Petition for A Writ of Certiorari — Murphy Oil Co. v. Burnet

Supreme Court brief1932

Ask Donna

What actually matters in this document.

Text

MET

Been alien

IN THE

Supreme Court of the United States

Ocroser Term, 1931.

MURPHY OIL COMPANY, a Corporation,

Petitioner,

US.

DAVID BURNET, Commissioner of Internal Revenue,

Respondent.

New York City.

‘ THOMAS R. DEMPSEY,

KENYON F. LEE,

’ RANDOLPH E. PAUL,

Attorney for Petitioner,

170 Broadway,

Of Counsel.

Pandick Press, Inc., 22 Thames St., New York, U.S. A.

Pr omeeag

INDEX.

PAGE

ath dared vcliidiasabetinenshsadiomonlendccenccsd unasigiebcecce. 1

oe A ORT 2

cimtonr op tum Case. 2

ho, RIT A ETON TNE 3

QUESTION INVOLVED. .0..00.0.2...0...-cccecccneeceececeecseeeosecce--... 7

Reasons ror GRANTING THE Perereen.......................... 8

Brier 1n Support or THE Perition........ 13

StaTEMENT—Opinion BELOW ....... 13

chips. , 4 fo OPS SESE ID ae eee 13

ewennee? SOU 15

ASSIGNMENTS OF ERROR.0000.0.00--cccecccecceeecseeeoeecce 15

ARGUMENT:

I. Depletion means actual exhaustion of the

depletable property and (1) should be

allowed only as actual exhaustion takes

place, and (2) should not be allocated to

particular taxable years by means of a

formula based upon receipt of income......... 17

II. The decision of the Circuit Court of Ap-

peals misapplies the decision in Lynch v.

Alworth-Stephens Co., 267 U.S. 364........... 29

Ill. The burden-of-proof rule does not extend

to the point of requiring the taxpayer to

submit evidence upon issues neither raised

by the pleadings nor at the trial... 36

ccc CPE URO pr CT ET 43

aR ae AS TE ROE a ARATE scr bamse 4

SS SNR ch Saar

Sh ad Sats ht Pan Ra De ad oes

AUTHORITIES CITED,

Alexander v. King, 46 F. (2d) 235 (C. C. A. 10th),

PAGE

co ge ATG | NEN a ene 22

The Alger-Sullivan Lumber Company v. Commis-

sioner, 1932 C. C. H. Standard Federal Tax Ser-

vice, Par, 9194, reversing and remanding 20 B. T.

FE SRR! Se ene Hates ORL Ola ec ace STEER 11, 41

Berg et ux. v. Commissioner, 33 F. (2d) 641 (Ct. of

App., D. C.), affirming 6 B. T. A. 1287, certiorari

rn a ed cacti 22

Burkett v. Commissioner, 31 F. (2d) 667 (C. C. A.

8th), affirming 7 B. T. A. 560, certiorari denied

BO, TB, Bon vvvsnesccecsee 22

Burnet v. Thompson Oil & Gas Co., 283 U. 8. 301, re-

versing 40 F. (2d) 493 (C. C. A. 10th), which

i kG ay ae 8, 26, 28, 44

Citizens’ Bank of Michigan City v. Opperman, 249

ES SARI B SCO UA RE See Oe SRST NS OPED tera 14

Dempster Mill Manufacturing Co. v. Burnet, 46 F.

(2d) 604 (Ct. of App., D. C.), reversing 12 B. T. A.

ee es ee DNOA cal od seen 11, 42

Kansas City Southern Railway Company v. Commis-

stoner, 52 F. (2d) 372 (C. C. A. 8th), certiorari de-

nied 284 U. S. Advance Sheets, Part 2, Page VIII 9,25

Lynch v. Alworth-Stephens Co., 267 U. 8. 364,

10, 18, 29, 33, 34, 35

Merle-Smith v. Commissioner, 42 F. (2d) 837 (C. C.

A. 2nd), certiorari denied 282 U. S. 897....0..00000.0...... 28

Morse v. United States, 270 U. S. 151.0000... 14

New Creek Co. v. Lederer, 295 Fed. 433......................... 23

Old Colony Trust Company et al., Executors, v. Com-

AI as aoc saci hsetacesecnnniioceneie nance

PAGE

Pugh et al. v. Commissioner, 49 F. (2d) 76 (C. C. A.

DI aaisaierisiidiigineas abil ectocusieioenilaieeba cscs se iets Shs 28

Rosenberger v. McCaughn, 25 F. (2d) 699 (C. C. A.

3rd), certiorari denied 278 U. S. 604... 23

Stanton v. Baltic Mining Co., 240 U.S. 103... 23

Stratton’s Independence, Ltd. v. H owbert, 231 U.S.

399, affirming 207 Fed. 419.0000. ccc 23, 28

Underwood v. Commissioner, 56 F. (2d) 67 (C. C. A.

4th), reversing 20 B. T. A. 1117.............................. 10, 12, 39

United States v. Biwabik Mining Co., 247 U. S. 116... 28

United States v. Ludey, 274 U.S. 295... 18, 24

Von Baumbach v. Sargent Land Co., 242 U. 8. 503,

reversing 219 Fed. 31 (C. C. A. 8th)... 23

Weiss v. Weiner, 279 U. S. 333, reversing 27 F. (2d)

200 (C. C. A. 6th), which reversed 17 F. (2d) 650... 22

Regulations 45, Art. 215 (a) 1920 ed... 4, 5,11, 21

Regulations 45, Art. 215 (a) as amended by T. D.

a Se: - een 4, 5, 8, 10, 11, 15,

16, 20, 21, 24, 25, 30, 37, 44

A. R. R. 1147, C. B. 1-2, p. 138.00... ececccccccceoccnee 19

m. &. M148, C. B, 0-1, p. 106.0 19

ovat ee ee REET 38

I I ee Ae ctecctaol ater hep lands akg. 2 38

ree rae EY SC 38

Revenue Act of 1918, Sec, 214 (a) Ee OO a 7, 29

Revenue Act of 1918, Sec. 234 (a) (9)........ 7, 17, 28, 29, 34, 35

Revenue Aet of 1926:

ihe wag con, TORRONE 14

Cn oye ey, EAE AREER NEL Soe ee 14

I ee a, ee ce 14

a - 14

5. ee eee ee

Revenue Act of 1928:

Co eeedibieolaii

Statutes at Large:

I artis cavehemieiaanieicnnsene

44 Page 109..............

eee reer rrr

EEE

United States Code Annotated, Title

Section 1048................2....-..

wanes

26:

ETE LON

Section 1295......................

Section 1226........

PAGE

IN THE

Supreme Court of the United States

Ocroser Term, 1931,

Murruy Om Company, a Corpo-

ration,

Petitioner,

vs.

Daviy Burnet, Commissioner or

InTERNAL RevENvE,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES CIRCUIT COURT OF

APPEALS, NINTH CIRCUIT.

To the Honorable Chief Justice and Associate Justices of

the Supreme Court of the United States:

Petitioner, Murphy Oil Company, a corporation, respect-

fully shows to this Honorable Court that this is a petition

for a writ of certiorari to the Circuit Court of Appeals,

Ninth Cireuit, to review a decision made and entered by

that Court on January 11, 1932 (R. II-296)*, reversing

* Since the record is a consolidation of the record in two ap-

peals, there is a duplication of page numbers. Therefore the figure

I is used where reference is had to the pages of the record in No.

6388 and the figure II is used where reference is had to the pages

of the record in No. 6459.

on the issue involved a decision of the United States Board

of Tax Appeals (R. I-61). Petitioner filed petition for a

rehearing on February 8, 1932, which was denied on Febru-

ary 23, 1932 (R. II-297).

Summary statement of the matter involved.

1. History of case.

This controversy was originated by a deficiency letter

issued by the Commissioner of Internal Revenue dated Feb-

ruary 6, 1926 (R. I-18), proposing a deficiency in income

tax against petitioner for the years 1919 and 1920 amount-

ing to $398,400.53 (R. 1-18). Petitioner appealed to the

Board of Tax Appeals which, on January 17, 1930, ren-

dered its decision eliminating the deficiency proposed (R.

I-62). Although the deficiency was eliminated the decision

of the Board was in favor of the petitioner taxpayer on

only one of the two issues contested before the Board, re-

ferred to herein as the bonus and expense points. The

contentions of the taxpayer prevailed as to the bonus

point and the contentions of the Commissioner prevailed as

to the expense point.

Separate appeals were taken by the Commissioner and

the taxpayer to the Circuit Court of Appeals, Ninth Cir-

euit (R. 1-62, I1-253), and that Court on January 11, 1932,

handed down decisions reversing the Board of Tax Appeals

on the bonus point, involved in the case of Murphy Ou

Company v. David Burnet, Commissioner of Internal Rev-

enue (R. 1-62), and affirming the Board on the expense

point, involved in the case of Commissioner of Internal

Revenue v. Murphy Oil Company (R. II-253), thus making

the ultimate decision on both points in favor of the Com-

missioner (R. II-296). Rehearing has been denied (R. II-

297). The records in the two appeals have now been con-

solidated by the Clerk of the Cireuit Court of Appeals. In

order to simplify issues and present to this Honorable

Court a clear-cut issue on the bonus point the taxpayer is

abandoning its contentions on the expense point and is ask-

ing for a writ of certiorari only with respect to the bonus

point. Therefore, such writ of certiorari is sought solely as

to the case of Murphy Oil Company v. David Burnet, Com-

missioner of Internal Revenue, Docket No, 6388 (R. I-1).

2. Facts involved in bonus point.

Prior to March 1, 1913, the taxpayer petitioner ac-

quired in fee two parcels of real estate in California, the

Coyote and Whittier properties (R. I-47). Oil and gas

were found upon the properties and on March 1, 1913, they

were both producing. On December 1, 1913, the taxpayer

leased the properties to the Standard Oil Company of Cali-

fornia for a term of forty years for the purpose of develop-

ing and producing oil and gas (R. I-50). The lessor re-

served a one-fourth royalty and the lessee agreed to and

did pay in installments from 1913 to 1918, inclusive, and

‘‘independently of and in addition to royalties’’, a so-called

bonus of $5,500,000.00. The bonus was not dependent

upon production (R. I-59). Personal property was trans-

ferred in connection with the lease to which has been allo-

cated $326,404.82, leaving a net bonus of $5,173,595.18

(R. I-51). The Commissioner has allocated this bonus be-

tween the properties, $4,517,402.70 to the Coyote property

and $656,192.48 to the Whittier property (R. I-52).

Since the properties were acquired prior to March 1,

1913, the basis of the taxpayer for computing depletion is

SIN ERE SNS RAM RE ees. |

si is

Bhat Fb ei

SCOT TSS Sead Spies

the value on March 1, 1913. That value has been found by

the Commissioner to be $15,710,899.52 for the Coyote prop-

erties and $1,450,207.08 for the Whittier properties, and is

not in dispute (R. II-272).*

Pursuant to Article 215 (a) of Regulations 45 as then

in effect (1920 edition) and before amendment by Treasury

Decision 3938, C. B. V.—2, p. 117, this bonus was treated in

the deficiency letter issued by the Commissioner as a return

of capital and the entire bonus was applied in reduction of

the value at March 1, 1913, as a basis for depletion (R.

I-18). The petitioner appealed to the Board on the ground

that the bonus was not a return of capital but was income

(R. I-6). The Commissioner answered and the case was

tried by both parties on the assumption that the issue was

whether or not the bonus was a return of capital or income.

Subsequent to the trial the Commissioner ‘‘confessed

error’’ in his brief (R. I-58), changing his position in ac-

cordance with the then recently issued amendment of Arti-

cle 215 (a) of Regulations 45 by Treasury Decision 3938,

supra, which provided that bonuses were to be treated not

as a return of capital but as income and that a certain

amount of depletion, according to the formula provided in

the amended regulation, should be allocated to the bonus

income as received irrespective of when oil was produced

from the properties. In its 1920 edition, Article 215 (a) of

Regulations 45, before amendment by Treasury Decision

3938, supra, provided as follows:

* The Circuit Court of Appeals deals only with the Coyote prop-

erty (see ‘‘Depletion Schedule’’, R. II-270), saying (R. I1-271) :

‘‘Hereinafter only the depletion of the Coyote property

as affected by the portion of the bonus allocated to that

property will be considered in detail, but the same princi-

ples are also applicable to the depletion of the Whittier

property.’’

“‘(a) Where a lessor receives a bonus or other

sum in addition to royalties, such bonus or other sum

shall be regarded as a return of capital to the lessor,

but only to the extent of the capital remaining to be

recovered through depletion by the lessor at the date

of lease. If the bonus exceeds the capital remaining

to be recovered, the excess and all the royalties there-

after received will be income and not depletable. If

the bonus is less than the capital remaining to be

recovered by the lessor through depletion, the differ-

ence may be recovered through depletion deductions

based on the royalties thereafter received. The

bonus or other sum paid by the lessee for a lease

made on or after March 1, 1913, will be his value for

depletion as of date of acquisition.’’

This language was revised by Treasury Decision 3938,

supra,

to read as follows:

‘“‘(a) Where a lessor receives a bonus in addi-

tion to royalties, there shall be allowed as a deple-

tion deduction in respect of the bonus an amount

equal to that proportion of the cost or value of the

property on the basic date which the amount of the

bonus bears to the sum of the bonus and the royal-

ties expected to be received. Such allowance shall

be deducted from the amount remaining to be recov-

ered by the lessor through depletion, and the re-

mainder is recoverable through depletion deductions

on the basis of royalties thereafter received.’

The contrast between these two editions of Article 215

(a) may be briefly illustrated in their applicability to the

instant case. If a bonus is treated as a “‘return of capital

to the

lessor’’ naturally the lessor’s capital sum returnable

through depletion is reduced in toto by the amount of the

bonus.

This was done in the deficiency letter. On the

nates yete

other hand, if a bonus is treated as ‘¢income’’ and a deduc-

tion for depletion is allowed ‘‘in respect of the bonus’’,

as in the amended article, the capital sum remaining at the

beginning of taxable years after the bonus has been re-

ceived has been reduced by whatever amount of depletion

has been so allocated to and allowed in respect of the

bonus. Thus, the capital sum at the beginning of the tax-

able year is reduced without a correlative reduction of re-

serves and the depletion unit per barrel is accordingly re-

duced. The effect is, of course, to lower the depletion allow-

ance in the taxable year.

For example, if a capital sum returnable through de-

pletion is allowed of $1,000,000 with a mineral reserve of

2,000,000 barrels, the depletion unit is $0.50 per barrel. As

production takes place both the mineral reserve and the capi-

tal sum returnable through depletion is reduced. If a bonus

of $200,000 is received and there is allocated to the bonus

depletion of $100,000, the capital sum is reduced to $900,000,

without a correlative reduction of the reserves; thus the

taxpayer’s depletion unit instead of being $0.50 per barrel,

is reduced to $0.45 per barrel—$900,000 divided by 2,000,000

barrels.

The Board held that the revised regulation was invalid

(R. I-60). It likewise impliedly rejected the principle of

the earlier regulation. It sustained the petitioner’s method

of computing depletion. In reversing the Board of Tax

Appeals the Circuit Court of Appeals approved the

amended regulation and its principle of offsetting deple-

tion against the bonus on the theory that the bonus was in

part a return of March 1, 1913, value and in part taxable

income (R. II-290). Inasmuch as the theory of the

amended regulation was raised by the Commissioner in his

a —

brief filed subsequent to the trial, no opportunity has ever

been furnished for the submission of the proof necessary

to determine the amount of the bonus which should be de-

ducted pursuant to the amended article and under the de-

cision of the Circuit Court of Appeals. The effect of the

decision of the Cirenit Court of Appeals is to affirm the

deficiency originally proposed of $398,400.53. The de-

ficiency, as computable under the formula prescribed in the

amended regulation approved by the Cireuit Court of Ap-

peals, would undoubtedly be different. The result is an

affirmance of the admittedly erroneous deficiency proposed

by the Commissioner in his deficiency letter (R. II-291).

3. Question involved.

The bonus point involves the meaning of the word ‘‘de-

pletion’’ as used in Sections 214(a) (10) and 234(a) (9) of

the Revenue Act of 1918, which provide:

“‘Section 234(a)—That in computing the net in-

come of a corporation subject to the tax imposed by

Section 230, there shall be allowed as deductions:

* . *

**(9) in the ease of mines, oil and gas wells, other

natural deposits, and timber, a reasonable allowance

for depletion * * *”,

(Section 214(a) (10) is identical in language. )

The question involved therefore is whether a bonus paid

to the taxpayer for entering on December 1, 1913, into a

lease of its oil properties, should be applied in reduction of

the depletable base of the taxpayer with respect to the

property leased, viz., in the instant case value at March 1,

1913. This question resolves itself into a question whether

| 7

depletion, which would be allowable to the taxpayer in the

years 1919 and 1920, on a production or exhaustion basis,

may be transferred to the prior years in which the bonus

was received. Article 215(a), as amended, by Treasury De-

cision 3938, swpra, and as approved by the Circuit Court of

Appeals, provides that depletion may be transferred or allo-

cated in accordance with income received and the validity

of the amended article is therefoie brought into issue. The

really basic question is whether depletion in a given tax-

able year is to be determined by reference to the measuring

rod of income received or by reference to the exhaustion or

' depletion of the property in the year—on a dollar or a

Oe EL, ial do soir seediea aesthetic A

barrel basis.

4 B.

Reasons for granting the petition.

(1) In its approval of Article 215(a), as amended by

Treasury Decision 3938, supra, the opinion of the Circuit

Court of Appeals is erroneous and in conflict with the deci-

sion of this Honorable Court in the case of Burnet v.

Thompson Oil € Gas Co., 283 U. S. 301, in that Article

215(a), as so amended, proposes by the mechanism of re-

ducing the taxpayer’s capital sum returnable through deple-

tion, to transfer depletion properly allowable in 1919 and

1920, when oil was produced, to prior years when income in

the form of a bonus was received.

Depletion means actual exhaustion of the depletable

property. The statutory allowance for depletion is to be

accorded only as actual exhaustion takes place. Article

215(a), as amended, allows a depletion ‘‘in respect of the

bonus”’ of ‘‘an amount equal to that proportion of the cost

or value of the property on the basic date which the amount

of the bonus bears to the sum of the bonus and the royalties

expected to be received’’.

This formula disregards exhaustion of the property

altogether as determining the amount of depletion. The

result of the application of the formula is to determine the

depletion deduction upon an income basis. It is established

that bonuses are income. In its approval of the amended

regulation, the decision of the Cireuit Court of Appeals is,

in principle, applicable not only to depletion in cases involv-

ing a bonus, but to depletion in cases in which no bonus is

involved. It is also applicable to other statutory deduc-

tions such as depreciation, obsolescence and losses, The de-

cision is, therefore, in conflict (a) with the basic statutory

concept that these deductions for any particular year should

be determined by what happens to the property in that

year and not by the amount of income received in any year,

and (b) with the decisions of other Circuit Courts of Ap-

peals, particularly the Eighth Circuit, in Kansas City South-

ern Ry. Co. v. Commissioner, 52 F. (2d) 372 (C. C. A. 8th),

certiorari denied 284 U. §, Advance Sheets, Part 2,

Page VIII. The decision strikes at the heart of the basic

concept of several of the statutory deductions and disre-

gards as well the established concept of the taxable year as

a unit of time. It is from this radical interpretation of the

unambiguous word ‘‘depletion’’, as used in the statute, that

an appeal is desired. If a decision so upsetting established

concepts and practice is not reviewed, great confusion

will result in the minds of millions of taxpayers and in the

administration of the income tax.

A ended tie

(2) The Cireuit Court of Appeals has erroneously con-

strued, and its decision is in conflict with the decision of

this Honorable Court in Lynch v. Alworth-Stephens Co.,

267 U. S. 364, in that it reasons from that ease that the

depletable base of the taxpayer as lessor and the depletable

base of the taxpayer’s lessee, the Standard Oil Company,

cannot exceed the value at March 1, 1913, of the taxpayer’s

properties. The decision in the Alworth-Stephens case,

supra, did not involve, as does the instant case, a lease made

after February 28, 1913. The statute plainly provides that

the depletable base of the lessor in such a ease shall be

the value of its property at March 1, 1913, and that the de-

pletable base of the lessee shall be the cost of its property.

There is absolutely no provision for deducting the lessee’s

cost from the lessor’s base, value at March 1, 1913, on ac-

count of a lease made after that date and the receipt of a

bonus in connection therewith.

(3) The Cireuit Court of Appeals opinion is contra-

dictory in asserting the validity of Article 215(a), as

amended; and in suggesting the division of the value at

March 1, 1913, between lessor and lessee, which division it

presumes to be required by the Alworth-Stephens case,

supra. Article 215(a) as amended does not purport to re-

duce the lessor’s capital sum returnable through depletion.

It simply provides for the distribution of the entire capital

sum returnable through depletion over the years in accord-

ance with a formula based upon the receipt of income, as

distinguished from exhaustion of the property.

(4) The decision of the Circuit Court of Appeals is in

eonflict with the decision of the Circuit Court of Appeals

for the Fourth Circuit in Underwood v. Commissioner, 56

F. (2d) 67, with the decision of.the Court of Appeals of

the District of Columbia in Dempster Mill Mfg. Co. v.

Burnet, 46 F. (2d) 604, and with the decision of the Cireuit

Court of Appeals for the Fifth Cireuit in The Alger Sul-

livan Lumber ( ‘ompany v. ( ‘ommissioner, 1932, Commerce

Clearing House, Standard Federal Tax Service, paragraph

9194 (not yet elsewhere reported), in that the court failed

to remand the case tried below upon an assumption pre-

sented by the pleadings (the Commissioner’s deficiency

letter, the taxpayer’s petition to the Board of Tax Appeals

and the Commissioner’s answer theretc) and shared by

both parties as to the issue involved, which assumption was

departed from by the Commissioner after the trial before

the Board.

Both parties shared the view at the trial that the only

question for determination was whether the instrument of

December 1, 1913, pursuant to which the bonus was paid

to the taxpayer, was an agreement of sale or lease. It

was asserted by the deficiency letter to be an agreement

of sale so that the bonus was a return of capital. The

deficiency letter was based upon the then outstanding 1920

edition of Article 215 (a) of Regulations 45. The taxpayer

contended that the instrument was a lease and that the

entire bonus was income. The position of the Commis-

sioner, taken after the Board hearing, upon the basis of the

amended edition of Article 215 (a), was that depletion

should be allocated to the years in which the bonus was

received, as distinguished from the years in which deple-

tion was sustained. It was this latter position which was

approved in principle by the Circuit Court of Appeals.

This disposition of an important case, on grounds not

in the minds of the contending parties and reaching a

result admittedly erroneous, raises grave problems of

practice and procedure involving upwards of seventeen

fe ORAL BAGS Ta ing aS = |

RPE

eee de ae)

‘ ae ae IEC eer owt

thousand cases now pending before the Board. These

problems should and can be settled only by this finally

authoritative tribunal. It is a matter of prime concern

to thousands of taxpayers to know whether the burden-of-

proof rule, to use the language of the Court in the Under-

wood case, supra, goes to the extent of requiring the Board

or Courts to ‘‘countenance”’ such an ‘‘obvious injustice’’ as

is involved in the decision of the Circuit Court of Appeals

in the instant case.

WHEREFORE, your petitioner respectfully prays that a

writ of certiorari be issued out of and under the seal of this

Honorable Court, directed to the United States Circuit

Court of Appeals for the Ninth Circuit commanding that

Court to certify and send to this Court for its review and

determination, on a day certain to be therein named, a full

and complete transcript of the record of all proceedings in

the cases numbered and entitled Docket No. 6388, Murphy

Oil Company, a Corporation, Petitioner, v. David Burnet,

Commissioner of Internal Revenue, Respondent, and Docket

No. 6459, David Burnet, Commissioner of Internal Revenue,

Petitioner, v. Murphy Oil Company, a Corporation, Re-

spondent, and that the judgment of the Circuit Court of

Appeals, Ninth Circuit, in Docket No. 6459 may be reversed

by this Honorable Court, and the decision of the Board of

the Tax Appeals be reinstated and affirmed, and that your

Petitioner may have such other and further relief in the

premises as to this Honorable Court may seem meet and

just; and your petitioner will ever pray.

Morruy Or Company,

By Ranvoutpx E. Pav,

Attorney for Petitioner,

170 Broadway,

New York City.

IN THE

Supreme Court of the United States

Ocroser TERM, 1931.

Murpny Om Company, a Corporation,

Petitioner,

vs.

Davy Burnet, Commissioner OF

INTERNAL REVENUE,

Respondent.

BRIEF IN SUPPORT OF PETITION FOR A WRIT OF

CERTIORARI TO THE UNITED STATES CIRCUIT

COURT OF APPEALS, NINTH CIRCUIT.

Opinion Below.

The opinion of the Cireuit Court of Appeals, Ninth

Circuit, is reported in 55 F. (2d) 17.

Il.

Jurisdiction.

: The jurisdiction of this Court is involved on the follow-

i ing grounds:

(1) The judgment to be reviewed was originally entered

January 11, 1932 (R. II-268). The taxpayer filed a peti-

tion for rehearing which was submitted on February 8,

1932, and denied February 23, 1932 (R. 11-297). Time to

apply for a writ of certiorari, therefore, runs from February

23, 1932. (Citizens’ Bank of Michigan City v. Opperman,

249 U. 8. 448, 450; Morse v. United States, 270 U. 8. 151,

153).

(2) The Board of Tax Appeals had jurisdiction of this

case under Section 274(a) of the Act of Congress, approved

February 26, 1926, entitled the ‘‘ Revenue Act of 1926’ (44

Stat. 55; 26 U. 8. C. A., Sec. 1048). The appeals to the Cir-

cuit Court of Appeals were taken in pursuance of the pro-

visions of Sections 1001, 1002 and 1003 of the Act of Con-

gress approved February 26, 1926, entitled the ‘‘ Revenue

Act of 1926”’ (44 Stat. 1, 109, 110; 26 U.S. C. A., Sections

1224, 1225, 1226), as amended by Section 603 of the Act of

Congress approved May 29, 1928, entitled the ‘‘Revenue

Act of 1928” (45 Stat. 873, 26 U. S. C. A., Section 1224).

(3) This Court has jurisdiction to review the judgment

of the Circuit Court of Appeals. Old Colony Trust Company

et al., Executors v. Commissioner, 279 U. S. 716.

Question involved.

The question immediately presented by the decision of

the Cirenit Court of Appeals in the instant case is whether

the taxpayer’s capital sum for purposes of depletion in

the years 1919 and 1920 should be reduced by a bonus re-

ceived by the taxpayer in previous years for entering on

December 1, 1913, into a lease of its oil properties. This

question resolves itself into a question whether depletion,

which would be allowable to the taxpayer in the years 1919

and 1920 on the producticn basis, may be transferred to

prior years when the bonus was received. The fundamental

question is, therefore, whether Article 215(a) of Regula-

tions 45, as amended by Treasury Decision 3938, C. B. V-2,

p. 117, is valid and in conformity with the Statute in deter-

mining the amount of depletion in any year in which a

bonus is received by reference to the income of that year

and not by reference to the exhaustion or depletion of the

property in that year.

IV.

Assignments of error.

(1) The Circuit Court of Appeals erred in holding that

the taxpayer’s capital sum for purposes of computing de-

pletion in the years 1919 and 1920 shculd be reduced by a

bonus received in previous years.

(2) The Circuit Court of Appeals erred in holding that

any part of the depletion allowance of the taxpayer, com-

putable upon a production or exhaustion basis for the years

1919 and 1920, should be transferred to previous years when

the taxpayer received a bonus for entering into a lease of

its oil properties.

(3) The Cireuit Court of Appeals erred in holding that

Article 215(a) of Regulations 45, as amended by Treasury

decision 3938, supra, is valid and in conformity with the

Statute.

(4) The Cireuit Court of Appeals erred in holding that

the word ‘‘depletion’’, which, as used in the Revenue Act

of 1918, means actual exhaustion of properties, may be

determined on the basis of income received, as distinguished

from exhaustion or reduction of mineral reserves.

(5) The Cireuit Court of Appeals erred in holding that

in the case of a lease entered into after February 28, 1913,

the total depletable interest of the lessor and lessee might

not exceed the value of the properties at February 28, 1913,

when there was no sale of the properties.

(6) The Circuit Court of Appeals erred in holding that

the burden-of-proof rule precluded the remanding of the

case for further evidence where the record was complete

on the theory of the case and issue stated in the pleadings

before the Board of Tax Appeals (deficiency letter, tax-

payer’s petition, and the Commissioner’s answer), but was

not complete on a theory of the case advanced by the Com-

missioner for the first time after the trial thereof. The

burden-of-proof rule does not go further than to require the

taxpayer to sustain the burden of proof with respect to the

issue presented by the pleadings and shared by the litigants

at the trial.

Argument.

Depletion means actual exhaustion of the depletable

property and (1) should be allowed only as actual exhaus-

tion takes place, and (2) should not be allocated to partic-

ular taxable years by means of a formula based upon

receipt of income,

The instant case involves a problem of depletion. The

statutory provision requiring interpretation is as follows:

“Section 234(a) That in computing the net in-

come of a corporation subject to the tax imposed by

section 230 there shall be allowed as deductions:

**(9) In the case of mines, oil and gas wells, other

natural deposits, and timber, a reasonable allowance

for depletion * * *,”

The question involved, simply stated, is whether under

this provision (See, 234 (a) (9) of the Revenue Act of 1918)

a depletion allowance may be made to a lessor of oil prop-

erties in respect to a bonus received and without reference

to the amount of oil taken from the properties. What is

the meaning of the word ‘‘depletion’”? as used in the

statute? The word is wholly unambiguous and has been

repeatedly defined by this Honorable Court and other

authorities.

The noun ‘‘depletion’’ is defined in Webster’s New

International Dictionary as ‘Act of depleting; a state of

being depleted’,

APR Lis), ade

The verb ‘‘deplete’’, according to the same authority,

means: ‘‘to reduce by destroying or consuming the vital

powers of; to exhaust, as a country of its strength or re-

sources, a treasury of money, etc.’’

In United States v. Ludey, 274 U. S. 295, 302, this Court,

referring to the depletion provision, said:

“The depletion charge * * * represents the re-

duction in the mineral contents of the reserves from

which the product is taken. The reserves are recog-

nized as wasting assets. The depletion effected by

operation is likened to the using up of raw material

in making the product of a manufacturing establish-

ment.”’

Again in Lynch v. Alworth-Stephens Co., 267 U. S. 364, 369,

this Court said:

‘*In the case of mines, a specific kind of property,

the exhaustion is described as depletion, * * *. The

interest of respondent under its leases in the mines

being property, its right to deduct a reasonable

allowance for exhaustion of such property, if there

be any, during the taxable year, results from the

plain terms of the statute, such deduction, since the

property is an interest in mines, to be limited to the

amount of the exhaustion of respondent’s interest

caused by the depletion of the mines during the tax-

able year We agree with the circuit court of appeals :

* * * that ‘The plain, clear, and reasonable meaning ‘

of the statute seems to be that the reasonable allow-

ance for depletion in case of a mine is to be made

to every one whose property right and interest

therein have been depleted by the extraction and dis-

position ‘‘of the product thereof which has been

mined and sold during the year for which the return

and computation are made’’.* * *’”’

PRED BO FMS COTM ONT POR LTO HL Net Met Ooch FEE OSE SPN IIIT BYE AOE T PERLE DI HET PB ARETE

A. R. R. 1147, U. B. I-2, p. 138 and A. R. M. 148, C. B.

I-1, p. 186, adhere to the definition of depletion contained in

the above authorities. In the latter of the two rulings it is

said at p. 187:

““* * * Where no mineral is produced upon the

premises it follows that the interest of the taxpayer

in the mineral reserves is not affected and that no

allowance can be made for depletion.’’

Under the accepted definition of the word ‘‘depletion”’ the

sine qua non of any allowance is the exhaustion of tax-

payer’s reserves. If there is no exhaustion, there can be

no depletion and there is no authority for an allowance

therefor. The depletion of the taxpayer’s properties in

the instant case was not a condition to the payment of the

bonus. The bonus was paid without reference to the ex-

haustion of the taxpayer’s properties and it is against the

plain meaning of the statutory provision and the authori-

ties defining depletion to allow depletion in respect of a

bonus which has no reference whatever to production. This

was distinctly recognized by the Board and forms the basis

of its decision, as indicated by the following quotation from

its opinion (15 B. T. A. 1195, at 1203) (R. I-59) :

‘“‘The bonus payment in the instant case was a

part of the consideration paid for the lease. While

expected production undoubtedly was considered in

fixing the amount of the bonus, it is elementary

under the laws governing such agreements that its

payment did not, in anywise, depend upon, or relate

to, production. The lessee’s liability therefore was

fixed by the terms f the contract. On the other

hand, the operation of the Frinciple of depletion de-

pends upon exhaustion of resources through produc-

tion—i.e., the recovery of capital through its con-

ES ROW LL PILE TN LOE

version from the form of oil resources or reserves

into marketable products or the equivalent received

for such product. Under such principle the deple-

tion allowance for the year or years of the bonus

payments can only be measured by reference to the

oil produced. If, as we have pointed out, the bonus

is income, no part of which represents recovery of

capital, it follows that any depletion allowance

against such income is a departure from the deple-

tion concept. The regulation relied on by the re-

spondent is clearly such a departure.’’

The opinion of the Cireuit Court of Appeals in the

instant case is not altogether easy to follow, but the effect

is to approve the regulation of the Commissioner allocating

depletion to a bonus received in connection with an oil

lease. This is indicated by the following quotation from

page 25 (R. IT-290) :

‘‘The regulation is not only not in conflict with

the statute, but directly conforms thereto.’’

The reference to the regulation so held to conform to

the statute is to Regulations 45, Article 215(a), as amended

on November 13, 1926, by Treasury Decision 3938, supra.

As so amended, the regulation provides (italics ours) :

‘‘(a) Where a lessor receives a bonus in addition

to royalties, there shall be allowed as a depletion

deduction in respect of the bonus an amount equal to

that proportion of the cost or value of the property

on the basic date which the amount of the bonus bears

to the sum of the bonus and the royalties expected to

be received. Such allowance shall be deducted from

the amount remaining to be recovered by the lessor

through depletion, and the remainder is recoverable

through depletion deductions on the basis of royal-

ties thereafter received.’’

PE CRE RE NOES LEN LENT IIS SON IRIE OUI cfr ENCE CN Se BSE NET pe Sp gery rs aaer ees aoeett

F |

Before amendment Article 215(a) in its 1920 edition pro-

vided (italics ours) :

“*(a) Where a lessor receives a bonus or other

sum in addition to royalties, such bonus or other sum

shall be regarded as a return of capital to the les-

sor, but only to the extent of the capital remaining

to be recovered through depletion by the lessor at

the date of lease. If the bonus exceeds the capital

remaining to be recovered, the excess and all the

royalties thereafter received will be income and not

depletable. If the bonus is less than the capital re-

maining to be recovered by the lessor through deple-

tion, the difference may be recovered through deple-

tion deductions based on the royalties thereafter

received. The bonus or other sum paid by the lessee

for a lease made on or after March 1, 1913, will be

his value for depletion as of date of acquisition.”

This regulation, as amended on November 13, 1926, rep-

resents the second change of mind and third attempt of the

Commissioner to deal with this subject. Originally, prior

to the promulgation of the 1920 edition of Regulations 45,

the Commissioner ruled that bonuses were income. When

he promulgated Article 215(a) of Regulations 45, 1920

edition, the Commissioner changed his mind and ruled

that a bonus ‘‘shall be regarded as a return of capital to the

lessor’’. On November 13, 1926, the Commisisoner again

changed his mind, and ruled in Treasury decision 3938,

supra, amending Article 215(a) of Regulations 45, that a

bonus was income; but in this regulation the Commissioner

added to his conception of a bonus as income an entirely new

conception—that a depletion deduction should be allowed

“in respect of the bonus”’ equal to the ‘‘proportion of the

cost or value of the property on the basic date which the

SSIES RAIN Ts OY

an LOOSE ERI EE AEGIS 6 AE —=* .

amount of the bonus bears to the sum of the bonus and

royalties expected to be received.”’

The expression ‘‘royalties expected to be received’’ de-

serves some parenthetical comment. It may be possible

under certain mineral leases to determine with reasonable

accuracy on a dollar basis the royalties to be expected over

the life of the property or the term of the lease. But the

lease involved in the instant case is an oil lease and any

estimation of royalties to be expected involves the deter-

mination © highly problematical factors such as future

price of oil over a long period—in the instant case forty

years. This Honorable Court will recognize the highly

speculative character of any estimate or prophecy of the

amount of royalties to be expected by this taxpayer; to ex-

press the amount in dollars involves almost insuperable

difficulties of proof ; indeed, it is extremely doubtful whether

future royalties are susceptible of proof. See Burnet v.

Logan, 283 U. S. 409, 412. This would indicate that the reg-

ulation, as amended, is so arbitrary and capricious that it

is beyond the scope of the Commissioner’s power which is

limited to authority to make reasonable regulations. How-

ever, the fundamental question is: Must depletion be com-

puted and allowed on the basis of mcome received, or on

the basis of the actual exhaustion of the properties?

It is not specifically said, but it is, of course, implied in

the amended regulation that a bonus is income. That it is

income is absolutely settled.* What causes the difficulty in

* Alexander v. King, 46 F. (2d) 235 (C. C. A. 10th), reversing

38 F. (2d) 256; Berg, et ux. v. Commissioner, 33 F. (2d) 641 (Ct.

of App. D. C.), affirming (6 B. T. A. 1287), certiorari denied, 280

U. S. 598; Burkett v. Commissioner, 31 F. (2d) 667 (C. C. A. 8th),

affirming 7 B. T. A. 560, certiorari denied, 280 U. S. 565; See also

Weiss v. Wiener, 279 U. S. 333, reversing 27 F. (2d) 200 (C. C. A.

the instant case is not the question whether a bonus is in-

come, but whether a depletion deduction shall be allowed in

respect of the bonus (the payment of which in the instant

case was not dependent upon production) and without ref-

erence to the exhaustion of the depletable property. In

other words, the whole issue is whether depletion shall be

deducted as and when a bonus is received and wholly inde-

pendently of production from or exhaustion of the prop-

erty—or as and when the mineral reserves are taken from

the property, and converted into marketable products. The

real question is whether depletion is to be allocated to years

when income is received, or to the years when the prop-

erty suffers depletion.

It does not require any elaborate discussion to point out

the far-reaching effects of a decision that depletion is to be

deducted, as the Circuit Court of Appeals has decided, not

as it occurs, but as income is received from the depletable

property. The uniform practice of the Commissioner has

been to calculate depletion for each annual period, not on a

dollar basis, according to the income from the property,

but on a barrel basis, according to the amount of mineral

taken from the property. It is only when bonuses are re-

ceived in connection with mineral leases that the Commis-

sioner indulges in the strange departure from his usual

practice, and from the concept of the statute.

If depletion is to be allocated in accordance with income,

there is absolutely no reason for differentiating between

6th), reversing 17 F. (2d) 650; Von Baumbach v. Sargent Land Co.,

242 U. S. 503, reversing 219 Fed. 31 (C. C. A. 8th) ; Stanton vy.

Baltic Mining Co., 240 U.S. 103 ; Stratton’s Independence, Ltd. v.

Howbert, 231 U. 8. 399, affirming 207 Fed. 419; Rosenberger v.

McCaughn, 25 F. (2d) 699 (C. C. A. 3rd), certiorari denied, 278

U. S. 604; New Creek Co. v. Lederer, 295 Fed. 433.

aN ss Po

leases involving bonuses and those which do not. A bonus

does not differ from ordinary royalties in being income;

both are income; the bonus in the instant case differs from

the ordinary royalty only in that it was payable whether

or not there was any production from the property and

whether or not the lessee entered upon the property. The

allocation of depletion to a bonus by the formula provided

in Article 215(a), as amended, amounts to the allocation of

depletion in accordance with income and not in accordance

with the exhaustion of the reserves in the depletable prop-

erty. The generic vice of the amended regulation is in

using income as a measuring rod of annual depletion instead

of the exhaustion of the property. The receipt of income

does not vary year by year solely in accordance with the

exhaustion of the property; other factors intervene, such

as the price of oil and the cost of extracting the oil.

Since bonuses and ordinary royalties are both income

the method used in Article 215(a), as amended, is, in

principle, equally applicable, if sound, to all depletion.

That being so, depletion should be measured by dollars

{income basis) rather than by barrels (exhaustion basis)

regardless of whether a bonus is involved.

If depletion should be computed on the dollar basis, de-

preciation, which is essentially the equivalent of deple-

tion,* should also be computed on a dollar basis according

to income and not according to exhaustion of the property.

It follows from this radical doctrine that every depletion

and every depreciation allowance ever computed by the

Commissioner is wrong. He should recompute all deple-

tion and depreciation allowances, spreading them over the

*In United States v. Ludey, 274 U. S. 295, 303, this Honor-

able Court has said: ‘‘In essence, the deduction for depletion does

not differ from the deductions for-depreciation.’’

years in proportion to the income received each year. In

this fundamental sense Article 215 (a), as amended, is a

revolutionary departure from the concept of the statute and

from the otherwise unvaried practice of the Commissioner.

What has been said with respect to depreciation applies

equally to obsolescence and losses—all the deductions which

are allowed to the taxpayer as a compensation for the ex-

haustion of property used in the production of income.

It was attempted by the taxpayer in Kansas City South-

ern Railway Company vy. Commissioner, 52 F. (2d) 372

(C. C. A. 8th), certiorari denied 284 U. S. Advance Sheets,

Part 2, Page VIII, to secure a deduction in 1918 and 1919

for obsolescence of a building which, as the Court observes,

“occurred prior to 1913”. The Cireuit Court of Appeals

for the Eighth Circuit showed throughout its opinion its

clear understanding of the statutory concept of deprecia-

tion and obsolescence. The concept is that income must be

taxed on an annual basis and that the deductions are per-

missible only on account of something happening in the

year, something apart from the mere receipt of income.

The Court said at page 376:

“The rule as to allowance for exhaustion, wear,

and tear of property used in the trade or business is

the same as the rule concerning obsolescence. We

think no case ean be found holding that exhaustion,

wear, and tear of former years may be carried over

and deducted in arriving at the income in some sub-

sequent year. A loss attributable to a particular

year is a loss occurring by reason of something hap-

pening in that year. It is not given to parties to

make choice as to the years in which they will take

reductions.’’

In the case of depreciation there must be, under the doc-

trine of the Kansas City Southern case, a diminishment of

the properties, an exhaustion of that which produces the

income. This decision of the Circuit Court of Appeals for

the Eighth Circuit is simply irreconcilable with the deci-

sion of the Ninth Circuit in the instant case.

This Honorable Court has passed only once on the ques-

tion of precisely how depletion shall be computed. The

Board of Tax Appeals stated the rule with absolute clear-

ness in Thompson Oil & Gas Co., 15 B. T. A. 993, affirmed

by this Court in 283 U. 8. 301. The Board said at page 997,

(italics ours) :

‘‘That a reasonable allowance for the depletion

of a wasting or exhaustible asset, such as we have

here, will be obtained by considering that the recov-

erable value will become exhausted in the same ratio

as that which gives value to the asset disappears, cau

hardly be questioned. Lynch v. Alworth-Stephens

Co., 267 U. S. 364. For example, if at January 1,

1917, a taxpayer had purchased a leasehold for the

recovery of oil at a cost of $100,000 with oil to be

recovered of 400,000 barrels, and if, during 1918,

100,000 barrels had been produced, a depletion allow-

ance of $25,000, or 25 cents per barrel would cer-

tainly be accepted as the reasonable depletion allow-

ance for 1918.”’

This Court, in affirming this decision, stated that the

question involved was whether in determining depletion

under the 1918 Act there should be deducted from the

capital sum, viz., the capital value recoverable through

depletion, depletion actually sustained in earlier years or

only so much of that depletion as was allowable as a deduc-

tion under revenue acts in force in earlier years. The de-

PE GEE ELEM T LITE BD IE 9 Nala

duction permitted for earlier years fell about $85,000 short

of the sustained depletion—the amount by which the re-

serve was exhausted. The taxpayer argued that only the

depletion allowed should be used to reduce the capital sum.

The Commissioner argued that the entire amount sustained

should reduce the capital recoverable.

Analyzing the contention of the taxpayer, this Court

held that it was in effect trying to make up in 1918 for the

depletion sustained but not allowed in earlier years as a

deduction—that it was attempting in 1918 to obtain a de-

duction for depletion not sustained in 1918. The court held

emphatically that only the sustained depletion of 1918 was

allowable, saying at page 306:

‘“‘The tax is an income tax for 1918, and in the

absence of express provision to the contrary, it is

not to be supposed that the taxpayer is authorized

to deduct from that year’s income, depreciation,

‘ depletion, business losses or other similar items

attributable to other years. * ** The construction

adopted by the court below in effect results in in-

cluding in the taxable year items referrable to other

years, and is contrary to the theory of a tax for

specific years.

‘“‘The nature of the tax as one for annual periods

has been repeatedly mentioned in dealing with its

application in various situations. The taxable year

1918, and that only, is involved, and deductions

applicable to that year only should be allowed.”’

This Court, in thus refusing the taxpayer in the Thomp-

son case the deduction of depletion not sustained in the

taxable year, announced a principle which is conclusive of

the real issue in the instant case. Depletion should be taken

and measured by that sustained.

HARES SRNR

The Revenue Act of 1918 grants in Section 234 (a) (9)

a reasonable allowance for depletion. It is true that the

allowance of depletion is a matter of legislative grace.*

Congress might grant any allowance it pleased or none

at all. But once Congress has legislated, giving a deduc-

tion in unambiguous terms by the use of the word ‘*deple-

tion,’’ there can be no excuse for departing from the con-

ception of the statute. The fact that the allowance of

depletion is a matter of legislative discretion does not

mean that the Commissioner, in interpreting the statute,

may exercise a discretion which contravenes the statute.

Nothing can be substituted for the will of Congress as

clearly expressed. The word ‘‘depletion”’ is unambiguous.

It stands for a fact, an exhaustion which happens to the

property in the taxable year. If then no depletion hap-

pens in the year, no depletion can under the statute be

allowed; if it does happen, depletion cannot legally be

shifted to other years. It is a perversion of the statute

and a denial of the will of Congress to allow or deny deple-

tion according to the wholly irrelevant existence or non-

existence in a year of a bonus, or any other type of income.

* Burnet v. Thompson Oil & Gas Co., 283 U. 8. 301, reversing

40 F. (2d) 493 (C. C. A. 10th), which reversed 15 B. T. A. 993 ;

United States v. Biwabik Mining Co., 247 U. S. 116; Stratton’s

Independence, Ltd. v. Howbert, 231 U. 8. 399, affirming 207 Fed.

419; Pugh, et al. v. Commissioner, 49 F. (2d) 76 (C. C. A. 5th) ;

Merle-Smith v. Commissioner, 42 F. (2d) 837 (C. C. A. 2nd),

certiorari denied, 282 U. S. 897.

The decision of the Circuit Court of Appeals misapplies

the decision of this Honorable Court in Lynch v. Alworth-

Stephens Co., 267 U. S. 364.

The opinion of the Circuit Court of Appeals is so diffi-

cult to follow that it may clarify the real issue involved

to refer to some further errors which may contribute to

the utimate error of that Court.

The opinion discusses the bonus question both on prin-

ciple and on authority (R. II-272-276). The conclusion

reached ‘‘on principle’’ is to the effect that the fee valu-

ation of $15,710,899.52 represented the total combined inter-

est at March 1, 1913, of the taxpayer, as lessor, and of the

lessee, and that no greater sum should be depleted (R. IT-

272). It is said that: ‘‘The allowance of the total depletion

to the lessor, as was required by the decision of the Board of

Tax Appeals, left nothing to be apportioned to the interest

of the lessee in the property” (R. II-282). In support of this

conclusion Section 234 (a) (9) of the 1918 Act, and also

Section 214 (a) (10) of that Act, are referred to, particu-

larly the last sentence, to the effect that the depletion

deduction ‘‘shall be equitably apportioned between the

lessor and lessee’’ (R. II-282).

To interpret the apportionment clause the Circuit Court

of Appeals refers to the case of Lynch v. Alworth-Stephens

Co., 267 U. 8. 364 (R. II-281), placing particular emphasis

on that part of the opinion of this Court, wherein it was

stated:

“* * * There is an exhaustion of property in the

one case as in the other; and the extent of it, with

the consequent deduction to be made, in each case 1s

to be arrived at in the same way, namely, by deter-

mining the aggregate amount of the depletion of the

mines in which the several interests inhere, based

upon the market value of the product, and allocating

that amount in proportion to the interest of each

severally considered. Pages 369, 370 of 267 U. S., 45

S. Ct. 274, 275, 69 L. Ed. 660. (Italics ours) ”’

The decision that not more than $15,547,522.17* should

be depleted after November 30, 1913, by lessor and lessee

cannot be reconciled with the later conclusion of the opin-

ion that Article 215 (a) of Regulations 45, as amended, is

valid (R. II-290). That regulation, to put it simply, per-

mits depletion to the lessor with respect to the entire March

1, 1913, value. It rules that the value at March 1, 1913,

allowable in full as depletion to the lessor, should be applied

in part against the bonus by providing that the lessor shall

be entitled to deduct ‘that proportion of the cost or value

of the property on the basic date which the amount of the

bonus bears to the sum of the bonus and royalties expected

to be received’’. Article 215 (a) simply deals, and makes

no attempt to do anything more than deal, with the distribu-

tion of depletion over the years.

Since the lessee is by the statute and the regulations

permitted depletion of the cost where the lease is entered

into subsquent to February 28, 1913, the depletion in the

instant case under the regulations, approved by the Circuit

Court of Appeals, must equal $15,710,899.52 allowed to the

lessor and $4,517,402.70 allowed the lessee, or a total of

$20,228,302.22.

Thus, the conclusion of the Circuit Court of Appeals

that Article 215 (a), as amended, conforms to the statute

*This is the value at March 1, 1913, $15,710,899.52 (Coyote

property), depleted to December 1, 1913, the date of the lease. See

footnote, page 4.

FEO RE GREE IO LEIE RAI OI SD MRA Dy NIH CIEE IMD AO gt NE LOME STIS E EY TEL EOS NEALE! ~ TON gR iene Meter a

is wholly inconsistent with its reasoning that not more than

the total basic value at March 1, 1913, should be deducted

by lessor and lessee.

As has been pointed out, the Circuit Court of Appeals

refers to the so-called “‘apportionment”’ clause of the de-

pletion provision in support of its conclusion that not more

than $15,547,522.17 may be depleted after November 30,

1913. The clause provides that ‘in the cases of leases the

deductions allowed by this paragraph shall be equitably

apportioned between the lessor and lessee; * * *.’? The

opinion of the Circuit Court of Appeals at pages 20-21 of

9° Federal Reporter, Second Series, (R. II-276) shows the

basic misapprehension under which it was laboring when

it says that land worth $15,547,522.17 could not be sold for

more subject to the lease than $11,030,119.47 (the value at

December 1, 1913, less the bonus) ‘‘which represented his

(the taxpayer’s) capital investment in the recoverable

royalty oil. It would seem then that the interest of the

landlord in the royalty oil at the surface would be his pro-

portion of the recoverable content of 10,190,814 barrels at

a price to equal $11,030,119.47, which would be $1.08236 per

barrel’? (R. II-276).

This quotation indicates an opinion that the bonus was

entirely a return of capital, which was the issue tried before

the Board and which was raised by the deficiency letter, the

petition and the Commissioner ’s answer thereto. Later in

its opinion the Circuit Court of Appeals holds that the bonus

is in part income and in part a return of capital (R. II-290).

These inconsistent views reflect a failure to distinguish be-

tween a return of capital in the ordinary sense and a return

of capital in the statutory sense. Any property subject to

a lease might be worth less than the same property clear

of a lease; the lease involves a surrender of an interest in

ALO IGEN Se Be I EC

the property less than the whole interest. But such a sur-

render does not make the rentals or royalties under the

lease any the less income, or in any sense reduce the basis

or amount which the taxpayer may deduct by way of de-

pletion or depreciation on account of the ownership of the

property. The only way in which that statutory basis can

be reduced is to sever from the taxpayer the title to part

of the property, to transfer alli or part of the basic under-

lying interest. Since depletion is a matter of legislative

discretion,* a return of capital in the statutory sense has

nothing to do with the return of capital in the ordinary

sense. The only way in which the statute calls for a return

of capital under these circumstances is through gradual

exhaustion of the property. Such return is accomplished

through the statutory allowance for depletion based on the

actual annual exhaustion of the properties.

The last quotation from the opinior of the Cireuit Court

of Appeals to the effect that land worth $15,547,542.17 could

not be sold for more subject to the lease than $11,030,119.47

is unobjectionable as a statement of fact, if it is meant that

the taxpayer’s residual or underlying interest might not be

saleable for more than the lower figure. Of course, this

assumption is unwarranted, for there is no reason why the

property may not have appreciated in value between March

1, 1913, and December 1, 1913, when the lease was made.

However, whether the property appreciated or depreciated

in value, the execution of a lease does not affect the statu-

tory basis for depletion or depreciation. If the owner of a

city office building having a depreciable base of $1,000,000

should lease the building for a term of years, receiving on

the execution of the lease a bonus of $500,000.00, the owner

* See cases cited in footnote 1, page 28.

wre, eegnpesns® MOP TATE YEG Bg Da aE TUR Aa oy CRSA APR tt PURINE Soh Yee er ouptt ge Sule: senate Penge ss

x .

; , aoe DR RPRIRIPES Te FAAS Seana aR oe ee RRS

ESA oh er nares ge yates SRI! AR Ny Od. x, die

would not be required nor permitted to reduce his depre-

ciable base. His depreciable base would remain stationary.

The $500,000 bonus would be income of the year of receipt

or accrual and the only offset would be the statutory allow-

ance for depreciation, which would be measured by the wear

and tear of the building during the year. Of course, the fee

owner’s interest in the building might not be saleable for

as much subject to a lease as clear of a lease, but that does

not affect in the slightest degree the basis provided by the

statute which may be returned over the life of the property

free from tax. There is no way by which that base may be

reduced short cf a sale of the property or by actual wear

and tear which is compensated for by the depreciation

allowance.

It is respectfully urged that the decision of the Circuit

Court of Appeals, based so largely on the decision of this

Court in the Alworth-Stephens case, reflects an incorrect

application of the true meaning of that decision. It is un-

necessary to review to this Honorable Court the situation

presented by the Alworth-Stephens case. The question pre-

sented was whether lessees were entitled under the 1918

Act to depletion based upon value at March 1, 1913. It

was held that where the lease was entered into prior to

March 1, 1913, and was in effect on that date the total inter-

est therein was to be divided between the lessor and lessee

and that the value at March 1, 1913, of the lessee’s inter-

est therein was depletable. As this Court well knows, its

theory was that although the lessee might not have acquired

the minerals in place, his privilege was a property right at

March 1, 1913, the value of which should be returned to the

lessee by the depletion allowance or otherwise.

The language of this Honorable Court in the Alworth-

Stephens case, italicized in the Cireuit Court of Appeals’

opinion in the instant case, should of course be interpreted

in the light of the problem before the Court and the decision

and the significance of the italicized words should be limited

to cases dealing with the apportionment of March 1, 1913,

value between a lessor and a lessee when the lease was

entered into prior to and existed on that date. There is no

question in the instant case as to apportionment of value

at March 1, 1913, between lessor and lessee because there

were not at that date a lessor and lessee. There was simply

a fee owner, the taxpayer. The lease involved in the Al-

worth-Stephens case was dated long before March 1, 1913.

The facts of the Alworth-Stephens case do not support a

conclusion that the capital sum of a fee owner returnable

through depletion should be reduced in cases in which a fee

owner leased property subsequent to February 28, 1913.

The statute prescribes ‘‘cost’’ as a general basis for de-

pletion in the first part of subdivision (9) of Section 234(a).

This provision gives the basis for the lessee’s depletion.

The first proviso has nothing to do with the lessee in the in-

stant case because its property was not ‘‘acquired prior to

March 1, 1913’’. This proviso does, however, apply to the

taxpayer because it had acquired its properties in 1904.

The proviso plainly establishes as the basis of the taxpay-

er’s depletion in lieu of the cost in 1904, or up to March 1,

1913, ‘‘the fair market value of the property (the taxpayer’s

interest therein)’’ on March 1, 1913, which is conceded to be

$15,710,899.52.* ‘‘The taxpayer’s interest therein’’ was the

entire interest in the property at that date. There was no

* For the Coyote prop rties only. See footnote 1, page 4.

FLERE LAR ENP ITY uC ROR INE ID A ROR i,

TRegrey hod agen Py NEE + Pr —

* EIS, Jel) rine td . BOGS Oa MN CRA Mh WH a hRORADTEK YY

interest in any other person. The lessee did not acquire its

interest until several months later.

There were not two or more interests at March 1, 1913,

among which the value at that date could be apportioned.

There is nothing in the statute from which it can even be

implied that the value of a taxpayer’s interest at March 1,

1913, should be reduced because the taxpayer subsequently

leases property and the lessee acquires a basis by reason

of his payment.

The results of such a doctrine would be astonishing.

Taxpayers owning property on March 1, 1913, should reduce

the basis or capital sum returnable through depletion or

depreciation in all cases in which any lease or license is

given after that date, whether or not a bonus is received.

It is respectfully submitted that in no case should the basis

for depletion or depreciation be reduced on account of the

receipt of wmcome; the reduction is justified only when

capital is returned. In the absence of sale capital is not

returned except as the statute provides. The statute pro-

vides that it shall be considered as returned under the

depletion allowance when the depletion is sustained.

The Alworth-Stephens case, supra, holds that the value

at March 1, 1913, should be apportioned between the inter-

ests in the property existing on that date, even though the

lessee of an oil and gas lease may have nothing more than

a privilege of extraction. The so-called apportionment

clause at the end of subdivision (9) of Section 234(a)

merely apportions the ‘‘deductions allowed by this para-

graph,’’ which means that the deduction of value at March

1, 1913, should be apportioned between the interests exist-

ing on that date, and not that the value of the taxpayer’s

interest on that date, which affords the basis for its deple-

Eero

Pr Ae BiTy "yr ERENT Eee oerr ~ HES Nt pl PEEL PAGE

tion deduction, should be reduced or modified on account of

the subsequent receipt of income from the property.

Cc.

The burden-of-proof rule does not extend to the point

of requiring the taxpayer to submit evidence upon issues

not raised by the Commissioner or involved in the theory of

the case shared at the trial by the taxpayer and the Com-

missioner.

It is believed that a writ of certiorari should be granted

because the instant case raises grave problems of Board of

Tax Appeals practice, affecting millions of taxpayers in the

important and often critical matter of tax liability.

On the bonus question the Commissioner, in effect, has

been sustained by the Circuit Court of Appeals because of

the burden-of-proof rule. Yet the Commissioner is admit-

tedly allowing erroneous depletion by deducting the whole

of the bonus from the capital sum returnable through deple-

tion (R. IT-291).

In other words, the tax liability established by the Cir-

cuit Court of Appeals decision is‘admittedly erroneous.

The bonus question was tried before the Board on the

issue whether the instrument in connection with which the

bonus was paid resulted in a sale or a lease, This was a

true issue, for if the instrument resulted in a sale, the Com-

missioner had correctly reduced the depletable capital

sum by the amount of the bonus. That was the issue raised

by the Commissioner in his deficiency letter (R. I-18). The

taxpayer’s petition was an appeal from that letter (R. I-6).

The letter and the petition and the Commissioner’s answer

to the petition framed the issue before the Board. The

proof was put in on the issue so framed. Months after the

ME REE SIRO MENTS YA GRAF OCI ERE EP SAS HAIN OE en ESA ROO EI EYP RINT a Sin REE 2 RP Ae. Seay Et Shs .

evidence was closed the Commissioner ““confessed error’’ in

his brief in failing to follow the recently revised edition of

Article 215(a) of Regulations 45, and urged the contention

that the bonus was only in part a return of capital and that

depletion should be allocated according to income. The

Board of Tax Appeals held that no part of such bonus in-

come was a return of capital so that a taxpayer could under

the statute take an allowance for depletion to compensate

for a loss of capital. The Cireuit Court of Appeals has now

reversed the Board without remanding the case for further

evidence, which it had the power and was urged to do. The

evidence on the bonus question was, therefore, presented

on a theory shared by both litigants different from that

which afforded the basis of the decision of the Circuit Court

of Appeals.

It should be kept distinctly in mind that the taxpayer

is not contesting the burden-of-proof rule. It does not need

to contest that rule. The taxpayer met the burden of proof

before the Board. It completely sustained the burden of

proof on the issues as framed by the pleadings. The find-

ings of fact of the Board show (R. I-50) the lease on the

Coyote property, the receipt, pursuant to the lease and in

addition to the royalties received in oil, of the sum of

$5,500,000 in instalments beginning December 31, 1913, and

extending to December 1, 1918. The bonus did not ‘in any

wise, depend upon, or relate to production”? (R. I-59).

Thus, the taxpayer proved all that it was necessary to

prove under the issues joined and the Board’s decision.

The taxpayer is merely contending that the burden-of-

proof rule does not extend beyond the scope of the theory

upon which the deficiency is asserted and does not require

any introduction of evidence by taxpayers of facts ex-

Dee LOVERS TR

traneous to the issues as framed by the pleadings. This

theory has been recognized by the Board of Tax Appeals

in its rules of practice.

Rule 30 provides as follows:

“The burden of proof shall be upon the peti-

tioner, except as otherwise provided by statute and

except that in respect of any new matter pleaded in

his answer, it shall be upon the respondent.”’

Rule 14 provides as follows:

“‘The answer shall be so drawn as fully and com-

pletely to advise the petitioner and the Board of

the nature of the defense. It shall contain a specific

admission or denial of each material allegation of

fact contained in the petition and a statement of any

facts on which the Commissioner relies for defense

or for affirmative relief * * *’’,

The care with which the rules of the Board are drawn

so as to prevent surprise at the trial is again illustrated

by Rule 18, which provides restrictions upon the filing of

amended petitions and gives the- Board discretion ‘‘at any

time before the conclusion of the hearing’’ to permit a

party to amend the pleadings to conform to the proof.

The position of the taxpayer is that the Commissioner’s

answer did not state the facts upon which the Commis-

sioner relied for defense; that the answer of the Commis-

sioner did not ‘‘fully and completely” advise the petitioner

of the nature of the defense; that the Commissioner did

not even at any time amend his pleadings to conform to

the proof, and that the remedy in a case in which the issues

are completely changed after the trial of the case is not

to give judgment to the Commissioner because the tax-

og EEL TRE TORI REE Ne RLS IB OKT AAO te IRA gmk OT | ORR Serge cl va WO RAS spot Reo Ge

payer had failed to sustain the burden of proof, but to give

an opportunity for further proof in conformity with the

reframed issues. In no other way can the Board of Tax

Appeals perform its true function which is correctly to

determine the amount of the deficiency.

This confusion of theories and issues is a stronger case

than was presented in Underwood v. Commissioner, 56 F.

(2d) 67 (C. C. A., 4th) for the taking of further evidence.

In that case the parties tried the case on a theory shared

by both of them that a certain issue was controlling. In

the opinion of the Circuit Court of Appeals that issue was

immaterial and the record was deficient in its evidence upon

the real issue. The Circuit Court of Appeals for the Fourth

Circuit did not give judgment to the Commissioner because

the taxpayer had failed to sustain the burden of proof, as

the Cireuit Court of Appeals for the N inth Circuit has done

in the instant case; it carefully limited the burden-of-proof

rule and remanded for further evidence, saying at page 72:

‘‘The case was tried below upon the assumption,

in which both parties shared, that the only question

for determination was whether the taxpayer was a

state employee or an independent contractor. But

this was not correct unless that question should be

decided adversely to the Commissioner and he should

be directed to exclude from the taxpayer’s income the

entire sums he received from the State of North

Carolina. On the other hand, if it should be decided

that the income from the State was taxable, it was

still necessary to determine the deductions for ordi-

nary and necessary expenses of the business to be

allowed under the Revenue Act of 1924, $214, 43

Stat. 269 (26 U. S.C. A. §955 and note).

: Tee Say hae ate oar eee ee “ae : : RNA a

‘‘Notwithstanding this state of affairs, the Com-

missioner failed to make any allowance for the tax-

payer’s expenses and assessed the tax on the gross

receipts; and this action was affirmed by the Board.

The only explanation offered in this court is that the

evidence before the Board did not disclose the

amount of the expenses incurred; that the burden

of proof in a case of this sort is upon the taxpayer

and therefore, the Board was obliged to affirm the

Commissioner’s determination. It is settled that the

taxpayer has the burden of proof by a number of

decisions of the Supreme Court. Burnet v. Houston,

283 U. S. 223, 51 S. Ct. 413, 75 L. Ed. 991; Botany

Mills v. U. S., 278 U. S. 282, 49 S. Ct. 129, 73 L. Ed.

379; Reinecke v. Spaulding, 280 U. S. 227, 50 S. Ct.

96, 74 L. Ed. 385; Niles Bement Pond Co. v. U. S.,

281 U. S. 357, 361, 50 S. Ct. 251, 74 L. Ed. 901. But

we do not think that this rule so restricts the powers

of the Board as to require it to countenance an ob-

vious injustice. ‘The Board of Tax Appeals is not a

court. It is an executive or administrative board.’

Old Colony Trust Co. v. Commissioner, 279 U. S. 716,

725, 49 S. Ct. 499, 502, 73 L. Ed. 918.

‘*The Board had ample power under the statute

to require the production of additional evidence

when it became clear that it could not do justice to

the taxpayer by reason of the deficiencies in the rec-

ord before it. It was unquestionably incumbent upon

the taxpayer to offer the testimony in the first in-

stance, and cases arise where the moving party must

suffer the consequences of his own neglect. Here, how-

ever, the Board’s own opinion showed that the Com-

missioner’s action was wrong in a material respect.

The information to correct the mistake was readily

obtainable from the same source as that from which

the gross receipts of the taxpayer were ascertained.

LF TR HRS SOUT 28 Saag ern etree per QAI EIEN MELE YIP EOE LE ARES ¥.M4 Nyheter Ter ryt aor ee

ennai

Under these circumstances, the Board should have

deferred its decision until testimony showing the

amount of the deductions to which the taxpayer was

entitled was introduced, and then have redetermined

the deficiency. The decision of the Board will there-

fore be reversed and the case remanded in order that

the course indicated may be followed.”’

A case very similar to the instant case is that of the

Alger Sullivan Lumber Co. vy. Commissioner, 1932 Com-

merce Clearing House, Standard Federal Tax Service,

paragraph 9194 (C. C. A.,, oth)". The deficiency letter

stated that the stock issued to the employees of the tax-

payer company was not a bonus; instead the transaction

was declared to be a sale to the employees. The issue of

whether it was a sale or a bonus was tried before the

Board of Tax Appeals. The Board decided that the trans-

action was a sale (20 B. T. A. 1109). On appeal the Com-

missioner for the first time raised the question of whether

the employees’ compensation was reasonable if the stock

had been given to them as a bonus. There was no evidence

in the record on the question of reasonableness. The Cir-

cuit Court of Appeals refused to render judgment for the

Commissioner on the ground of failure of proof. It said at

page 8588 of the Commerce Clearing House Report:

‘*However, it is apparent that the point was not

deemed to be material by either petitioner or re-

spondent in the proceedings before the Board and

the Board did not consider it. In this situation it

would be just and fair to both sides that evidence

be admitted on this point and a decision be had upon

the question by the Board.”’

* Not yet elsewhere reported.

1 . meemene —— tage

” eee . ms LEP IMSTLBETE EAR, PRY POA RP WARS

Rpts oa. RENN eee er te am peering cary wc: CEEOL SPEEA ION LIS FG 8 NEIL eS MESS Bi Sg

P ay ae WP Te rn

~ a

In still another case decided by the Court of Appeals

of the District of Columbia (Dempster Mill Mfg. Co. v.

Burnet, 46 F. (2d) 604) a new trial was ordered in the in-

terests of reaching ‘‘substantial justice’? where the evi-

dence disclosed that the taxpayer had rights but did not

fully disclose the extent of those rights. The Board in

that case, disregarding the uncontroverted evidence of an

interested witness, decided that certain property was with-

out value on March 1, 1913. The Circuit Court of Appeals

for the District of Columbia thought there was evidence of

value but could not determine the exact value. It therefore

said, at page 606:

“«<* * * we are of the opinion that substantial

justice in this case demands a new trial where the

parties can be given an opportunity to adduce such

testimony as they may have to offer pertaining to

the real issues involved.’’

Upwards of 17,000 cases are now pending before the

Board of Tax Appeals. Many of them have several issues

pending. Proof must be submitted on all these issues.

The presentation of proof is often a difficult and expensive

matter for taxpayers. Justice would seem to require that

taxpayers should be protected when they present proof

on the issues as framed by the pleadings. All tribunals

function most efficiently on this basis; if anything, the

practice of the Board, which is not a court, should be more

liberal than the practise of the courts. It is one thing to

hold that the burden-of-proof rule requires that the tax-

payer sustain the burden in proving the issues framed by

the pleadings; it is a long step further to require that it

submit evidence on all imaginable issues not disclosed in the

deficiency letter and answer of the Commissioner to the

petition. This is particularly true where the remedy of

taking further evidence is so readily available.

In the state of confusion that exists the simple truth

is that this Honorable Court should make some definition,

for the information of taxpayers, of the burden-of-proof

rule. The propriety of the rule is not being contested on

this application; it is being suggested merely that the rule

can be carried to utterly unreasonable lengths; it can be

made to do more harm than good; it can frustrate, instead

of advancing, justice. It is an important matter to tax-

payers to know what its limitations are. Where Circuit

Courts of Appeals differ it is respectfully urged that this

Court should give both government and taxpayers the

benefit of its views.

Conclusion.

The essence of the taxpayer’s case is simple. It has

been shown that a deduction for depletion should be taken

only in the years in which depletion is sustained. This is

the only true concept of depletion and the only true inter-

pretation of the Revenue Act of 1918, It has also been

shown that the bonus payments, which were not dependent

upon production, may not be offset by depletion, particu-

larly where the depletion occurs years after the receipt of

the payments. It has further been shown that there is no

support in the law for the Commissioner’s position, and

that his amended regulation, approved by the Circuit Court

of Appeals, is entirely unjustifiable. The regulation is

merely an attempt to legislate and a usurpation of the func-

tions of Congress.

At the beginning of the taxable years involved, 1919 and

1920, the taxpayer had whatever mineral reserve it had

—— . . ” ak Ar ee it ery

EAE HEE LEME ELIE EE LER OL RSE IMIR Se BTA te te

on the basic date, less the amount of minerals actually ex-

tracted. Its depletable base, returnable through depletion,

was not in fact or in law depleted, lessened, or exhausted by

the receipt of the bonus payments. These bonus payments,

as the Board held, were by the very terms of the lease

made payable unconditionally. They were not in any wise

dependent upon extraction or production. It cannot be

logically or correctly said that the taxpayer’s depletable

base was reduced by the receipt of the bonus payments.

Reduced to its real outlines, the regulation in question,

Article 215(a), as amended, violates the theory of the stat-

ute which gives a depletion allowance on account of ‘‘the

reduction of the mineral contents of the reserve’’. All other

arguments are extraneous. Arguments as to what should be

are irrelevant. The point is: What did Congress provide?

This Honorable Court has answered this question. (Burnet

v. Thompson Oil & Gas Co., 283 U. 8. 301). Congress pro-

vided in no uncertain terms that depletion should be al-

lowed as a deduction when sustained.

It is respectfully urged that this petition should be

granted in order that this Honorable Court may affirm the

decision of the Board of Tax Appeals herein, and reverse

the decision of the Circuit Court of Appeals.

Respectfully submitted,

Ranvotpy FE. Pavt,

Attorney for Petitioner,

170 Broadway,

New York City.

Tuomas R. Dempsey.

Kenyon F. Lez,

Of Counsel.

LPO CFE SNP NERO FOBT aK A LURID See Rt UTR rere RN tt te Da mers cg repos

RAPE ike SF Cee 2 RRM He a yy

PAPI RIS A GS RES EN MPmENEE TAY p>

RAGS CALAA PARAM &

Rs SAGE 7 i

ORE, UT FPL:

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.