dissenting: I respectfully dissent, since I cannot agree that OG & E obtained a depletable economic interest in minerals in place as required by the regulations. Sec. 1.636-l(a)(l)(i); sec. 1.611-l(b), Income Tax Regs. Unless this paramount condition is met there is no production payment to which section 636(a) can apply.
A paradigm form of production payment is illustrated by the facts in Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958). The Supreme Court summarized the facts as follows:
Lake is a corporation engaged in the business of producing oil and gas. It has a seven-eighths working interest in two commercial oil and gas leases. In 1950 it was indebted to its president in the sum of $600,000 and in consideration of his cancellation of the debt assigned him an oil payment right in the amount of $600,000, plus an amount equal to interest at 3 percent a year on the unpaid balance remaining from month to month, payable out of 25 percent of the oil attributable to the taxpayer’s working interest in the two leases. At the time of the assignment it could have been estimated with reasonable accuracy that the assigned oil payment right would pay out in three or more years. It did in fact pay out in a little over three years. [356 U.S. at 261-262],
The legislative history of section 636(a)(enacted in 1969) makes it clear that the section was a legislative response to certain perceived tax avoidance schemes following in the wake of P.G. Lake. See S. Rept. 91-552, 1969-3 C.B. 423, 538. For example, by certain maneuvering with production payments taxpayers were said to be able to avoid the 50-percent taxable income limitation for percentage depletion purposes, the foreign tax credit limitation, the 5-year net operating loss carryover limitation, and the seven-year investment credit limitation. Taxpayers were also seen as being able to amortize or pay off what was essentially a loan with before-tax dollars. 1969-3 C.B. at 539.
The congressional response, as reflected in section 636(a), was to provide that production payment transactions in general are to be treated as loan transactions. I do not believe, however, that by taking this step to close one loophole Congress intended to open another. I agree that the form of a production payment transaction and that of a mortgage loan need not be precise analogues as the regulations themselves make clear.1 Nevertheless, taxpayers must always make a threshold showing that the rights conveyed were a production payment; i.e., a depletable economic interest in minerals in place. I think petitioners have failed in their attempt to do so in this case.
As the regulations make clear, “an economic interest is possessed in every case in which the taxpayer [e.g., OG & E] has acquired by investment any interest in mineral in place * * * and secures, by any form of legal relationship, income derived from the extraction of the mineral * * *, to which he [OG & E] must look for a return of his capital.” (Emphasis added.) Section 1.61 l-l(b)(l), Income Tax Regs.2 By this definition, OG & E must have acquired the gas as an investment and be recovering its capital through sales to third parties. That is not, in fact, what happened. It seems plain to me that OG & E is simply buying petitioners’ gas at the wellhead, not mineral in place. OG & E then presumably transports the gas through its pipeline to its processing plant, for later sale to consumers.
I think this case is controlled by the Supreme Court’s decision in Helvering v. Bankline Oil Co., 303 U.S. 362 (1938). One of the contracts involved in Bankline provided for the purchase by the taxpayer from the producer of “all natural gas produced at a given well, the [taxpayer] paying 33 1/3 percent of the gross proceeds received by it from the sale of the gasoline extracted from such gas.” The Supreme Court quoted with approval the Government’s representation that “under the contracts [taxpayer] took no part in the production of the * * * gas, conducted no drilling operations upon any of the producing premises, did not pump oil or gas from the wells, and had no interest as a lessor or lessee, or as sublessor or sublessee, in any of the producing wells.” 303 U.S. at 365. The purchaser [taxpayer] merely attached pipelines to the various wells and carried the gas from those wells to its processing plant where the gas was commingled with gas from other sources.
The Supreme Court pointed out in Bankline that “Some of the contracts, reciting that the producer was the owner of the gas produced, provided for its treatment [i.e., reduction of dry gas to gasoline] by [taxpayer]. Other contracts were couched in terms of purchase. In either case the gas was to be delivered to [taxpayer] at the casingheads or gas traps installed by the producer.” 303 U.S. at 367-368.
The Court went on to say that “The controlling fact is that [purchaser] had no interest in the gas in place. [Purchaser] had no capital investment in the mineral deposit which suffered depletion and is not entitled to the statutory allowance.” 303 U.S. at 368.
I believe that OG & E is in exactly the same posture here as was the purchaser-taxpayer in Bankline Oil Co. The contracts in this case speak in terms of gas “sold and delivered” to OG & E. Section 2.2 provides that “Seller [petitioners] shall have the right to operate wells from which gas is produced * * * for delivery ’’into Buyer’s pipeline [i.e., OG & E’s pipeline.]” Article 5, entitled “Points of Delivery and Delivery Pressure,” provides that the gas produced “shall be delivered at the wellhead of each well, or at the outlet of the well separator, if any. Title to all gas sold hereunder shall pass from Seller to Buyer at said point of delivery.” (Emphasis added.) There is absolutely nothing in either contract which says anything about OG & E making a capital investment in the gas in place. It follows, then, that this case simply does not involve production payments, and section 636(a) does not apply.
Section 61(a) provides that “gross income means all income from whatever source derived.” Section 451 provides that “The amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.” Under the facts of this case, the $484,416.34 received by petitioners in the years before the Court, and which the majority permits petitioners to defer for up to 20 years, should be included in petitioners’ gross income in the years received, and I would so hold.
Jacobs, Parr, and Williams, JJ., agree with this dissent. PARR, J.,dissenting: In addition to the reasons articulated in the dissenting opinions of Judges Nims and Williams, in which I have joined, I dissent on an additional ground. What the majority has done here in holding that OG & E possesses an economic interest in the mineral in place extends the concept of “economic interest” much too broadly, and may provoke unforeseen consequences. This concept is fundamental in determining the tax consequences of transactions involving mineral properties. In particular, it is critical in determining who receives gross income from the property, who is entitled to depletion, and whether the disposition of an interest is a sale or a lease.
The majority’s opinion has the result of elevating a prepaid contractual right to a supply of a mineral to the level of an investment in the mineral in place, an economic interest. In this case, the majority’s finding of an economic interest leads to the finding that a production payment exists, which is treated not as a depletable economic interest but as a loan, pursuant to section 636. It might be argued in this context that there has been no shifting of ordinary depletable income and thus little or no abuse in terms of tax dollars as a result of this decision, if both parties reported the transaction consistently.1 However, in other contexts the finding that such a contractual right amounts to an economic interest may have a greater tax impact, such as entitlement to depletion deductions. Moreover, what the Court has done today is to mischaracterize a straightforward transaction, the tax consequences of which were clearly and correctly stated in Rev. Rui. 80-48, 1980-1 C.B. 99, and to open the door to the possible distortion of the tax consequences of all transactions involving natural resources.
NlMS, J., agrees with this dissent. WILLIAMS, J.,dissenting: The crux of this case is whether OG & E has an economic interest in the gas in place. I submit that it does not. At most, OG & E has secured for itself the economic advantage of a long-term, stable supply of gas. As a consumer and not as an investor, it has prepaid for future deliveries to maintain both that supply and its good relations with the supplier. OG & E has the right to command delivery to itself of any gas, once extracted, that meets certain specifications of the contract. In my view, that contractual right does not constitute an economic interest in the gas in place notwithstanding that OG & E might well take all of the gas extracted.
In Palmer v. Bender, 287 U.S. 551 (1933), the Supreme Court, faced with defining a depletable interest in minerals, stated as follows:
The language of the statute is broad enough to provide, at least, for every case in which the taxpayer has acquired, by investment, any interest in the oil in place, and secures, by any form of legal relationship, income derived from the extraction of the oil, to which he must look for a return of his capital. [287 U.S. at 557. Emphasis added.]
This language means that (a) the taxpayer must have a legal right to the mineral in the ground, (b) that right must be acquired by investment, and (c) a return of the taxpayer’s investment must be realized out of income to be derived from extracting the mineral. See also sec. 1.611-l(b)(l), Income Tax Regs.
In this case, OG & E has no legal right to the mineral in the ground; the contract provides that OG & E’s legal ownership commences at the point of delivery (i.e., “the wellhead or the outlet of the well separator, if any”). OG & E has prepaid for a quantity of extracted gas that must be delivered to it in accordance with certain quality specifications and at a given pressure. Under the contract if the gas fails to meet quality specifications (e.g., maximum sulfur content), the parties will adjust the price or, failing adequate adjustment, OG & E can exclude such gas from the contract. If the gas fails to meet the pressure specification, section 5.4 of the contract provides that unless either OG & E or the petitioners elect to install the equipment necessary to compress the gas to the acceptable pressure, “the Buyer [OG & E] shall, on request of Seller [petitioners] release the production from any such well, together with the acreage attributable thereto, from the provisions of this agreement.” It seems to me that in either circumstance (failure of quality or pressure), OG & E has no interest in the gas in place and no right to any income from the sale of such gas. Further, if production from the well is released, it is unclear whether OG & E can recover any prepayment for the gas or whether the sellers must make up deficient deliveries from other wells.1 On this basis I believe that OG & E has not invested in this well, but has only prepaid for a commodity to be delivered to it. OG & E’s right to the gas begins at the metering station on the pipeline and not in the well.
Furthermore, the price that OG & E pays for the gas is itself a strong indicator that OG & E has not invested in the gas well and does not look to its extraction to recover any “investment.” The contract price for the gas is determined by reference to the market price paid by OG & E to other contract suppliers of gas of similar quality and pressure from similar formations and locations in identified counties. In general terms, this formula price can be said to reflect the local market price at the wellhead of a particular quality of gas at a given pressure. If the formula works as contemplated it should produce a price that is, within tolerable limits of deviation, the fair market value of such gas after extraction. OG & E is not, therefore, in a position to profit from any resale of this gas at the wellhead. Consequently, OG & E is not seeking a return from extracting the gas; rather, it is a consumer buying a supply of the commodity it consumes.
Finally, section 3.1 of the contract provides that the quantity of the gas to be delivered under the contract is the lesser of (a) 80 percent of the well’s “deliverability” or (b) “80% of the volume of gas made available by Seller to Buyer.” This provision seems to me to undercut the majority’s view that “deliverability” and “production” are equivalent terms notwithstanding the seller’s obligation under section 2.2 of the contract to operate the wells so that they “will deliver gas into Buyer’s pipeline when desired by Buyer at the maximum rate at which said wells are capable of production.”
In summary, this agreement is nothing more than a long-term supply contract that gives OG & E some assurance that a relatively stable source of natural gas can be delivered to its pipeline according to its specifications when its needs dictate.
Nims, JACOBS, and Parr, JJagree with this dissent.
Sec. 1.636-3(a)(2), Income Tax Regs., provides that “A right which is in substance economically equivalent to a production payment shall be treated as a production payment for purposes of section 636 and the regulations thereunder, regardless of the language used to describe such right, the method of creation of such right, or the form in which such right is cast (even though such form is that of an operating mineral interest).”
Sec. 1.611-l(b)(l), Income Tax Regs., has been characterized as having been drawn primarily from the opinions in Palmer v. Bender, 287 U.S. 551 (1933), and Helvering v. Bankline Oil Co., 303 U.S. 362 (1938). See 1 B. Bittker, Federal Income Taxation of Income, Estates and Gifts, par. 24.1.2, at 24-7 (1981 ed.).
The record is silent with regard to og & e’s actual treatment of the payments. However, the majority opinion would preclude og & E from deducting the payments to petitioners, and would require og & E to report imputed interest on the amount treated as a loan. See sec. 1.636-l(a), Income Tax Regs.
The contract is silent. Bearing the risk of such loss (assuming that deficient deliveries are not made up as a business practice), however, can make economic sense. The economic advantage of a stable long-term supply may be worth losing the prepayment, e.g., where the cost of securing the supply on the spot market is higher than the price of long-term supply under the contract (including any forfeited prepayments). The record is apparently barren on this point, and I offer the observation only to counter any speculation that the prepayment must necessarily be an “investment” simply because og & E in fact paid for gas in 1979 that was not delivered to it.