Opinion
Docket No. 38928.
1953-10-9
WESTATES PETROLEUM COMPANY (AND WHOLLY-OWNED SUBSIDIARY WESTATES PETROLEUM CORPORATION), PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
George D. Hardisty, Esq., and Herbert F. Baker, C.P.A., for the petitioners. Aaron S. Resnick, Esq., for the respondent.
George D. Hardisty, Esq., and Herbert F. Baker, C.P.A., for the petitioners. Aaron S. Resnick, Esq., for the respondent.
An amount received by the taxpayers upon assignment of a portion of their interest in oil and gas leases held includible in gross income and subject to an allowance for depletion.
The respondent determined deficiencies in income tax against the petitioners in the years 1948 and 1949, as follows:
+--------------------+ ¦Year ¦Deficiency ¦ +------+-------------¦ ¦1948 ¦$6,660.23 ¦ +------+-------------¦ ¦1949 ¦1,026.00 ¦ +--------------------+
The sole question in issue, after concession of other issues raised by the pleadings, is whether the amount of $21,709.76 received by the petitioners is to be taxed as ordinary income or as the proceeds from the sale of a capital asset.
FINDINGS OF FACT.
The facts stipulated are found accordingly.
Westates Petroleum Company is a corporation organized under the laws of Delaware with its principal place of business in San Francisco, California. It is the parent and the owner of all of the outstanding capital stock of Westates Petroleum Corporation, a Nevada corporation (hereinafter sometimes referred to as Westates). The consolidated tax return of the petitioners for the calendar year 1948 was filed with the collector of internal revenue for the first district of California.
On November 10, 1947, Westates and Stanolind Oil and Gas Company (hereinafter sometimes referred to as Stanolind) entered into an option and operating agreement. This agreement set forth that Westates was the owner of certain oil and gas leases on land of the United States and the State of Wyoming having primary terms extending at least to January 1, 1950. The United States leases bore an overriding royalty not in excess of 5 per cent and the State of Wyoming leases bore an overriding royalty not in excess of 4 1/6 per cent.
The agreement further provided that Westates granted to Stanolind, for a period of 12 months, the right to enter upon the lands covered by Westates' leases and to conduct seismograph explorations of these lands and to explore these lands by any other geological method which Stanolind might desire. It was provided that in the event Stanolind commenced exploratory work prior to the approval of titles Stanolind would pay $1.50 per gross acre at that time to Westates. For the same consideration and for the same period, Westates granted Stanolind the exclusive right and option to acquire a 75 per cent interest in the rights below 4,500 feet in and to the oil and gas leases. Provision was made in the agreement for Westates to furnish Stanolind with abstracts of title covering the lands under lease which were to be examined by Stanolind and either accepted or objected to. If Stanolind accepted the lease acreage, it was thereupon to pay Westates $1.50 per gross acre for each acre under lease if Stanolind had not heretofore made this payment. Provision was also made in the agreement for Westates to pay all delay rentals accruing under the leases except that if Stanolind exercised its option these payments were to be borne equally by the parties. If Stanolind acquired the lease acreage, it was to commence operations on the land for the drilling of a test well within 60 days. This well was to be drilled to a maximum depth of 11,500 feet unless production of oil or gas in paying quantities was encountered at a lesser depth but below 4,500 feet. If this well proved dry, it was to be plugged and abandoned by Stanolind and Westates was not to be liable for any part of the cost of drilling and plugging the dry hole. If this well proved productive of oil or gas in paying quantities, Westates was to own an undivided 25 per cent interest in the well and equipment therein. Westates was to pay in cash it proportionate part of the cost of pumping equipment and Stanolind was to charge Westates 25 per cent of the operating cost of this well. If the test well proved dry, Stanolind, within 18 months, was to commence operation for the drilling of an additional test well or to reassign its interest in the leased lands to Westates. Twenty-five per cent of the cost of this well was to be charged to Westates. If this well was completed as a commercial producer and a market established for its production, Stanolind was to continue development of the production zone. If Stanolind acquired the lease acreage, it was to have the exclusive control and direction of the drilling and development of the jointly-owned lease acreage for the production of oil and/or gas for the joint account of the parties to the agreement in the proportions of 75 per cent for Stanolind and 25 per cent for Westates. Stanolind was to pay all costs for the drilling development and operation of all wells and to charge Estates 25 per cent thereof. For all wells other than the first test well, Westates was to retain a 5 per cent net profit interest and a carried working interest of 20 per cent in production from formations below the depth of 4,500 feet. This agreement was amended as of November 10, 1947, by a letter which referred to the delay rentals and overriding royalties.
On or about May 3, 1948, Westates received a payment by check from Stanolind in the amount of $21,709.76 pursuant to the terms of the agreement for the payment of $1.50 per acre of the lands covered by the oil and gas leases. A letter accompanying this check referred to the payment required if Stanolind began exploratory work prior to the approval of titles. Westates acknowledged the receipt of this amount as payment of the agreed option price of $1.50 per acre. Westates recorded the receipt of this amount on its books with a debit to cash receipts and a credit to a suspense account. At a later date, a credit was made to a fixed capital assets account denominated ‘undeveloped properties.‘
On November 5, 1948, after a 30-day extension of the option had been granted, Stanolind exercised its option to acquire the oil and gas leases. In its annual report for the year 1948, Westates declared that Stanolind began work preparatory to drilling the first test well in January 1949. The report further stated that Westates retained all rights from the surface to 4,500 feet and also retained a 25 per cent interest below 4,500 feet. In its annual report for 1952, Westates declared that the well on this property would be reentered and new methods used to test all of the possible gas horizons.
Westates and Stanolind did not file a partnership return of income nor a corporation income tax return with reference to the operations on the property referred to in the option and operating agreement. The amount of $21,709.76 received by Westates from Stanolind was deposited in its bank account in the ordinary course of its business and distributed on Westates' books to the credit of various component leases. No part of the receipt of $21,709.76 was reported either as ordinary income or as capital gain on the consolidated tax return of the petitioners. In the respondent's statutory notice of deficiency, it was was determined that the receipt in 1948 by Westates of this sum represented ordinary income and was subject to depletion. The respondent increased accordingly the depletion deduction taken by the petitioners.
OPINION.
VAN FOSSAN, Judge:
The only question presented for determination is the treatment to be accorded, for tax purposes, the receipt by the petitioners of the sum of $21,709.76. This amount was received by the taxpayers pursuant to the terms of the option and operating agreement with Stanolind entered into in November 1947. The facts are fully set out in our findings and need not be repeated in extenso.
The petitioners contend that the amount received represented the proceeds of the sale of the right to enter upon the land and the right to remove oil and gas in place and that it constituted merely a return of capital. Is is the respondent's view that the amount in question was received as ordinary income subject to a depletion allowance. The transaction took the form of an option to explore and acquire oil and gas rights below 4,500 feet on the leased lands. The sum received was in consideration of the option to acquire the 75 per cent interest in the rights below 4,500 feet and was payable either at the commencement of the exploration, if prior to approval of titles, or upon acceptance of the lease acreage after approval of titles. The amount in question was, therefore, paid by Stanolind to acquire an option on the oil and gas rights below 4,500 feet with provision being made for a continuing interest in Westates in the deeper rights in the amount of 25 per cent, as well as all of the shallow rights. Provision was made in the agreement for Westates to own an undivided 25 per cent in a paying well and to pay its proportionate share of the operating costs. If the first well should prove dry, a second drilling could be undertaken. Westates was to bear 25 per cent of the cost of this well and to retain a 5 per cent net profit interest in addition to a ‘carried working interest‘ of 20 per cent.
It is our opinion that the sum of $21,709.76 was received as payment for the option to acquire by assignment, the lease on the oil and gas rights below 4,500 feet and that it constituted a bonus payment additional to the retained 25 per cent interest in the oil and gas proceeds. Bonus or advanced royalty payments for the assignment of an oil and gas lease do not represent the proceeds from the sale of a capital asset but constitute ordinary income. Burnet v. Harmel, 287 U.S. 103. It was there said:
* * * Nor would the payments made by lessee to lessor generally be denominated the purchase price of the oil and gas. By virtue of the lease, the lessee acquires the privilege of exploiting the land for the production of oil and gas for a prescribed period; he may explore, drill, and produce oil and gas, if found. * * *
Bonus and royalties are both consideration for the lease, and are income of the lessor. We cannot say that such payments by the lessee to the lessor, to be retained by him regardless of the production of any oil or gas, are any more to be taxed as capital gains than royalties which are measured by the actual production. * * *
The fact that the transaction took a form other than that of a sublease or that it was designated a sale of a portion of the lease rights is not determinative that a capital transaction occurred. Palmer v. Bender, 287 U.S. 551. In Kirby Petroleum Co. v. Commissioner, 326 U.S. 599, it was held that an owner who leased his lands for the production of oil, gas, and other minerals and received in consideration a cash bonus, royalty, and additional payments from the net profits of the operations of the lessee was entitled to a percentage depletion deduction from gross income in respect of the net profits as well as the bonus and royalties. A cash bonus payment paid as consideration for such a lease is regarded as advance royalties and as gross income to the lessor. Sunray Oil Co. v. Commissioner, 147 F.2d 962. The amount received by the taxpayers here must similarly be classified as a bonus paid to obtain the option to explore and drill for oil or gas on the leased property and must be included in gross income by Westates. Westates did not sell or otherwise dispose of its interest in the land it had leased but retained a portion of its interest in the oil and gas in place while assigning the right for a limited time to explore and drill for the oil and gas.
The inclusion in gross income and allowance for depletion on the payment received is not dependent upon actual production of oil or gas during the the taxable years. Herring v. Commissioner, 293 U.S. 322; Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25. The petitioners rely upon Berry Oil Co. v. United States, 25 F.Supp. 96, wherein an amount received by the taxpayer for the assignment of a half interest in oil and gas below 2,000 feet was held to represent the purchase price of an agreement and not ordinary income. The controlling factor was stated as the fact that there was no depletion of the oil and gas by production. This rule, however, has not been followed in the later cases, Herring v. Commissioner, supra, J. T. Sneed, Jr., 33 B.T.A. 478, and such payments have been included in income and depletion allowed thereon subject to the proposition that if the leases or mineral rights for which the advance payment was made are abandoned or terminated prior to the removal of the oil or gas, the lessor must report as taxable income the amount previously allowed to him as depletion as to which no production has occurred. Douglas v. Commissioner, 322 U.S. 275; Grace M. Barnett, 39 B.T.A 864. We conclude that the petitioners erred in not including the amount in question in ordinary income.
Decision will be entered for the respondent.