Decision will be entered for the respondent. 28
Petitioners made assignments in 1975 of two oil and gas leases held by them, retaining, however, overriding royalties of 4 percent from one lease and 5 percent from the other. As part of the consideration for the assignments, they received advance royalties totaling $ 7,600. There was no production of oil or gas from either of the leases during 1975. Held, under
*915 OPINION
Respondent determined a deficiency in the amount of $ 4,957.65 in petitioners' Federal income tax for 1975. Petitioners failed to take exception to certain items of adjustment; therefore, the only issue for decision is whether a percentage depletion deduction is allowable under
All of the facts have been stipulated.
At the time the petition was filed, petitioners, who are husband and wife, were legal residents of Hartland, Wis. They filed their joint Federal income tax return for 1975 with the Internal Revenue Service Center, Kansas City, Mo.
Effective July 1, 1975, petitioner Fred L. Engle (Fred) procured an oil and gas lease covering 80 acres of land in Campbell County, Wyo. On October 6, 1975, he assigned the lease to Getty Oil Co., retaining, however, a 5-percent overriding royalty. 2*118 As part of the consideration for the assignment, he received an advance royalty in the amount of $ 6,000.
*916 Fred was also the lessee under an oil and gas lease, effective beginning September 2, 1975, covering 160 acres *119 of land in Carbon County, Wyo. On October 22, 1975, petitioners assigned this lease to Marshall & Winston, Inc., 3 retaining a 4-percent overriding royalty. As part of the consideration for the assignment, they received an advance royalty in the amount of $ 1,600.
The amounts received as consideration for the assignments of the leases constituted the only taxable income from the described properties in 1975. There were no related expenses. Prior to the end of 1975, no discovery or exploratory work had been done on the properties covered by the leases, and no oil or gas had been produced from the properties. During 1975, petitioners had no average daily production of domestic crude oil or natural gas and no average daily secondary or tertiary production of domestic crude oil or natural gas, within the meaning of
Prior to 1975, it was well settled that the recipient of advance royalties (i.e., royalties paid in advance of the actual production of a mineral) under an oil and gas lease was entitled to compute depletion on the basis of both the cost method and the percentage method and to deduct the greater of the two amounts so computed. See, e.g., *122
A taxpayer's "average daily production" of domestic crude oil or natural gas is determined by dividing his aggregate production 9 during the taxable year by the number of days in such taxable year.
The number of barrels constituting the taxpayer's tentative depletable oil quantity is set forth in a "Phase-out table" in *920
Respondent, in this case and in proposed regulations under
Petitioners, on the other hand, emphasize that percentage depletion was allowable with respect to advance royalties prior to the enactment of
We hold that petitioners are not entitled to deduct in 1975, a year in which they had no production of oil or gas, percentage depletion computed with reference to their $ 7,600 in advance royalties. Petitioners may deduct only cost depletion with respect to that sum, and they have made no claim to such a deduction.
As petitioners point out, the amount of the percentage depletion allowance under
In our view, the express language of
Further support for this conclusion is found in the table in
Petitioners' position that
Nor does the language in the Conference Committee report, quoted in note 15 supra, to the effect that the Senate version of the bill "retains percentage depletion" for the small independent producer, aid petitioners' cause. That language was clearly intended to refer to the fact that, under the Senate version, the 22-percent rate for percentage depletion was to be retained on a permanent basis in connection with the exemption for independent producers. It was not the Senate version of the bill, but a Conference substitute, that was enacted into law. The Conference report makes it plain that, although the Conference substitute followed the Senate version by providing a limited exemption for independent producers, 19*137 the exemption was to be gradually phased down both in terms of the exempt quantity of production and the rate to be applied in computing percentage *924 depletion. Conf. Rept. 94-120 (1975),
A large body of law has developed under
It is true that, as petitioners emphasize, the Supreme Court in
Of course, actual production of oil or gas at some point in time has always been an implicit requirement of the allowance for depletion under either the cost or the percentage method. 25 However, we do not think, as petitioners appear to contend, that income from possible production in a future year will suffice for the purposes of
*926
Finally, numerous practical problems would arise in the application of
*927 In our view, the fact that
To reflect the foregoing,
Decision will be entered for the respondent. 28
Goffe, J., concurring: I wholeheartedly concur, not only in the result, but also in the rationale of the majority opinion, which, contrary to the complaint in Judge Fay's dissent, clearly explains why percentage depletion is not allowable against advance royalties which are not attributable to actual, existing production. Though I am inclined to pinpoint some of the aspects of our discourse on the thorny problems posed by
The majority's recitation of the historical treatment of advance royalties for percentage depletion purposes, as well as its explanation of the basic provisions of
At the outset, it should be pointed out that the 1975 revision to the previously existing percentage depletion scheme is a drafting nightmare. The denial contained in the cross-referencing of
The majority opinion has, in my view, taken a mangled statute that is unattended by any germane or informative legislative history and has interpreted it by a direct and simple construction of one of the least ambiguous words in the statute: production. Repeated readings of
Judge Fay's dissenting opinion focuses almost entirely upon situations where extraction and payment for the extracted hydrocarbon occur in different taxable years. This is the *147 exception rather than the commonplace situation. It is even more exceptional in the case of royalty owners than independent producers. Normally, oil or gas is sold in the taxable year in which it is extracted and the matching of the income with the allowable percentage depletion is simple.
*929 If, for some reason, payment for the hydrocarbon is received in a calendar year subsequent to the year of extraction, we must determine in which taxable year, if either, the taxpayer is entitled to percentage depletion. This question is answered in section 1.613A-3(a)(4), example (7), Proposed Regs.,
Example (7). H, a calendar year taxpayer, owns a domestic oil well which produced 100,000 barrels of oil in 1975. The proceeds from the sale of 15,000 barrels of that production are not includible in H's income until 1976. The 15,000 barrels produced in 1975 are included in H's average daily production for 1976 and excluded from such production for 1975.
At first blush, the example appears reasonable. It merely provides for tracing the income from the oil extracted and applying the barrels produced to the taxable year the income is received. Because *148 of the two new major ingredients introduced into the allowable percentage depletion deduction by the 1975 amendment, I conclude that the method is not fair. The 1975 revision to the percentage depletion deduction established an annual limitation on the deduction which varies for different calendar years from 1975 to 1980 and it also specified a variable percentage allowable for different calendar years from 1980 to 1984. Because of these variables, it makes a substantial difference as to which taxable year one refers in allowing percentage depletion on hydrocarbon income derived from the sale of production extracted in an earlier taxable year.
The majority clearly holds that the intent of the statute is to allow the percentage depletion deduction for hydrocarbons "produced." "Production" means extraction. No one familiar with the "oil business" would seriously question such a definition of "production." Because the focus of the percentage depletion deduction is on production (or extraction), in my view, that identification should be preserved if payment for the hydrocarbon fortuitously fails to coincide with extraction in the same calendar year. The barrel limitation expressed as *149 average daily production in
As to the barrel limitation on the 15,000 barrels, I would also look to the year of extraction rather than a *150 subsequent year of sale.
To illustrate this concept, let us assume that the taxpayer had 380,000 barrels of production in 1981 of which 25,000 barrels were not sold until 1982. I would allow no percentage depletion on the 25,000 barrels sold in 1982 because in the year of extraction the taxpayer exceeded the 365,000-barrel limitation.
Let us assume instead that the taxpayer had only 365,000 barrels of production in 1981, all of which were sold in 1981 except 30,000 barrels, which were sold in 1982. Assume further that in 1982 the taxpayer extracted 365,000 barrels. Because the oil extracted in 1981, including the 30,000 barrels sold in 1982, did not exceed the taxpayer's limitation of 365,000 barrels when extracted, he should be entitled to percentage depletion on the proceeds from the sale of such oil in 1982, and he should be allowed percentage depletion at the rate of 20 percent (allowable for 1981) rather than 18 percent (allowable for 1982).
Although I have referred, for the sake of clarity, to specific barrels being extracted in one year and sold in the next, I recognize that a literal tracing of barrels of oil (or cubic feet of gas) would present a recordkeeping nightmare. However, *151 such tracing is unnecessary. By taking a cue from normal first-in, first-out inventory accounting, it is fairly easy to devise a system whereby the appropriate percentage depletion allowable with respect to production extracted in a given taxable year and sold in a subsequent taxable year can be determined on the basis of the amount of extraction, the tentative quantity, and the applicable percentage for such taxable year. Any unsold production from a taxable year can be "inventoried," by recording not *931 only the amount remaining unsold but also the appropriate percentage by which the proceeds from the sale of such production will be multiplied when it is eventually sold to arrive at allowable percentage depletion. Working from the assumption that the first oil or gas sold in a taxable year is the oldest oil or gas in inventory, all of the allowable percentage depletion will eventually be matched with the proceeds from the sale of the production which qualified for percentage depletion.
The following example illustrates this procedure: assume extraction and sales of oil (at an assumed price of $ 10 per barrel) in these amounts for the calendar years 1981 through 1983:
| 1981 | 1982 | 1983 | |
| Extraction (in barrels) | 1,460,000 | 365,000 | 36,500 |
| Sales (in barrels) | 730,000 | 365,000 | 766,500 |
| Sales (in dollars) | $ 7,300,000 | $ 3,650,000 | $ 7,665,000 |
We *152 should note that, in reality, the percentage depletion limitations are not imposed by applying the applicable percentage to a limited amount of barrels (though that is the effect and basic concept of the scheme), but rather, such limitations are imposed by reducing the percentage applied to all barrels.
According to
| 1981 | 1982 | 1983 | |
| 1*153 ADP | 4,000 | 1,000 | 100 |
| 2 DOQ | 1,000 | 1,000 | 1,000 |
| 3 AP | 0.20 | 0.18 | 0.16 |
| 4 PDF | 0.05 | 0.18 | 0.16 |
| 1981 = | 1,460,000 / 365 | = 4,000 |
| 1982 = | 365,000 / 365 | = 1,000 |
| 1983 = | 36,500 / 365 | = 100 |
*932 All oil extracted in those years should eventually be depleted at the PDF rate applicable to the year of such extraction, regardless of when sold. If that occurs, the total percentage depletion allowed would be as follows:
| 1981 | 1982 | 1983 | Total | |
| Extraction | 1,460,000 | 365,000 | 36,500 | |
| Times sales price | x $ 10 | x $ 10 | x $ 10 | |
| Gross income | $ 14,600,000 | $ 3,650,000 | $ 365,000 | |
| Times PDF | x 0.05 | x 0.18 | x 0.16 | |
| Total percentage | ||||
| depletion | 730,000 | 657,000 | 58,400 | $ 1,445,400 |
Mechanically, each year's percentage depletion deduction (assuming that the 50 percent of taxable income from the property limit is not exceeded) would be computed as follows:
| 1981 | ||
| Total sales -- 730,000 barrels | ||
| PDF x (barrels sold x price per barrel) | ||
| 0.05 x (730,000 x $ 10) | ||
| 0.05 x $ 7,300,000 | ||
| $ 365,000 -- 1981 percentage depletion | ||
| Inventory (in barrels) | Beginning | 0 |
| 1 Extracted | 1,460,000 at 0.05 | |
| Subtotal | 1,460,000 at 0.05 | |
| Sold | (730,000 at 0.05) | |
| Ending | 730,000 at 0.05 | |
| 1982 | ||
| Total sales -- 365,000 barrels | ||
| PDF x (barrels sold x price per barrel) | ||
| 2 0.05 x (365,000 x $ 10) | ||
| 0.05 x $ 3,650,000 | ||
| $ 182,500 -- 1982 percentage depletion | ||
| Inventory | Beginning | 730,000 at 0.05 |
| Extracted | 365,000 at 0.18 | |
| Subtotal | 730,000 at 0.05 | |
| 365,000 at 0.18 | ||
| Sold | (365,000 at 0.05) | |
| Ending | 365,000 at 0.05 | |
| 365,000 at 0.18 | ||
| 1983 | ||
| Total sales -- 766,500 barrels | ||
| PDF x (barrels sold x price per barrel) | ||
| [0.05 x (365,000 x $ 10)] + [0.18 x (365,000 x $ 10)] | ||
| + [0.16 x (36,500 x $ 10)] | ||
| $ 182,500 + 657,000 + 58,400 | ||
| $ 897,900 -- 1983 percentage depletion | ||
| Inventory | Beginning | 365,000 at 0.05 |
| 365,000 at 0.18 | ||
| Extracted | 36,500 at 0.16 | |
| Subtotal | 365,000 at 0.05 | |
| 365,000 at 0.18 | ||
| 36,500 at 0.16 | ||
| Sold | (365,000 at 0.05) | |
| (365,000 at 0.18) | ||
| (36,500 at 0.16) | ||
| Ending | 0 | |
*933 Thus, the cycle is complete. Note that the total percentage depletion arrived at in these detailed calculations ($ 365,000 + $ 182,500 + $ 897,900 = $ 1,445,000) equals the amount calculated at the outset of this example,
Although I speculate as to whether the Commissioner may, by regulation, establish such a scheme when *155 the statute does not *934 specifically authorize it, the question apparently does not disturb the Commissioner because he has proposed, also without statutory mandate, his own brand of carryforward set forth above. That being the case, I would urge the Commissioner, who has just prevailed in the instant case as to advance royalties and in
My proposal, which I contend is far from the characterization of "impossible" (dissenting opinion, infra at 942 note 6), easily conforms with the general requirements of
Having said all this, it is easy to see the most glaring flaw in the analysis of the dissent. The statute requires a counting of the barrels of production in a taxable year in order to determine what production percentage depletion will be allowed "with respect to" and to determine the applicable percentage "in the case of production during the calendar year."
Similarly I, like the majority, am convinced that
The chant found throughout Judge Fay's dissenting opinion is that because
Thus, I fully support the holding and rationale of the majority opinion. Though the author of that opinion did not need to extend its *159 legal reasoning as far as I have in order to dispose of the issue before us, it is apparent that much of what I have outlined above is the necessary implication of the holding *936 embodied in the majority opinion. Moreover, I agree that an alternative holding based upon a theory such as that found in the dissenting opinion would produce numerous practical problems, as outlined in the majority opinion at pages 926 and 927. The dissent's attempt to address these problems is feeble. (See dissenting opinion, infra at 948 note 15). Since 6,000 cubic feet of gas may not sell for the same price as a barrel of oil, the need to know the makeup of the production is critical, particularly where there is "excess production."
The dissent's strident examples prove nothing. Under the majority's approach, which has the virtue of interpreting the word "production" in its ordinary, everyday sense (
I would like to turn briefly to other problems presented by the construction and application of
It can hardly be denied that the rationale of the majority, when applied to the question of whether percentage depletion on lease *163 bonuses remains available, requires a negative answer to such question. See
Another nettlesome problem arises when we consider the situation where a bonus, which is not *165 subject to percentage depletion but should conceivably always be subject to cost depletion, is received in the same year as a royalty (or a recouped advance royalty), which royalty is subject to percentage depletion as limited by
There are, no doubt, other technical problems in the percentage depletion area caused by the drastic revision made in 1975. The proposed regulations should be examined not only to resolve *940 the problems I have enumerated above but also to speak to some others which lurk behind the scene. Hopefully, the Commissioner will perform a comprehensive review of the proposed regulations.
Fay, J., dissenting: While the grounds upon which the majority opinion rests its holding are unclear, I nevertheless disagree. In my view, advance payments for oil or gas do in fact represent "production" for purposes of
First, the majority opinion could be read as defining "production" *941 as extraction alone. Thus, percentage depletion would be allowable only with respect to extraction occurring during the taxable year. While such a definition might come to mind upon a simplistic first reading of the statute, it becomes absurd after further reflection. Reading
Perhaps the majority opinion would allow our taxpayer, B, percentage depletion in 1976 since it is unclear whether it requires extraction in the same year as a percentage depletion deduction is claimed. 5 Respondent, in his proposed regulations under
Consider the following example: During 1975, C, a cash basis, calendar year taxpayer, extracts 2,000 barrels and receives income for 3,000 barrels. In 1976, C extracts 5,000 barrels and receives income for 4,000 barrels. Those facts are charted below:
| 1975 | 1976 | |
| Extraction in barrels | 2,000 | 5,000 |
| Income in barrels | 3,000 | 4,000 |
Under the regulations' approach (and, perhaps, the majority's), C would have 2,000 barrels of "production" in 1975 because, while 3,000 barrels gave rise to income, only 2,000 of those barrels were backed by extraction. In 1976, C would have 4,000 barrels of "production" because, while 5,000 barrels were extracted only 4,000 barrels gave rise to income. Even though C did not exceed his depletable oil quantity in either year, he is deprived of percentage depletion with respect to the 1,000 barrels which gave rise to income in 1975 but were *174 extracted in 1976. Respondent gets the best of both worlds, and a harsh result *943 obtains. Since respondent recognizes that "production" cannot mean just extraction this year but must necessarily somehow relate to gross income, I am at a loss to understand his rationale for distinguishing between income received before extraction and income received after or with extraction. In other words, if "production" is based on income when extraction has occurred in the past, it is capricious to say that "production" is not based on income solely because extraction will occur only in the future. 7
Furthermore, not only does requiring income to be backed by extraction deny percentage depletion with respect to any oil paid for before it is extracted, respondent's interpretation creates additional accounting requirements. Extraction not matched by current sales must be noted and carried forward until the income therefrom is recognized for tax purposes. There is absolutely no statutory authority for such a requirement, which causes "production" *175 to take on an excessively complicated and burdensome meaning. Therefore, I would reject respondent's income-backed-by-extraction interpretation of "production." 8
There is a third possible meaning which the majority might be attaching to "production," that is that "production" means a combination of extraction and income regardless of which occurs first. Under this approach, both elements are required with "production" for
Assume the following facts: In 1975, D, a calendar year, cash basis taxpayer extracts 1,000 barrels and receives income for 5,000 barrels. In 1976, D extracts 2,000 barrels and receives income for 1,000 barrels. In 1977, D extracts 5,000 barrels and receives income for 1,000 barrels. Those *176 facts are charted below: *944
| 1975 | 1976 | 1977 | |
| Extraction in barrels | 1,000 | 2,000 | 5,000 |
| Income in barrels | 5,000 | 1,000 | 1,000 |
Under this third approach, which may or may not be that of the majority, D would have 1,000 barrels of "production" in 1975 since the required element of extraction had only occurred with respect to 1,000 barrels. In 1976, D would have 2,000 barrels of "production" because 2,000 more barrels had been both extracted and paid for by 1976. In 1977, D would have 4,000 barrels of "production" because, while 5,000 barrels were extracted, only 4,000 barrels worth of unaccounted for income would have been received. Thus, 1,000 barrels of extraction would be carried forward until it could be matched with its income.
While the above interpretation might achieve some interplay between
If, for
In summary, whatever interpretation the majority opinion is silently giving "production" in order to deny percentage depletion with respect to advance payments, I believe its position is unsupportable. 11*179 I see only one possible interpretation of "production."
In my view "production" *180 means the extraction (past, current, or future) properly attributable to a taxpayer's taxable year as measured by the income received in that year. In other words, the number of barrels giving rise to income in a year is the number of barrels of "production" that year. Thus, if a taxpayer had the following extraction and barrels giving rise to income:
| 1975 | 1976 | 1977 | |
| Extraction in barrels | 2,000 | 6,000 | |
| Income in barrels | 5,000 | 1,000 | 1,000 |
his "production" under
Placing extraction in a year by reference to income interprets the term "production" without reading a myriad of calculations and carryovers into the statute. Not only is it a straightforward interpretation, it comports with the basic rule of natural resources taxation that depletion is calculated on income rather than on the physical withdrawal of the mineral from its resting place. See
Furthermore, *181 my interpretation fulfills what I perceive to be the intent of Congress. While the legislative history of
Under pre-
The majority *184 opinion states that considering future extraction "would mean that 'production' as used in
Furthermore, it is a simple matter to measure "production" in terms of income. "Production" is the number of barrels paid for whether or not the extraction of those barrels has actually occurred. Given the fluctuating prices of oil and gas, Congress drafted the
Based on the foregoing, I would hold that petitioners are entitled to a percentage depletion deduction calculated on the full $ 7,600 in advance royalties received by them in 1975. Those advance royalties were paid with respect to oil and gas extraction, albeit future extraction. See
Footnotes
28. See
Glass v. Commissioner, 76 T.C. 949↩ (1981) , filed this day.1. All section references are to the Internal Revenue Code of 1954, as in effect during the tax year in issue, unless otherwise noted.↩
2. The term "royalty," as used in the area of natural resources taxation, refers to a fractional interest in the "production" (i.e., extraction) of oil and gas or other minerals that is created by the owner (in fee) of the minerals. F. Burke & R. Bowhay, Income Taxation of Natural Resources, sec. 2.03 (1980); 1 L. Fiske, Federal Taxation of Oil & Gas Transactions, sec. 2.08 (1980 rev.).
As stated in Income Taxation of Natural Resources, supra at sec. 2.05:
"An overriding royalty is similar to a royalty in that, for Federal tax purposes, each is a right to minerals in place that entitles its owner to a specified fraction of production, in kind or in value, and neither is burdened with the costs of development or operation. They differ in that an overriding royalty is created from the operating interest, and its term is co-extensive with that of the operating interest from which it was created.
"The overriding royalty may be carved out or retained. It is said to be carved out if the owner of the working interest assigns a right to a fractional share of production free and clear of development and operating expense. It is retained if the lessee assigns the working interest and retains a fractional share of production free of development and operating costs."
For convenience, we shall herein use the term royalty in a more general sense in referring to the advances that petitioners received on overriding royalties.↩
3. Although only Fred had signed the lease as lessee, both petitioners executed the assignment to Marshall & Winston, Inc.↩
4. In practice, a taxpayer may be able to recover his investment several times over due to the allowance of percentage depletion, under
secs. 613 and613A , which will be discussed infra↩.5.
SEC. 612 . BASIS FOR COST DEPLETION.Except as otherwise provided in this subchapter, the basis on which depletion is to be allowed in respect of any property shall be the adjusted basis provided in section 1011 for the purpose of determining the gain upon the sale or other disposition of such property.
See
sec. 1.611-2(a), Income Tax Regs.↩ 6.
SEC. 613 . PERCENTAGE DEPLETION.(a) General Rule. -- In the case of the mines, wells, and other natural deposits listed in subsection (b), the allowance for depletion under
section 611 shall be the percentage, specified in subsection (b), of the gross income from the property 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 percent of the taxpayer's taxable income from the property (computed without allowance for depletion). * * * In no case shall the allowance for depletion undersection 611 be less than it would be if computed without reference to this section.But see
sec. 613A↩ regarding the percentage depletion allowance for oil and gas wells.7.
SEC. 613A . LIMITATIONS ON PERCENTAGE DEPLETION IN CASE OF OIL AND GAS WELLS.(a) General Rule. -- Except as otherwise provided in this section, the allowance for depletion under
section 611 with respect to any oil or gas well shall be computed without regard tosection 613 [i.e., without regard to percentage depletion].See also
sec. 613(d) , providing as follows:(d) Denial of Percentage Depletion in Case of Oil and Gas Wells. -- Except as provided in
Section 613A↩ , in the case of any oil or gas well, the allowance for depletion shall be computed without reference to this section.8.
Sec. 613A(c) provides in part as follows:(c) Exemption for Independent Producers and Royalty Owners. --
(1) In general. -- Except as provided in subsection (d), the allowance for depletion under
section 611 shall be computed in accordance withsection 613 with respect to --(A) so much of the taxpayer's average daily production of domestic crude oil as does not exceed the taxpayer's depletable oil quantity; and
(B) so much of the taxpayer's average daily production of domestic natural gas as does not exceed the taxpayer's depletable natural gas quantity;
and the applicable percentage (determined in accordance with the table contained in paragraph (5)) shall be deemed to be specified in subsection (b) of
section 613 for purposes of subsection (a) of that section.(2) Average daily production. -- For purposes of paragraph (1) --
(A) the taxpayer's average daily production of domestic crude oil or natural gas for any taxable year, shall be determined by dividing his aggregate production of domestic crude oil or natural gas, as the case may be, during the taxable year by the number of days in such taxable year, and
(B) in the case of a taxpayer holding a partial interest in the production from any property (including an interest held in a partnership) such taxpayer's production shall be considered to be that amount of such production determined by multiplying the total production of such property by the taxpayer's percentage participation in the revenues from such property.
In applying this paragraph, there shall not be taken into account any production of crude oil or natural gas resulting from secondary or tertiary processes (as defined in regulations prescribed by the Secretary or his delegate).
(3) Depletable oil quantity. --
(A) In general. -- For purposes of paragraph (1), the taxpayer's depletable oil quantity shall be equal to --
(i) the tentative quantity determined under the table contained in subparagraph (B), reduced (but not below zero) by
(ii) the taxpayer's average daily secondary or tertiary production for the taxable year.
(B) Phase-out table. -- For purposes of subparagraph (A) --
In the case of production The tentative quantity during the calendar year: in barrels is: 1975 2,000 1976 1,800 1977 1,600 1978 1,400 1979 1,200 1980 and thereafter 1,000 (4) Daily depletable natural gas quantity. -- For purposes of paragraph (1), the depletable natural gas quantity of any taxpayer for any taxable year shall be equal to 6,000 cubic feet multiplied by the number of barrels of the taxpayer's depletable oil quantity to which the taxpayer elects to have this paragraph apply. The taxpayer's depletable oil quantity for any calendar year shall be reduced by the number of barrels with respect to which an election under this paragraph applies. Such election shall be made at such time and in such manner as the Secretary or his delegate shall by regulations prescribe.
(5) Applicable percentage. -- For purposes of paragraph (1) --
↩In the case of production The applicable during the calendar year: percentage is: 1975 22 1976 22 1977 22 1978 22 1979 22 1980 22 1981 20 1982 18 1983 16 1984 and thereafter 15 9. In the case of a taxpayer holding a partial interest in the production of oil and gas from any property, his production for purposes of
sec. 613A(c) is to be "determined by multiplying the total production of such property by the taxpayer's percentage participation in the revenues from such property."Sec. 613A(c)(2)(B)↩ .10. Separate provisions are made for the allowance of percentage depletion on secondary or tertiary production of domestic crude oil and natural gas. See
sec. 613A(c)(6)↩ .11. Under
sec. 613A(c)(2) , a taxpayer's average daily production is determined with reference to his aggregate production during the "taxable year." However, the phase-out table insec. 613A(c)(3) prescribing the tentative number of barrels in the taxpayer's depletable oil quantity, as well as the table insec. 613A(c)(5) specifying the percentage to be used in computing percentage depletion, is keyed to the "calendar year." Thus, if a taxpayer is on a fiscal year, "each portion of such taxable year which occurs during a single calendar year shall be treated as if it were a short taxable year."Sec. 613A(c)(10)↩ .12. Under
sec. 613A(b) , which is not pertinent here, certain domestic gas wells are exempt from the repeal of percentage depletion in the case of oil and gas. Natural gas that is exempt undersec. 613A(b) is not to be taken into account in determining a taxpayer's depletable natural gas quantity undersec. 613A(c) .Sec. 613A(c)(11)↩ .13. For purposes of this election, 6,000 cubic feet of natural gas is equivalent to 1 barrel of oil.
Sec. 613A(c)(4)↩ .14. See sec. 1.613A-3(a)(4), examples (4) and (5), Proposed Regs.,
42 Fed. Reg. 24281 (May 13, 1977). The proposed regulations provide that percentage depletion is allowable undersec. 613A(c) only with respect to gross income attributable to oil and gas produced in a prior or current taxable year. See sec. 1.613A-7(f), Proposed Regs.,42 Fed. Reg. 24287↩ (May 13, 1977).15. Petitioners rely heavily on the following portion of the Conference Committee report on the Tax Reduction Act of 1975, Conf. Rept. 94-120 (1975),
1 C.B. 624">1975-1 C.B. 624 , 629-630:"Senate amendment. -- Under the Senate amendment, the deduction for percentage depletion is generally eliminated with respect to oil and gas produced on or after January 1, 1975, with certain exceptions. These include the exceptions provided under the House bill. In addition, the Senate amendment retains percentage depletion at 22 percent on a permanent basis for the small independent producer to the extent that his average daily production of oil does not exceed 2,000 barrels a day, or his average daily production of natural gas does not exceed 12,000,000 cubic feet. Where the independent producer has both oil and natural gas production, the exemption must be allocated between the two types of production. [Emphasis added.]"
16. See note 11 supra↩.
17. In this connection, see and compare L. Bravenec, "Continued Availability of Percentage Depletion on Oil and Gas," 23 Oil & Gas Tax Q. 204, 215-216 (1974-75), with T. Englebrecht & R. Hutchins, "Percentage Depletion Deductions for Oil and Gas Operations: A Review and Analysis,"
56 Taxes 48">56 Taxes 48↩ , 54 (1978).18.
Sec. 613A(c)(7) provides as follows:(7) Special rules. --
(A) Production of crude oil in excess of depletable oil quantity. -- If the taxpayer's average daily production of domestic crude oil exceeds his depletable oil quantity, the allowance under paragraph (1)(A) with respect to oil produced during the taxable year from each property in the United States shall be that amount which bears the same ratio to the amount of depletion which would have been allowable under
section 613(a) for all of the taxpayer's oil produced from such property during the taxable year (computed as ifsection 613 applied to all of such production at the rate specified in paragraph (5) or (6), as the case may be) as his depletable oil quantity bears to the aggregate number of barrels representing the average daily production of domestic crude oil of the taxpayer for such year.(B) Production of natural gas in excess of depletable natural gas quantity. -- If the taxpayer's average daily production of domestic natural gas exceeds his depletable natural gas quantity, the allowance under paragraph (1)(B) with respect to natural gas produced during the taxable year from each property in the United States shall be that amount which bears the same ratio to the amount of depletion which would have been allowable under
section 613(a) for all of the taxpayer's natural gas produced from such property during the taxable year (computed as ifsection 613 applied to all of such production at the rate specified in paragraph (5) or (6), as the case may be) as the amount of his depletable natural gas quantity in cubic feet bears to the aggregate number of cubic feet representing the average daily production of domestic natural gas of the taxpayer for such year.19. The House version of the bill contained no exemption for independent producers and royalty owners.
20. Aside from the Conference report cited above, which itself does not adequately explain the complex provisions of
sec. 613A(c) , the legislative history is quite sketchy.Sec. 613A was introduced as a Senate floor amendment, and as a result the provision was not considered in either the House report (H. Rept. 94-19 (1975),1 C.B. 569">1975-1 C.B. 569 ) or the Senate report (S. Rept. 94-36, (1975),1 C.B. 590">1975-1 C.B. 590 ) on the bill leading to the Tax Reduction Act of 1975. Similarly, the substance of the debates with respect to the exemption for independent producers and royalty owners is of little assistance in interpreting the provisions ofsec. 613A(c)↩ .21. See note 6 supra↩.
22.
Sec. 1.613-5, Income Tax Regs.↩ 23. See the discussion entitled "Taxable Income from the Property for Depletion Purposes" in Miller's Oil & Gas Federal Income Taxation, ch. 10, p. 145 (J. Houghton ed. 1980).↩
24. Even so, if there was no production of oil or gas prior to the cancellation of the lease (i.e., no actual depletion), the taxpayer was required to restore the previously deducted depletion to income.
Douglas v. Commissioner, 322 U.S. 275">322 U.S. 275 , 285 (1944);Sneed v. Commissioner, 119 F.2d 767">119 F.2d 767 , 771 (5th Cir. 1941), affg.40 B.T.A. 1136">40 B.T.A. 1136 (1939), cert. denied314 U.S. 686">314 U.S. 686↩ (1942).25. See note 24 supra;
sec. 1.612-3(a)(2) and(b)(2), Income Tax Regs.↩ 26. See M. Backus, "A Stitch in Time Necessary to Save Lease Bonus Depletion,"
55 Taxes 313">55 Taxes 313 (1977); L. Bravenec, "Continued Availability of Percentage Depletion on Oil and Gas," 23 Oil & Gas Tax Q. 204, 211 (1974-75) (while contending that "production" as used insec. 613A(c)↩ should be interpreted as meaning "sales," the author notes that it "is difficult to sustain * * * [such a] construction by reference to the statutory language").27. Pub. L. 95-618, 92 Stat. 3204 (Nov. 9, 1978). The amendment applies to natural gas produced from geopressured brine and "which is produced from any well the drilling of which began after September 30, 1978, and before January 1, 1984."↩
28. See
Glass v. Commissioner, 76 T.C. 949↩ (1981) , filed this day.1. All section references are to the Internal Revenue Code of 1954 as amended.↩
1. ADP = Total production divided by number of days in the taxable year.
Sec. 613A(c)(2)(A)↩ .2.
Sec. 613A(c)(3)↩ .3.
Sec. 613A(c)(5)↩ .4. Because ADP is greater than DOQ in 1981 --
PDF = (DOQ / ADP) x 0.20 = (1000 / 4000) x 0.20 = 0.05.
In 1982 and 1983, ADP is less than DOQ, so PDF = AP.↩
1. Must note the PDF previously calculated for production extracted that year.↩
2. Use FIFO to determine what barrels were sold, and, therefore, which PDF to use.↩
2. A similar result obtains, stresses the dissent, when production is sold prior to extraction. If, in such a highly improbable situation, the well is dry or blows out, and the seller must refund the sales proceeds, then such amounts are mere deposits. If the seller may keep the funds, again I wonder whether or not he has gotten the better end of the trade between money in hand and possible percentage depletion deductions.↩
3. In a wildcat area, the present treatment of bonuses received may be more advantageous than it would have been prior to 1975. See
Collums v. United States, 480 F. Supp. 864">480 F. Supp. 864↩ (D. Wyo. 1979).4. It appears that the Commissioner still clings to the bonus exhaustion rule. See
Rev. Rul. 79-73, 1 C.B. 218">1979-1 C.B. 218↩ ; IRS National Office Technical Advice Memorandum, written determination No. 8026011 dated Mar. 20, 1980.1. Unless otherwise provided, all section references are to the Internal Revenue Code of 1954 as amended and in effect during the year in issue.
2. I realize petitioners stipulated they had no "average daily production" of oil or gas; however, it is obvious they were equating "production" with extraction. Therefore, I would not base any denial of petitioners' percentage depletion deduction on that stipulation.↩
3. I use the term "extraction" to mean the physical withdrawal of oil or gas.↩
4. I shall be using examples throughout this dissent. For convenience, I am assuming a "depletable oil quantity" of 1,000 barrels. See
sec. 613A(c)(3)(B)↩ . Thus a taxpayer could have 365,000 barrels of "production" in a calendar year of 365 days without having his "average daily production" exceed his "depletable oil quantity."5. The majority opinion,
supra↩ at 921 , seems to imply that only future extraction is tainted when it refers to an "exempt quantity of production." However, the matter is left unresolved.6. It is unclear under the proposed regulations whether, for purposes of determining if the depletable oil quantity has been exceeded, one would look to the income or to the required backup extraction. Thus if 300,000 barrels were extracted each year for 4 years, and all 1,200,000 barrels were sold in year 5, average daily production would exceed the depletable oil quantity in year 5 if reference were only made to income. See note 4 supra.
Arguably, income would be required to be backed up by extraction, but whether "production" is exempt would be determined by reference to the year of extraction and income would only determine the timing of the percentage depletion deduction. If 300,000 barrels were extracted each year for 4 years, all 1,200,000 barrels would be exempt "production" since the depletable oil quantity measured by extraction was never exceeded in any year. The entire year-5, income would be subject to a full allowance without reference to
sec. 613A(c)(7)(A)↩ . Such an analysis would require a detailed and perhaps impossible tracing of extraction necessary to determine what extraction was being sold.7. In essence, respondent is using
sec. 613A(c) to revert to his position which the U.S. Supreme Court rejected inHerring v. Commissioner, 293 U.S. 322↩ (1934) .8. Respondent's interpretation is found in proposed regulations which "carry no more weight than a position advanced on brief by the respondent."
F.W. Woolworth Co. v. Commissioner, 54 T.C. 1233">54 T.C. 1233 , 1265-1266 (1970). The Court was not presented with final regulations which "must be sustained unless unreasonable and plainly inconsistent with the statute." SeeBingler v. Johnson, 394 U.S. 741">394 U.S. 741 , 750↩ (1969).9. Presumably, even though D received income with respect to all 1,200,000 barrels of his oil in one year he would get a percentage deduction with respect to all of it since he spread out extraction. See note 6 supra↩.
10. Furthermore, if income were recognized in one year and percentage depletion deductions calculated on that income were taken in other years, the amount of deduction limits based on taxable income found in
secs. 613(a) and613A(d)(1) would be nonsensical. See alsosec. 613A(c)(7)(C)↩ .11. The majority opinion repeatedly notes that there has been no extraction under the oil and gas leases herein. The question which immediately leaps to mind is what if one barrel of oil had been extracted? Respondent's reply is clear -- no percentage depletion deduction because that barrel of oil cannot be specifically traced to any of the advance royalties. See sec. 1.613A-7(f), Proposed Regs.,
42 Fed. Reg. 24287 (May 13, 1977);Rev. Rul. 81-44, 1981 I.R.B. 6 . The majority opinion may well be adopting respondent's position; I cannot tell. On the other hand the majority opinion may contemplate allowing a percentage depletion deduction calculated on the part of the advance payment which it feels is attributable to the extraction. How it would achieve such attribution without ultimately allowing all income received to represent barrels is beyond me.Moreover, if advance royalties are recoupable against earned royalties, respondent will allow percentage depletion with respect to the part of the advance payment which can be tied by recoupment to extraction in the year the advance payment is received. Nevertheless, that portion of the advance payment recouped through later years' extraction would not be subject to percentage depletion. See sec. 1.613A-3(a)(4), example (4), Proposed Regs.,
42 Fed. Reg. 24281↩ (May 13, 1977).12. If a taxpayer's average daily production exceeds his depletable oil quantity, he is still entitled to percentage depletion, but its benefits are greatly reduced. See
sec. 613A(c)(7)(A)↩ .13. Conf. Rept. 94-120, (1975),
1 C.B. 624">1975-1 C.B. 624 , 630, states that: "The Senate amendment retains percentage depletion at 22 percent on a permanent basis for the small independent producer * * * [Emphasis added.]"The above-quoted language indicates retention rather than abrogation of basic percentage depletion rules. However, the majority opinion disclaims that language by characterizing it as explaining an unenacted "Senate version of the bill." Majority, supra at 923. In fact, the legislative history reveals that the enacted Conference substitute "follows the Senate amendment in providing a small producer exemption from the repeal of percentage depletion for oil and gas." Conf. Rept. 94-120,
supra↩ at 630 . (Emphasis added.) The enacted bill was, in effect, the Senate version -- the only differences being phase downs of percentages and barrel amounts and elimination of a plowback requirement.14. The treatment of the lessee-payor with respect to depletion and advance payments need not be consistent with the treatment of the lessor-payee. See discussion in
Shamrock Oil & Gas Corp. v. Commissioner, 35 T.C. 979">35 T.C. 979 (1961), affd.346 F.2d 377">346 F.2d 377 (5th Cir. 1965), cert. denied382 U.S. 892">382 U.S. 892 (1965). See also E. Price & M. Cassell, "Revenue Ruling 79-23 Ignores Tax Reduction Act of 1975," 28 Oil & Gas Tax Q. 76 (1979). Nevertheless, it seems that the proposed regulation's denial of percentage depletion on advance payments is inconsistent with the "bonus exhaustion" rule ofsec. 1.613-2(c)(5)(ii), Income Tax Regs. , which is applicable to lessees. See Bravenec & Flag, "Initial ProposedSection 613A↩ Regulations," 24 Oil & Gas Tax Q. 218, 224 (1975).15. The majority attempts to disclaim any income-based interpretation of "production" as creating "numerous practical problems" (majority,
supra at 926 ), due to differences between depletable oil quantities and depletable natural gas quantities. A careful reading ofsec. 613A(c) belies such worries.Sec. 613A(c)(3) sets a depletable oil quantity (e.g., 2,000 barrels) whilesec. 613A(c)(4) in effect converts gas to barrels (6,000 cubic feet per barrel) which uses up part of the depletable oil quantity. Secondary or tertiary production also reduces the depletable oil quantity. In reality, an overall limit of barrels (e.g., 2,000) is being imposed regardless of whether the barrels are oil or gas. The statute merely ensures that a taxpayer does not get a full barrel allowance of each.The only arguable problem is that secondary or tertiary barrels are depleted at 22 percent until 1983 while other barrels fall to 18 percent by 1983. See
secs. 613A(c)(6)(A)(ii) and613A(c)(5) . I do not envisage the problem being insurmountable by the burden of proof. At the time of payment, it will probably be known whether secondary or tertiary "production" is involved. The same is true concerning gas "produced from geopressurred brine."Sec. 613A(b)(3)(C) . Additionally, I note that currentsec. 613A(b)(2)↩ was nonexistent in 1975 and should not be considered in a case concerning petitioners' 1975 taxable year.16. As shown on their Federal income tax return for 1975, petitioners were calendar year taxpayers in 1975. Calendar year 1975 was made up of 365 days. Thus, if 720,000 barrels were petitioners' "aggregate production" in 1975, their "average daily production" would be 2,000 barrels/day. See
sec. 613A(c)(2)(A)↩ .17. Of course, if there is never any extraction under the leases involved in this case, petitioners would be required to recapture the percentage depletion deduction. See
sec. 1.612-3(b)(2), Income Tax Regs. See also majority, supra↩ at note 24.