1927 BTA LEXIS 2545">*2545 1. Royalty income from certain oil and gas leases held not to be capital gain as defined in section 206 of the Revenue Act of 1921.
2. Profits derived from the sale of undivided interests in oil and gas underlying land owned for more than two years prior to date of conveyance, held to be capital gain as defined in section 206 of said Act.
9 B.T.A. 610">*610 The Commissioner determined a deficiency in income tax for the year 1922, in the amount of $7,762.99. It is claimed that the Commissioner erred in refusing to compute the tax under section 206 of the Revenue Act of 1921, upon that portion of petitioner's income derived from certain oil and gas leases and from sales and conveyances by petitioner of oil and gas rights in certain properties. Two deficiency notices were mailed for the fiscal year and separate petitions were filed. The proceedings were, upon motion made and granted, consolidated. The facts are found as stipulated.
9 B.T.A. 610">*611 FINDINGS OF FACT.
The petitioner is and was during the year 1922, a resident of El Dorado, Ark., and filed1927 BTA LEXIS 2545">*2546 his return for said year with the collector of internal revenue at Little Rock, Ark.
The net taxable income of petitioner for 1922, less capital net gains of $2,750, was $69,895.06, of which amount the sum of $64,987.70, represented net income from the sale or transfer of oil and gas leases and royalty interests.
During the year 1922, petitioner executed certain oil and gas leases to divers parties on lands in which he had held an undivided fee simple interest for more than two years prior to the execution of such leases. In this year petitioner also transferred by warranty deeds to divers parties, interests in the oil, gas, and other minerals in and upon lands which he had owned for more than two years prior to the date of each sale. Each conveyance was made subject to an oil and gas lease thereupon granted on the land described. The material provisions of all the leases and warranty deeds were in all respects similar. The material portion of one of the leases follows:
THIS AGREEMENT, Made and entered into this the 26th day of July, 1922, by and between J. E. Murphy and Nannie B. Murphy, his wife, of Union County, Arkansas, party of the first part, hereinafter called lessor1927 BTA LEXIS 2545">*2547 (whether one or more), and the Simms Oil Co., a corporation, party of the second part, hereinafter called the lessee.
WITNESSETH, That the said lessor for and in consideration of NINE THOUSAND DOLLARS cash in hand paid, the receipt of which is hereby acknowledged, and of the covenants and agreements hereinafter contained on the part of the lessee to be paid, kept and performed, have granted, conveyed, demised, leased and let, and by these presents do grant, convey, demise, lease and let unto said lessee, for the sole and only purpose of mining and operating for oil and gas, and laying of pipe lines, and of building tanks, towers, stations and structures thereon to produce, save and take care of said products, and all that certain tract of land situated in the County of Ouachita, State of Arkansas, Northwest quarter of southwest quarter of section twenty-eight Township Fifteen south, Range fifteen west and containing 40 acres, more or less.
It is agreed that this lease shall remain in force for a term of from this date, and as long thereafter as oil or gas, or either of them is produced from said land by the lessee.
In consideration of the premises the said lessee covenants1927 BTA LEXIS 2545">*2548 and agrees:
1st. To deliver to the credit of the lessor, free of costs in tanks or pipe line to which it may connect its wells, the equal one-eighth part of all oil produced and saved from the lease premises.
2nd. To pay the lessor the market value of 1/8 of the production each year, for the gas from each well where gas only is found, while the same is being used off the premises and lessor to have gas free of cost from any such well for all stoves and all inside lights in the principal dwelling houses on said land during the same time by making his own connection with the well at his own risk and expense.
9 B.T.A. 610">*612 3rd. To pay lessor for gas produced from any oil well used off the premises at the rate of the market value of 1/8 of the production, for the time during which such gas shall be used, such payments to be made each three months.
If no well be commenced on said land on or before the 26th day of July, 1923, this lease shall terminate as to both parties, unless the lessee, on or before that date, shall pay or tender to the lessor, or to the lessor's credit in the Ouachita Valley Bank of Camden, Arkansas, or its successors, which shall continue as the depository1927 BTA LEXIS 2545">*2549 regardless of changes in the ownership of said land, the sum of One Dollar per acre per year, while shall operate as a rental and cover the privilege of deferring the commencement of a well for one year from said date. In like manner and upon like payments or tenders the commencement of a well may be further deferred for the like periods in the same number of months successively. And it is understood and agreed that the consideration, first recited herein, the down payment, covers not only the privileges granted to the date when said first rental is payable as aforesaid, but also the lessee's option of extending that period as aforesaid, and any and all other rights conferred.
Should the first well drilled on the above described land be a dry hole, then, in that event, if a second well is not commenced on said land within twelve months from the expiration of the last rental period from which rental has been paid, this lease shall terminate as to both parties, unless the lessee on or before the expiration of said twelve months shall resume the payment of rentals in the same amount and in the same manner as hereinafter provided. And it is agreed that upon the resumption of the1927 BTA LEXIS 2545">*2550 payment of rentals, as above provided, that the last preceding paragraph hereof governing the payment of rentals and the effect thereof, shall continue in force just as though there had been no interruption in the rental payments.
The provisions of one of the warranty deeds follow:
KNOW ALL MEN BY THESE PRESENTS: That, We, J. E. Murphy and Nannie B. Murphy, his wife for and in consideration of the sum of Seven Thousand Dollars, to us cash in hand paid by W. A. Haynes and J. L. Haynes, partners doing business under the firm name and style "Haynes Brothers" at Shreveport, La. receipt of which is hereby acknowledged, do hereby grant, sell and convey unto the said W. A. Haynes and J. L. Haynes, partners doing business under the firm name and style of "Haynes Brothers," and unto their successors, heirs, and assigns forever, an undivided one-half interest in and to all of the oil, gas and other minerals in under and upon the following described lands lying within the County of Ouachita, State of Arkansas, to wit:
Southwest quarter of Northwest quarter and Southwest quarter of Northwest quarter of Section 28, Township 15 South, Range 15 West, containing in all 80 acres more or less1927 BTA LEXIS 2545">*2551 - subject, however to two certain oil, gas and mineral leases, as follows:
The SW 1/4 Sec. 28, Twp. 15 S.R. 15 West, leased to T. J. Murphy, by instrument dated July 27th, 1922, and filed for record on July 28th, 1922, but not yet recorded:
The SW 1/4 of NW 1/4 Sec. 28, Twp. 15 S.R. 15 West, leased to D. F. Hugus, Trustee, May 22, 1922, by instrument recorded in the Recorders Office of Ouachita County, Arkansas, Record Book 16 Page 247, and now assigned to Standard Oil Co., of La., as shown by instrument recorded Book 16 page 418.
And for said consideration we do hereby grant and convey unto the said W. A. Haynes and J. L. Haynes, doing business as partnership under name of Haynes Brothers, their heirs, and assigns, the right to collect and receive under 9 B.T.A. 610">*613 the aforementioned leases one half of the oil and gas royalties due under said leases. It being the intention by this instrument to convey to the grantees herein what is commonly known as a one sixteenth royalty or one half of the one eighth royalty to come to the lessors in the leases above described.
TO HAVE AND TO HOLD the above mentioned property, together with all and singular the1927 BTA LEXIS 2545">*2552 rights and appurtenances thereto in any wise belonging, unto the said W. A. Haynes and J. L. Haynes, as partners under name of Haynes Brothers, and unto their heirs and assigns forever, And we hereby covenant with the said grantees herein that we will forever warrant and defend the title to the above described lands and the rights therein conveyed against the lawful claims of all persons whomsoever, subject to the conditions above mentioned and described.
The net income of petitioner from the various transactions above referred to is summarized as follows:
| Net income from the issuance of oil leases | $52,062.70 |
| Net income from transfer oil and gas interests | 12,925.00 |
| Total | 64,987.70 |
On the original return as filed by petitioner, the income from the above sources was computed as $65,472.70, and the tax was computed thereon by petitioner at 12 1/2 per cent of such amount on the theory that such computation was authorized by section 206 of the Revenue Act of 1921.
The respondent, in computing the tax, did not consider the income arising from the leasing of the oil and gas rights and the income from the transfer of interests in oil and gas as being a gain from1927 BTA LEXIS 2545">*2553 the sale of a capital asset under the provisions of section 206 of the Revenue Act of 1921, and computed the tax under sections 210 and 211 of that Act, thereby arriving at a deficiency of $7,762.99.
OPINION.
LITTLETON: Petitioner had been the owner of the land and the oil and gas rights for more than two years prior to the execution and delivery of the leases and deeds, and is, therefore, entitled to have his income taxed under section 206 of the Revenue Act of 1921 provided it was gain from the sale of "capital assets" as therein defined.
The oil and gas leases are similar to those involved in Henry L. Berg et al.,6 B.T.A. 1287">6 B.T.A. 1287. Upon decision of the Board in that proceeding the action of respondent in refusing to tax income derived from the leases under section 206 is approved. To the same effect see John T. Burkett,7 B.T.A. 560">7 B.T.A. 560, and D. R. McDonald,7 B.T.A. 1078">7 B.T.A. 1078; Rosenberger v. McCaughn, 20 Fed.(2d) 139.
In the Berg case, supra, the Board left open the question whether gain from an outright sale of oil and gas underlying land owned for more than two years is "capital gain" as that term1927 BTA LEXIS 2545">*2554 is defined by section 206. By each warranty deed petitioner sold and conveyed 9 B.T.A. 610">*614 subject to a prior oil and gas lease, an undivided interest in the oil and gas underlying the tract described. Since each conveyance was subject to a prior oil and gas lease, the immediate effect of such conveyance was to assign an interest in the royalty, but it is clear that this right grew out of the absolute sale and conveyance of an undivided interest in the oil and gas. The question reserved in the Berg case, supra, is presented here.
Petitioner contends that since he had owned the land under which the oil and gas laid for more than two years prior to each conveyance, he was the owner of such minerals and, therefore, possessed at the date of sale a capital asset. On the other hand, respondent asserts that oil and gas, being of a fugitive nature, are, until reduced to possession at the surface, incapable of private ownership, and following this line of thought he argues that petitioner could not acquire and hold for two years that which no private individual could own.
It is obvious that respondent's contention if carried to its logical conclusion would result in the establishment1927 BTA LEXIS 2545">*2555 of the rule that oil and gas in place are incapable of private ownership and therefore belong to the public at large. Before discussing this question the legal consequences resulting from the application of such a rule should be stated.
Suppose the petitioner had purchased a farm on which oil was subsequently discovered and after such discovery, sold his land and oil rights for a vastly larger amount than he had originally paid for the land. Could it be seriously contended that, since by far the larger portion of the purchase price was attributable to the oil, such price should be divided into two parts and the vendor deprived of the benefit of section 206 to the extent of that portion of the purchase price allocable to the oil? It is obvious that in such case the moving cause for the sale would be the oil and not the land. Assume that the owner should sell the surface to one person and the oil to another. Would there be any difference in the legal aspects of the two cases? What would result if such owner should sell the oil and reserve the land? The last mentioned question is the one involved in this proceeding and the solution thereof depends upon a determination as to1927 BTA LEXIS 2545">*2556 the rights of an owner in fee to oil and gas beneath his land. These rights were discussed at length in Ohio Oil Co. v.Indiana (No. 1), 177 U.S. 190">177 U.S. 190. The issue involved in this case is thus stated by the court:
The assignments of error all in substance are resolvable into one proposition; which is, that the enforcement of the provisions of the Indiana statute as against the plaintiff in error, constituted a taking of private property without adequate compensation, and therefore amounted to a denial of due process of law in violation of the Fourteenth Amendment. * * *
The 9 B.T.A. 610">*615 statute involved in effect forbade the waste of gas and imposed penalties for its violation. The court, after pointing out that to a certain extent there was an analogy between oil and gas and animals ferae naturae, but that such analogy was subject to certain limitations, said:
* * * In things ferae naturae all are endowed with the power of seeking to reduce a portion of the public property to the domain of private ownership by reducing them to possession. In the case of natural gas and oil no such rights exists in the public. It is vested only in the owners in1927 BTA LEXIS 2545">*2557 fee of the surface of the earth within the area of the gas field. This difference points at once to the distinction between the power which the lawmaker may exercise as to the two. In the one, as the public are the owners, every one may be absolutely prevented from seeking to reduce to possession. No divesting of private property, under such a condition, can be conceived because the public are the owners, and the enacting by the State of a law as to the public ownership is but the discharge of the governmental trust resting in the State as to property of that character. Geer v. Connecticut,161 U.S. 519">161 U.S. 519. On the other hand, as to gas and oil, the surface proprietors within the gas field all have the right to reduce to possession the gas and oil beneath. They could not be absolutely deprived of this right which belongs to them without a taking of private property. But there is a co-equal right in them all to take from a common source of supply, the two substances which in the nature of things are united, though separate. It follows from the essence of their right and from the situation of the things, as to which it can be exerted, that the use by one of1927 BTA LEXIS 2545">*2558 his power to speak to convert a part of the common fund to actual possession may result in an undue proportion being attributed to one of the possessors of the right, to the detriment of the others, or by waste by one or more, to the annihilation of the rights of the remainder. Hence it is that the legislative power, from the peculiar nature of the right and the objects upon which it is to be exerted, can be manifested for the purpose of protecting all the collective owners, by securing a just distribution, to arise from the enjoyment by them, of their privilege to reduce to possession, and to reach the like end by preventing waste. This necessarily implied legislative authority is borne out by the analogy suggested by things ferae naturae, which it is unquestioned the legislature has the authority to forbid all from taking, in order to protect them from undue destruction, so that the right of the common owners, the public, to reduce to possession may be ultimately efficaciously enjoyed. Viewed, then, as a statute to protect or to prevent the waste of the common property of the surface owners, the law of the State of Indiana which is here attacked because it is asserted that1927 BTA LEXIS 2545">*2559 it divested private property without due compensation, in substance, is a statute protecting private property and preventing it from being taken by one of the common owners without regard to the enjoyment of the others. Indeed, the entire argument, upon which the attack on the statute must depend, involves a dilemma, which is this: If the right of the collective owners of the surface to take from the common fund and thus reduce a portion of it to possession, does not create a property interest in the common fund, then the statute does not provide for the taking of private property without compensation. If, on the other hand, there be, as a consequence of the right of the surface owners to reduce to possession, a right of property in them, in and to the substances contained in the common reservoir of supply, then as a necessary result of the right of property, its indivisible quality and 9 B.T.A. 610">*616 the peculiar position of the things to which it relates, there must arise the legislative power to protect the right of property from destruction. To illustrate by another form of statement, the argument is this: There is property in the surface owners in the gas and oil held in the1927 BTA LEXIS 2545">*2560 natural reservoir. Their right to take cannot be regulated without devesting them of their property without adequate compensation, in violation of the Fourteenth Amendment, and this, although it be that if regulation cannot be exerted one property owner may deprive all the others of their rights, since his act in so doing will be damnum absque injuria. This is but to say that one common owner may devest all others of their rights without wrongdoing, but the lawmaking power cannot protect all the owners in their enjoyment without violating the Constitution of the United States. * * * (Italics ours.)
This case was followed in Lindsley v. Natural Carbonic Gas Co.,220 U.S. 61">220 U.S. 61, involving a New York statute; in Oklahoma v. Kansas Natural Gas Co.,221 U.S. 229">221 U.S. 229, involving an Oklahoma statute, and in Walls v. Midland Carbon Co.,254 U.S. 300">254 U.S. 300, involving a Wyoming statute. The court in the Lindsley case based its opinion on the rule laid down in the Ohio Oil Co. case, and added, "But were the question an open one we should still solve it in the same way." From these cases the following rules may be deduced: The right1927 BTA LEXIS 2545">*2561 to reduce to possession gas and oil underneath one's land is a property right protected by the Fourteenth Amendment. Oil and gas do not belong to the state but constitute the common property of all owners of the soil that lies above the oil and gas deposit. This common ownership is subject to the right of individual ownership, when the oil or gas is reduced to possession by any one of the common owners. Such common ownership is the private property of the owners of the soil and as such may be protected by statute.
All the property rights above enumerated had been acquired and held by petitioner for more than two years prior to the date of each conveyance. Under the facts the Board is of the opinion that the oil and gas conveyed by petitioner to his grantee were "capital assets," as defined in section 206. To hold otherwise would be to give to a relief statute a narrow construction which would do violence to the intention of Congress as expressed both in the words of the section and the report of the Committee on Ways and Means of the House of Representatives. See 1927 BTA LEXIS 2545">*2562 6 B.T.A. 1287">Henry L. Berg et al, supra.
Petitioner is entitled to have so much of his income as resulted from a gain derived from sales of oil, gas and other minerals, taxed under the provisions of section 206.
Reviewed by the Board.
Judgment will be entered on 15 days' notice, under Rule 50.