UNITED STATES TAX COURT

106 T.C. No. 22

UNITED STATES TAX COURT

STEPHEN R. AND MARY K. HERBEL, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

JERRY R. AND CAROLYN M. WEBB, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 22079-93, 22080-93.

Filed June 5, 1996.

M, a subch. S corporation, purchased working

interests in various gas wells that were subject

to a gas purchase contract with A. To avoid

litigation over a so-called take or pay provision

in the contract, M and A entered into a Settlement Agreement under which A paid $1,850,000 to

M in 1988 but reserved the right to recoup the

payment from future gas purchases under the

contract. The Settlement Agreement further

provided that M would pay any unrecouped amount

to A in cash in the event that it terminated the

contract or the wells became substantially

depleted. M did not report the payment as income

in 1988. R determined that A's payment to M was

an advance payment for gas, and is includable in

M's income in 1988, the year received. Sec.

1.451-1(a), Income Tax Regs.

Ps, shareholders of M, filed a motion for

summary judgment in which they argue that, under

- 2 general tax principles, the subject payment is

a deposit in the nature of a loan and is not

includable in income in 1988 under Commissioner

v. Indianapolis Power & Light Co., 493 U.S. 203

(1990). Ps further argue that A's right of

recoupment is a production payment under sec.

636(a), with the result that the transaction

must be treated as a loan. In support thereof,

Ps assert that sec. 1.636-3(a)(1), Income Tax

Regs., is invalid to the extent it limits the

definition of production payment to interests

which are economic interests in the mineral in

place.

Held: A's payment is an advance payment

for the purchase of gas under the gas purchase

contract and is includable in M's income in

the year received. Held, further, sec. 1.636(a)(1), Income Tax Regs., is valid and, A's right

of recoupment is not a production payment under

sec. 636(a).

Frederick R. Parker, Jr., and W. Deryl Medlin, for

petitioners.

Martin M. Van Brauman and Josh O. Ungerman, for

respondent.

OPINION

WHALEN, Judge:

These consolidated cases are before

the Court to decide petitioners' motion for summary

judgment.

The issue presented by petitioners' motion is

whether a payment received in settlement of a contractual

dispute involving a so-called take or pay contract for

the purchase and sale of natural gas is includable in

petitioners' income in the year received, as respondent

- 3 contends, or whether the payment is a deposit in the

nature of a loan, as petitioners contend.

In addition to

petitioners' motion for summary judgment and memorandum

in support thereof, respondent's notice of objection and

memorandum in support thereof, and petitioners' reply, the

parties have filed a stipulation of facts in each of the

consolidated cases, together with exhibits attached

thereto.

The stipulations and accompanying exhibits are

incorporated by this reference.

The facts set forth in

this opinion are taken from the pleadings and

the stipulations of facts.

Background

Respondent issued a notice of deficiency to Stephen R.

and Mary K. Herbel, petitioners in the case at docket No.

22079-93, in which respondent determined the following

deficiency in, and additions to, their 1988 tax:

Deficiency

$42,725

Additions to Tax

Sec. 6653(a)(1)

Sec. 6661(a)

$2,136

$10,681

All section references are to the Internal Revenue Code as

in effect during 1988, unless stated otherwise.

Respondent

also issued a notice of deficiency to Jerry R. and Carolyn

M. Webb, petitioners in the case at docket No. 22080-93,

- 4 in which respondent determined the following deficiency in,

and additions to, their 1988 tax:

Additions to Tax

Sec. 6653(a)(1)

Sec. 6661(a)

Deficiency

$366,244

$18,312

$91,561

All petitioners resided in Shreveport, Louisiana, at the

time they filed their petitions with this Court.

Petitioners owned all of the outstanding stock of

Malibu Petroleum, Inc. (Malibu).

Malibu had been

incorporated under Texas law on or about February 18, 1988,

to engage in the business of exploring for and producing

oil and natural gas.

During 1988, petitioners Stephen and

Mary Herbel owned 10 percent of Malibu's outstanding stock,

and petitioners Jerry and Carolyn Webb owned 90 percent of

Malibu's stock.

Mr. Herbel was Malibu's president.

For Federal income tax purposes, Malibu was an S

corporation within the meaning of section 1361(a)(1).

Malibu and each petitioner reported income and deductions

for Federal income tax purposes using the cash receipts

and disbursements method of accounting.

At various times during 1988, Malibu acquired the

interests of Regency Exploration, Inc. (Regency), and

others in certain gas wells located in Sebastian County,

Arkansas, that were covered by a gas purchase contract

dated January 2, 1981, between Revere Corp., an Arkansas

- 5 corporation, as seller, and Arkansas Louisiana Gas Co.

(Arkla) as buyer.

In this opinion, we refer to the gas

purchase contract as the Contract.

Section 9 of the

Contract provides as follows:

Section 9.

QUANTITIES.

(A)(1) The following phrases are used in

this agreement with the following meanings:

(a) "Daily Deliverability,” with

respect to a particular well, refers

to the average daily rate at which the

well can lawfully deliver gas under

the conditions of this contract as

determined by a 5-day test, such 5-day

tests to be conducted by Buyer from

time to time as operations may indicate

to be necessary. The results of a

particular 5-day test shall be effective hereunder from the completion of

the test until the completion of the

next such test.

(b) “Average Daily Volume,” with

respect to a particular well, refers to

75% of the Daily Deliverability of that

well as in effect from time to time.

(c) "Contract Annual Volume,”

with respect to a particular well,

refers to an annual volume equal

to the cumulative total of the

Average Daily Volumes effective

hereunder from time to time for

that well during the particular

Contract Year.

(2) Subject to the further provisions

hereof, Buyer shall receive the Contract Annual

Volume during each Contract Year from each

Contract Well.

(3) Buyer’s receipts of gas hereunder will

fluctuate from time to time because of Buyer’s

- 6 fluctuating requirements for its system, and

Buyer shall balance its receipts hereunder from

each Contract Well over each Contract Year in

order to receive the Contract Annual Volume,

provided that to permit such balancing of

receipts, Buyer shall have the right to require

deliveries hereunder from the well at a daily

rate of at least the Daily Deliverability of that

well as in effect from time to time, and to the

extent that Seller is unable lawfully to deliver

gas at the required rate, Buyer shall be relieved

of its take obligations hereunder.

(B) The provisions of this Section are

subject to all the other terms and conditions

of this contract and to the physical ability

of any given well or wells to lawfully deliver

the quantities of gas herein contemplated in

accordance with such other terms and conditions

and the rules and regulations of any regulatory

authority having jurisdiction.

(C) Except as may otherwise appear in

context, this entire contract presupposes that

it covers 100% of the interests in all wells from

which gas is now or may hereafter be deliverable

hereunder, and accordingly, to the extent that

all the production from any particular well or

wells is not thus subject hereto and deliverable

hereunder during any particular accounting

period, or part thereof, then Buyer’s take

obligations hereunder in respect of such well or

wells shall be reduced proportionately. Reserves

attributable to an interest subject to a prior

call or other such right in a third party to

require delivery of production otherwise

deliverable hereunder, shall not be considered

for purposes of determining any obligations of

Buyer based on reserves until such time as the

interest is unconditionally dedicated to this

contract free and clear of any such prior rights

in third parties.

(D) Buyer shall have the right to purchase

hereunder, in addition to the minimum volumes

provided to be received hereunder, such

additional volumes of gas as Buyer may in the

prudent operation of its business require from

the subject properties from time to time and

- 7 which Seller can lawfully deliver hereunder

consistently with prudent operation of Seller’s

wells and with all rules and regulations of any

regulatory authority having jurisdiction.

(E) If any given subject well or wells be

connected to Buyer’s pipeline system and prepared

to deliver gas to Buyer hereunder during only

part of any given accounting period, then Buyer’s

take obligation in respect of such well or wells

for such accounting period shall be that proportion of the take obligation otherwise applicable

which the number of days such well or wells are

connected to Buyer’s system and prepared to

deliver gas to Buyer hereunder during such period

bears to the total number of days in the period.

(F) In order to avoid disproportionate

withdrawals of gas from any well or wells, it

is agreed that if gas from any particular well

or wells otherwise deliverable hereunder is not

delivered to Buyer, either because the gas is

delivered to Seller’s lessors or used by Seller

for operations in the area pursuant to other

provisions of this contract or for any other

reason, then Buyer’s take obligations hereunder

in respect of such well or wells may, at Buyer’s

option, be reduced by amounts equivalent to such

volumes produced but not delivered to Buyer.

(G) Seller recognizes that the efficient

conduct of Buyer’s business requires the maintenance of accurate gas reserve records, and

Seller agrees to cooperate with Buyer to that end

and to make available to Buyer such information

as to subject wells as may be necessary or useful

to Buyer from time to time in its reserve

studies.

(H) If Buyer does not receive the annual

minimum which Buyer is obligated to receive

hereunder during a particular Contract Year, and

the annual minimum was available and tendered by

Seller for delivery hereunder in accordance with

the provisions of this contract, Buyer shall pay

to Seller at the price per Mcf payable hereunder

on the last day of the particular Contract Year

for a volume (hereinafter for convenience

referred to as the "annual shortage") equal to

- 8 the difference between the volume actually

received during the Contract Year and the minimum

volume Buyer was obligated to receive during the

year. If Buyer thus pays for an annual shortage

not actually received, Buyer shall have the right

to recoup the volume thus paid for but not

received out of future production from any or all

wells delivering gas under this contract, without

further payment, and to that end, so long as

there is an unrecouped balance of annual

shortages paid for but not received:

(1) 25% of all volumes of gas

received from any or all wells under

this contract will be credited toward

recoupment whenever Buyer is requesting

full deliverability of gas from such

well or wells under this contract and

receiving all gas delivered by Seller.

As and when recoupment volumes are

credited toward recoupment, such

volumes shall be deemed currently

purchased and received by Buyer for

all other purposes of this contract,

including satisfaction of current take

or pay obligations.

(2) In addition to volumes

credited toward recoupment under the

preceding paragraph, it is also agreed

that all additional gas received by

Buyer during each Contract Year in

excess of the annual minimum Buyer is

obligated hereunder to receive during

that Contract Year will also be

credited toward recoupment.

(3) If recoupment gas can be credited

hereunder to more than one prior Contract

Year in which gas was paid for but not

received, the recoupment gas shall be

credited first to the oldest unrecouped

annual shortage until the same has been

recouped.

(4) If Buyer has not recouped

particular gas paid for but not

received hereunder within 5 years after

the close of the Contract Year in which

- 9 the particular unrecouped annual

shortage occurred, the right to recoup

the remainder of that particular annual

shortage will terminate.

(5) Tax reimbursements, if any,

due by Buyer to Seller hereunder will

be payable as and when gas is actually

received, without regard to whether the

gas being received is recouped gas or

gas currently being purchased and paid

for.

(6) If the price

payable under this contract

when particular recoupment

gas is received is higher

than the price Buyer paid

hereunder for the particular

annual shortage against which

that recoupment gas is

credited, then Buyer will pay

the difference at the time

the recoupment gas is

received.

Shortly after Malibu acquired its interest in the

subject wells, Mr. Herbel wrote to Arkla and demanded

payment in the amount of $4,749,123 due to Arkla's failure

to take and pay for, or to pay for if not taken, a minimum

quantity of gas during the period April 1983 through April

1987, as required by section 9 of the Contract quoted

above.

In a letter dated March 9, 1988, Mr. Herbel reduced

Malibu's claim to $3,539,040 to account for the fact that

the original claim had overstated Malibu's working interest

in one of the wells.

He further reduced the claim to

$2,418,170, "After making certain adjustments because of

- 10 testing procedures" for one of the wells.

Arkla responded

to Malibu's claim by denying that it had a take or pay

obligation under the Contract.

To settle this dispute without litigation, Arkla and

Malibu entered into a "Settlement Agreement" on April 25,

1988, and Arkla issued a check to Malibu dated April 28,

1988, in the amount of $1,850,000.

The Settlement

Agreement provides as follows:

SETTLEMENT AGREEMENT

THIS AGREEMENT, executed as of this 25th

day of April, 1988, by and between ARKLA ENERGY

RESOURCES, a division of Arkla, Inc., a Delaware

corporation (hereinafter referred to as "Buyer")

(formerly known as Arkansas Louisiana Gas

Company, a division of Arkla, Inc.), represented

herein by James M. Monk, its duly authorized

Vice President, and MALIBU PETROLEUM, INC., a

Texas corporation, (hereinafter referred to

as "Seller") represented herein by Stephen R.

Herbel , its duly authorized agent .

WITNESSETH THAT:

WHEREAS, by gas purchase contract identified

on Exhibit A hereto, Seller agreed to sell and

Buyer agreed to purchase production from certain

natural gas properties, which contract, as the

same may have heretofore been supplemented,

modified and amended, is hereinafter referred to

as the "Contract"; and

WHEREAS, a controversy has arisen between

Seller on the one hand and Buyer on the other

hand concerning the obligations of Buyer under

the Quantities provisions of the Contract; and

WHEREAS, after balancing their hope of

prevailing in, against the possibility of losing,

- 11 the aforesaid disputes, and in order to avoid

litigation, to limit the hazards and the uncertainties of litigation and in order to buy their

peace, the parties have freely and voluntarily

agreed to settle and compromise all aspects of

the disputes upon the terms and conditions

hereinafter set forth;

NOW, THEREFORE, for and in consideration

of the premises and the mutual covenants herein

contained, Seller and Buyer hereby contract and

agree as follows:

1.

Seller and Buyer agree to execute

simultaneously with the execution of this

Settlement Agreement a gas purchase contract

amendment to the Contract in the form of that

attached hereto as Exhibit B, the provisions of

which shall govern the relations of the parties

as to the matters contained therein from its

effective date forward. Upon execution of the

amendment, the obligations imposed by this

paragraph of the Settlement Agreement shall be

completed and the Contract and this Settlement

Agreement shall be completed and the Contract and

this Settlement Agreement shall be treated as

separate and independent contracts so that

ongoing future performance under the Contract

shall not constitute performance under the

Settlement Agreement.

2.

Buyer has this date made a lump sum

prepayment (hereinafter referred to as the

"Prepayment") to Seller in the total sum of

$1,850,000.00 which shall constitute a prepayment

in advance for natural gas to be delivered by

Seller to Buyer on and after May 1, 1988 from all

wells subject to the Contract (hereinafter the

"Subject Wells"). Buyer shall have the right to

receive and recoup out of all natural gas to the

extent specified below produced from the Subject

Wells, attributable to the Gross Working Interest

of Seller, a volume of natural gas which has a

value equal to the Prepayment, calculated by

applying the price per MMBtu in effect under the

terms of the Contract, as amended this date, at

- 12 the time such natural gas is requested for

delivery under the Contract. As used herein,

"Gross Working Interest" shall mean the share of

gas Seller has the right to sell, specifically

being prior to reduction for royalties, overriding royalties and other non-operating

interests. Such recoupment shall be accomplished

as follows:

(a)

Fifty percent (50%) of the volumes

of natural gas delivered from any

Subject Well and sold to Buyer or

to Buyer and Buyer's partial

assignee under the Contract each

month during the period May 1,

1988 through the remaining term

of the Contract, or until such

time as the Prepayment is fully

recouped or refunded, whichever

first occurs (the "Recoupment

Period"), shall be considered

recoupment gas and received

without further payment and,

accordingly, all such natural gas

purchased pursuant to the Contract

from the Subject Wells will be

retained by Buyer or by Buyer and

Buyer's partial assignee and

applied against the Prepayment

until Buyer has thereby recouped

the entire Prepayment.

(b)

Buyer or Buyer and Buyer's partial

assignee shall have the right to

require deliveries and purchases

from each Subject Well at a daily

rate of up to the Daily Deliverability of that well in effect

from time to time. In the event

Seller fails or is unable for any

reason to tender and deliver gas

from any Subject Well at the rate

requested, then Buyer, in addition

to all other rights and remedies

available to Buyer, shall be

entitled to deduct an amount equal

to fifty percent (50%) of the

difference between the volume

requested and the volume actually

delivered, multiplied by the price

- 13 in effect under the Contract at

the time of the request for

delivery, from any payment due

Seller under the terms of the

Contract and to credit the same

against the Prepayment.

(c)

Seller shall refund to Buyer

the unrecouped balance of the

Prepayment, if any, at the earlier

of such time as (i) the Contract

is cancelled or otherwise

terminated by Seller, (ii) the

Contract's primary term expires

and the Contract is terminated by

Seller or (iii) the wells subject

to the Contract substantially

deplete.

(d)

In connection with the recoupment

rights granted Buyer herein,

Seller has this date executed an

Assignment of Limited Term Overriding Royalty (Production Payment) in the form of that attached

hereto as Exhibit C. It is agreed

that the said Assignment of

Production Payment shall have a

term which equals the Recoupment

Period. Upon the end of the term,

Buyer shall furnish to Seller, in

recordable form, a duly executed

release of the said Assignment of

Production Payment.

3.

Buyer and Seller agree that, upon request of

Seller, they shall enter into a Release Agreement

in the form of that attached hereto as Exhibit D.

Arkla Energy Resources agrees that both prior to

and during the Release Period it shall continue

to make its requests ratably for the delivery of

gas for its system purchases in accordance with

the applicable rules, regulations and statutes of

any governmental body having jurisdiction.

4.

- 14 Nothing contained herein is intended to

diminish Buyer's rights under the provisions of

Paragraph (K) of the General Terms and Conditions

of the Contract, it being specifically understood

that the said provisions shall be applicable to

the Prepayment and, accordingly, that Seller

shall bear the economic burdens, if any, of and

shall pay all royalties, overriding royalties,

production payments, taxes and other payments and

settlements of whatsoever kind and nature due in

respect of production prepaid for herein. Seller

further agrees to indemnify Buyer and save it

harmless from all claims, suits, actions, debts,

accounts, damages, costs, losses, attorneys' fees

and expenses arising out of adverse claims of any

and all persons or entities to or against said

production and said Prepayment.

5.

In addition to the warranty provided for in

Paragraph (K) of the General Terms and Conditions

Supplement to the Contract, Seller hereby represents, warrants and guarantees that it is the

owner of the Gross Working Interest stipulated in

Exhibit E and has the right to sell and deliver

to Buyer that share of gas produced represented

by such Gross Working Interest without the

joinder of any other person whomsoever. Seller

further represents, warrants and guarantees that

it is the owner of all rights and claims

attributable to the said Gross Working Interest

arising out of the Quantities provisions of the

Contract for all periods commencing after the

Effective Date of the Contract. It is

acknowledged that the amount of the Prepayment

is predicated upon the foregoing representations.

Seller further represents, warrants and guarantees that there exist no encumbrances or other

rights superior to the rights of Buyer to recoup

the said Prepayment. Seller agrees and covenants

that until such time as Buyer has fully recouped

the Prepayment, it shall not assign, transfer or

otherwise encumber its interests in the Subject

Well, in whole or in part, without the prior

written consent of Buyer, which consent shall not

be unreasonably withheld. No such transfer,

however, shall relieve Seller of its obligations

to Buyer hereunder.

- 15 6.

Seller hereby waives any and all claims

relating to or arising out of the Contract,

including any failure to take gas or to pay for

gas not taken by Buyer, in respect of all natural

gas available for production from all properties

committed to the Contract from the Effective Date

of the Contract through June 30, 1990.

7.

This Settlement Agreement and the exhibits

attached hereto represent the entire agreement

between the parties regarding the settlement of

their disputes and all previous negotiations and

representations are superseded.

8.

It is understood and agreed that this is a

compromise of disputed claims and that Buyer

denies any liability whatsoever in the premises,

this compromise settlement being entered into

primarily for the purpose of avoiding litigation.

9.

The parties to this Settlement Agreement

and their attorneys agree that, unless required

to do so by order of the court or regulatory

body asserting competent jurisdiction, they

will refrain from disclosing to any persons or

entities the terms of this Settlement Agreement

and any information or materials obtained in

connection with the settlement discussions

resulting in this Settlement Agreement.

Notwithstanding this restriction, Seller and

Buyer agree that this information may be

disclosed to financial institutions, lawyers or

other consulting personnel, as may be necessary

in the ordinary course of business, provided that

such financial institutions, lawyers or other

consulting personnel agree and covenant in

writing to all other parties to refrain from

disclosing the information to other persons or

entities, unless such institutions and professionals are already required by their normal

conduct of business to maintain client confidentiality. The parties further agree that

- 16 this restriction shall not be construed as

prohibiting any party from reflecting the

payments made herein in financial statements

or in regulatory filings by Buyer.

10.

It is the intent of the parties to include

all gas sales and purchase agreements between

Buyer and Seller within the definition of "Contract," whether or not specifically identified

on Exhibit A. To the extent the same may be

hereafter required, the parties agree to execute

further instruments to evidence this intent.

11.

This Settlement Agreement shall be binding

upon and inure to the benefit of the parties

hereto, their respective successors and assigns.

IN WITNESS WHEREOF, the parties have

executed this Settlement Agreement, in duplicate

originals, as of the day and year first

hereinabove written.

Pursuant to paragraph 1 of the Settlement Agreement

quoted above, Arkla and Malibu also entered into the Gas

Purchase Contract Amendment (contract amendment) attached

thereto as an exhibit.

The purpose and effect of the

contract amendment was to change the mechanism for

determining the price of gas purchased by Arkla under the

Contract, effective May 1, 1988.

Pursuant to paragraph 2(d) of the Settlement

Agreement, quoted above, Malibu executed an Assignment of

Limited Term Overriding Royalty (Production Payment),

granting Arkla the following interest in the subject wells:

- 17 as a limited term overriding royalty interest,

fifty percent (50%) of all of Assignor's

[Malibu's] interest in all gas produced, saved,

and sold to Assignee [Arkla], if as and when

produced, saved, and sold to Assignee but not

otherwise, on and after May 1, 1988 from those

certain wells specified on Exhibit A attached

hereto ("Subject Wells") and by this reference

made a part hereof, under the gas purchase

agreement between Assignor and Assignee applicable to the Subject Wells. Assignor further does

hereby grant bargain, sell, transfer, set over,

convey and deliver unto Assignee an interest in

the oil and gas leases and other mineral rights

of Assignor within the drilling and spacing unit

for each Subject Well sufficient to convey to

Assignee the overriding royalty interest above

described, the legal description of which unit is

more fully described on Exhibit A.

The assignment was to last until:

such time as the total production attributable

to the interest assigned hereunder equals in

value that certain total sum stipulated in the

"Settlement Agreement" between Assignor and

Assignee dated April 25 , 1988, at which time

the interest assigned hereunder shall terminate

and revert to Assignor. * * *

Finally, paragraph 3 of the Settlement Agreement,

quoted above, provides that upon Malibu's request, the

parties will enter into a Release Agreement in the form

attached to the Settlement Agreement as an exhibit.

Under

the Release Agreement, Malibu and Arkla would agree as

follows:

1.

Buyer [Arkla] and Seller [Malibu] hereby

agree to release from commitment to the

Contracts for a primary term commencing

May 1, 1988, and extending through June 30,

1990 and continuing on a month to month

- 18 basis thereafter, unless and until

terminated by either party upon 30 days

written notice prior to the end of the

primary term or any monthly extension

(the "Release Period"), all gas otherwise

deliverable by Seller each day from any well

or wells committed to the performance of the

Contracts which is (i) gas that is priced

pursuant to the applicable Contract above

the replacement cost of gas deliverability

estimated by Buyer to be available on its

system at the time of this release; (ii)

gas that was not committed or dedicated to

interstate commerce as of November 8, 1978

(within the meaning of Section 2(18) of the

Natural Gas Policy Act), or if so committed

or dedicated gas that qualifies under Sections 102(c), 103(c), or 107(c)(1-4) of

the Natural Gas Policy Act; and (iii) gas

deliverability that is in excess of the

quantities of gas requested by Buyer, from

time to time, from Seller's interest in such

well or wells under the subject Contracts;

and Seller shall have the right to sell such

excess gas deliverability to third parties

on such day during the Release Period.

2.

Buyer further agrees to release from

commitment to the Contracts during the

Release Period, subject to the prior receipt

of any necessary governmental authorizations

on terms and conditions acceptable to both

parties, any other supplies of natural gas

deliverable by Seller each day from any well

or wells committed to the performance of the

Contracts, provided that the gas released

shall be limited to (i) gas from wells,

priced at the lower of the contract price

or maximum lawful price for such gas, which

when combined with the deliverability and

contract price of the gas released under

Paragraph 1 hereof, exceeds the current

replacement cost of gas deliverability

estimated by Buyer to be available on its

system; and (ii) deliverability from such

wells which is in excess of the quantities

of gas requested by Buyer, from time to

time, during the Release Period from

Seller's interest in such wells under the

subject Contracts; and Seller shall have the

- 19 right to sell such excess gas deliverability

to third parties on such day during the

Release Period.

3.

Seller agrees that for each MMBtu of

released gas nominated for purchase by any

purchaser or sold by Seller (including any

gas taken by Seller or an affiliate) in

accordance with this agreement, Buyer shall

be entitled to credit such quantities of gas

against any obligations and liabilities it

may have to take gas, or to pay for gas not

taken, under any gas sales and purchase

agreements between Buyer and Seller.

4.

Seller further hereby agrees to waive and

release Buyer from any and all obligations

and liabilities Buyer has or may have

arising out of any failure to take gas,

or to pay for gas not taken, under the

Contracts for all contract years commincing

[sic] prior to the end of the Release

Period.

None of the documents executed in connection with the

settlement transaction placed any restriction on Malibu's

use of the $1,850,000 payment that it received from Arkla.

In fact, shortly after the settlement, Malibu lent

approximately one-half of the settlement payment to its

shareholders.

On April 28, 1988, and May 2, 1988,

respectively, Malibu lent $823,263.20 to Mr. Webb and

$112,000 to Mr. Herbel.

Each loan was authorized by a

corporate resolution and was evidenced by a promissory note

signed on the same day as the resolution.

rate on both loans was 8.6 percent.

The interest

For the first 3 years,

both loans called for the borrower to pay interest only,

- 20 compounded annually.

After that, principal was amortized

over 11 years and was payable annually with interest.

At the time the Settlement Agreement was executed, the

total estimated recoverable reserves of natural gas from

the wells subject to the Contract exceeded the amount

necessary to recoup the $1,850,000 payment.

During 1988,

Arkla recouped $19,501.54 of the settlement payment from

deliveries of natural gas by Malibu, pursuant to paragraph

2 of the Settlement Agreement, resulting in an unrecouped

balance of the settlement payment of $1,830,498.46 as of

the end of 1988.

Malibu treated this amount as a liability

and reported it on the line designated "Mortgages, notes,

bonds payable in 1 year or more" on the balance sheet that

is attached as Schedule L to Malibu's 1988 income tax

return on Form 1120S, U.S. Income Tax Return for an S

Corporation.

As of June 1990, the unrecouped balance of

the settlement payment was $1,797,175.15, and as of

March 31, 1994, the unrecouped balance was $1,627,241.23.

The amounts reported on Malibu's 1988 income tax

return are summarized as follows:

Gross receipts or sales

Cost of goods sold

and/or operations

2,945

$24,914

Gross profit

$21,969

Depreciation

Dryhole costs

Legal and professional

3,204

53,000

1,882

- 21 Postage and delivery

Amortization-organization cap

Bank charges

87

135

55

Total deductions

58,363

Ordinary loss

(36,394)

Attached to Malibu's 1988 return are two Schedules K-1,

Shareholder's Share of Income, Credits, Deductions, Etc.

Mr. Herbel's Schedule K-1 reports $3,639 as his

distributive share of Malibu's loss, and Mr. Webb's

Schedule K-1 reports $32,755 as his share.

Upon audit of Malibu’s return for 1988, respondent

determined that Malibu had understated its gross receipts

by $1,825,086.

Respondent's agent made the following

explanation of this adjustment:

It is determined that payments made to you by

Arkla, Inc. and Subsidiaries under a "take or

pay" contract, in the amount of $1,825,086.00

were not reported by you on your 1988 tax

return. Therefore, taxable income is increased

$1,825,086.00 for 1988.

The following schedule summarizes the amounts reported

on Malibu's 1988 return, and the adjustments determined by

respondent:

Malibu's

1988 Return

on Form 1120S

Per Return

Adjustments

Corrected

Gross receipts

Cost of goods sold

$24,914.00

(2,945.00)

$1,825,086.00

--

$1,850,000.00

(2,945.00)

Total income

21,969.00

1,825,086.00

1,847,055.00

- 22 Depreciation

Other deductions

Total deductions

(3,204.00)

(55,159.00)

---

(3,204.00)

(55,159.00)

(58,363.00)

--

(58,363.00)

Ordinary income (loss) (36,394.00)

1,825,086.00

1,788,692.00

182,508.60

1,642,577.40

178,869.20

1,609,822.80

Schedules K-1:

Mr. Herbel (10%)

Mr. Webb (90%)

(3,639.40)

(32,754.60)

Based upon respondent's determination that Malibu's

gross receipts had been understated, respondent further

determined that the gross income of each of Malibu's

shareholders had been understated.

The notice of

deficiency issued to Mr. Herbel, who owned 10 percent

of Malibu's stock, states as follows:

Due to the audit of Malibu Petroleum, Inc. and

Subsidiaries, it is determined that your share of

the corporation's taxable income is $178,869.00.

Therefore, taxable income is increased

$178,869.00 for 1988. * * *

The notice of deficiency issued to Mr. Webb, who owned 90

percent of Malibu's stock, states as follows:

Due to the audit of Malibu Petroleum, Inc. and

Subsidiaries, it is determined that your share of

the corporation's taxable income is $1,609,823.00

rather than the loss of $32,755.00 as reported on

your 1988 tax return. Therefore, taxable income

is increased $1,642,578.00 for 1988. * * *

Discussion

The issue presented in these consolidated cases is

whether the payment of $1,850,000 received by Malibu during

- 23 1988 pursuant to the Settlement Agreement is includable

in Malibu’s gross income for 1988, as determined by

respondent.

The payment was made by Arkla to settle a

contractual dispute between Malibu and Arkla over the

so-called take or pay provisions set forth in section 9 of

the Contract.

Respondent determined in the subject notices

of deficiency that the settlement payment constituted

income to Malibu in 1988, and that each of Malibu’s

stockholders is required to include in income for 1988

his pro rata share of the payment, pursuant to the rules

applicable to S corporations.

Sec. 1366(a).

Petitioners, Malibu’s stockholders, take the position

that the payment is in the nature of a deposit or loan

which will become income only as, and to the extent that,

Arkla chooses to recoup the payment by taking natural gas

produced from Malibu's interest in wells covered by the

Contract.

In support of that position, petitioners argue

that the Settlement Agreement imposes on Malibu a “fixed

and unconditional obligation” to repay the full amount of

the payment to Arkla, and, under certain circumstances, it

requires Malibu to repay the unrecouped balance of the

payment in cash.

Petitioners also argue that, while the

Settlement Agreement gives Arkla the right to recoup the

payment in kind from future production, it does not impose

- 24 an obligation on Arkla to purchase any minimum quantity of

gas from Malibu.

According to petitioners, the effect of the Settlement

Agreement is to give “Arkla the option either to seek

repayment by delivery of gas in kind or to forego recoupment and await repayment in cash upon depletion of the

Contract Wells.”

Petitioners argue that the Settlement

Agreement “effected the creation of a loan in its

traditional sense”.

In support of this argument,

petitioners cite the opinion of the Supreme Court in

Commissioner v. Indianapolis Power & Light Co., 493 U.S.

203 (1990), and the opinions of this Court and its

predecessor in Arlen v. Commissioner, 48 T.C. 640 (1967);

Veenstra & DeHaan Coal Co. v. Commissioner, 11 T.C. 964

(1948); and Summit Coal Co. v. Commissioner, 18 B.T.A.

(1930).

983

Petitioners also argue that the Settlement

Agreement is “a contingent and executory contract” and that

Malibu has no right to keep the settlement payment made

thereunder until the condition set forth therein is

satisfied; i.e., until, and to the extent, Arkla recoups

the advance payment by purchasing gas under the contract.

Respondent argues that in form and in substance the

subject payment is not a loan but is a prepayment for

natural gas.

Respondent notes that the Settlement

Agreement itself describes the payment as a “prepayment in

- 25 advance for natural gas”, and that the other language used

in the Settlement Agreement is consistent with a sale of

gas, rather than a loan.

Respondent also notes that no

loan documents, such as promissory notes, were executed by

the parties, and no interest was charged on the unrecouped

balance of the payment.

Finally, respondent notes that the

treatment of the payment by the parties suggests that it

was an advance payment for the sale of gas and not a loan.

In this regard, respondent points out that Arkla booked the

payment to an account entitled “Gas Purchased In Advance of

Delivery”, an asset account and not a loan account, and

that minutes of a meeting of Malibu’s Board of Directors

state that the payment “constitutes prepayment in advance

for gas to be delivered by Malibu Petroleum, Inc.”

Respondent argues that the payment does not constitute

a loan because “the maker of the payment, Arkla, has no

right to demand a refund of the payment in cash as long as

the recipient of the payment, Malibu, does not terminate

the Gas Contract and maintains certain levels of production

from the wells subject to the Gas Contract.”

Respondent

also argues that the cases cited by petitioners, such as

Commissioner v. Indianapolis Power & Light Co., supra, are

“completely inapplicable or clearly distinguishable.”

Respondent notes that Malibu reports income under the

cash receipts and disbursements method of accounting, and

- 26 citing section 1.451-1(a), Income Tax Regs., argues that

Malibu is required under that method of accounting to

include the payment in income in the year of receipt.

Respondent acknowledges that section 1.451-5(g), Income Tax

Regs., provides an exception to the general rule in section

1.451-1(a), Income Tax Regs., for certain advance payments

treated as mortgage loans pursuant to section 636(a).

However, respondent argues that the subject payment is not

eligible for the exception for two reasons.

First, it is

not an “advance payment”, as defined by section 1.451-5(a),

Income Tax Regs., because Malibu is not a taxpayer using an

accrual method of accounting as required by that provision.

Second, it is not a “production payment” for purposes of

section 636(a) because "recoupment by Arkla can occur by

gas deliveries or by a cash repayment (but not by cash

payments from the sale of the minerals), the payment from

Malibu fails to satisfy the Treas. Reg. § 1.636-3(a)

criteria".

Finally, respondent asserts that "there are genuine

issues as to material facts", and that summary judgment is

not proper.

See Rule 121.

All Rule references are to the

Tax Court Rules of Practice and Procedure.

In support of

that position, respondent relies on two affidavits attached

to respondent’s objection, one by an employee of Arkla's

- 27 successor corporation, NorAm Gas Transmission Co. (NorAm),

and one by an attorney for NorAm.

The issues in this case involve the tax treatment

of the consideration paid by Arkla under the Settlement

Agreement, as opposed to Arkla's right of recoupment set

forth in paragraph 2 of the Settlement Agreement.

However,

the first issue presented by petitioners' motion for

summary judgment is whether Arkla's right of recoupment is

a carved-out production payment, as described by section

636(a), such that the settlement transaction must be

treated as a mortgage loan on the mineral property.

Section 636(a) provides as follows:

SEC. 636(a). Carved-out Production Payment.

--A production payment carved out of mineral

property shall be treated, for purposes of this

subtitle, as if it were a mortgage loan on the

property, and shall not qualify as an economic

interest in the mineral property. In the case of

a production payment carved out for exploration

or development of a mineral property, the preceding sentence shall apply only if and to the

extent gross income from the property (for

purposes of section 613) would be realized, in

the absence of the application of such sentence,

by the person creating the production payment.

The regulations promulgated under section 636(a) define the

term “production payment” to mean "in general, a right to a

specified share of the production from mineral in place

(if, as, and when produced), or the proceeds from such

production.

Such right must be an economic interest in

- 28 such mineral in place."

Sec. 1.636-3(a)(1), Income Tax

Regs.

Petitioners never explicitly argue that section 636

governs the settlement between Malibu and Arkla.

However,

they argue at length that the definition of production

payment set forth in section 1.636-3(a), Income Tax Regs.,

is "inconsistent with the express language of Section 636

* * * [and] with the legislative history" of section 636 to

the extent that it limits the definition to cases in which

the right to production is "an economic interest in such

mineral in place."

Sec. 1.636-3(a)(1), Income Tax Regs.

According to petitioners, no such limitation was intended

by Congress, and section 1.636-3(a), Income Tax Regs.,

"must be declared invalid."

In making this argument,

petitioners in effect concede that Arkla's right of

recoupment under the Settlement Agreement is not an

economic interest in the minerals in place, but they argue

that it should nevertheless be treated as a mortgage loan

pursuant to section 636(a).

We agree with the proposition, implicit in

petitioners' argument, that Arkla's right of recoupment or

refund is not "an economic interest in such mineral in

place", as required by section 1.636-3(a)(1), Income Tax

Regs.

Generally, courts have applied a two-part test for

determining whether there is an economic interest.

See,

- 29 e.g., Freede v. Commissioner, 864 F.2d 671, 673-674 (10th

Cir. 1988), revg. 86 T.C. 340 (1986); Christie v. United

States, 436 F.2d 1216, 1218 (5th Cir. 1971).

In Freede v.

Commissioner, supra at 674, the court described the twopart test as follows:

"(1) there must be an interest,

acquired by capital investment, in the minerals in place;

and (2) the return on the investment must be realized

solely from the extraction of the minerals."

In this case,

it is readily apparent that Arkla was not required to look

solely to the extraction of the minerals for a return of

its payment of $1,850,000.

To the contrary, the Settlement

Agreement provides that Arkla would receive "the unrecouped

balance of the Prepayment" in the event that the Contract

were terminated by Malibu or the wells became substantially

depleted.

Therefore, since Arkla is not required to look

solely to the extraction of the minerals for return of its

payment, Arkla's right of recoupment is not an economic

interest in minerals in place.

See, e.g., Anderson v.

Helvering, 310 U.S. 404 (1940); Christie v. United States,

supra at 1220-1221; Commissioner v. Estate of Donnell, 417

F.2d 106, 115 (5th Cir. 1969), affg. in part and revg. in

part 48 T.C. 552 (1967).

Accordingly, Arkla's right of

recoupment does not constitute a "production payment"

within the meaning of section 636.

Income Tax Regs.

Sec. 1.636-3(a)(1),

- 30 Notwithstanding Arkla's lack of an economic interest

in the mineral in place, petitioners argue that Congress

intended to apply "Section 636 loan treatment in all cases

without regard to whether the 'purchaser' acquired an

interest in the minerals which would constitute an

'economic interest' within the traditional meaning of the

term."

Thus, petitioners take the position that Arkla's

right of recoupment under the Settlement Agreement is a

"production payment" within the meaning of section 636(a),

with the result that the consideration paid by Arkla under

the agreement is required to be treated as a mortgage loan.

We disagree.

Section 636 was added to the Internal Revenue Code by

the Tax Reform Act of 1969, Pub. L. 91-172, sec. 503(a), 83

Stat. 487, 630.

In order to address petitioners' argument

that section 1.636-3(a)(1), Income Tax Regs., is invalid,

it is necessary to review the tax treatment of production

payments prior to the passage of section 636.

Before section 636 became law, the owner of a mineral

property who sold, or carved out, a portion of his future

production was required to treat the consideration received

for the production payment as ordinary income, subject to

depletion, and to include such amount in income in the year

received.

(1958).

Commissioner v. P.G. Lake, Inc., 356 U.S. 260

The courts had adopted the Commissioner's view

- 31 that the transaction was essentially an assignment of

expected income for a fixed or determinable period of time,

and, thus, the consideration paid for such right should be

treated as ordinary income, rather than capital gain.

Id.

at 265 n.5; see I.T. 4003, 1950-1 C.B. 10, obs. Rev. Rul.

70-277, 1970-1 C.B. 280; I.T. 3935, 1949-1 C.B. 39, obs.

Rev. Rul. 67-123, 1967-1 C.B. 383; G.C.M. 24849, 1946-1

C.B. 66, obs. Rev. Rul. 70-277, 1970-1 C.B. 280.

The owner of the mineral property was permitted to

exclude from income the amounts utilized during the payout

period to pay the production payment, and the owner was

permitted to deduct the expenses attributable to producing

the production payment in the year the expenses were

incurred.

Thomas v. Perkins, 301 U.S. 655 (1937); S. Rept.

91-552, at 182 (1969), 1969-3 C.B. 423, 539.

The holder of

the production payment, on the other hand, was required to

treat the payments received as income but was permitted to

deduct a reasonable allowance for depletion, pursuant to

section 611(a).

United States v. Witte, 306 F.2d 81, 87

n.12 (5th Cir. 1962); S. Rept. 91-552, supra at 182, 1969-3

C.B. at 539.

The above tax treatment applied only if the transaction involved a "production payment" or "oil payment";

that is, "the right to a specified sum of money, payable

out of a specified percentage of the oil, or the proceeds

- 32 received from the sale of such oil, if, as and when

produced."

Commissioner v. P.G. Lake, Inc., supra at 261

n.1 (quoting Anderson v. Helvering, supra at 410).

To

qualify as a "production payment" or "oil payment", it was

necessary for the right to consist of an economic interest

in the mineral in place, as opposed to merely the right to

cash payments.

See Anderson v. Helvering, supra at 409-

411; Thomas v. Perkins, supra.

This is the same

requirement that must be met in order to be eligible to

deduct an allowance for depletion.

See Anderson v.

Helvering, supra at 407.

If the transaction involved a right to cash payments,

as opposed to an economic interest in the mineral in place,

then the tax consequences of the transaction differed from

those summarized above.

In that case, the consideration

received by the owner of the mineral property constituted a

loan or something other than ordinary income.

See Lehigh

Portland Cement Co. v. United States, 433 F. Supp. 639

(E.D. Pa. 1977), affd. without published opinion 577 F.2d

727 (3d Cir. 1978).

Additionally, the amounts utilized to

make the cash payments during the payout period were

includable in the owner's income and not in the income of

the payee.

See, e.g., Anderson v. Helvering, supra at 413;

Holbrook v. Commissioner, 450 F.2d 134, 137 (5th Cir.

1971), revg. 54 T.C. 1617 (1970); Christie v. United

- 33 States, supra at 1219, 1221; Commissioner v. Estate of

Donnell, supra; Landreth v. Commissioner, 50 T.C. 803, 807

(1968).

In reviewing the above law in connection with its

consideration of the Tax Reform Act of 1969, Congress noted

that taxpayers were able to use carved-out production

payments to artificially advance the time income is

reported for tax purposes, thereby avoiding limitations

based upon net or taxable income, such as the 50-percent

limitation on taxable income from the property for

depletion purposes, the foreign tax credit, and the

limitations on carryover of net operating losses and

investment credits.

S. Rept. 91-552, supra at 183,

1969-3 C.B. at 539; H. Rept. 91-413 (Part 1), at 139

(1969), 1969-3 C.B. 200, 287.

The report of the Senate

Finance Committee states as follows:

The committee agrees with the House that there is no reason

why a person who, in effect, is the borrower in a

production payment trans-action should be allowed to pay

off the loan with tax-free dollars while a borrower of

funds in any other industry must satisfy the loan out of

taxed dollars. In addition, the committee agrees with the

House that Congress did not intend to permit the avoidance

of the limitation on depletion deductions and the

mismatching of income and expenses which creates artificial

tax losses by the use of production payments. Moreover,

there is a substantial revenue loss which results from the

use of production payments. It is estimated that the

combined revenue loss from ABC trans-actions and carved-out

production payments is between $200 and $350 million

annually. An acceleration of the revenue loss can be

- 34 expected unless corrective action is taken.

552, supra at 184, 1969-3 C.B. at 540.]

[S. Rept. 91-

See also H. Rept. 91-413, supra at 140-141, 1969-3 C.B. at

288.

In order to remedy the above abuse, section 636(a)

treats a carved-out production payment as a mortgage loan.

The committee reports issued in connection with the Tax

Reform Act of 1969 describe the operation of section 636(a)

as follows:

In the case of a carved-out production

payment, the bill provides the payment is to

be treated as a mortgage loan on the mineral

property (rather than as an economic interest in

the property). Thus, the proceeds received by

the seller upon a sale of a production payment

would not be taxable to him. However, as income

is derived from the property subject to the carve

out, that income would be taxable to the owner of

the property, subject to the depletion allowance.

The cost of producing minerals used to satisfy

carved-out production payments would be deductible when incurred. Thus, the use of a carvedout production payment would not cause income

to be accelerated, and there would be, thus, no

avoidance of the limitation on the percentage

depletion deduction. [S. Rept. 91-552, supra

at 185, 1969-3 C.B. at 540; H. Rept. 91-413,

supra at 141, 1969-3 C.B. at 288.]

It is readily apparent from the above discussion that

the abuse Congress sought to prevent by the passage of

section 636, namely the artificial acceleration of income

from the mineral property, could come about only through

the use of a right to payments which constituted an

economic interest in the mineral in place.

As described

- 35 above, if the transaction did not involve an economic

interest in the mineral in place, then the owner of the

mineral would not necessarily derive ordinary income in the

year of the transaction in the amount of the consideration

paid for the interest, but would continue to be taxed on

the income derived from the mineral property without regard

to the transaction.

Christie v. United States, 436 F.2d

1216 (5th Cir. 1971).

Contrary to petitioners' argument, we find no basis

to conclude that Congress intended to apply section 636

"in all cases without regard to whether the 'purchaser'

acquired an interest in the minerals which would constitute

an 'economic interest' within the traditional meaning of

the term."

We conclude that Congress intended section

636 to apply only when the production payment qualifies as

an economic interest in the mineral in place.

Accordingly,

we reject petitioners' argument that section 1.636-3(a)(1),

Income Tax Regs., is not consistent with the congressional

purpose in enacting section 636 because it limits the

definition of the term "production payment" to a right to

production which is "an economic interest in such mineral

in place".

The principal question presented by petitioners'

motion for summary judgment is whether, under general tax

principles, Arkla's payment is an advance payment for gas

- 36 to be purchased in the future or is a refundable deposit

in the nature of a loan.

The parties agree that an advance

payment is includable in income in the year received but

that a deposit in the nature of a loan is not income.

See

Oak Industries, Inc. v. Commissioner, 96 T.C. 559, 563-564

(1991).

The question presented by petitioners' motion for

summary judgment is whether the subject payment of

$1,850,000 is the latter and not the former.

As the Supreme Court noted in the leading case on this

question:

"The distinction between a loan and an advance

payment is one of degree rather than of kind."

Commis-

sioner v. Indianapolis Power & Light Co., 493 U.S. at 208.

Both types of transactions confer economic benefits on the

recipient, but economic benefits qualify as income only

if they are "'undeniable accessions to wealth, clearly

realized, and over which the taxpayers have complete

dominion.'"

Id. at 209 (quoting Commissioner v. Glenshaw

Glass Co., 348 U.S. 426, 431 (1955)).

The key to

determining whether a taxpayer enjoys "complete dominion"

over a given sum is not whether the taxpayer has

unconstrained use of the funds during some period, but

whether the taxpayer "has some guarantee that he will be

allowed to keep the money."

Id. at 210.

In the case of a loan, the recipient has no such

guaranty because the funds are acquired subject to an

- 37 express obligation to repay that does not require the payor

to purchase goods or services.

Therefore, if the payor

fulfills his legal obligations, then the loan will be

refunded to him.

Id. at 209.

In the case of an advance

payment, on the other hand, the payor retains no right to

insist upon return of the funds so long as the recipient

fulfills the terms of the bargain, and the recipient is

assured that so long as he fulfills his contractual

obligations, then he can keep the money.

Id. at 210-211.

In distinguishing between loans and advance payments,

an important factor is whether the payor or the recipient

controls the conditions under which repayment or refund

of the amount at issue will be made.

See id. at 212.

In

Commissioner v. Indianapolis Power & Light Co., supra, the

payor, the utility customer, controlled the timing and the

method of the refund of his or her deposit.

Id. at 209.

Based upon that fact, the Court held that the recipient,

the utility company, did not have a guaranty that it would

be allowed to keep the money, and thus, it did not enjoy

complete dominion over the funds.

Id. at 211.

Therefore,

if the payor controls the conditions under which the money

will be repaid or refunded, generally, the payment is not

income to the recipient.

See Highland Farms, Inc. v.

Commissioner, 106 T.C. ____ (1996) (entrance fees paid to

retirement community to occupy apartments or lodges);

- 38 Kansas City S. Industries, Inc. v. Commissioner, 98 T.C.

242 (1992) (deposits charged by railroad to build

side

track); Oak Industries, Inc. v. Commissioner, supra

(security deposit collected by subscription TV company

upon installation of electronic decoder box); Houston

Industries, Inc. v. United States, 32 Fed. Cl. 202 (1994)

(fuel cost overrecoveries received by a public utility

company).

On the other hand, if the recipient of the payment

controls the conditions under which the payment will be

repaid or refunded, we have held that the recipient has

some guaranty that it will be allowed to keep the money,

and hence, the recipient enjoys complete dominion over the

payment.

Milenbach v. Commissioner, 106 T.C. 184 (1996);

Michaelis Nursery, Inc. v. Commissioner, T.C. Memo. 1995143.

For example, Milenbach v. Commissioner, supra,

involved a payment of $6.7 million by the Los Angeles

Memorial Coliseum Commission to the Los Angeles Raiders.

The agreement under which the payment was made provided

that the money was to be repaid from revenues derived from

the operation of suites to be constructed by the Raiders at

the Los Angeles Coliseum.

In view of the fact that the

construction of the suites was within the sole control of

the Raiders, and the fact that there was no default or

alternative payment provision, we found that the Raiders

- 39 had the ability to control the repayment.

Id. at 197.

Accordingly, we held "the Raiders' dominion and control

over the funds at the time they received them was

sufficient to require their inclusion in the Raiders' gross

income."

Id.

The distinction between a loan and an advance payment

turns upon the nature of the rights and obligations that

the payor and recipient assume when the payment is made.

Commissioner v. Indianapolis Power & Light Co., supra at

209; Highland Farms, Inc. v. Commissioner, supra at ___,

(slip op. at 24-25); Oak Industries, Inc. v. Commissioner,

supra at 568.

Accordingly, in this case we must analyze

the terms of the settlement under which Arkla made the

subject payment of $1,850,000 to Malibu.

At the outset, we note that the parties to the

settlement did not terminate the Contract as part of the

settlement, nor did they amend section 9 of the Contract

which includes the so-called take or pay provisions under

which the dispute arose.

Therefore, Malibu's share of the

natural gas produced from "all Contract Wells" remained

committed for sale to Arkla under the Contract.

Similarly,

Arkla remained obligated under section 9 of the Contract to

take a minimum volume of gas on an annual basis or to pay

Malibu for a volume of gas "equal to the difference between

the volume actually received during the Contract Year and

- 40 the minimum volume Buyer [i.e., Arkla] was obligated to

receive during the year."

The Settlement Agreement provides that Arkla's payment

of $1,850,000 "shall constitute a prepayment in advance for

natural gas to be delivered by Seller to Buyer on and after

May 1, 1988 from all wells subject to the Contract".

In

order to effectuate Arkla's receipt of a volume of natural

gas in an amount equal to the prepayment, the Settlement

Agreement further provides that 50 percent of the volume of

natural gas delivered to Arkla under the Contract during

the period May 1, 1988, through the remaining term of the

Contract or until the prepayment is fully recouped, shall

be considered recoupment gas and shall be received without

further payment.

The value of the gas delivered to Arkla

under the Contract is to be based upon "the price per MMBtu

in effect under the terms of the Contract, as amended this

date, at the time such natural gas is requested for

delivery under the Contract."

While the Settlement Agreement does not disturb

Arkla's obligation of purchasing gas from Malibu, or

Malibu's obligation of selling gas to Arkla, the binding

nature of those obligations is alleviated somewhat under

the Settlement Agreement.

As to Arkla's take or pay

obligation, the Settlement Agreement provides that Malibu:

- 41 waives any and all claims relating to or arising

out of the Contract, including any failure to

take gas or to pay for gas not taken by Buyer

[Arkla], in respect of all natural gas available

for production from all properties committed to

the Contract from the Effective Date of the

Contract through June 30, 1990.

As to Malibu's obligation to sell gas produced from

the subject wells to Arkla, the Settlement Agreement

provides that, upon Malibu's request, the parties to the

settlement shall enter into a Release Agreement under which

gas committed to the performance of the Contract that is

in excess of the quantity requested by Arkla can be

released from the Contract and sold to third parties.

In consideration of the release of gas from the Contract,

Malibu would agree in the Release Agreement that Arkla

would be entitled to credit any gas released and sold to

third parties against "any obligations and liabilities

it may have to take gas, or to pay for gas not taken".

Furthermore, Malibu would also agree in the Release

Agreement to waive and release Arkla from any obligations

and liabilities for failure to take gas, or to pay for

gas not taken, during the time the Release Agreement is in

effect.

If Malibu requests it, the Release Agreement would

continue for a primary term beginning on May 1, 1988, and

extending through to June 30, 1990, and would continue on

a month-to-month basis thereafter, unless and until

terminated by either party upon 30 days' written notice.

- 42 There is insufficient evidence in the record to find

whether or not such Release Agreement was ever executed.

The Settlement Agreement further provides that any

part of the prepayment which is not recouped from

deliveries of natural gas shall be refunded to Arkla upon

the happening of any one of three events.

The Settlement

Agreement provides as follows:

Seller [Malibu] shall refund to Buyer [Arkla] the

unrecouped balance of the Prepayment, if any, at

the earlier of such time as (i) the Contract is

cancelled or otherwise terminated by Seller, (ii)

the Contract's primary term expires and the

Contract is terminated by Seller or (iii) the

wells subject to the Contract substantially

deplete.

In summary, the underlying premise of the settlement

is that Arkla would continue as the principal purchaser of

gas produced from Malibu's interest in the Contract wells.

Based upon the agreements forming the settlement, we agree

with respondent's contention that Arkla's payment of

$1,850,000 is a prepayment for the purchase of natural gas

under the Contract.

The agreements contemplate that Arkla

would recoup the prepayment from its purchases of natural

gas under the Contract.

The refund provision quoted above

is in the nature of a guaranty, to the effect that any

unrecouped balance of the settlement payment will be

returned to Arkla in the event that Malibu terminates the

Contract, or the wells became substantially depleted.

None

- 43 of the three events which trigger a cash refund is within

Arkla's control, such that Arkla is in control of the

timing and method of repayment.

See Commissioner v.

Indianapolis Power & Light Co., 493 U.S. at 209.

To the

contrary, Arkla retained no right to insist upon the return

of the payment so long as Malibu does not terminate the

Contract, and the wells do not become substantially

depleted.

Petitioners argue that Malibu lacks complete dominion

over the settlement payment.

According to petitioners,

Arkla could refrain from ordering any natural gas under the

Contract, and could await the substantial depletion of the

wells.

In this way, petitioners argue, Arkla could force

Malibu to make a cash refund of the settlement payment.

Petitioners assert that this is possible because Arkla is

not obligated to purchase any gas under the Settlement

Agreement.

We disagree with the premise of petitioners' argument.

In fact, Arkla is obligated to take a minimum volume of gas

per year under the Contract.

Under the Settlement Agree-

ment, however, Malibu has agreed to waive any claims

relating to or arising out of the Contract, including

Arkla's failure to take or pay for gas through June 30,

1990.

After that date, there will be no waiver of Arkla's

- 44 take or pay obligation, except through the Release Agreement that Malibu must invoke.

In any event, even if Arkla could refrain from taking

any gas under the Contract, the refund of any unrecouped

balance of the settlement payment requires that "the wells

subject to the Contract substantially deplete."

As

mentioned above, that event is not within Arkla's control.

Moreover, we agree with the court in Continental Ill. Corp.

v. Commissioner, 998 F.2d 513, 521 (7th Cir. 1993), affg.

in part and revg. in part T.C. Memo. 1991-66, T.C. Memo.

1989-636, and T.C. Memo. 1988-318, which observed in a

similar case that "income does not cease to be such because

there is some likelihood that the recipient may have to

give it back."

In these cases, the possibility that the

wells might become substantially depleted before the

settlement payment is fully recouped may reduce the

certainty of Malibu's income stream, but it does not

convert income into the equivalent of a deposit or a

bailment.

See id.

In light of the foregoing,

An appropriate order will

be issued denying petitioners'

motion for summary judgment.