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 section 613A, I.R.C. 1954,1 I am moved to write this concurrence primarily because the dissenting opinion by Judge Fay suffers greatly from flaws of construction and oversights in application.
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 section 613A, needs no elaboration. It is undisputed that, prior to the enactment of section 613A, percentage depletion was allowable on advance royalties received, whether they were to be recouped against future production or not. However, who can deny that the 1975 legislation drastically reduced allowable percentage depletion? By dint of the construction of the disallowance, it is now the exception, rather than the rule, when percentage depletion is allowable.
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 section 613(d), the almost-total denial contained in section 613A(a), and the exemption contained in and the cross-referencing of section 613A(c)(l), combine to provide a maze through which we must now approach the percentage depletion deduction. Furthermore, the controlling statute, as amended, fails to directly address not only the issues before us, but also raises multiple collateral issues which we are not asked to decide in this case. It is doubtful whether even reasonable regulations, if such regulations are forthcoming from the Commissioner, can completely unscramble the present version of this item of “legislative grace.”
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 sections 611, 612, 613, and 613A lead me to the conclusion that percentage depletion, to the extent allowable at all, can be obtained only with respect to a limited quantity of actual production (oil or gas extracted from the ground) per year. The year of extraction controls the number of barrels of production with respect to which percentage depletion is allowable (such must be the necessary implication of a yearly depletable oil quantity — see sec. 613A(c)(3)), and it is that same year that determines the appropriate percentage to be applied to such barrels (such is the logical implication of the columnar heading in section 613A(c)(5) which states “In the case of production during the calendar year”).
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 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.
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., 42 Fed. Reg. 24281 (May 13,1977), as follows:
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 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 average daily production in section 613A(c)(2) refers to the taxpayer’s “production” for any taxable year; the phase-out table in section 613A(c)(3)(B) is headed “In the case of production during the calendar year [emphasis added]”; and in section 613A(c)(5), the heading for the applicable percentage for specified calendar years reads, “In the case of production during the calendar year [emphasis added].” Because these limitations (barrel limitation and percentage allowable) are unmistakably defined in terms of production during the year, the income from all qualifying production in that year should be subject to percentage depletion regardless of the year of payment, for that production. I would apply that rationale to example (7) above by holding that the 15,000 barrels of oil produced in 1975 would be entitled to percentage depletion of 22 percent regardless of the percentage allowable in the year the oil is sold. If the years were instead 1980 (year of extraction) and 1981 (year of sale), I would allow 20-percent depletion on the 15,000 barrels rather than 18 percent.
As to the barrel limitation on the 15,000 barrels, I would also look to the year of extraction rather than a 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 1982.1 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, 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 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 1988
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 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. Secs. 613(a), 613A(c)(l), (5) and (7). For purposes of this example, I will refer to this percentage which is actually applied to all production income (which percentage may be equal to or less than the relevant applicable percentage specified in section 613A(c)(5)) as the “percentage depletion fraction” (PDF).
According to section 613A(c)(l), if a taxpayer’s average daily production (ADP) is less than or equal to his depletable oil quantity (DOQ), the PDF equals the applicable percentage (AP) set forth in section 613A(c)(5). If, however, a taxpayer’s ADP is greater than his DOQ, his PDF equals the AP multiplied by a fraction the numerator of which is the DOQ and the denominator of which is the ADP. Thus, in our example, the PDF for each year is as follows:
1981 1982 1983
ADP1 4,000 1,000 100
DOQ2 1,000 1,000 1,000
AP3 0.20 0.18 0.16
PDF 4 0.05 0.18 0.16
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
Extracted1 1,460,000 @ 0.05
Subtotal ... 1,460,000 @ 0.05
Sold . . (730,000 @ 0.05)
Ending ... .. 730,000 @ 0.05
1982
Total sales — 365,000 barrels
PDF x (barrels sold x price per barrel)
0.05 X (365,000 X $10)2
0.05 X $3,650,000
$182,500 — 1982 percentage depletion
Inventory Beginning . 730,000 @ 0.05
Extracted . 365,000 @ 0.18
Subtotal . 730,000 @ 0.05
365,000 @ 0.18
Sold .2(365,000 @ 0.05)
Ending . 365,000 @ 0.05
365,000 @ 0.18
1988
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 @ 0.05
365,000 @ 0.18
Extracted .36,500 @ 0.16
Subtotal . 365,000 @ 0.05
365,000 @ 0.18
36,500 @ 0.16
Sold .(365,000 @ 0.05)
(365,000 @ 0.18)
(36,500 @ 0.16)
Ending .0
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, supra at page 918. No actual physical tracing of extraction is needed because this inventory-type method will accomplish the results sought by my interpretation of the statute. Some may quibble that the assumption of a constant price of oil invalidates this example. On the contrary, if prices rise or fall, the above-outlined method will result in percentage depletion calculated on the basis of the actual “gross income from the property” in the year the extraction is sold, which result dovetails nicely with the general percentage depletion formula in section 613(a). The allowability, as well as the appropriate rate, of percentage depletion is determined as of the taxable year of extraction, as it should be.
Although I speculate as to whether the Commissioner may, by regulation, establish such a scheme when the statute does not 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 Glass v. Commissioner, 76 T.C. 949 (1981), as to lease bonuses, to reexamine his proposed regulations (which have been proposed since 1977) in light of the opinions in these two cases in order to make them more compatible with the statute as amended in 1975. Surely, our holdings in these two cases should encourage the Commissioner to reexamine the proposed regulations and attempt to finalize them in a form that correctly interprets the statute. Hope springs eternal that such an admonition will be heeded.
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 section 613(a), a section which the dissent over and over ... and over ... abjures us not to neglect, that the deduction is allowable by taking a percentage of the gross income from the property.
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.” Sec. 613A(c)(5).
One cannot count barrels of production that do not yet, and may never, exist. When a taxpayer receives an advance royalty, no one knows whether hydrocarbons will be extracted from that property. A cursory examination of newspaper accounts of drilling activity readily demonstrates the folly of concluding that production will necessarily follow receipt of an advance royalty. As the majority points out so clearly on pages 925-927 of its opinion, the problems of statutory construction and obvious practical problems of imputing possible future production into a present-year calculation under new section 613A are insurmountable.
Similarly I, like the majority, am convinced that Herring v. Commissioner, 293 U.S. 322 (1934), provides little guidance here because of the drastic changes in the law made subsequent to that decision. No matter how many times the dissent proclaims that we are undermining the holding in Herring, the fact of the matter is that Herring simply does not apply. Just as the Cohan rule became largely irrelevant in the travel and entertainment expense context after the enactment of section 274, the Herring decision no longer holds complete sway in the percentage-depletion-on-advance-royalty context after the 1975 enactment of sections 613(d) and 613A.
The chant found throughout Judge Fay’s dissenting opinion is that because section 613A(c)(l) provides that the allowance for depletion under section 611 “shall be computed in accordance with section 613,” production has to have some relation to gross income. In such incantations, he continually states the obvious while overlooking the stated, i.e., that percentage depletion is now allowed only with respect to a limited amount of actual production. Of course, because percentage depletion is derived by multiplying gross income from the property by the applicable percentage, production must have some relation to gross income. Thus, only gross income attributable to the sale of so much of a taxpayer’s average daily production as does not exceed his depletable quantity is now eligible for percentage depletion. The now-extant sections controlling this deduction do not speak to the timing of the deduction, except that section 613(a) requires that there be some gross income from the property in a taxable year as a necessary precondition to having something to multiply by the applicable percentage. Production limits the amount of the deduction; ergo, in order to compute the percentage depletion deduction for a taxable year, it is necessary to have had some actual production before or during such taxable year in order to qualify some barrels under section 613A(c), the proceeds from the sale of which constitute the gross income of which section 613(a) speaks. When the dissent starts from the above-stated proposition that production and income must be related, and reasons to the conclusion that hypothetical future production will somehow support a present percentage depletion deduction, it has engaged in a brand of deductive sophistry which I am loath to embrace.
Thus, I fully support the holding and rationale of the majority opinion. Though the author of that opinion did not need to extend its 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 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.” Sec. 613A(c)(7)(A) and (B). In addition, it will be the exception, rather than the rule, when a taxpayer knows, at the time an advance royalty or bonus is paid, whether secondary or tertiary recovery methods will be necessary or economically feasible. Furthermore, the dissent never addresses this obvious question: if an unrecouped advance royalty represents production in the year of receipt, how would one convert the raw dollar amount received into a quantity of barrels for purposes of determining the taxpayer’s average daily production under section 613A(c)? How many dollars equal a barrel of oil, or, for that matter, 6,000 cubic feet of gas? The practical problem surely exists, even though the dissent does not, by reason of the small amount here involved, feel compelled to address it.
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 (Malat v. Riddel, 383 U.S. 569 (1966)), the otherwise allowable percentage depletion on advance royalties recoupable against future production which are paid but not recouped in the year of payment will be lost forever. Quaere whether or not this is an inequitable result inasmuch as- the taxpayer has received, in exchange for risking the loss of otherwise allowable percentage depletion, an advance royalty on production which may never exist.2 Under the dissent’s approach, the same inequitable result suggested by example (7) of section 1.613A-3(a), Proposed Regs., 42 Fed. Reg. 24281 (May 13, 1977), will occur, though for a slightly different reason (see discussion, supra). The proposed regulation would throw unsold, but otherwise allowable production, into the second year and include it in the average daily production computation, which treatment could produce an average daily production in excess of the allowable depletable quantity in the later year, resulting in partial permanent disallowance of percentage depletion, even though actual production in neither year exceeded the maximum depletable amount. Likewise, the dissent’s approach would permanently deprive a similarly situated taxpayer of the same amount of depletion. By looking only at income, and then deriving from that amount the number of barrels represented, the dissent would say that all of the “production” occurred in the later year. Under an example where a taxpayer produced 365,000 barrels in 1981, 365,000 barrels in 1982, and sold all 730,000 barrels in 1982, the dissent’s approach would conclude that the average daily production in 1982 is 2,000 barrels. Since the tentative quantity for 1982 is 1,000 barrels, this approach would effectively deny percentage depletion on half of the production sold in 1982. Thus, whenever oil is stored from one year to the next (a not uncommon phenomenon for an independent producer), such oil, the proceeds from the sale of which would have been subject to percentage depletion had such oil been sold when extracted, quite likely will not be subject to percentage depletion when sold in a later year, and an extremely “harsh result obtains” (see dissent at p. 948). It is apparent that examples can be marshalled to show the inequity of any construction of this statute. Thus, once again, I am content to follow the majority’s simple, but not simplistic, interpretation of the term “production.”
I would like to turn briefly to other problems presented by the construction and application of sections 611 through 614.
It can hardly be denied that the rationale of the majority, when applied to the question of whether percentage depletion on lease bonuses remains available, requires a negative answer to such question. See Glass v. Commissioner, 76 T.C. 949 (1981). Though percentage depletion was available to a lessor with respect to lease bonuses received prior to the 1975 change in the law (Herring v. Commissioner, supra), under the rationale of the majority here and under our decision this day in Glass v. Commissioner, supra, the diminution of the reservoir of hydrocarbons represented by the bonus payment is now recoverable only through the use of cost depletion.3 That being the case, it is questionable whether there remains any reasonable need for the “bonus exhaustion rule” embodied in section 1.613-2(c)(5)(ii), Income Tax Regs. See also Quintana Petroleum Co. v. Commissioner, 143 F.2d 588 (5th Cir. 1944). The bonus exhaustion rule required that a lessee, in computing his “gross income from the property” (which is the amount to which the applicable percentage is applied in order to determine the allowable percentage depletion), exclude therefrom a proportionate part of any bonus paid with respect to such property on the theory that, because bonuses were characterized as advance royalties, to allow percentage depletion on both the bonus and on all of the production income from a property would result in double depletion on production income in an amount equal to the bonus paid. Inasmuch as bonuses are no longer subject to percentage depletion, the rationale for that rule no longer exists. See L. Bravenec & J. Flagg, “Initial Proposed Section 613A Regulations,” 24 Oil & Gas Tax Q. 218, 224 (1975); F. Burke, “Proposed Regulations Under Section 613A — An Analysis and Critical Review,” P-H Oil & Gas/Natural Resources (1976).4 Quaere whether this rationale is also applicable to the unrecouped portion of advance royalties paid. See sec. 1.613-2(c)(5)(iii), Income Tax Regs.; Rev. Rul. 79-386, 1979-2 C.B. 246.
Another nettlesome problem arises when we consider the situation where a bonus, which is not 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 section 613A. At first blush, one would think that the recipient would just take cost depletion on the bonus (with regard only to the bonus) as outlined in section 1.612-3(a), Income Tax Regs., then calculate both cost and allowable percentage depletion on the royalty received and, pursuant to sections 1.611-l(a)(l), 1.612-3(d), and 1.613-1, Income Tax Regs., deduct the greater of the two (subject to basis limitations for the deduction of cost depletion — sec. 1.611-2(b)(2), Income Tax Regs.). However, under my understanding of sections 1.611-1(a) and 1.613-1, Income Tax Regs., as they presently exist, a taxpayer may deduct, with respect to each “property” (which is defined under sec. 614(a) as “each separate interest owned by the taxpayer in each mineral deposit in each separate tract or parcel of land”), either cost or percentage depletion in the same taxable year, but not both. Thus, a taxpayer in the above fact situation would be allowed to deduct (subject to sec. 1.611-2(b)(2), Income Tax Regs.) only the greater of (1) an amount equal to the sum of cost depletion calculated with regard to the bonus under the formula set forth in section 1.612-3(a), Income Tax Regs., and cost depletion calculated under the formula set forth in section 1.611-2(a), Income Tax Regs., with regard to the royalty (or recouped advance royalty) received during that taxable year, or (2) an amount equal to the percentage depletion allowable under section 613A with respect only to the royalty (or recouped advance royalty) received during that taxable year. Compelling a choice between these two incomplete alternatives does not seem fair, and were I faced with a case requiring a construction of such regulations, I am not sure I could abide such an inequitable result. The controlling regulations were, of course, issued prior to the enactment of section 613A under the statutory mandate of section 611(a) that “there shall be allowed as a deduction in computing taxable income a reasonable allowance for depletion * * * such reasonable allowance in all cases to be made under regulations prescribed by the Secretary.” Though such regulations no doubt were reasonable prior to the enactment of section 613A, I question whether they continue to provide a “reasonable allowance for depletion” under the revised legislative scheme for calculating the percentage depletion deduction. I would hope that the Commissioner would promptly propose regulations that would allow a taxpayer to take cost depletion with respect to a bonus received, regardless of whether cost or percentage depletion is higher as to the income from actual production received during the same taxable year.
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 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.
All section references are to the Internal Revenue Code of 1954 as amended.
ADP = Total production divided by number of days in the taxable year. Sec. 613A(c)(2XA).
1981 = 1,460,000 -4- 365 = 4,000
1982 = 865,000 + 365 = 1,000
1983 = 36,500 + 365 = 100
Sec. 613A(cX3).
Sec. 613A(cX5).
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.
Must note the PDF previously calculated for production extracted that year.
Use FIFO to determine what barrels were sold, and, therefore, which PDF to use.
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.
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 (D. Wyo. 1979).
It appears that the Commissioner still clings to the bonus exhaustion rule. See Rev. Rul. 79-73, 1979-1 C.B. 218; IRS National Office Technical Advice Memorandum, written determination No. 8026011 dated Mar. 20, 1980.