1946 U.S. Tax Ct. LEXIS 185">*185 Decision will be entered under Rule 50.
1. Excess Profits Tax -- Net Abnormal Income Attributable to Prior Years. -- In determining the amount of net abnormal income of the petitioner attributable to prior years under section 721 (b), Internal Revenue Code, all of it which resulted from sales of crude oil at higher prices in the taxable year than in prior years should be allocated to the taxable year.
2. Id. -- In determining the amount of the net abnormal income attributable to prior years no diminution thereof is necessitated by the fact that the unit cost per barrel of crude oil produced was lower in the taxable year than in prior years, where such reduction in cost, as here, was due solely to increased production from newly discovered wells and not to any reduction in wages or cost of materials, supplies, etc.
6 T.C. 1124">*1125 This proceeding is for the redetermination of a deficiency in excess profits tax for the calendar year 1940 in the amount of $ 29,707.82. The question in issue is the measure of relief to which petitioner is entitled under section 721, Internal Revenue Code, on account of the realization in 1940 of net abnormal income attributable to other taxable years.
Most of the essential facts are contained in a stipulation filed by the parties, which is incorporated in our findings by reference. The following numbered paragraphs1946 U.S. Tax Ct. LEXIS 185">*187 of our findings of fact are substantially as set forth in the stipulation. The stipulation authorizes two minor adjustments in petitioner's 1940 tax liability which are not related to the matter in controversy.
FINDINGS OF FACT.
1. The petitioner is a corporation, organized in 1909 under the laws of the State of Delaware. Its principal office is located in Pittsburgh, Pennsylvania. Its business is that of producing crude petroleum, with its oil fields located in the State of Illinois. At all times pertinent hereto its operations were confined to leases on properties located in or near Sandoval, Illinois.
2. The amount of the deficiency asserted in the deficiency notice is $ 29,707.82.
3. Petitioner filed its corporation income, declared value excess profits, and defense tax return (Form 1120) and its corporation excess profits tax return (Form 1121) for the calendar year 1940 with the collector of internal revenue for the twenty-third district of Pennsylvania, at Pittsburgh. Such returns, as well as petitioner's Federal income tax returns for the years 1936 to 1939, inclusive, were filed on the accrual basis.
4. In its excess profits tax return so filed for the calendar year 1946 U.S. Tax Ct. LEXIS 185">*188 1940 petitioner claimed a deduction of $ 98,080.50 abnormal income attributable to other years and, as a result, the return showed no income subject to excess profits tax. A statement was attached to the return showing that the item of $ 98,080.50 was computed on the basis of 6 T.C. 1124">*1126 production from prior years' development. In the Commissioner's notice of deficiency the deduction of the $ 98,080.50 was disallowed as abnormal income attributable to other years.
5. During the years 1936, 1937, and 1938 petitioner's entire income was derived from the sale of crude petroleum produced by wells that had been drilled many years prior to 1936. The wells were drilled by petitioner upon leases designated as the Benoist, Warfield, and Stein leases, all located in Marion County, Illinois. The last of these wells was drilled in 1926. Each of the three leases was obtained from a different lessor, but they covered contiguous land. The petitioner's income from the operation of the wells for the years 1936, 1937, and 1938 was as follows:
| Year | Gross income | Net income |
| 1936 | $ 17,371.09 | $ 851.77 |
| 1937 | 16,371.15 | 1,726.17 |
| 1938 | 12,352.29 | (-1,928.57) |
6. In 1938 petitioner decided1946 U.S. Tax Ct. LEXIS 185">*189 to drill a well to a greater depth than any well on the Benoist, Warfield, and Stein leases in the hope of finding a hitherto unknown oil-bearing stratum. Such drilling operations were started on the Benoist lease in September 1938, and late in December 1938 oil was found in large quantities in what is known as the Devonian lime. Expenses of the drilling operation of this well were not billed until 1939. In 1939 four additional wells were completed to the Devonian lime on the Benoist lease and one on the Warfield lease. In 1940 one additional well to the Devonian lime was completed on the Benoist lease, two on the Stein lease, and one on the Warfield lease. In the income tax returns filed by petitioner the drilling costs of these wells for the appropriate years were claimed and allowed as deductions from gross income.
7. In 1939 the first crude petroleum produced by these new wells drilled to the Devonian lime was sold and sales continued throughout 1939 and 1940. Over 98 percent of the income received by petitioner in 1940 resulted from the sale of crude petroleum produced by these wells drilled to the Devonian lime.
8. In 1939 the gross income received by petitioner from wells1946 U.S. Tax Ct. LEXIS 185">*190 drilled in the Benoist, Warfield, and Stein leases, segregated as to old and new wells, was as follows:
| Leases | Old wells | New wells | Total |
| Benoist | $ 9,532.10 | $ 145,754.28 | $ 155,286.38 |
| Warfield | 729.00 | 18,832.78 | 19,561.78 |
| Stein | 3,721.43 | 3,721.43 | |
| Total | 13,982.53 | 164,587.06 | 178,569.59 |
6 T.C. 1124">*1127 9. In 1940 the gross income received by petitioner from wells drilled in the Benoist, Warfield, and Stein leases, segregated as to old and new wells, was as follows:
| Leases | Old wells | New wells | Total |
| Benoist | $ 2,597.95 | $ 266,855.53 | $ 269,453.48 |
| Warfield | 328.65 | 77,246.74 | 77,575.39 |
| Stein | 3,117.40 | 17,526.54 | 20,643.94 |
| Total | 6,044.00 | 361,628.81 | 367,672.81 |
10. The income and expenses of petitioner for the years 1936 to 1940, as taken from the income tax returns filed by the petitioner for those years, were as follows:
| Years | Income | Expenses | Net income |
| per return | |||
| 1936 | $ 17,371.09 | $ 16,519.32 | $ 851.77 |
| 1937 | 16,371.15 | 14,644.98 | 1,726.17 |
| 1938 | 12,352.29 | 14,280.86 | (-1,928.57) |
| 1939 | 178,921.61 | 134,137.73 | 44,783.88 |
| 1940 | 368,258.61 | 205,997.07 | 162,261.54 |
The expenses of petitioner for the year 1939, in the amount1946 U.S. Tax Ct. LEXIS 185">*191 of $ 134,137.73, as shown on the income tax return filed, were properly adjusted to $ 137,913.
11. No new well to the Devonian lime had been completed on the Stein lease in 1939 and there was no production from such a well on the Stein lease for a period of twelve months prior to December 31, 1940.
12. The development costs, both tangible and intangible, incurred during the respective years 1939 and 1940, of the new wells to the Devonian lime drilled on the Benoist and Warfield leases and the percentages of the total allocable to the two years are as follows:
| Benoist | Warfield | |||
| Year | ||||
| Percentage | Percentage | |||
| Amount | of total | Amount | of total | |
| 1939 | $ 98,070.51 | 81.80663854 | $ 20,254.09 | 57.9523462 |
| 1940 | 21,810.36 | 18.19336146 | 14,695.47 | 42.0476538 |
| Total | 119,880.87 | 100.00000000 | 34,949.36 | 100.0000000 |
13. The net income for declared value excess profits computation of petitioner for the year 1940 was $ 162,472.79.
14. The base period excess profits credit of petitioner for the year 1940, based on income, is $ 21,054.
15. The following table sets forth a complete computation of petitioner's net abnormal income for the year 1940, computed in accordance1946 U.S. Tax Ct. LEXIS 185">*192 with section 721 of the Internal Revenue Code: 6 T.C. 1124">*1128
| Total | Benoist | ||
| Income resulting from exploration, discovery, | |||
| and development of tangible property | $ 368,258.61 | $ 270,039.28 | |
| Less portion thereof not extending over a period | |||
| of more than 12 months | 19,996.42 | ||
| Balance extending over a period of more | |||
| than 12 months | 348,262.19 | 270,039.28 | |
| Less 125% of average for the 4 previous years | 70,317.55 | 56,846.48 | |
| Gross abnormal income | 277,944.64 | 213,192.80 | |
| Less applicable expense | 140,373.98 | 104,669.91 | |
| Net abnormal income | 137,570.66 | 108,522.89 |
| Warfield | Other | ||
| Income resulting from exploration, discovery, | |||
| and development of tangible property | $ 77,575.39 | $ 20,643.94 | |
| Less portion thereof not extending over a period | |||
| of more than 12 months | 19,996.42 | ||
| Balance extending over a period of more | |||
| than 12 months | 77,575.39 | 647.52 | |
| Less 125% of average for the 4 previous years | 6,946.57 | 6,524.50 | |
| Gross abnormal income | 70,628.82 | (-5,876.98) | |
| Less applicable expense | 41,581.05 | (-5,876.98) | |
| Net abnormal income | 29,047.77 | None |
16. The average price per barrel for crude petroleum sold by petitioner during the year 19401946 U.S. Tax Ct. LEXIS 185">*193 was $ 0.068990659 higher than the average price per barrel for crude petroleum sold by petitioner during the years 1936 to 1939, inclusive.
17. The gross income of petitioner in 1940 attributable to the higher price was $ 17,809.86 and $ 5,015.12 for the Benoist and Warfield leases, respectively.
18. The total wages paid by petitioner to its employees for the years 1936 to 1940, inclusive, were as follows:
| 1936 | $ 5,839 |
| 1937 | 5,538 |
| 1938 | 6,294 |
| 1939 | 12,326 |
| 1940 | 27,893 |
The rates of wages paid by petitioner for the years 1936 to 1940, inclusive, computed on the basis of the average monthly wage per man for those years, were as follows:
| 1936 | $ 92.65 |
| 1937 | 92.30 |
| 1938 | 93.94 |
| 1939 | 96.29 |
| 1940 | 115.26 |
19. There was no decrease in petitioner's material and supply prices in 1940 from similar prices for the 4 preceding years. A comparison between the weighted averages of prices of 34 representative items used by petitioner for the years 1936 to 1940 showed that in 1940 such weighted average price had increased 3.89 percent over the similar average price for the years 1936 to 1939, inclusive.
20. The comparative operating costs of petitioner per well, exclusive of percentage1946 U.S. Tax Ct. LEXIS 185">*194 depletion and drilling costs, for the years 1936 to 1939 and for the year 1940, were as follows:
| Year | Operating | Operating | Cost per |
| costs | wells | well | |
| 1936 | $ 15,367.57 | 13 | $ 1,182.12 |
| 1937 | 12,918.82 | 13 | 993.75 |
| 1938 | 14,280.86 | 13 | 1,098.52 |
| 1939 | 32,217.69 | 19 | 1,695.66 |
| 1940 | 69,653.39 | 23 | 3,024.06 |
6 T.C. 1124">*1129 21. The petitioner's gross income and expenses for the years 1936 to 1939, inclusive, and for the year 1940, with respect to the Benoist and Warfield leases, were:
| Benoist | Warfield | |||
| Year | ||||
| Gross income | Expenses | Gross income | Expenses | |
| 1936 | $ 10,486.03 | $ 9,873.76 | $ 884.20 | $ 783.35 |
| 1937 | 9,144.93 | 8,107.72 | 993.73 | 833.54 |
| 1938 | 6,639.35 | 7,792.41 | 789.32 | 807.00 |
| 1939 | 155,638.40 | 116,109.29 | 19,561.78 | 19,752.66 |
| 181,908.71 | 141,883.18 | 22,229.03 | 22,176.55 | |
| 1940 | 270,039.28 | 129,868.74 | 77,575.39 | 45,041.52 |
| Percentage of Expenses to Gross Income | ||
| Year | Benoist | Warfield |
| 1936-1939 | 77.9969139 | 99.7639123 |
| 1940 | 48.0925367 | 58.0616094 |
The following facts are based on evidence other than that contained in the stipulation.
There was a rapid development in the field in which petitioner's leases were located after the discovery1946 U.S. Tax Ct. LEXIS 185">*195 in 1938 of large quantities of oil in the Devonian lime. Many new wells were drilled in that vicinity by other producers and new pipe lines and storage facilities were installed.
Crude oil was the only product sold by petitioner. It did no refining or processing. The oil from its wells was delivered to the tanks of the purchasers located on its premises. The quality and quantity of the oil produced by the petitioner depended upon the location and depth of each of the producing wells.
There was no substantial change in petitioner's methods of operation in 1940 from those of prior years. The increase in its production and its gross income in 1940 was due to the discovery of rich deposits of oil in the deeper stratum and the resulting development on its leases. There was a ready market for all the oil produced by petitioner both in 1940 and in all prior years with which we are here concerned.
OPINION.
The general purpose of section 721, Internal Revenue Code, added by section 201 of the Second Revenue Act of 1940, as amended in 1941 and 1942, is to relieve the burden of the excess profits tax in certain hardship cases by permitting the reallocation of certain portions of its income, 1946 U.S. Tax Ct. LEXIS 185">*196 described as net abnormal income, from the year of its actual realization to other years. The tax for the current year is not to exceed the sum of the tax for such year computed without 6 T.C. 1124">*1130 the inclusion of the income attributable to prior years and the resulting increase in the tax for such prior years (sec. 721 (c)).
Section 721 (a) defines the terms "abnormal income" and "net abnormal income." We are not so much concerned with those definitions in this proceeding because the parties have stipulated that a certain portion of petitioner's income for the taxable year 1940, to wit, $ 137,570.66, was "net abnormal income," being income "resulting from exploration, discovery, prospecting, research, or development of tangible property * * * extending over a period of more than 12 months." (Sec. 721 (a) (2) (C).)
Section 721 (b) provides that:
(b) Amount Attributable to Other Years. -- The amount of the net abnormal income that is attributable to any previous or future taxable year or years shall be determined under regulations prescribed by the Commissioner with the approval of the Secretary. * * *
The parties here are in disagreement only as to the portions of the stipulated1946 U.S. Tax Ct. LEXIS 185">*197 net abnormal income which are attributable to prior taxable years. The respondent determined in his deficiency notice that none of it was. He now concedes, however, that $ 15,586.59 of the net abnormal income from the Benoist lease is attributable to 1939.
Pursuant to the authority specifically granted in section 721 (b) above, the Commissioner promulgated regulations covering the determination of the amount of net abnormal income attributable to other taxable years. Regulations 103 provides in part as follows:
Sec. 30.721-3. Amount attributable to other years. -- The mere fact that an item includible in gross income is of a class abnormal either in kind or in amount does not result in the exclusion of any part of such item from excess profits net income. It is necessary that the item be found attributable under these regulations in whole or in part to other taxable years. Only that portion of the item which is found to be attributable to other years may be excluded from the gross income of the taxpayer for the year for which the excess profits tax is being computed.
Items of net abnormal income are to be attributed to other years in the light of the events in which such1946 U.S. Tax Ct. LEXIS 185">*198 items had their origin, and only in such amounts as are reasonable in the light of such events. To the extent that any items of net abnormal income in the taxable year are the result of high prices, low operating costs, or increased physical volume of sales due to increased demand for or decreased competition in the type of product sold by the taxpayer, such items shall not be attributed to other taxable years. Thus, no portion of an item is to be attributed to other years if such item is of a class of income which is in excess of 125 percent of the average income of the same class for the four previous taxable years solely because of an improvement in business conditions. In attributing items of net abnormal income to other years, particular attention must be paid to changes in those years in the factors which determined the amount of such income, such as changes in prices, amount of production, and demand for the product. No portion of an item of net abnormal income is to be attributed to any previous year solely by reason of an investment by the 6 T.C. 1124">*1131 taxpayer in assets, tangible or intangible, employed in or contributing to the production of such income.
* * * *
Sec. 1946 U.S. Tax Ct. LEXIS 185">*199 30.721-8. Exploration, discovery, prospecting, research, or development. -- The third class of potentially abnormal income specifically set forth in section 721 (a) (2) is income resulting from exploration, discovery, prospecting, research, or development of tangible property (such as mines, oil producing property, and timber tracts), patents, formulae, or processes, or any combination thereof, extending over a period of more than 12 months. The exploration, discovery, prospecting, research, or development must be that of the taxpayer. Income resulting from activities of such a character carried on by a predecessor is not entitled to the treatment provided in section 721.
An item of income resulting from exploration, discovery, prospecting, research, or development is all such income for the taxable year arising out of a unit of property such as an oil lease or other mineral property defined in section 19.23 (m)-1 (i), a patent, or a formula. If the taxpayer engages in manufacturing, marketing, mining, oil production, or similar activities, only such portion of the resulting income as is attributable to exploration, discovery, prospecting, research, or development is within1946 U.S. Tax Ct. LEXIS 185">*200 the class of income described in this section. * * *
In general, an item of net abnormal income of the class described in this section is to be attributed to the taxable years during which expenditures were made for the particular exploration, discovery, prospecting, research, or development which resulted in such item being realized and in the proportion which the amount of such expenditures made during each such year bears to the total of such expenditures. Allocation of items of net abnormal income of the class described in this section must be made according to the principles set forth in section 30.721-3.
It will be noted that the last paragraph of the foregoing regulations directs that "Allocations of items of net abnormal income of the class described in this section must be made according to the principles set forth in section 30.721-3." That section of the regulations reads in part:
* * * To the extent that any items of net abnormal income in the taxable year are the result of high prices, low operating costs, or increased physical volume of sales due to increased demand for or decreased competition in the type of product sold by the taxpayer, such items shall not be attributed1946 U.S. Tax Ct. LEXIS 185">*201 to other taxable years. * * *
Thus, to bring in harmony the various provisions of the regulations and the statute, we must compute the amount of the net abnormal income attributable to prior years by eliminating from the net abnormal income the portions thereof which resulted from (1) high prices, (2) low operating costs, or (3) increased physical volume of sales due to increased demand for or decreased competition in the type of product sold by the taxpayer.
In computing the amount of the net abnormal income which he now concedes is attributable to prior years, viz., $ 15,586.59, the respondent reduced the stipulated net abnormal income of $ 108,522.89 from the 6 T.C. 1124">*1132 Benoist lease by $ 14,042.29 as the amount due to higher prices and $ 75,427.64 representing the amount due to lower operating costs, leaving a balance of $ 19,052.96, a portion of which, or $ 15,586.59, he allocated to the production and sale of oil from the new wells.
It is stipulated that the gross income for 1940 attributable to higher prices was $ 17,809.86 for the Benoist lease and $ 5,015.12 for the Warfield lease. In other words, petitioner realized $ 22,824.98 more income in 1940 than it would have realized1946 U.S. Tax Ct. LEXIS 185">*202 had it received the same prices for its crude oil in that year that it received during the base period. We think that all of such income was due to higher prices in 1940, which we take the stipulation to mean, and, therefore, should not be allocated to prior years. Since petitioner's operating costs would have been the same whether the oil was sold for a higher or lower price, we see no reason for taking them into account in determining the amount of income attributable to the higher prices.
There is no agreement between the parties as to the amount of the current year's income, if any, which is attributable to "low operating costs." However, the parties have stipulated the comparative operating costs, exclusive of drilling costs and depletion, the gross income and expenses, and the percentage of expenses to gross income, for both the current year 1940 and the prior four years of the base period. From those figures the respondent has computed the amount due to lower operating costs at $ 75,427.64 for the Benoist lease and $ 30,259.30 for the Warfield lease. As to the Warfield lease, the amounts which the respondent found to be due to high prices and low operating costs exceeded1946 U.S. Tax Ct. LEXIS 185">*203 the amount of the net abnormal income from that lease, so that nothing remained for allocation to prior years. The respondent's computation is based upon a comparison of the percentages of operating costs to gross sales in 1940 and in the prior years of the base period. Petitioner contends that this method of computing the amount of net abnormal income attributable to low operating costs is erroneous in that it is based upon a comparison of the percentage of operating costs to gross sales. It argues that the expenses were not dependent upon, and were only remotely related to, the volume of production and sales; that they remained more or less constant for each producing well, regardless of the amount of oil which it produced.
According to the stipulated facts the monthly wages per man paid in 1940 were approximately $ 20 higher than during the base period. Likewise, the cost of materials was $ 8,176.24 in 1940 against an average cost of $ 7,869.56 for the base period. The total per well operating costs, exclusive of drilling costs and percentage depletion, were $ 3,024.06 in 1940 against an average of $ 1,289.39 for the base period.
6 T.C. 1124">*1133 While it is true that the per barrel1946 U.S. Tax Ct. LEXIS 185">*204 operating costs declined as the volume of production increased, and was therefore considerably less in 1940 than during the base period, this decline was due to the increased volume of production resulting from discovery rather than to other factors associated with cost of production, such as wages, cost of materials, overhead, etc.
We agree with the petitioner's conclusion that none of its net abnormal income for 1940 may be attributable to low operating costs not directly related to discovery.
The respondent makes the further contention in his brief that certain undetermined portions of the stipulated net abnormal income for 1940 resulted from factors not considered in his determination, viz., "increased demand" for the crude oil and "improved business conditions."
There is no merit in this contention, even if we consider those questions timely raised in the respondent's brief. The evidence is that during the base period, as well as in 1940, there was a ready demand for every barrel of oil that could be produced from the field. So far as it affected the petitioner, there was no increased demand for oil in 1940.
As to the alleged improved business conditions, the respondent points1946 U.S. Tax Ct. LEXIS 185">*205 out that (1) gross sales were greater, (2) the number of employees was increased, (3) sale prices were higher, and (4) the profit per unit (barrel of oil) was higher.
We have already determined that none of the $ 22,824.98 resulting from the higher prices which prevailed in 1940 can be attributed to other years under the regulations. None of the other factors mentioned above necessarily indicated improved business conditions.
As the basis for the stipulation that petitioner had net abnormal income of $ 137,570.66 in 1940, the respondent has admitted that that portion of petitioner's income resulted from "exploration, discovery, and development." After the necessary adjustment for the portion thereof attributable to higher prices in accordance with our above ruling, the remainder should be "attributed to the taxable years during which expenditures were made for the particular exploration, discovery, prospecting, research, or development which resulted in such item being realized and in the proportion which the amount of such expenditures made during each such year bears to the total of such expenditures," as contemplated by the regulations quoted above. Cf. W. B. Knight Machinery Co., 6 T.C. 519.
1946 U.S. Tax Ct. LEXIS 185">*206 Reviewed by the Special Division.
Decision will be entered under Rule 50.