayer has the necessary economic interest for purposes of the depletion allowance. See Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25 (1946), and cases therein cited, for a thorough discussion of the principles involved. As was stated in Southwest Exploration Co., supra, the depletion allowance in the Internal Revenue Code of 1939 is solely a matter of congressional grace and is limited to the 27% percent of the gross income from the property after eliminating certain items paid by the taxpayer with respect to the property.
The fact is that a depletion allowance is not given to anyone until the product is taken from the ground. If an owner of a piece of land sells it outright he gets no depletion allowance because, in fact, there is no depletion. Until there is some separation and thus some exhaustion and until that separated portion is marketed or sold in some form that produces income, there is no tax and in the nature of things there can be no deduction for depletion. Production and marketing, under standard oil and gas lease contracts, are as intimately linked as the law of demand and supply.
We quote from the case of Palmer v. Bender, 287 U.S. 551 (1933), at pages 557-558, the following:
Similarly, the lessor’s right to a depletion allowance does not depend upon his retention of ownership or any other particular form of legal interest in the mineral content of the land. It is enough if, by virtue of the leasing transaction, he has retained a right to share in the oil produced. If so he has an economic interest in the oil, in place, which is depleted by production. Thus, we have recently held that the lessor is entitled to a depletion allowance on bonus and royalties, although by the local law ownership of the minerals, in place, passed from the lessor upon the execution of the lease.
The case of Helvering v. Bankline Oil Co., 303 U.S. 362 (1938), which both parties cite, makes the distinction between economic advantage and economic interest. It recognizes that the language of the statute is broad enough to cover any form of legal relationship, and cites Palmer v.
The defendant undertakes to cite this authority for the claim that in the instant case the taxpayer had made no
Plaintiff traded all these advantages for a new contract that simply gave it an assured right to participate on a definite basis of a definite percentage of all the residue gas produced by Shamrock during the life of the field. This was certainly the cancellation and surrender of a valuable right and was full and adequate consideration for an economic interest in the gas in place. This is especially true since neither Shamrock nor any assignee could produce or extract a single cubic foot of natural gas nor secure one cent of revenue for itself without accounting to the plaintiff for the payment of its proportionate share of the gross income.
The 1952 contract was an arm’s length transaction in which plaintiff released its absolute right to purchase a portion of Shamrock’s reserve and received in consideration the equivalent of an overriding royalty. This was certainly a substantial investment. Plaintiff’s right to the payment for the gas sold by Shamrock was noncancellable and an indefeasible right to the payment so long as production existed.
Plaintiff’s interest in the gas was as depletable under the new contract as was the interest of Shamrock. Both oil and gas are depletable products; sometimes very rapidly and sometimes before the cost of drilling is paid for. When the product is exhausted all interests of either party are gone. Both Shamrock and plaintiff had an economic interest under the new contract in the gas in place. The attorneys for both
There is no doubt that someone was entitled to the entire 27% percent. When asked in oral argument how it came to pass that only a part of the statutory 27% percent was allowed for 1953, the response of defendant’s counsel was that Shamrock probably made a mistake in not claiming the balance. At any rate, Someone is entitled to the exhaustion or depletion allowance of that portion of the gross income which is represented by plaintiff’s part of the gross income. It seems manifest from the record that plaintiff had an economic interest in the gas in place and is entitled to a depletion deduction with respect to its income from that interest. We so find.
The amount of recovery will be determined pursuant to Bule 38 (c) of the rules of this court.
Pertinent parts of the two sections are as follows:
Ҥ 23. Deductions from gross income.
“In computing net income there shall be allowed as deductions:
*****
"(m) Depletion.
“In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each case ; such reasonable allowance in all cases to be made under rules and regulations to be prescribed by the Commissioner, with the approval of the Secretary. * * *
“For percentage depletion allowable under this subsection, see section 114(b) (3) and (4).
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Ҥ 114. Basis for depreciation and depletion.
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“Basis for depletion.
*****
“(3) Percentage depletion for oil and gas wells.
“In the case of oil and gas wells the allowance for depletion under section 23(m) shall be 27% per centum of the gross income from the property during the taxable year, excluding from such gross income an amount equal to any rents or royalties paid or incurred by the taxpayer in respect of the property. 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 under section 23 (m) be less than it would be if computed without reference to this paragraph.”
Pertinent parts of Treasury Regulations 118 are as follows :
“§ 39.23 (m)-l. Depletion of mines, oil and gas wells, other natural deposits, and timber; depreciation of improvements.—
“(a) Section 23(m) provides that there shall be allowed as a deduction in computing net income in, the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of improvements. iSection 114 prescribes the bases upon which depreciation and depletion are to be allowed.
“(b) under such provisions, the owner of an economic interest in. mineral deposits or standing timber is allowed annual depletion deductions. * * *
* * » * *
“(i) ‘The property,’ as used in section 114(b) (2), (3) and (4) and §§ 39.23(m)-l to 39.23 (m)-19, inclusive, means the interest owned by the taxpayer in any mineral property. The taxpayer’s interest in each separate mineral property is a separate ‘property’; but, where two or more mineral properties are included in a single tract or parcel of land, the taxpayer’s interest in such mineral properties may be considered to be a single ‘property,’ provided such treatment is consistently followed.”
The 1935 contract contained the following provision:
“* * * nothing herein contained shall prevent Seller from selling, trading or abandoning any lease or gas contract in the ordinary course of business, or of exchanging any part of its gas resources for other gas resources of substantially equal amount.”
The 1952 contract ran with the land. In fact both contracts ran with the land. Any contract runs with the land if it affects the land, is in writing, duly acknowledged and filed with the deed records. This is true in practically all the states. The provision is fashioned after the old English statute of frauds which was enacted to prevent oral contracts affecting and complicating land titles.
No doubt the reason for including the specific provision in the original contract was the fact that in that agreement Shamrock had the right to substitute other lands for those designated, provided they had equivalent productive quality. It was simply to make certain that such substitution would not affect plaintiff’s purchase contract. No substitution was provided in the new contract. Plaintiff's interest was tied to the specific lands. Due to the cancellation, there was of course no obligation on the part of plaintiff to purchase any gas after January 1, 1953.
We Rave examined all the cases cited by both parties, as well as some other decisions, and while there is some overlapping and indeed some confusion, this clear dividing line is recognized by all of them. This was true in Scofield v. La Gloria Oil and Gas Co., 268 F. 2d 699 (1959), and in Parsons, et al. v. Smith, 359 U.S. 215 (1959), as well as in the other cases which defendant discusses.
The Palmer v. Bender case, supra, makes it clear that the right to depletion allowance does not depend on ownership, or any other particular form of legal interest in the contract.
In Commissioner v. Southwest Exploration Company, supra, which involved slant or whipstock drilling, the owner of the upland site had no title or ownership in the underwater oil. It simply contracted as an upland owner to furnish the site for the drilling equipment and machinery and was to receive a percentage of the net profits. The drilling leaseholder claimed the entire 27% per centum of the depletion allowance, but the Supreme Court held that the upland owner who merely owned the site was entitled to its proportion of the depletion and the leaseholder to the balance. The Court does mention in Southwest that the site furnished was essential to the drilling contract, but this was only one of the elements mentioned by the Supreme Court. We have seen no case that holds that a party must be essential to a drilling contract in order to have an economic interest. There are many cases where the holder of an economic interest was not essential to a drilling contract, except in the sense that no minerals could be marketed without payment to the holder of the interest. It would be futile to drill if the product could not be sold. Neither in the Southwest case nor in the case at bar could the minerals be removed without compensating the contract holder of an interest in the proceeds of any minerals produced or removed.
The case of Elm Development Company v. Commissioner, 315 F. 2d 488 (1963), affecting coal, deals with the same principle involved here, and holds that an Independent operator who contracts with the lessee to mine coal at a certain adjustable price per ton has an economic interest entitled to depletion deduction. It contains an excellent discussion of the subject and distinguishes that case from Parsons v. Smith, supra.
None of the other cases cited by either party materially changes this over-all picture.
We further summarize our position as follows:
1. See footnote 4.
2. By the terms of the November 19, 1952 contract, the earlier contracts were terminated and were to have “no further force and effect [after January 1, 1953] except as to final accounting.” Whatever may have been their terms they were cancelled as of January 1, 1953. For this reason, the terms of the 1935 contract have no bearing on the 1952 contracts. Any claim for depletion deduction that plaintiff might possibly have made under the old contract has long since been barred by limitations. However, since that contract has been under discussion, we would like to state why we conclude that plaintiff never had any depletion rights under the former contracts.
3. The 1935 contract was a purchase contract, that is, plaintiff had a priority right to purchase a minimum amount of gas at a specified price. The plaintiff is termed “Buyer” and Shamrock “Seller.” The Buyer could burn or resell the excess gas. Should the area designated prove insufficient to supply plaintiff with enough gas to meet its needs, the Seller would not be responsible for the shortage but plaintiff might purchase the balance of its needs elsewhere.
4. The: cases generally hold that a purchaser of gas after it is produced does not have a depletable interest. There are literally thousands of such purchasers who, if their purchase of marketable gas entitled them to depletion deduction, would be making claims, thus vastly complicating the present problems. Hence, the necessity for drawing a line.
5. Under the terms of the 1952 contract, plaintiff was no longer a Buyer, and Shamrock was no longer a Seller to plaintiff. Shamrock, which had been the Seller in the old contracts, now took over the complete production and marketing of the gas. The former Buyer had no part in the marketing. It only had the right to 6 cents per thousand cubic feet of any gas that might be produced and either used or marketed by any one. Shamrock agreed to take over from plaintiff the resale of any gas which plaintiff was obligated to purchase under the terms of the old contracts. This applied merely to any gas plaintiff was obligated to purchase under the old contracts up to the time of the effective date of the new contract, i.e„ January 1, 1953.
3. By article 5 of the earlier contracts, the Seller was not only to produce but was required to build a 22-inch pipeline and deliver the gas to purchaser’s plant. By section 14 of the original contract, that part of the purchase price of gas which Seller was to receive in carbon black is classed as royalty to Seller.
7. while the 1935 contract was binding on both parties, their successors and assigns, the limitations on the numerous rights of the respective parties would also bind the assigns. The Buyer was not required to purchase all the gas produced on the property in question. There was a minimum and a maximum amount of gas the Buyer was required to purchase.
8. By the terms of the new contract, the former Buyer was no longer in
9. By article 10 of the 1952 contract, plaintiff’s rights could not be transferred until Shamrock had been furnished with the original instrument of transfer. By article 11, it was stipulated that “This Agreement [1952 contract] shall continue so long as gas is produced from any gas well or wells” described in the contract. By article 12, the contract was made binding on the parties, their successors and assigns. These provisions are usual in any royalty contract.
10. The eases uniformly hold that legal title is not required, but only an economic interest in the minerals in place, and that no particular form is necessary in preserving that interest.
Dissenting Opinion
dissenting:
The court holds, and plaintiff expressly admits in its briefs, that prior to the 1952 contract plaintiff had no depletable interest in the natural gas produced by and purchased from Shamrock. At the oral argument, after questioning from the bench, plaintiff ultimately withdrew from this concession, but its original position was clearly right. Under the
I can discern no transformation, via the 1952 contract, from a mere economic advantage to an economic interest in the gas in place. That new contract did not purport to grant plaintiff any property interest — e.g., leasehold or fee— either in the land from which Shamrock drew its gas or in the gas itself.
Aside from Commissioner v. Southwest Exploration Co., 350 U.S. 308 (1956), no Supreme Court decision has allowed depletion to a taxpayer who did not have either a fee or leasehold interest in the oil-producing property itself. Taxpayer equates itself with the upland owners in Southwest Exploration whose land was essential to drilling operations and whose contribution of that essential upland “was an investment in the oil in place sufficient to establish their economic interest” (id. at 316). The investment here, it is argued, was the former contractual right to obtain residue gas from Shamrock; that contribution, it is also said, is essential to Shamrock’s producing activities. The opinion
The upland in Southwest Exploration was physically essential (under California law) “to the drilling for and extraction of oil” (350 U.S. at 317); but no interest of plaintiff’s, contractual or proprietary, was essential to the physical process of extraction and production of gas by Shamrock. That company could bring up and process the gas without trenching on any of taxpayer’s rights and without its leave. Taxpayer’s concern did not begin with the raw gas as it came from the well. Nor did that concern even commence with the manufacture of residue gas. Just as in the pre-1953 period, taxpayer’s concern only began with the sale by Shamrock of the residue gas. Prior to that stage, plaintiff had no connection with the mineral. Under the express provisions of the 1952 agreement, Shamrock could use the gas, without accounting to plaintiff in any way, for specified ends of its own — -including use for fuel for compression purposes, for processing and production purposes, and for manufacturing steam. Not until the moment of sale did any obligation to plaintiff arise or plaintiff have any concern with the gas.
The court, in holding otherwise, stresses the fact that there was no way for either party to receive any funds unless Shamrock removed and used or sold the commodity itself. But the test of a depletable interest is not the mere participation of the taxpayer in the realization of gain from the mineral. The regulations provide (Treas. Beg. 118, § 39.23
I am concerned, too, that the rearrangement of plaintiff’s contract with Shamrock should be considered the equivalent of a capital investment, in 1952, in the mineral. If such an investment is deemed to have been made here, it would appear relatively easy for a contractor with a mere “economic advantage” to obtain a depletable “economic interest” by a reshuffling of the contractual terms — and without the grant of a recognizable property interest in the land or mineral. The Supreme Court seems to have had a more conventional and substantial type of “investment” in mind. See Parsons v. Smith, supra; Commissioner v. Southwest Exploration Co., supra.
For these reasons, I would grant judgment for the defendant.
FINDINGS OF FACT
The court, having considered the evidence, the report of Trial Commissioner Mastín Gr. White, and the briefs and argument of counsel, makes findings of fact as follows:
1. The plaintiff was, at all times pertinent to this litigation, a corporation organized and existing under the laws of the State of Delaware, with its principal office and place of business at No. 380 Madison Avenue, New York 17, New
2. Jurisdiction to hear and determine this cause at this time is conferred upon the Court of Claims by section 3772 (a) (2) of the Internal Revenue Code of 1939' and by section 7422(a) of the Internal Revenue Code of 1954. Jurisdiction of the subject matter is conferred upon the Court of Claims by section 1491, Title 28, U.S. Code.
¡3. This action is brought for the recovery of the total amount of $46,320.60, representing income tax collected from the plaintiff for the calendar year (hereinafter referred to as the “tax year”) 1953, or such other amount as may be legally refundable, together with statutory interest thereon.
¡4. The plaintiff kept its books and reported its income for Federal tax purposes on the accrual and calendar year basis.
5. The plaintiff duly made and timely filed its Federal Consolidated Corporate Income Tax Return for the tax year 1953, which showed a consolidated income tax liability of $3,921,707.66. The consolidated income tax liability of $3,921,707.66 shown on the return was duly paid by the plaintiff on the following dates:
Date of payment Amount
March 12, 1954-$1, 771,438.60
June 14, 1954_ 1, 758, 098. 30
September 15, 1954- 196,085. 39
December 14, 1954_ 196, 085.37
3,921,707.66
7. (a) On or about June 28, 1956, the plaintiff made and duly filed with the District Director of Internal Revenue for the Upper Manhattan District of New York a claim for the refund of an alleged overpayment of income tax for the tax year 1953 in the amount of $46,320.60, or such greater amount as might be legally refundable, together with statutory interest thereon. The claim for refund asserted that the Commissioner had erred in disallowing a deduction for percentage depletion under section 114(b) (3) of the Internal Revenue Code of 1939 on account of royalty payments to the plaintiff from The Shamrock Oil and Gas Corporation.
(b) Statutory notice of the disallowance of the plaintiff’s claim for refund was issued on May 29, 1959.
(c) No action or suit has been commenced or is pending in any other court on account of this claim. No action has been had thereon in the Congress or by any of the executive departments or agencies, other than as stated herein.
(d) The plaintiff is the owner of the claim stated herein, and no assignment or transfer of legal title thereto has been made.
8. The chain of events leading up to the present litigation began in October 1935. At that time, The Shamrock Oil and Gas Corporation (which will usually be referred to hereafter in the findings as “Shamrock”) was engaged in the production of natural gas from lands owned or leased by
¡9. Natural gas is ordinarily composed of various hydrocarbons, which, in turn, are composed of atoms of carbon and atoms of hydrogen in various combinations, such as the f ollowing:
Methane (CH4)
Ethane (C2H6)
Propane (CSH8)
Isobutane (O4H10)
Normal butane (C4H10)
Isopentane (0„H12)
Normal pentane (C6H12)
Hexane (C6H14)
Some of the hydrocarbons are in liquid form as the natural gas reaches the surface of the ground in the process of production, and others are liquefiable. Such hydrocarbons can be, and they frequently are, separated by the producer from the lighter hydrocarbons in the natural gas.
JO. After the liquid and liquefiable hydrocarbons are removed from the raw gas, there remains approximately 95 percent of the volume of the original raw gas. The remaining gas is sometimes referred to as residue gas.
11. After Shamrock removed some or all of the liquid and liquefiable hydrocarbons from its natural gas, the lighter hydrocarbons that remained in the natural gas were not altered in their individual physical or chemical characteristics.
12. (a) On October 1, 1935, Shamrock entered into an agreement with the Western Carbon Company, which was engaged in the manufacture of carbon black. Under this agreement, the Western Carbon Company agreed to construct, in the vicinity of Shamrock’s McKee Plant, a plant for the manufacture of carbon black that would have a capacity to handle a minimum of 30,000,000 cubic feet of natural gas per day. The agreement also provided that Shamrock (referred to in the agreement as “Seller”) would sell to the Western Carbon Company (referred to in the
(b) The agreement referred to in paragraph (a) of this finding further provided in part as follows:
6. It is understood and agreed that all of the said gas so to be delivered by Seller to Buyer shall be used by Buyer in the manufacture of carbon black, except (1) so much thereof as may be necessary for the operation of the said carbon black plant and for use in the dwellings of employees of the Buyer, and (2) that said gas may be resold by Buyer upon the following terms and conditions:
Buyer shall have the right at any time to cease burning all or any part of the gas it has been burning, and resell for other purposes said gas, or such part thereof as it ceases to burn, at the price of not less than two (2<f.) cents per thousand cubic feet, and in the event of such resale Seller shall receive said base price of two (2‡) cents per thousand cubic feet to take care of royalties, lease expenses, etc., and the remainder of the said resale price shall be divided between the parties hereto in the proportion of fifty per cent (50%) thereof to Buyer and fifty per cent (50%) thereof to Seller. If Buyer at any time is prevented by law from burning all or any part of the gas which it has been burning and is unable to make resale thereof when so prevented, and Seller is later able to make sale thereof, Buyer shall be entitled to the same part of the proceeds of sale as if it had negotiated or effected said sale.
* * # # *
8. The duration of this agreement shall be the duration of the natural gas resources of Seller at any time legally available for the manufacture of carbon black derived from sources owned or controlled by it (including purchase or processing agreements) located in Moore County, Texas, or tributary to gasoline extraction plants of Seller located in Moore County, Texas. * * * *****
14. The price to be paid to Seller for gas delivered to Buyer shall be 30% of the carbon black production of Buyer’s plant, hereinafter referred to as royalty, which shall, at Buyer’s expense, be placed in Buyer’s warehouse in paper bags, uncompressed. * * *
*****
*564 18. All rights and obligations hereunder shall extend to and be binding upon the parties hereto, their successors and assigns. It is further agreed that the provisions of this agreement regarding the production and delivery of gas by Seller, and the acceptance and payment for same by Buyer, shall be deemed to be covenants running with the respective lands, leases, purchase agreements, plants and pipe lines, together with their appurtenances, of the parties hereto. And the parties hereto covenant that they will not dispose of any of same in bulk, or in such material part as to disable them from performing their obligations hereunder, without causing the party to whom such property shall be transferred, together with its successors and assigns, to assume and be bound by the terms hereof. Provided, however, that nothing herein contained shall prevent Seller from selling, trading or abandoning any lease or gas contract in the ordinary course of business, or of exchanging any part of its gas resources for other gas resources of substantially equal amount.
¡13. An agreement similar to the one referred to in finding 12 was entered into on October 1, 1935, between Shamrock (as “Seller”) and the Eeliance Carbon Company, Inc. (as “Buyer”).
14. In connection with the agreements referred to in findings 12 and 13, Shamrock, Eeliance Carbon Company, Inc., and Western Carbon Company entered into a subsidiary agreement, also dated October 1, 1935. In this subsidiary agreement, Shamrock granted to Eeliance Carbon Company, Inc., and to Western Carbon Company “* * * the first right, in priority to all other uses or dispositions of its natural gas made by * * * [Shamrock] in twelve thousand (12,000) acres of gas territory owned or controlled by * * * [Shamrock] and located in Moore County, Texas.” The subsidiary agreement further provided (among other things) that “All rights and obligations hereunder shall extend to and be binding upon the parties hereto, their successors and assigns.”
15. In a third agreement that was entered into on October 1, 1935, between Shamrock and the Western Carbon Company, it was provided in part as follows:
2. It is agreed between the parties hereto that in the event any flat tax is levied upon the production or sale of the natural gas, which is the subject of said agreement,*565 either by the United States, the State of Texas or a,ny municipal division thereof, Buyer shall bear one-third of said tax and Seller shall bear two-thirds thereof. If Buyer is required to pay said tax, Seller shall reimburse Buyer accordingly, and if Seller is required to pay said tax, Buyer shall reimburse Seller accordingly.
8. In the event the gas which is the subject of said agreement shall not be used in the manufacture of carbon black but shall be resold, as in said agreement provided, the amount of any such tax shall be added to the base price thereof, and the remainder of the price of said gas upon resale divided equally between the parties hereto.
4. All rights and obligations hereunder shall extend to and be binding upon the parties hereto, their successors and assigns.
16. Subsequent to the making of the agreement referred to in finding 12, the Western Carbon Company constructed in Moore County, Texas, a carbon black plant that had a capacity sufficient to handle a minimum of 30,000,000 cubic feet of natural gas per day. The plant was located in the general vicinity of Shamrock’s McKee Plant. The cost of the carbon black plant was $1,221,405.
17. On January 2, 1936, the Western Carbon Company assigned to the plaintiff all of the former’s rights in the agreements referred to in findings 12, 14, and 15.
18. An agreement amendatory of the agreement referred to in finding 12 was entered into between Shamrock and the plaintiff under the date of January 4,1937. In the amenda-tory agreement, the plaintiff, which was then operating the carbon black plant mentioned in findings 12(a) and 16, agreed to expand its carbon black plant by the construction of additional units that would have a capacity to handle a •minimum of 15,000,000 cubic feet of natural gas per day. Also, the amount of gas to be sold by Shamrock and purchased by the plaintiff was increased to the extent of an additional daily minimum of 15,000,000 cubic feet of gas. The amendatory agreement further provided (among other things) that “Buyer [plaintiff] shall have the first right hereunder in priority to all other uses or disposition of its natural gas made by Seller [Shamrock] in three thousand (3,000) acres of gas territory owned or controlled by Seller
19. In April 1945, the plaintiff completed the construction of additional units to its carbon black plant. These additional units were of a capacity sufficient to handle a minimum of 15,000,000 cubic feet of natural gas per day. The cost of the additional units was $216,455.
20. (a) By means of an agreement dated November 11, 1946, between Shamrock and the plaintiff, Shamrock increased “ * * * the acreage reserves from which the Buyer [plaintiff] has the prior right to purchase and receive gas under the Gas Sales Agreements dated, respectively, October 1,1935, and January 4,1937, by an additional amount of 3,250 acres * * * .”
(b) The agreement of November 11, 1946, amended paragraph 6 of the agreement mentioned in finding 12 by substituting “Three Cents (3$)” for “two (24) cents” where-ever the latter appeared in the paragraph, and by adding the following to the paragraph:
Seller will desulphurize all said gas to be resold so that same shall contain not more than one-half (%) grain of hydrogen-sulphide per one hundred (100) cubic feet, and will cause same to enter the pipe line extending from Seller’s processing plant to the plant of Buyer at a pressure of not less than one hundred (100) pounds per square inch gauge.
(c) The agreement of November 11, 1946, substituted for paragraph 14 of the agreement mentioned in finding 12 a provision calling for the payment of a fixed price per Mcf on the gas delivered by Shamrock to the plaintiff after January 1, 1946.
Price per Mcf Period (cents)
Jan. 1-July 31, 1946_2.435
Aug. 1, 1946-Dec. 31, 1947_3
Jan. 1, 1948-Dec. 31, 1952_4
Jan. 1, 1953-Dec. 31, 1957_4.25
After Jan. 1, 1958_5.5
* * * [T]he aggregate volumes of residue gas which Buyer [plaintiff] has the prior right to purchase and which Seller [Shamrock] has the obligation to sell and deliver to Buyer * * * is the fractional part of the residue gas remaining (after being processed for the recovery of liquid hydrocarbons in either Seller’s McKee plant or its recently acquired Sunray plant, located near Sunray, Moore County, Texas) from all of the sour gas reserves of Seller heretofore accepted by Buyer * * * represented by a fraction, the nominator [sic] of which is 12,250, and the denominator of which is 62,225 * * *. Said fractional part of said residue gas is hereinafter referred to as the “dedicated reserves” of Buyer. It is agreed, however, if there shall be available from such dedicated reserves of Buyer in excess of forty million (40,000,000) cubic feet daily, averaged monthly, Buyer shall not be obligated to purchase in excess of forty million (40,000,000) cubic feet daily, but shall be privileged to purchase, by notifying Seller in writing of its desire to so purchase, the volumes attributable to the reserves of Buyer up to forty-two million (42,000,000) cubic feet daily when such volumes are available from such sources * * *.
22. Subsequent to September 11, 1951, Shamrock represented to the plaintiff that Shamrock desired to be free of the dedication to the plaintiff of its sour gas reserves in Moore County, Texas, in order that Shamrock would be free to negotiate more favorable contracts with the Northern Natural Gas Company.
23. On October 15, 1952, Shamrock negotiated a contract effective January 1, 1953, for the sale of gas — including gas from the acreage previously dedicated for the life of the field
Price per Mcf
Period (cents)
Jan. 1-Aug. 31, 1953_ 9
Sept. 1,1953-Dee. 31,1957_10. 5
Jan. 1, 1958-Dec. 31, 1982_11.5
After Jan. 1, 1963_12.5
The contract of October 15, 1952, provides that the prices are to be reduced should the gas delivered to the Northern Natural Gas Company contain less than 975 B.t.u.’s per cubic foot, such reduction to be the product obtained by multiplying the contract price stated by the quotient obtained by dividing the heating value of the delivered gas in B.t.u.’s per cubic foot by 975.
24. On November 19, 1952, Shamrock and the plaintiff entered into a contract that superseded the prior agreements between the parties. This contract provides in part as follows:
1. Effective January 1,1958, the aforesaid agreements and contracts between Shamrock and Columbian (or its predecessor) shall be terminated and be and become of no further force and effect, except as to final accounting between the parties thereto with respect to sales ana deliveries of residue gas thereunder consummated prior to January 1, 1953, and thereafter this contract and the provisions hereof shall fully control the rights, duties and obligations of the parties hereto with respect to the subject matter of the aforesaid contracts.
2. Shamrock agrees that it will pay to Columbian, as hereinafter provided, certain monetary consideration12 in respect of certain volumes of residue gas hereinafter specified, subject to the provisions hereinafter contained. The volumes of residue gas upon which payments will accrue and are to be made by Shamrock to Columbian shall be that part of all of the residue gas remaining from gas produced on and after January 1, 1953 from Shamrock’s sour gas reserves (as those reserves are described on Schedule A attached hereto) from gas wells having a shut-in pressure of more than fifty (50) pounds per square inch gauge represented by a fraction, the numerator of which is 9,000 and the denominator of which is 62,625.
*569 8, In determining the volumes of residue gas remaining from gas produced from Shamrock’s sour gas reserves there shall be deducted from gas produced therefrom:
(a) All liquids or liquefiable hydrocarbons extracted or removed by Shamrock from such production;
(b) All volumes of gas reserved to lessors under the provisions of oil and gas leases referred to on Schedule A attached hereto;
(c) Such volumes of gas produced from such reserves and used for drilling wells for the production of oil and gas and for maintenance and operation of the leases and the production of oil and gas from the lands referred to in Schedule A attached hereto; and
(d) The proportionate part of gas produced from said reserves that the total volumes of gas produced therefrom bear to the total volumes of all gas gathered and processed by Shamrock for the recovery of liquid hydrocarbons at its McKee and Sunray Plants in Moore County, Texas (or other plants where any part of the gas from such reserves is processed for liquid hydrocarbons) that may be lost or used in such processing (including the removal of hydrogen sulphide therefrom) through line and gathering losses, volumes used for fuel for compressors and compressor stations (except compressor fuel required to deliver casinghead gas into Shamrock’s main line gathering system), volumes for fuel for plants for recovery, fractionating and processing liquids and liquid hydrocarbons and hydrogen sulphide from the gas and the manufacturing of elemental sulphur and for steam in connection with such purposes, houses of employees and offices of Shamrock in the field.
4. There shall be no restriction nor limitation on Shamrock’s right to remove liquid or liquefiable hydrocarbons or hydrogen sulphide from the gas produced from said reserves and there shall be no obligation, express or implied, on Shamrock’s part to make payments to Columbian on the proportionate part of said residue gas above specified, except as, if and when such residue gas is sold or used by Shamrock for purposes other than specified in subparagraphs (a), (b), (c) and (d) of Section 3 above; provided that if Shamrock should cease to process through its plant or plants the gas produced from its sour gas reserves, or any part thereof, and shall make sale thereof at the well or wells where produced, then such payments shall be applicable to the propor*570 tionate part of tlie raw gas volumes that may be sold by Shamrock.
‡ * ❖
9. Shamrock will pay all ad valorem taxes on its leases and on its properties. No portion of gross production taxes, severance taxes or other excise taxes levied prior to March 1, 1950 upon or with respect to the volumes of residue gas in respect of which Shamrock shall become obligated to make payments to Columbian hereunder shall be borne by Columbian. Columbian agrees to pay to Shamrock, when billed by Shamrock, sums equal to one-sixth (%) of seven-eighths (%) of all increases, effective March 1, 1950 and thereafter, in such present gross production taxes, severance taxes and other excise taxes upon, and one-sixth (%) of seven-eighths (%) of any new or additional excise taxes levied upon or with respect to the volumes of residue gas in respect of which Shamrock may be required hereunder to make payments to Columbian or the production, transportation or handling thereof. If any such tax is imposed upon or with respect to raw gas from which residue gas is attributable, the portion of such tax attributable to such residue gas for the purposes hereof shall be represented by a fraction, the numerator of which is the volume of such residue gas the denominator of which is the volume of such raw gas; that is, for example, if a new or increased tax is imposed with respect to a unit of one thousand (1,000) cubic feet of raw gas from which nine hundred fifty (950) cubic feet of residue gas are attributable in respect of settlement to Columbian hereunder, Columbian shall pay one-sixth {%) of seven-eighths (%) of 950/1,000 of the tax imposed on such unit of one thousand (1,000) cubic feet of gas. Provided, however, if such tax or taxes should hereafter eliminate or not include royalty owners as taxpayers thereunder, then the fraction of seven-eighths (%) first above used in this paragraph shall be increased to eight-eighths (8/8) with respect to any such tax.
25. (a) By a letter agreement among the plaintiff, United Carbon Company, Inc. (Maryland), and Shamrock dated December 16, 1952, the plaintiff arranged to obtain from Shamrock natural gas, with the liquid and liquefiable hydrocarbons removed, in a volume approximating 21,000,000 cubic feet daily, which natural gas Shamrock was under contract to deliver to United Carbon Company, Inc. (Maryland).
(c) The letter agreement dated December 16, 1952, covered the period from 7:00 a.m. on January 1, 1953, to 7:00 a.m. on September 1,1953.
26.Pursuant to the contract dated November 19, 1952, as modified by the letter agreement dated December 16,1952, Shamrock paid the plaintiff the following amounts in the tax year 1953:
Mcf sold to Gross pay-Northern Natural ment due Month Gas Company plaintiff Amount due United Carbon Co. Net payment due plaintiff
January - 705,004 $42,300.24 $16, 920.10 $25,380.14
February _ 616,380 36,982.80 14, 793.12 22,189. 68
March- 676,091 40,565.46 16,226.18 24,339. 28
April - 635,444 38,126.64 15,250. 66 22, 875.98
May- 620,040 37,202.40 14, 880.96 22,321.44
June - 631,155 37,869.30 15,147. 72 22, 721. 58
July_ 591,978 35,518.68 14,207.47 21,311.21
August _ 532,989 31,979.34 12,791. 74 19,187. 60
September _ 551,076 33,064.56 33, 064. 56
October_ 523,680 31,420.80 31,420.80
November_ 580,497 34,829.82 34, 829.82
December_ 538,019 32,281.14 32,281.14
27. In January 1955, the plaintiff paid to Shamrock the sum of $3,217.45, constituting the plaintiff’s share of increased production taxes, severance taxes, and other excise taxes levied upon or with respect to the volumes of gas for the period from January 1, 1953, to December 31, 1955, inclusive, as specified in paragraph 9 of the contract dated November 19,1952, between the plantiff and Shamrock. The plaintiff made such payments for the years 1956, 1957, and 1958 and for the period from January 1, 1959, through October 31, 1959, in the amounts of $1,378.94, $1,464.46, $965.23, and $812.32, respectively.
28. From 7:00 a.m. on July 29, 1956, through 7:00 p.m. on July 30, 1956, the Shamrock plant was shut down due to a fire. On that occasion, the raw gas was passed through
29. During the tax year 1953, Shamrock did not claim a deduction for percentage depletion with respect to any of the payments that were made to the plaintiff under the contract dated November 19, 1952.
CONCLUSION OK LAW
Upon the foregoing findings of fact, which are made a part of the judgment herein, the court concludes as a matter of law that plaintiff is entitled to recover, and judgment is entered to that effect. The amount of recovery will be determined pursuant to Pule 38(c) of the rules of this court.
In accordance with the opinion of the court and a memorandum report of the commissioner as to the amount due thereunder, it was ordered on March 20,1964, that judgment be entered for the plaintiff for $53,952.70, together with interest thereon, as provided by law, from April 17,1957.
The 1962 agreement contains no provision declaring it a covenant running with the land, but merely the ordinary clause stating that the contract shall be binding and inure to the parties and their successors and assigns. In contrast, the earlier agreement contained, in addition to the normal clause relating to assignment, another clause specifically agreeing “that the provisions of this agreement * * * shall be deemed to be covenants running with the respective lands, leases,” etc., and also covenanting that the “parties * * * will not dispose of any of same in bulk, or in such material part as to disable them from performing their obligations hereunder, without causing the party to whom such property shall be transferred, together with its successors and assigns, to assume and be bound by the terms hereof.”
The preamble to the 1952 contract discloses (In its fourth paragraph) that plaintiff desires to shut down its carbon black plant and “desires to effect a resale of the volumes of gas it is authorized to resell under the terms and provisions of the aforesaid contracts [i.e., the pre-1952 contracts].” (Emphasis added). In the fifth paragraph of the preamble, it is pointed out that any purchaser of such residue gas would have to receive it from Shamrock and would likewise have to deal with Shamrock on various matters (e.g., pressure, deliveries', etc.) ; the preamble then goes on to say that “the parties hereto, having considered such matters, have concluded that it would be more economical and convenient to arrange for the resale of the aforesaid volumes to be made by Shamrock in its own name and on its responsibility as between the seller and the purchaser of such gas and that an accounting between the parties hereto with respect to such resale volumes be made on a basis mutually satisfactory in lieu of the accounting between the parties required under the terms of the aforesaid contracts in the event a resale of such volumes to another purchaser should be accomplished by Columbian.” (Emphasis added.) The sixth paragraph of the preamble states that Shamrock “is willing to undertake to accomplish a resale of the volumes of residue gas which Columbian is authorized to resell under the provisions of the aforesaid contracts in lieu of making delivery thereof to Columbian, and is willing to make certain payments to Columbian with respect to the volumes of residue gas remaining from gas produced from its sour gas reserves to the extent of the volumes which Columbian would, except for this contract, be authorized to sell to others.” (Emphasis added.)
The contract provided :
“4. There shall be no restriction nor limitation on Shamrock’s right to remove liquid or liquefiable hydrocarbons or hydrogen sulphide from the gas produced from said reserves and there shall be no obligation, express or Implied, on Shamrock’s part to make payments to Columbian [plaintiff] on the proportionate part of said residue gas above specified, except as, if and when such residue gas Is sold or used by Shamrock for purposes other than specified In subparagraphs (a), (b), (c) and (d) of Section 3 above; provided that if Shamrock should cease to process through its plant or plants the gas produced from its sour gas reserves, or any part thereof, and shall make sale thereof at the well or wells where produced, then such payments shall be applicable to the proportionate part of the raw gas volumes that may be sold by Shamrock.”
In Anderson v. Helvering, 310 U.S. 404, 409 (1940), the Court said:
“A share In the net profits derived from development and operation * * * does not entitle the holder of such interest to a depletion allowance even though continued production is essential to the realization of such profits.”
Other changes made by the agreement of November 11, 1946, do not have any particular significance from the standpoint of the present litigation.
Basically, Shamrock agrees to pay the plaintiff 6 cents per Mcf in connection with the sales of residue gas tha,t are within the scope of this contract.
