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 section 613A(c).1
Section 613A(c)(l) allows percentage depletion with respect to so much of a taxpayer’s “average daily production” as does not exceed his “depletable oil quantity.” Section 613A(c)(2)(A) defines “average daily production” as “aggregate production” divided by the number of days in the taxable year. The critical word is “production.” Unfortunately, the majority opinion makes no attempt to define “production” but cavalierly assumes there was no “production” in this case.2 See majority, supra at 921. Evidently, the majority requires extraction but provides no enlightenment as to whether “production” means only extraction or whether extraction is merely one required element of “production.”3 While I agree that some tie to extraction is essential for percentage depletion, I see no reason why future extraction as well as past or current extraction cannot suffice. See generally Herring v. Commissioner, 293 U.S. 322 (1934). I would interpret “production” to mean the extraction (past, current, or future) properly attributable to a taxpayer’s taxable year. The number of barrels properly attributable to a year is easily measured by income. This interpretation follows closely what I perceive to be the intent of Congress without leading to inexplicable, illogical results as different factual cases emerge. Whatever interpretation the majority opinion is giving to “production,” that interpretation is simply wrong.
First, the majority opinion could be read as defining “production” 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 section 613A(c) as requiring extraction during the taxable year effectively ignores the mandate found in section 613A(c)(l) that allowable percentage depletion be computed “in accordance with section 613.”
Section 613(a) grants a deduction calculated by taking a percentage of the gross income from property. Therefore, in order for section 613A(c) to mesh with section 613(a) both logically and administratively, “production” has to have some relation to gross income. See sec. 1.613-3(a), Income Tax Regs. The illogical result which obtains from interpreting section 613A(c) as requiring extraction in the taxable year is illustrated by the following example. Assume these facts: In December 1975, B, a cash basis, calendar year taxpayer, extracts 10,000 barrels of oil for which he is paid in 1976.4 B neither extracts nor sells any more oil in 1975 or in 1976. If “production” meant only extraction, B would have “production” in 1975 but no gross income from the property in that year to serve as a basis for calculating percentage depletion under section 613(a). In 1976, B would have gross income from the property, but it would not be with respect to any 1976 “production” since B did not extract any oil in 1976. In effect, B would be denied his percentage depletion allowance with respect to all 10,000 barrels. That is obviously not what Congress intended; therefore, I am very hesitant to attribute such reasoning to the majority.
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 section 613A(c), takes the position that “production” occurs in the year income is received if and only if the income is backed by past or year-of-income extraction. See sec. 1.613A-3(a)(4), example {If), Proposed Regs., 42 Fed. Reg. 24281 (May 13, 1977).6 In my example above, B would have 10,000 barrels of “production” in 1976 because income from 10,000 barrels was recognized in 1976 under B’s method of accounting and because there had been at least 10,000 barrels extracted before or in the same year as the income. Thus, the proposed regulations reach a reasonable result when the income from oil or gas is received with or following extraction. But if income precedes extraction, that is, if advance payment is received, respondent contends there is no “production.” That contention produces clearly untenable results.
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 extracted in 1976. Respondent gets the best of both worlds, and a harsh result 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” 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 section 613A(c) purposes occurring when the later of extraction or income occurs.
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 facts are charted below:
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 sections 613A(c) and 613(a) without wholesale denial of percentage depletion with respect to advance payments, it would effectively rewrite section 613(a). As I have previously noted, section 613(a) grants a deduction based on a percentage of “gross income.” Section 1.613-3(a), Income Tax Regs., defines “gross income” as “the amount for which the taxpayer sells the oil or gas.” Thus, section 613(a) always has been applied as granting a deduction in the same year as the taxpayer recognizes the gross income under his method of accounting. See Herring v. Commissioner, 293 U.S. 322 (1934). See, e.g., United States v. Shelly Oil Co., 394 U.S. 678 (1969). See also sec. 1.611-2(a)(2), Income Tax Regs. There is no support for interpreting section 613(a) differently when section 613A(c) is involved than when section 613A(c) is not involved. Section 613A(c) does not rewrite section 613(a). In fact, section 613A(c)(l) directs computation “in accordance with section 613.”
If, for section 613A(c) purposes, a percentage depletion deduction could be taken only when the later of extraction or income occurred, not only would long established interpretations of section 613(a) be overruled, but a serious mismatching of income and deductions would obtain. For example, if our taxpayer, D, had income from 1,200,000 barrels in year 1 prior to any extraction, he would have a large amount of income in that year but no percentage depletion deduction. If, in years 2 through 5, D actually extracted 300,000 barrels each year he would be entitled to a deduction based on the prior income from those barrels even though he had no gross income in the years of extraction.9 I cannot help but wonder whether such a result would represent a failure clearly to reflect income under section 446(b).10 For the above reasons, I would reject any later-of-income-or-extraction interpretation of “production.”
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 I see only one possible interpretation of “production.”
In my view “production” 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 section 613A(c) would be 5,000 barrels in 1975, 1,000 barrels in 1976, and 1,000 barrels in 1977 since those are the numbers of barrels represented by income in each of those years.
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 sec. 1.611-2(a)(2), Income Tax Regs. See generally Shamrock Oil & Gas Corp., 35 T.C. 979 (1961), affd. 346 F.2d 377 (5th Cir.), cert. denied 382 U.S. 892 (1965).
Furthermore, my interpretation fulfills what I perceive to be the intent of Congress. While the legislative history of section 613A(c) is limited, see majority, supra at note 20, the one salient fact that emerges from a perusal of the floor debates is that Congress intended to preserve the percentage depletion deduction for certain taxpayers, small independent producers and royalty owners, while severely curtailing its benefits to major oil producers.12 Most importantly, there is no evidence of any intent to alter the manner in which percentage depletion is calculated or to overrule prior law concerning advance payments.13
Under pre-section 613A law, the treatment of advance royalties was clear. When the lessor-royalty owner took the advance payment into income, it was gross income from the property and subject to percentage depletion regardless of whether or not any oil and gas extraction had taken place. Anderson v. Helvering, 310 U.S. 404, 409 (1940); Herring v. Commissioner, 293 U.S. 322 (1934). As far as a lessor-royalty owner is concerned, advance royalties are received with respect to extraction that will occur in the future rather than occurring now or in the past.14 To restrict “production” in section 613A(c) to current or past extraction while excluding future extraction “in effect overrules prior case law without a clear statutory mandate.” See Linden, “Oil and Gas Depletion Regulations: Complexity Compounded,” 24 Oil & Gas Tax Q. 351, 380 (1976). See also Bravenec, “Continued Availability of Percentage Depletion On Oil and Gas,” 23 Oil & Gas Tax Q. 204 (1975). On the other hand, interpreting “production” as extraction attributable to a year by reference to income allows almost 50 years of clear law to stand.
The majority opinion states that considering future extraction “would mean that ‘production’ as used in section 613A(c) should be read to mean ‘sales of future production.’” Majority opinion, swpra at 925. I strongly disagree. I am not maintaining that Congress accidentally wrote “production” rather than “sales.” I do maintain that Congress intended “production during the taxable year” to include all extraction properly attributable to that year whether it be past, current, or future extraction. Even respondent recognizes that “production” must be interpreted with reference to income.
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 section 613A(c) limitations on percentage depletion couched in terms of “production” rather than some yearly income amount to avoid the need for constant amendments. However, by referring to section 613(a), Congress made it clear that “production” is inexorably tied to income. Respondent recognizes the tie between income and “production” when the receipt of income is accompanied by current or past extraction, but refuses to acknowledge that tie when income is received prior to extraction.151 simply do not see how he can justify such a distinction.
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 Anderson v. Helvering, supra. Since the taxable year involved herein is 1975, petitioners’ “depletable oil quantity” was 2,000 barrels. See sec. 613A(c)(3). Thus, petitioners were allowed 720,000 barrels of “production” in 1975 before their “average daily production” would exceed their “depletable oil quantity.”16 By no stretch of the imagination would $7,600 represent anything near 720,000 barrels in 1975. Accordingly, I would allow petitioners their claimed percentage depletion deduction.17
Unless otherwise provided, all section references are to the Internal Revenue Code of 1954 as amended and in effect during the year in issue.
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.
I use the term “extraction” to mean the physical withdrawal of oil or gas.
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)(3XB). 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.”
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.
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.
In essence, respondent is using sec. 613A(c) to revert to his position which the U.S. Supreme Court rejected in Herring v. Commissioner, 293 U.S. 322 (1934).
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, 1265-1266 (1970). The Court was not presented with final regulations which “must be sustained unless unreasonable and plainly inconsistent with the statute.” See Bingler v. Johnson, 394 U.S. 741, 750 (1969).
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.
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) and 613A(dXl) would be nonsensical. See also sec. 613A(c)(7)(C).
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).
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(eX7X A).
Conf. Rept. 94-120, (1975), 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. 94r-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.
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 (1961), affd. 346 F.2d 377 (5th Cir. 1965), cert. denied 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 of sec. 1.613-2(cX5)(ii), Income Tax Regs., which is applicable to lessees. See Bravenec & Flag, “Initial Proposed Section 613A Regulations,” 24 Oil & Gas Tax Q. 218, 224(1975).
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 of sec. 613A(c) belies such worries. Sec. 613A(c)(3) sets a depletable oil quantity (e.g., 2,000 barrels) while sec. 613A(cX4) 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(cX6XAXii) and 613A(cX5). 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 current sec. 613A(bX2) was nonexistent in 1975 and should not be considered in a case concerning petitioners’ 1975 taxable year.
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).
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(bX2), Income Tax Regs. See also majority, supra at note 24.