Petitioners Brief — Booth v. United States

' eee eee eee ee eee eee 1

EE AE ea a ee ea 2

E Question Presented ..................05 Lsiec ee dae 2

; Statutes and Regulations Involved .................. 2

EEE Ee a 5

- Specification of Errors to be Urged ................. 7

ES IEEE a ee ne nn 7

' Legislation allowing a deduction for depletion..... 9

Changes resulting from the adoption of percentage

EE eee ra near ee 11

_ Taxation of advance royalties or bonuses ........ 12

. MI BGS 6 Shee ee NA cede nesaenencassreccoeren 26

; SETS Ser ae aa A a re 27

F Dissenting Opinion of Judge Sibley in Herring Case. 27

> Dissenting Opinion in Lizzie H. Glide Case.......... 31

= TABLE OF CASES CITED.

- Baltic Mining Co., Stanton v., 240 U.S. 103..... haven —

' Bankers Pocahontas Coal Co., Burnet v., 287 U. S.

4 COC eae e er ee Ces he eh 4h4 64 bs60e sk ke ae es 7, 29

= peender, Palmer v., 287 U. S. 561 .... 2... cee cee 15, 29

’ Biwabik Mining Co., United States v., 247 U.S. 116.. 9

f Burnet v. Bankers Pocahontas Coal Co., 287 U. S.

a Tete SIS UTA eadeuhs wdc cubs uwataadaacns 7, 29

= Burnet v. Harmel, 287 U.S. 103 .............000 7, 13, 29

: Burnet, Murphy Oil Co. v., 287 U. S. 299......... 7, 13, 29

| Burnet, Murphy Oil Co. v., 55 F. (2d) 17............ 13

; Dakota-Montana Oil Co., United States v., 288 U. S.

q Eee ae ee een ba ea an aes 8, 18, 31

meGlide, Lizzie H., 27 B. T, A. 1264................. 6, 19, 31

Index Continued:

Harmel, Burnet v., 287 U.S. 103................. 7, 13, 29

Howbert, Stratton’s Independence v., 231 U. S. 399... 9

Beueeet,, Were ©., BOn U. B. GOR. ow ce ccccceccscces 7, 24

Murphy Oil Co. v. Burnet, 287 U. S. 299.......... 7, 8, 13

Murphy Oil'Co. v. Burnet, 55 F. (2d) 17 ............ 13

ee ee ee 13

Palmer v. Bender, 287 U. S. 551 .................. 15, 29

Sargent Land Co., Van Baumbach v., 242 U.S. 503.... = 8

Sneed, J: T., Jr., 30 B. T. A.. Advance Sheet No. 171.. 18

Stanton v. Baltic Mining Co., 240 U. S. 103......... 9

Stratton’s. Independence v. Howbert 231 U. S. 399:. 9

United: States v. Biwabik Mining Co., 247 U.S. 116.. 9

United States v. Dakota-Montana Oil Co., 288 U. S.

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

Weeeen 0. Memeeee, BEL WU. By Te no ccc e ccc ecccccscnces

— STATUTES CITED.

1926 Revenue Act, Section 214 (a) ................

1926 Revenue Act, Section 204 (c) ................

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eS ats wae a Gow hea eas

ee ee ee US Dg wba och i dsveesacsueen'’s

Ne el bake ahaa kee w as

i vs. vend ev cha dek ce bacecatnansebas

ee dis Lake ead p kun cae weeens

I eo Oe ew ew

REGULATIONS CITED.

Regulations 45, Article.215 (a) .............seeeee

Regulations 62, Article 215 a ............e cece eeeee

Regulations 65, Article 216 (a) .............--+ee+

Regulations 69, Article 216...............ceeeeeeees

Index Continued. iii

OTHER AUTHORITIES CITED.

Page

Treasury Decision 3938, Internal Revenue Bulletin V-2

Ee heb cha CAs McA W es SA Ok 4a Sasa eee: 4, 12

Finance Committee Report, Revenue Act of 1926 .... 10

Conference Committee Report, Revenue Act of 1926. 10

General Counsels Memorandum 11384, Internal Rev-

ONS DUO BIi-] p. GE wince cc ceccestseess

I. T. 2384, Internal Revenue Bulletin VI-2, p. 22.....

Nos. 176 and 177.

IN THE

Supreme Court of the Gnited States

- OCTOBER TERM 1934.

WILLIAM E. HERRING AND EULA DAY HERRING,

Petitioners,

Us.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

On Writs of Certiorari to the United States Circuit Court

of Appeals for the Fifth Circuit.

BRIEF FOR PETITIONERS.

Opinions Below.

The opinion of the Circuit Court of Appeals for the Fifth

Circuit (Judge Sibley delivering a dissenting opinion) ap-

pears in the record on pages 37 to 46 and is reported in 70

F, (2d) 785. The opinion of the Board of Tax Appeals,

PA CRI

2

which was a memorandum opinion not officially reported,

appears in the record at pages 13 and 14.

Jurisdiction.

The judgment of the Circuit Court of Appeals for the

Fifth Circuit was entered April 24, 1934 (R. 46), petition

for rehearing denied June 8, 1934 (R. 47), Writs of Cer-

tiorari were granted October 8, 1934. Jurisdiction is con-

ferred upon this Court by Section 240 (a) of the Judteial

Code as amended by the Act of February 13, 1925.

Question Presented.

In computing net taxable income for 1926 are the peti-

tioners entitled to deduct the statutory allowance for de-

pletion from the advance royalties or ‘‘bonuses’’ received

by them in 1926 upon the execution in that year of ordi-

nary oil and gas leases?) Or must they lose that allowance |

because the land leased was not producing oil or gas when

the leases were made, and because the land did not produce

oil or gas until after 1926?

Statutes and Regulations Involved.

Section 214(a) 1926 Revenue Act.

‘‘In computing net income 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 and for depreciation of improvements,

according to the peculiar conditions in each case; such

reasonable allowance in all cases to be made under

rules and regulations to be prescribed by the Com-

missioner, with the approval of the Secretary. In the

case of leases the deduction allowed by this paragraph

shall be equitably apportioned between the lessor and

lessee ;’’

3

Section 204(c) 1926 Revenue Act.

‘‘The basis upon which depletion, exhaustion, wear

and tear, and obsolescence are to be allowed in respect

of any property shall be the same as is provided in

subdivision (a) or (b) for the purpose of determining

the gain or loss upon the sale or other disposition of

such property, except that—

(1) In the case of mines discovered by the taxpayer

after February 28, 1913, the basis for depletion shall

be the fair market value of the property at the date

of discovery or within thirty days thereafter, if such

mines were not acquired as the result of purchase of

a proven tract or lease, and if the fair market value

of the property is materially disproportionate to the

cost. The depletion allowance based on discovery

value provided in this paragraph shall not exceed 50

per centum of the net income of the taxpayer (com-

puted without allowance for depletion) from the prop-

erty upon which the discovery was made, except that

in no ease shall the depletion allowance be less than

it would be if computed without reference to discovery

value. Discoveries shall include minerals in commer-

cial quantities contained within a vein or deposit dis-

covered in an existing mine or mining tract by the tax-

payer after February 28, 1913, if the vein or deposit

thus discovered was not merely the uninterrupted ex-

tension of a continuing commercial vein or deposit al-

ready. known to exist, and if the discovered minerals

are of sufficient value and quantity that they could be

separately mined and marketed at a profit. .

(2) In the case of oil and gas wells the allowance

for depletion shall be 27% per centum of the gross

income from the property during the taxable year.

Such allowance shall not exceed 50 per centum of the

net income of the taxpayer (computed without allow-

ance for depletion) from the property, except that in

no case shall the depletion allowance be less than it

would be if computed without reference to this para-

graph.

a

—_ : toe eh i en ne

4

Article 216, Regulations 69.

“‘Depletion—Adjustments of accounts based on

bonus or advanced royalty.

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

to royalties, there shall be allowed as a depletion de-

duction 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 re-

ceived. 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 royalties

thereafter received. :

* hal * * * * * *

‘*(c) © If for any reason any such mineral lease

shall be terminated or abandoned before the mineral

which has been paid for in advance has been extracted

and removed, and the lessor repossesses the leased

property, the lessor shall adjust his capital accounts

() Article 215(a) of Regulations 45 (1918 Act) read as follows:

‘*Where a lessor receives a bonus or other sum in addition to royal-

ties, 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 recov

ered 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 remaining to be recovered by the lessor

through depletion, the difference 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.’’

Treasury Decision 3938, promulgated November 13, 1926, Internal Revenue

Bulletin V-2, page 117, changed subdivision (a) to read as follows:

‘*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 deple-

tion, and the remainder is recoverable through depletion deductions ou

the basis of royalties thereafter received.’’

Murphy OW Co. v. Burnet, 287 U. S. 299, dealt with subdivision (a) as

originally promulgated and as oe

(2) All regulations beginning with those under the 1918 Act have contained

provisions identical with subsections (c) and (d).

5

by restoring to the capital sum of the property the

depletion deductions made in prior years on account

of royalties on mineral paid for but not removed, and

his income account shall be adjusted so as to include

the amount so restored to capital sum as income of

the year such lease is terminated or the property re-

possessed, and the tax thereon paid.

‘*(d) Upon the expiration, termination, or abandon-

ment of the lease, without the removal of any or all of

the mineral contemplated by the lease, the lessor shall

be required to restore to capital account the excess of

the depletion theretofore allowable in respect of the

bonus and royalty payments over the actual depletion

or loss in value sustained as a result of the operations

under the lease, and a corresponding amount must be

returned as income for the year in which the lease ex-

pires, terminates, or is abandoned.”’

‘*(e) “ In lieu of the treatment provided for in the

above paragraphs the lessor of oil and gas wells may

take as a depletion deduction in respect of any bonus,

royalties, and other income from the property for the

taxable year 27% per cent of the amount thereof, but

the deduction shall not exceed 50 per cent of the net

income (computed without allowance for depletion)

from the property.”’

Statement.

During the year 1926 the community estate of William E.

Herring and his wife Eula Day Herring owned a 50 per

cent interest in the partnership C. T. Herring & Son. For

that year petitioner William E. Herring and his wife, peti-

tioner Eula Day Herring, filed separate income tax returns

under the community property laws of Texas. In 1926 the

partnership owned a large tract of land in the vicinity of

Amarillo, Texas, and its principal business was cattle rais-

ing. During 1926 the partnership leased portions of its

land for the ‘‘sole and only purpose of mining and operat-

(1) This subsection was first introduced into the regulations under the 1926

Act, due to the option contained in that Act to compute oil and gas depletion

by the ‘‘percentage’’ method.

6

ing for oil and gas,’’ etc. These leases were in all respects

the customary oil and gas leases (R. 30). The lessees paid

in the aggregate to the partnership lessor, in 1926, $683,-

793.75 as advance royalties or bonuses and agreed to pay

further royalties of 1/8th of the product, or its value, as oil

or gas was actually produced under the leases.

The lessor had no control over the time wells would be

drilled by the lessees. At the time the leases were executed

and during the remainder of the year 1926 there was no oil

or gas well on the land and no oil or gas was produced there-

from. However, in 1930 four wells were drilled, all of which

were commercial gas wells, all had a showing of oil, and one

produced from eight to ten barrels of oil a day.

In 1926, when the leases were executed, it was highly

probable that the land would, when explored, produce oil

or gas or both. This is shown in the record by the fact

that wells comparatively close and on all sides of the prop-

erty were producing; by uncontradicted expert testimony

as to geological conditions and, perhaps more convincing

to those who cannot qualify as technical oil and gas men,

by the fact that the lessees, who were engaged in the oil

and gas business, were willing to pay $683,793.75 for the

privilege of exploring the property for oil and gas.

The partnership claimed its members were entitled to a

deduction in 1926 on account of depletion in the aggregate

amount of $188,043.28, which represented 271% per cent of

the advance royalties or bonus payments. Each of the pres-

ent petitioners deducted from income on their income tax

returns their proportionate share of the said depletion de-

duction claimed by the partnership. The Commissioner of

Internal Revenue refused to allow the deduction on the

ground that ‘‘the property on which depletion was claimed

was neither proven nor producing during the year in ques-

tion.’? The Board of Tax Appeals, in a memorandum opin-

ion, affirmed the Commissioner on the authority of Lvzzie

H. Glide, 27 B. T. A. 1264, which held that there must be a

well on the property before the lessor could be allowed the

a Ree Ay thd

alae lindas 2 ? °

7

depletion deduction. The Circuit Court of Appeals, Sib-

ley, Circuit Judge, dissenting, affirmed the Board on the

ground that there was no production on the property with-

in the taxable year.

Specification of Errors to Be Urged.

1. The Court below erred in holding that advance royal-

ties or bonuses are not subject to depletion.

2. The Court below erred in not holding that percentage

depletion is based upon income, the allowance of which

looks forward or backward to actual production.

3. The Court below erred in denying petitioners the rea-

sonable allowance for depletion which the statute permits.

4. The Court below erred in affirming the Board of Tax

Appeals.

“ Argument.

Decision should be for the petitioners for the following

reasons:

1. The advance royalties are taxable income. Burnet v.

Harmel, 287 U. S. 103; Bankers Coal Co. v. Burnet, 287

U.S. 309;

2. The advance royalties are not proceeds from the sale

of property but payments in advance for oil and gas to be

produced (Murphy Oil Co. v. Burnet, 287 U. S. 299; Work

v. Mosier, 261 U. S. 352); therefore they come within the

term ‘‘gross income from the property’’ as used in See.

204 (c) (2) of the Revenue Act of 1926—requiring that

‘“percentage’’ depletionsbe allowed on such ‘‘gross income.”’

3. The right to the deduction is not defeated by the

qualifying phrase ‘‘in the case of oil and gas wells’’. This

phrase does not require either the existence of an oil or

gas well when the lease is made, or later in the same year,

nor production in that year. It is satisfied if, at any time

8

during the term of the lease, oil or gas is produced. This is

so, because:

(a). This construction was placed upon the same lan-

guage in prior Revenue Acts, and the language re-

enacted in the light of that construction. United States

v. Dakota-Montana Ou Co., 288 U.S. 459.

(b). Practice and rulings, under the same or similar

language, permitted depletion with respect to advance

royalties when no well was in existence during the year

the lease was executed and the bonus was received,

and when no oil or gas was produced in that year.

(c). This Court has expressly held that an allowance

for depletion should be made with respect to advance

royalties, and this without the qualifications which the

Government now seeks to impose and uphold. Mur-

phy Ou Co. v. Burnet, 287 U.S. 299.

(d). Treasury Regulations have, since 1918, pro-

vided for the recapture of all, or part, of such an al-

lowance if the execution of the lease was not followed

by actual production and exhaustion of the oil or gas

content. This not only warrants the practice but pre-

vents fiscal loss if no depletion is actually sustained.

(e). The allowance for ‘‘percentage depletion”’ is

based upon receipt of income from the property in

the tax year—not upon actual production and exhaus-

tion in the tax year. Necessarily it must look forward

or backward to actual production and exhaustion, but

the requirement of contemporaneous production de-

stroys the basic principle of percentage depletion.

(f). The theory of the Government in this case, and

of the majority below, as well as the Board of Tax

Appeals, is not the theory of the Treasury. This is ex-

pressed in G. C. M. 11384. It conflicts directly with

the reasoning of the Government here. If G. C. M.

11384 is construed to deny Petitioners’ claim, the re-

sult is so arbitrary and whimsical that even its more

liberal theory must be enlarged to cover the situation

herein presented.

9

In order to present a complete picture of the problem in-

volved this brief presents a short history of the legislation

allowing a deduction for depletion (p. 9), a discussion

of the changes resulting from the adoption of percentage

depletion in the case of oil and gas wells (p. 10) and

a history of the taxation of advance royalties, or bonuses

(p. 12).

History of legislation allowing a deduction for depletion.

The Excise Tax Act of 1909 (36 Stat. 11, 112) had no pro-

vision for depletion. Under that Act it was held that a de-

duction for depletion could not be taken as the right to

such deduction is statutory. Stratton’s Independence v.

Howbert, 231 U. S. 399; Von Baumbach v. Sargent Land

Co., 242 U. S. 503; United States v. Biwabik Mining Co.,

247 U.S. 116.

The Act of October 3, 1913 (38 Stat. 114, 166-167—Sec-

tion II) provided for the deduction ‘‘in the case of mines,

five per centum of the gross income at the mine of the out-

put for the year for which the computation is made, etce.”’

The amount of the deduction was attacked on the ground

it was inadequate. In Stanton v. Baltic Mining Co., 240

U.S. 103, this Court sustained the right of Congress to put

an arbitrary limit on the allowance.

The Revenue Act of 1916 (39 Stat. 756, 767) allowed:

‘‘In the case of oil and gas wells a reasonable allowance

for actual reduction in flow and production * * *; in the

case of mines a reasonable allowance for depletion there-

of * * .

The same language was used in the Excess Profits Tax

Act of 1917.

The Revenue Act of 1918 (40 Stat. 1057, 1077) allowed

(Sec. 234 (a) (9)): ‘‘In the case of mines, oil and gas

wells, other natural deposits and timber, a reasonable al-

lowance for depletion * * * according to the peculiar

conditions in each case * * *’’, The section also pro-

=~

10

vided for the computation of the deduction based on ‘‘dis-

covery’’ instead of cost, when the value was materially dis-

proportionate to cost.

The Revenue Acts of 1921 and 1924 contained exactly the

same provisions regarding depletion except for certain lim-

itations on ‘‘discovery’’ depletion which are not material

here.

The Revenue Act of 1926 (which is applicable here) abol-

ished discovery depletion for oil and gas properties and

substituted percentage depletion therefor. Section 204 (c)

provided that the basis for depletion should be the same

as the basis for gain or loss from a sale, except that in the

case of mines discovery value was still permitted, and:

‘*(2) In the case of oil and gas wells the allowance

for depletion shall be 2714 per centum of the gross in-

come from the property during the taxable year. Such

allowance shall not exceed 50 per centum of the net

income of the taxpayer (computed without allowance

for depletion) from the property, except that in no case

shall the depletion allowance be less than it would be if

computed without reference to this paragraph.’’

In other words, taxpayers owning interests in oil and

gas properties could still choose between cost, or March 1,

1913 value, and percentage depletion, instead of between

cost, or March 1, 1913 value, and discovery depletion.

The principal motive of Congress in making this change

was to avoid the administrative difficulties of discovery

depletion.”

The allowance of percentage depletion in the case of oil

(2) The Finance Committee Report on the 1926 Act (Senate Report No. 52,

69th Congress, 1st Session) states at page 17:

‘‘The administration of the discovery provision of existing law in the

case of oil and gas wells has been very difficult because of the discovery

valuation that had to be made in the case of each discovered well. In the

interest of simplicity and certainty in administration your committce

recommends etc.’’ To the same effect see ‘‘Statement of the Managers

on the Part of the House’’ at page 31 of the Conference Report (House

Report No. 356, 69th Congress 1st Session).

11

and gas wells has been continued in the 1928, 1932 and 1934

Revenue Acts.

Changes resulting from the adoption of percentage

depletion.

The abandoning of discovery depletion and the substitu-

tion of percentage depletion resulted in two important

changes regarding the depletion allowance. In the case of

percentage depletion there is no limit to the amount of de-

pletion which can be allowed with respect to any particular

property. In other words, there is no basis which, when

exhausted, stops the allowance. When depletion is based

on cost, March 1, 1913 value, or discovery value, the deduc-

tion stops when it aggregates the basis. For example, if

the basis is $100,000, whenever a taxpayer has been allowed

depletion deductions in the aggregate amount of $100,000

he is entitled to no further allowance, even though the prop-

erty may continue to produce for many years.

The other important change resulting from the adoption

of percentage depletion is that the allowance for depletion

is no longer related to, or @ependent upon, the actual pro-

duction from, or the exhaustion of, the property. This is

clearly illustrated as follows:

In the case of depletion based upon cost, or other fixed

basis, if ten per cent of the oil or gas reserve was extracted

in a particular year the taxpayer must be allowed ten per

cent of the basis. In the case of percentage depletion the

allowance is entirely different.

In Texas in recent years oil has sold for $2.00 or more

per barrel, and as low as ten cents per barrel. If in one

year ten cents per barrel is paid for the production from a

particular property and in another year $2.00 per barrel

is paid for oil from the same property, it is apparent that

the amount of the depletion allowance is twenty times more

dependent upon the price of oil than it is upon the amount

of oil produced. As percentage depletion is limited not

SELLE TILER LIL VENI EAS LT SRE ELIT AHI

12

only by gross income, but by net income, the allowance, in

actual practice, will vary more on account of price than the

actual ratio of difference in the price.

For example, assume that the operating expense of a

particular property is twenty-five cents a barrel. In one

year the property produces 100,000 barrels of oil which

was sold for $1. a barrel, or $100,000. As the operating ex-

pense was twenty-five cents a barrel the net income was

$75,000. The taxpayer would thus be permitted to deduct

$27,500 depletion, because that amount is 27% per cent of

the gross income and less than 50 per cent of the net in-

come. |

The next yeaftthe same property produced 100,000 bar-

rels of oil, which sold for but 30 cents a barrel with the

same operating cost, so there was a net income of $5,000.

The depletion allowance would be but $2,500 because of the

limitation that it should not exceed 50 per cent of the net

income. Had the price of oil been 25 cents a barrel there

would have been no net income and no allowance for de-

pletion. In each of the cases mentioned the exhaustion of

the oil reserves would be identical.

History of the taxation of advance royalties or bonuses.

The foregoing has been devoted to a history of depletion

allowances generally. We now direct ourselves to the his-

tory of the treatment-of advance royalties, or bonuses, re-

ceived for executing oil and gas leases.

In dealing with cost depletion the Commissioner of In-

ternal Revenue has, since 1918, held that advance royalties, —

or bonus payments, are subject to depletion. As originally

issued Article 215 (a) of Regulations 45 (1918 Act) pro-

vided that the bonus ‘‘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 Treasury Decision 3938, promulgated in 1926, (Inter-

nal Revenue Bulletin V-2, p. 117) the subdivision just

B

quoted was changed to read, as all regulations dealing with

cost depletion have since read, ‘‘ * * * there shall be al-

lowed as a depletion deduction in respect of the bonus an

amount equal to that proportion of the cost or value of

the property * * * which the amount of the bonus bears to

the sum of the bonus and the royalties expected to be re-

ceived * * *’*. The same Treasury Decision made a

similar change in Article 215 (a) of Regulations 62 (1921

Act) and Article 216 (a) of Regulations 65 (1924 Act).

Article 216 (a) of Regulations 69 (1926 Act) was similar

to the regulations under the prior Acts as amended by

Treasury Decision 3938. .

All of the Regulations beginning with Regulations 45

under the 1918 Act have provided that if depletion is al-

lowed with respect to an advance royalty and no oil or

other mineral is produced by the lessee during the life of

the lease, the lessor is requiyed to restore the allowance to

his accounts and to report it as income in the year the lease

is terminated.

The Regulations under the 1918 Act were questioned by

the Board of Tax Appeals which held, in Murphy Oi Co.,

15 B. T. A. 1195, that, as a bonus bore no relationship to

production, it could not be subject to a depletion deduction.

The Circuit Court of Appeals for the Ninth Circuit reversed

the Board, 55 F. (2d) 17, and this Court granted certiorari.

Before this Court passed on the Murphy case it disposed

of Burnet v. Harmel, 287 U. S. 103, in which present coun-

sel contended that a bonus received for executing an oil and ~

gas lease in Texas was taxable as ‘‘capital gain’’ because,

under Texas law, the leases conveyed fee title to the min-

erals in place. In disposing of the case this Court denied

the taxpayer’s contention largely on the ground that the

bonuses involved were advance royalties subject to deple-

_ @ Article 215 (a) of Regulations 45 and Article 216 of the various Regula-

; <o — with the change made by T. D. 3938, are set forth at page 4

0 rief.

‘2) The applicable provisions of the Regulations are set forth at page 4

of this brief. :

a er celine oan

14

tion. There was no showing in the Harmel case that there

was oil upon the property when it was leased or that pro-

duction was obtained thereon in the same year or later.”

The Court in the Harmel case states (P. 111):

‘*The Court below thought that the bonus payments,

as distinguished from the royalties, should be treated

as capital gain, apparently because it assumed that the

statute authorizes a depletion allowance upon the roy-

alties alone. See Ferguson v. Commissioner of Inter-

nal Revenue (C. C. A. 5th) 45 F. (2) 573, 577. But

bonus payments to the lessor have been deemed to be

subject to depletion allowances under Section 214(a)

(9) Revenue Act of 1924, by Art. 216, Treasury Regu-

lations 65, as well as under earlier acts. Section

214(a) (10), Revenue Act of 1921, Art. 215, Treasury

Regulations 62. Cf. Murphy Oil Co. v. Burnet (C. C.

A. 9th) 55 F. (2d) 17. The distinction, so far as we

are advised, has not been taken in any other case * * *.

We see no basis for it.’’

The Harmel decision was followed shortly thereafter by

the decision in Murphy Oil Co. v. Burnet, 287 U. S. 299,

wherein the question involved was (1) whether a substan-

tial bonus, or advance royalty, paid to a lessor of oil land

by his lessee was non-depletable income in its entirety

when received, or (2) whether, by an allowance for deple-

tion with respect thereto, the basic depletable value should

be reduced, so that, in later years, the allowance for deple-

tion on ordinary royalties, would be based upon such de-

pletable value less the depletion allowable with respect to

the advance royalty, instead of upon the full value, as

would have been the case if no depletion had been allow-

able with respect to the advance royalty. This Court said

(p. 302) that it was no longer open to doubt that:

‘¢# * * when the execution of an oil lease is followed

by production of oil, the bonus and royalties paid to the

(1) In its brief filed in the Harmel case in this Court the Government argued,

without qualification, that the lessor was entitled to depletion on the advance

royalty, and therefore, the advance royalty should not be taxed as capital gain.

2 MAC APR ERR at Ris

bl ats 0 ead RITE PAT ee al S

15

lessor both involve at least some return of his capital

investment in oil in the ground, for which a depletion

allowance must be made under Section 234. See Bur-

net v. Harmel, supra. This is obvious where royalties

alone are insufficient to return the capital investment.

A distinction between royalties and bonus, which

would allow a depletion deduction on the former but

tax the latter in full as income, when received, making

no provision for a reasonably anticipated production

of oil on the leased premises, would deny the ‘reason-

able allowance for depletion’ which the statute pro-

vides. * * * Doubts, if any, whether the statute au-

thorizes depletion of bonus payments have been defi-

‘nitely set at rest by the repeated re-enactment, without

substantial changes, of the provisions of Sec. 234(a)

(9) since the promulgation of treasury regulations

providing for such depletion. * * * In addition, pro-

vision is made by subdivisions (c) and (d) of the

Regulations, as amended, for such necessary capital

readjustments as may be occasioned by the termina-

tion, abandonment or expiration of the lease before

all the oil is extracted.’’™

The rule was reiterated in Palmer v. Bender, 287 U. S.

501, wherein the Court stated ‘‘Thus we have recently held

that the lessor is entitled to a depletion allowance on bonus

and royalties’’ (p. 557).

The Bureau of Internal Revenue apparently endeavoring

to follow this Court’s ruling in the Murphy case, on Janu-

ary 16, 1933, promulgated General Counsel’s Memorandum

11384 (Internal Revenue Bulletin XII-1 Page 64) in which

the possible situations which could arise were divided into

four classifications as follows:

(1) No oil being produced when the bonus was

received, but future production practically assured

because of near-by wells and geological indications.

(4) In the Murphy case, the fact that oil was produced from the property

during the year the bonus was collected and subsequent thereto was fortui-

tous, and this Court does not appear to have placed any weight on this fact.

It seems clear that this Court’s decision in the Murphy case would have been

the same if the bonus or advance royalty had been collected the last moment

of the tax year so that there could be no production, and, therefore, no

actual depletion of oil reserves in that year.

—_—— ELT NEY IG ET? SOT ND AOE FN ENS NN IR IN WIE ARN AR RN RN ENYA ey ©

, rs ¢ a a

16

(2) No oil being produced when the bonus was re-

ceived, but property became productive within the tax-

able year.

(3) No oil being produced when the bonus was re-

ceived, and not more than a speculative prospect of

future oil production at that time, but property is

now known to have become productive after the tax-

able year.

(4) Property has never become productive.

The ruling held that percentage depletion would be al-

lowed in situations (1) and (2), but denied in situations

(3) and (4).

The difficulties of administration of G.C.M. 11384 are

immediately apparent. Taxpayers would be compelled to

employ expensive experts to prove to the Government ex-

perts that when the leases were signed production was

‘practically assured’’ and disprove that there was ‘‘not

more than a speculative prospect of future production.”’

One of the reasons for the adoption, in the 1926 Act, of per-

centage depletion, in lieu of discovery depletion, was to sim-

plify administration and avoid such battles of experts.

Furthermore the requirements of G. C. M. 11384 are

discriminatory and unfair. Under it the deduction for de-

pletion with respect to a bonus can be dependent upon the

time of the year a lease is made, upon the time necessary to

drill a well, or the diligence of the lessee.

Suppose that, at the beginning of 1926, adjoining farms,

as to which the prospects for finding oil were substantially

equal, were owned by Jones and Smith. Neither farm met

the requirement of ‘‘production practically assured because

of nearby wells and geological conditions.’’ Early in the

year Jones leased his farm and received $10,000 bonus. His

lessee immediately moved on the property and, notwith-

standing the opinion of geologists, secured production on

December 31, 1926, which was within the calendar year.

_ i

17

Under the G. C. M. he is entitled to depletion, so paid tax

on but $7,250 of the bonus.

Smith started negotiations for a lease on his farm at the

same time as Jones, but due to some delay on account of

his abstract, or the like, was unable to actually execute the

lease until later in the year. His lessee was diligent, but,

despite every effort, was unable to complete the well and

secure production until January 1, 1927, which was in the

year following the receipt of the bonus. Under the G. C.

M. Smith is not entitled to any depletion on the bonus, so

must pay tax on- $10,000.

We submit that no one can find any support for such

theory in the law, the Regulations or the decisions of the

Courts.

The Board of Tax Appeals on April 26, 1933, decided the

case of Lizzie H. Glide, 27 B. T. A. 1264 (now pending in

the Ninth Circuit) in which the taxpayer contended she

was entitled to depletion on a bonus. The Board admitted

that bonuses were advance royalties, but held that, unless

there was production within the same year as the bonuses

were received, there could be no deduction for depletion.

The decision mentioned G. C. M. 11384 but held that as the

facts presented did not come within the conditions under

which depletion would be allowed under the G. C. M. the

Board would not pass on it. The dissenting opinion of

Board Member Van Fossan, Lansdon and Leech concur-

ring, in the Glide case, is printed in the appendix to this

brief at page 31.

The majority opinion in the Glide case apparently denies

the deduction because the statute allows depletion in the

ease of ‘‘oil and gas wells’’, and cites with approval I.:T.

2384 (Internal Revenue Bulletin VI-2 page 22) which held:

‘Tt will be noted that the above quoted section of the

law operates only in cases of oil and gas wells and that

the allowance for depletion at the rate therein pro-

vided is expressly limited to the gross income from

>. ST TD =

18

such property. Accordingly it must be concluded that

the application of Article 216 (e) of Regulations 69 js

dependent upon whether or not the lease in question is

of an oil or gas well, and that Article 216 (e) of the

regulation does not apply to leases covering property

on which no well is in existence.’’

The phrase ‘‘in the case of oil and gas wells”’ in the 1926

Act is identical with that in all earlier acts under which the

allowance was made on bonuses regardless of whether or

not there was a well. No attempt was made, either in I. T.

2384, or in the Glide decision, to explain why the phrase

meant one thing in the Acts of 1918, 1921 and 1924 and

something else in the Act of 1926. Likewise no attempt is

made to explain the fact that before, contemporaneously

with, and after the issuance of the I. T. the Bureau con-

tinued to allow depletion based on cost or March 1, 1913,

value, irrespective of a well.’ This Court, however, set-

tled the question. In United States v. Dakota-Montana Oil

Co., 288 U. S. 459, it was contended that, because of the

advent of percentage depletion, the phrase ‘‘in the case of

oil and gas wells’’ meant something different from what it

had meant in earlier Acts. At page 467 the Court states:

‘“‘There is no ground for supposing that Congress,

by providing a new method for computing the allow-

ance for depletion intended to break with the past and

narrow the function of that allowance. The reasonable

inference is that it did not and that depletion includes

under the 1926 Act precisely what it included under

the earlier acts.”’ .

On June 29, 1934, the Board decided the case of J. T.

Sneed, Jr., 30 B. T. A. Advance Sheet No. 171, wherein it

appeared that in a year prior to the receipt of the bonuses

a gas well had been drilled, but it did not produce commer-

cially until later years because of lack of pipe line facilities.

(1) The later ruling of the Bureau of Internal Revenue in G. & M. 11384

had the effect of overruling I. T. 2384 because it permitted percentage deple-

tion where there was no well on the property.

19

No wells were completed in the years the bonuses were re-

ceived, but when the case was tried there were fifteen or

twenty wells on the property. The Board found that when

the bonuses were received production was practically as-

sured and, therefore, the case came squarely within the

provisions of G. C. M. 11384 which permitted a depletion

deduction on account of the bonus payment. The Board,

however, refused to follow the G. C. M. and held the lessor

was not entitled to depletion on the bonus because of the

absence of production, with two members dissenting ‘‘for

the reasons so ably set forth by Judge Sibley’’ in the case

at bar.

The Board’s memorandum opinion in the case at bar

merely found that the bonus payments were received in

1926 and that there was no production on the property un-

til 1930. The case was disposed of on the authority of the

Inzzte H. Glide case, 27 B. T. A. 1264 because there was ‘‘no

production during the taxable year before us, nor was

there at that time more than a speculative possibility of

production.’’

If the opinions below are affirmed the present petitioners

will never secure a depletion allowance on account of the

advance royalties received in 1926, although their prop-

erty is now producing commercially under the leases

granted in that year. It is, of course, understood that the

allowance for depletion based upon a percentage of income

from the property can never be made as to the royalty eol-

lected in advance unless made in the year in which the ad-

vance royalty is collected. If the lessor had developed the

property himself, or leased without advance royalty, but

with a larger ordinary royalty, he would have been allowed

depletion on all his royalties when received. The Court be-

low denied the depletion allowance, which the taxpayer

must have to place him on equal footing with others simi-

larly situated, from a practical standpoint, solely because

of the fortuitous circumstances that the oil was developed

SETTER TAN LOE SR TES ENA ONY |

20

by a lessee, who chose to begin operations in a later year,

even though had development not been successful, and had

no ‘‘actual depletion’’ occurred, the allowance would have

been restored to income and taxed in the year this possi-

bility materialized.’ In order to secure the depletion al-

lowance, Herring in this case, must look alone to the pro-

duction of oil, but the allowance looks forward or backward

to actual production.‘”

The controlling statute here expressly required the al-

lowances for depletion to ‘‘be equitably apportioned be-

tween the lessor and lessee.’’ (Sec. 214 (a) (9) Rev. Act

of 1926.)

The allowance for depletion of the type here involved

is predicated primarily upon income. The allowance is

27'4% of the gross income, but not more than 50% of the

net income, from the property each year. Considered with

the Regulations heretofore quoted, it plainly appears that

the allowance depends upon receipts more than actual ex-

haustion of oil or gas reserves, and that, if the allowance

be not made as the receipts come in and are taxed, the

Congressional intention of allowing, over the life of the

property to every one having an economic interest in the

property, 27'4% of their respective gross incomes there-

from, cannot be carried out. On the other hand, if the al-

lowance is made as royalties are received, any allowance

not followed by actual depletion through production can be

recovered-and taxed by the terms of the Regulation hereto-

fore quoted.

The majority below in the case at bar held that a lessor

(1) Article 216 of Regulations 69 provides: ‘‘(¢c) If for any reason any such

mineral lease shall be terminated or abandoned before the mineral which has

been paid for in advance has been extracted and removed, and the lessor

repossesses the leased property, the lessor shal] adjust his capital accounts by

restoring to the capital sum of the property the depletion deductions made

in prior years on account of royalties on mineral paid for but not removed,

and his income account shall be adjusted so as to include the amount so re-

stored to capital sum as income of the year such lease is terminated or thd

property repossessed, and the tax thereon paid.’’

(2) See Judge Sibley’s dissenting opinion in this case, R. 42, and page 27

this brief.

- iene = EINE EIR —

21

was not entitled to the statutory allowance for depletion

with respect to advance royalties unless oil or gas was actu-

ally produced from the property during the tax year in

which the advance royalties or bonus was received:

‘‘The depletion charge permitted as a deduction from

gross income in determining taxable income ‘in the

case of oil and gas wells’ represents the reduction, dur-

ing the taxable year in question, of oil or gas in place

in land in which the taxpayer has an interest. Helver-

ing v. Falk, U. S. Sup. Ct. Jan. 15, 1934; U. S. v.

Ludey, 274 U. S. 295, 302. No statutory provision

which has come to our notice authorizes such a deduc-

tion to be based on an expectation, however well

founded, that oil or gas remaining in place in land

during the taxable year in question will be extracted

in subsequent years. Depletion of oil or gas is a re-

sult of the production and sale thereof. Palmer v.

Bender, 287 U. S. 551, 558.’ (R. 42.)

The majority opinion takes no notice of the fact that an

allowance for ‘‘percentage’’ depletion can only be taken

as to advance royalties in the year the royalties are taxed;

and that in cases where ‘‘percentage’’ depletion is not

applied, the allowance with respect to the bonus or advance

royalty will not be made in any other year; and that, in

neither case, can subsequent allowances be increased on

account of the fact that no depletion was allowed on the

advance royalty.” Nor does it refer to the fact that, if

depletion is allowed with respect to an advance royalty,

and no oil or other mineral is produced by the lessee during

the life of the lease, the lessor is required to restore the

allowance to his accounts and to report it as income in the

year the lease is terminated.‘

(1) As pointed out earlier in this brief ‘‘percentage’’ depletion, first intro-

duced in the 1926 Revenue Act, is unique in that the total allowances to be

made over the life of the property are not limited to any particular cost or

basis. Under the alternate system in the 1926 law, and the only one in earlier

acts since 1918, when the total allowances equalled the basis or cost, no more

was allowable. ‘‘Percentage’’ depletion allowances are unlimited in that

respect. It is therefore impossible to make up for the denial of the allowance

on a bonus in a later year.

(2) Regulations 69, Art. 216(a) supra.

22

The opinion of the majority below indicates a misunder-

standing of the Murphy decision. After reciting that oil

was extracted in 1919 and 1920 it cites the Murphy case as

holding that ‘‘the depletion charge permitted as a deduc-

tion from gross income in determining taxable income ‘in

case of oil and gas wells’ represents the reduction, during

the taxable year in question, of oil or gas in place in land

in which the taxpayer has an interest’’ (R. 42). The fact

is that the leases in the Murphy case were made in 1913

and the bonuses were all paid prior to 1919. The question

was whether the bonuses should be considered in their en-

tirety as income when received, or if they should be treated

as advance royalties and be reduced by a depletion allow-

ance, and thus reduce the basis for the depletion allow-

ance on income from production in later years. This Court

held that allowable depletion must be deducted from the

bonus in the year the bonus was received and the deplet-

able base reduced accordingly. In other words, the decision

holds that a part of the depletion deduction allowable on

account of 1919 ard 1920 production must be taken in the

years the bonuses were received, irrespective of the actual

depletion in those years. This means that the 1919 and 1920

allowance was not, as the majority below states, in step with

actual depletion, but was less than the actual depletion in-

curred in those years, because a portion of the allowance

was properly attributable to the prior years in which the

bonuses were paid.

as Swithis hrief. reneatediv states the allowance permitted

by the statute follows income and looks forward or back-

ward to actual depletion, and such has always been, and

now is, the practice. For instance, payment for ‘‘oil runs’”’

is ordinarily made in the month following the run. In

computing depletion the Bureau of Internal Revenue con-

sistently holds that the depletion allowance for December

of any year is not allowable in the year in which the actual

depletion occurs but in the following year when the income

from the oil is received.

23

A further illustration of the misconception of the prob-

lem by the majority below is the statement (R. 41) that

““Tt was suggested in argument that, by reason of Peti-

tioner’s receipt in that year of the large sum in bonuses,

depletion allowances made in that year probably would be

more beneficial to Petitioner than such allowances made in

‘later years were likely to be’’. As appears quite obvious

nothing that is done with respect to the allowance in the

year here involved will have any effect on subsequent years.

In later years the allowance will be 274% per cent of the in-

come from the property in those years.

Petitioners’ view that the majority opinion below is in

conflict with the decisions of this Court heretofore men-

tioned is reinforced by the similar view of the minority

below. Judge Sibley, in dissenting said:

‘*Both (bonuses and ordinary royalties) are equally

income to the lessor from his land, and both are alike

subject to be reduced by allowance for depletion.

Burnet v. Harmel, 287 U. S. 103; Murphy Oil Com-

pany v. Burnet, 287 U. S. 299; Bankers Coal Co. v.

Burnet, 287 U. S. 309, Palmer v. Bender, 287 U. S.

991. The income tax statutes have studiously endea-

vored to tax net income only, and to make just allow-

ances for expenses and for a return of capital lost in

producing it. The statute in question nowhere says

~ that the depletion allowance commanded is to be taken

when the oil is extracted, but the general provision

has always been that a reasonable allowance shall be

made according to the peculiar conditions in each case.

Construing it as to a bonus, it is said in Murvhv Oil

Company v. Burnet, supra, at page 307: ‘Here an an-

ticipated depletion of capital is to be returned from

bonus and future royalties to the extent the applicable

statutes allow, and the problem is to allocate such antic-

ipated depletion to a payment made in advance of its

occurrence.’ * * * If the tax officer treats a bonus pay-

ment as income, he must deplete it 27 %% under the

command of the statute.’’ (R. 45 and p. 27 this brief)

AR IOENE ES PRs EAE CPN pa OE BE Sm RIE 09 CONAN ORGS tr iSite Nas atl aati a

24

The question should be considered in the light of well-

known practical facts. Among these are the following:

It is most unusual for an oil and gas lease to be made

on a tract of land already producing. Such leases ordi-

narily are the meats by which the landowner secures the

exploration of his property for oil or gas, and its discoy-

ery, as well as its development and exploitation. It is the

custom for ‘‘ordinary royalties’’ to be the same in any ter-

ritory, regardless of differences in the prospect of securing

oil or gas on various tracts. This difference is ordinarily

adjusted in commercial transactions by the amount of the

advance royalty or bonus. Cf. Work v. Mosier, 261 U. 8.

352.

The Treasury Regulations which, from 1918 to 1926,

have expressly provided for depletion with respect to

bonuses or advance royalties (See Murphy Oil Company v.

Burnet, supra) never made any distinction whatsoever be-

cause one property might be producing when leased and

another undeveloped, or because production might be se-

cured in the year the lease was made on one and not until

later on another. But these practical facts must have been

known to the authors of these Regulations.

It is equally well known that, in the case of most oil and

gas leases (including those involved in this case), the lessor

cannot control the time development is begun. It can ordi-

narily be delayed by the payment of nominal rentals dur-

ing the entire primary term of the lease. Likewise, the

length of time for drilling a well varies, because of depth

and geological conditions, from a few days to several

months. '

It is difficult to believe that this Court will hold that past

practice is to be disregarded and the regulation applied

only in the most unusual case (7. e., in the case of the leas-

ing of a property already producing), when that limitation

is not plainly expressed.

A regulation which would grant an allowance for deple-

tion equal to 27%4% of over $680,000. of advance royalties,

pied tt ners SR EA EY NETRA Sere A He

° 25

if one or two hundred barrels of oil, worth, perhaps, $100.00

or $200.00 had been produced in the year of leasing, and

deny the allowance if no production is secured until the

next year, is arbitrary and capricious. The same is true of

a regulation which would grant the allowance if one lessor

grants his lease early in his tax year so that a well can be,

and is, completed within that year, but denies it to a neigh-

bor similarly situated, who leases so late in the year that

his equally diligent lessee cannot secure actual production

until the next year.

A further ‘illustration of the inconsistency of the hold-

ing below is shown by the following quotation from Judge

Sibley’s dissenting opinion, wherein he states (R. 44 and

p. 27 this brief) :

‘Tf not a constitutional necessity, it is certainly more

reasonable, where income is produced by a commer-

cial depletion, to deduct the depletion from the par-

ticular income produced by it as an element of cost

rather than to make it an offset against general ineome

in some other year. If for example the owner of tim-

ber leases it to a sawmiller to be exhausted over a

term of years and is paid as the timber is cut, the ac-

tual depletion of his timber by cutting corresponds

with his receipt of income and no problem is presented.

But if the sawmiller should pay for all after the end

of the term, it would be unreasonable to allow the

owner depletion in the years the timber was cut when

he had no income and no tax to pay, and to tax his

whole income without any depletion at the end. So

if the whole timber should be paid for in advance.

Again, if the timber owner is cutting and selling his

own timber, he should be allowed to deduct the value

of his timber from the income as received, no matter

when the trees were cut or delivered. Although oil

and gas are underground and timber is not, both are

by the statute depletable and the same principle ap-

plies. The bonus on an oil and gas lease is so far as

authority can make it merely royalties paid in ad-

vance, and both bonus and royalties are the considera-

tion for the oil expected to be recovered by the lessee.’’

26

The Court is referred to the dissenting opinion below (R.

42 and p. 27 this brief), as well as the dissenting opinion

in the Glide case (p. 31 this brief), for a more extended

discussion of such inconsistencies.

Conclusion.

As the decisions of this Court have established that a

deduction for depletion is allowable on advance royalties;

as Treasury Regulations have, since 1918, consistently al-

lowed the same deduction; as Congress has repeatedly re-

enacted the depletion sections in the same language and

in the light of the Treasury Regulations mentioned, and,

as the rule of the opinion below is discriminatory, unfair,

and ignores the practical aspects of the problem, the de-

cision below should be reversed.

Roserr Asu,

Munsey Building,

Washington, D. C.

Lesuiz EK, MartLew

Waggoner Building,

Wichita Falls, Texas,

October 1934. Attorneys for Petitioner.

RTE A en

27

Dissenting opinion, Circuit Court of Appeals, in this case

APPENDIX.

Dissenting Opinion of Judge Sibley in Herring Case.

‘“‘Srpuey, Circuit Judge, Dissenting:

‘‘The question is whether a percentage depletion is allow-

able on bonuses received in 1926 for oil and gas leases which

are to endure so long as oil or gas is produced when no well

was drilled and no oil produced under them during that

year, although the oil and gas were present and were pro-

duced later. The Board of Tax Appeals denied the allow-

ance because there was no well, and this court denies it

because no oil was taken out. One of the pertinent provi-

~ sions of the Revenue Act of 1926, ‘In computing net income

there shall be allowed a deduction .. . in the case of mines,

oil and gas wells, and other mineral deposits and timber, a

reasonable allowance for depletion and for depreciation of

improvements according to the peculiar conditions in each

case,’ occurred in previous acts. The other provision: ‘In

case of oil and gas wells the allowance for depletion shall

be 27144 percentum of the gross income from the property

during the taxable year,’ is new. Great difficulty was found

under the former provision in estimating the content of an

oil and gas reserve under the ground and in arriving at

what proportion of it was represented by the operations of

a particular taxable year, and also in fixing the value of the

reserve under the rules relating to discovery value. To

avoid these difficulties Congress in the new provision ig-

nored both the size and the value of the reserve, assumed

that the value of any production of oil or gas would on the

average be 2714 per cent original capital investment not to

be taxed, and the remaining 62'4 per cent would be taxable

income, and provided for its taxation in the year it was

received. It is evident that the 27%4 per cent deduction

which the statute not only permits but commands must be

made in the year that the income which measures it is re-

28

Dissenting opinion, Circuit Court of Appeals, in this case

ceived and taxed, that it cannot be taken any subsequent

year, and that it is entirely independent of actual deple-

tion, being so named because it looks forward or backward

to the exhaustion represented by the income received. The

purpose and command of the provision is defeated by the

decision in this case. The oil and gas were present to be

produced, as was of course supposed when nearly a half-

million dollars were paid in advance for them as bonuses,

and as was proven when the wells were drilled. That the

lessees by their own choice not to drill the first year should

control the taxability of the lessor’s bonuses, or that the

depletion allowance on the entire bonuses should depend on ©

the production in the taxable year of a few gallons of oil

or a few feet of gas seems to me both unreasonable under

the general provision for depletion and in contradiction of

the special provision for the percentage deduction.

‘‘Tt is true that depletion, like depreciation because of

wear and tear and obsolescence, is based on the actual grad-

ual loss of capital. The allowance for wear and tear and

obsolescence is, however, always estimated and distrib-

uted over the useful life of the property considered, and

does not depend on a demonstration of what actually hap-

pened to it in the particular taxable year. The allowance

for them is a general offset against all income for the tax-

able year rather than a deduction from some particular

item of income, because wear and tear and obsolescence,

although a loss of capital, do not directly produce any

particular income. Depletion also may sometimes be a

mere loss, as when oil or gas runs to waste or standing

timber dies and rots. But ordinarily depletion refers to a

commercial use of part of a reserved store, as where ore

or gas or oil is extracted for sale, or timber or ore or oil

is manufactured into lumber or metal or gasoline and sold.

In such cases the capital represented by the depletion is

used directly to produce income and is converted into it.

29

Dissenting opinion, Circuit Court of Appeals, in this case

According to Eisner v. McComber, 252 U. S. 189, only gain

is taxable income under the Sixteenth Amendment where

a conversion of property is involved. Congress is there-

fore merely staying on safe constitutional ground in pro-

viding for this percentage depletion against income re-

ceived from oil and gas. If not a constitutional necessity,

it is certainly more reasonable, where income is produced

by a commercial depletion, to deduct the depletion from

the particular income produced by it as an element of cost

rather than to make it an offset against general income

in some other year. If for example the owner of timber

leases it to a sawmiller to be exhausted over a term of years

and is paid as the timber is cut, the actual depletion of

his timber by cutting corresponds-with his receipt of in-

come and no problem is presented. But if the sawmiller

should pay for all after the end of the term, it would be

unreasonable to allow the owner depletion in the years the

timber was cut when he had no income and no tax to pay,

and to tax his whole income without any depletion at the

end. So if the whole timber should be paid for in advance.

Again, if the timber owner is cutting and selling his own

timbers he should be allowed to deduct the value of his

timber from the income as received, no matter when the

trees were cut or delivered. Although oil and gas are un-

derground and timber is not, both are by the statute de-

pletable and the same principle applies. The bonus on

an oil and gas lease is so far as authority can make it

merely royalties paid in advance, and both bonus and roy-

alties are the consideration for the oil expected to be recov-

ered by the lessee. Both are equally income to the lessor

from his land, and both are alike subject to be reduced

by allowance for depletion. Burnet v. Harmel, 287 U. S.

103; Murphy Oil Co. v. Burnet, 287 U. S. 299; Bankers

Coal Co. v. Burnet, 287 U. S. 309; Palmer v. Bender, 287

U. S. 551. The income tax statutes have studiously en-

30

Dissenting opinion, Circuit Court of Appeals, in this case

deavored to tax net income only, and to make just allow-

ances for expenses and for a return of capital lost in pro-

ducing it. The statute in question nowhere says that the

depletion allowance commanded is to be taken when the

oil is extracted, but the general provision has always been

that a reasonable allowance shall be made according to the

peculiar conditions of each case. Construing it as to a

bonus, it is said in Murphy Ou Co. v. Burnet, supra, at

page 307: ‘Here an anticipated depletion of capital is to

be returned from bonus and future royalties to the extent

the applicable statutes allow, and the problem is to allo-

cate such anticipated depletion to a payment made in ad-

vance of its occurrence. The allocation is permitted by

statute.’ This language is quite at variance with that of

the court below quoted in the majority opinion. When this

provision was first enacted in 1918, Regulation 45, Art.

215 (d), provided that on the expiration or abandonment

of a lease without the removal of any or all of the mineral

contemplated by the lease, there must be a return to capital

account of so much of the bonus deducted from the recover-

able capital as exceeds actual depletion, and that amount

must be treated as income the year the lease was ended.

This shows that it was understood that the bonus payment

was considered depletable in advance of actual depletion

and that if the contemplated depletion does not occur the

correction is to be made at the end of the lease. The same

Regulation has been continued ever since, as Congress has

reenacted the same depletion provision, and it is referred

to and its operation approved in Murphy Oil Co. v. Burnet,

supra, at page 304, and again at page 306. The statutory

words: ‘In case of oil and gas wells’ are directly connected

with ‘or other mineral deposits.’ Wells as such were not

in the mind of Congress as subjects of depletion, but the

deposits of oil and gas and other minerals were in mind,

31

Dissenting opinion, Board of Tax Appeals in

Lizzie H. Glide case

and as shown above, depletion of bonuses on leases was

regularly allowed although in most cases, no doubt, actual

production is not accomplished in the year the lease is made.

When in the Act of 1926 Congress again used the expres-

sion, ‘In case of oil and gas wells’ in connection with the

percentage depletion no narrower meaning is to be attrib-

uted to it. United States v. Dakota-Montana Oil Co., 288

U.S. 459. On the contrary, even more plainly the receipt

of income and not the existence of a well or of production

from it is made the generating cause of the depletion allow-

ance. If the tax officer treats a bonus payment as income

he must deplete it 27% per cent under the command of the

statute.

“In Helvering v. Falk, .. U.S. . -» depletion under all

the Acts through that of 1926 was under consideration and

the cases were reviewed with this conclusion: ‘Whatever

may be said concerning the power of Congress to treat the

entire proceeds of a mine as income, obviously the statute

has not undertaken to do so. The plain purpose we think

was to tax only that portion of the proceeds remaining after

proper allowance for depletion. This allowance represents

property consumed, is treated as if capital assets, and no

tax is laid upon it. The statute must be so applied in prac-

tice as to carry out this purpose.’ The judgment in the case

at bar defeats the statutory purpose and by denying the

allowance which the statute commands taxes that part of

the money received which ought to be treated as if capital

assets.’’

Dissenting Opinion in Lizzie H. Glide Case.

“Van Fossan, dissenting: I find it necessary tc dis-

sent from the decision of the majority. In considering the

32

Dissenting opinion, Board of Tax Appeals in

Lizzie H. Glide case

right of a taxpayer to depletion, I am unwilling to decide

the question on any basis so highly technical and artificial

as that employed in the prevailing opinion. Under the

reasoning of the majority, the right to depletion depends

on the existence of a well on the property. Obviously the

production of the well, provided there be a well, need bear

no relation to the amount of depletion. The law allows a flat

percentage of income from the property (not from the well)

as depletion. The Supreme Court has held that a bonus is

income. Therefore if the bonus be paid and there happens

to be a well in existence (however inconsequential the pro-

duction) the taxpayer gets full statutory depletion. If

there be no well, regardless of other conditions, the tax-

payer gets no depletion. But assume a case where, as fre-

quently happens, a bonus is paid in one year and there is

no well completed until the next year. The taxpayer would

get no depletion on account of the bonus (or advance roy-

alties, as the Supreme Court has called them) because

there was no well on the property though all surrounding

property bore productive wells, nor would he get depletion

of the bonus in the next year even if a producing well be

completed, because the bonus was not income in that year.

Variations of this illustration, emphasizing the absurdities

of the situation, could easily be multiplied.

‘‘T am unable to see any defensble basis for a distinction

that would produce such an inequitable and illogical re-

sult. The prevailing opinion introduces a new concept into

the theory of depletion and in many cases sets at naught

the intention of Congress as interpreted by the decisions of

the Supreme Court so far as depletion of bonuses is con-

cerned. Murphy Oil Co. v. Burnet, 287 U. S. 299.. The

cited case clearly decides that a bonus is depletable and

makes no suggestion that this right should be governed by

_

“33

Dissenting opinion, Board of Tax Appeals in

Lizzie H. Glide case

such a rule as laid down by the majority. The court clearly

suggests the opposite:

‘“‘A distinction between royalties and bonus, which

would allow a depletion deduction, on the former but

tax the latter in full as income, when received, making

no provision for a reasonably anticipated production

of ow on the leased premises would deny the ‘reason-

able allowance for depletion’ which the statute pro-

vides. * * * (Italics supplied.)

‘‘Moreover, I further find myself in disagreement with

the majority opinion in the summary manner in which

G.C.M. 11384 is disposed of. That the Commissioner is not

now contending for such a rule as proposed by the majority

is clear from this memorandum, which provides that de-

pletion should be allowed if future production is practically

assured because of nearby wells and geological indications.

Whether this interpretation is too narrow it is not neces-

sary to discuss, but certainly it is broad enough to cover the

instant case. The facts show that oil was being produced

in the same township and in the same oil field. This brings

the petitioner squarely within the first of the four situations

referred to in the memorandum. The prevailing opinion

dismisses the matter on the basis of failure of proof.

“In my opinion the majority of the Board throughout this

opinion have grasped at a shadow of diction and allowed

the substance of the thought and intention of Congress and

the Supreme Court to escape them.

‘“‘Lansdon and Leech agree with this dissent.’?