Petition for Writ of Certiorari — Rhoades Oil Co. v. United States
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vee ol 1 SEP 1 7 1997
—BFHCE Ob tHe CL eR
N
IN THE
SUPREME COURT OF THE UNITED STATES
OCTOBER TERM 1997
RHOADES OIL COMPANY
Petitioner,
THE UNITED STATES OF AMERICA
Respondent.
PETITION FOR A WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE TENTH CIRCUIT
JOHN B. TURNER *
CHARLES GREENOUGH
STUART, BIOLCHINI,
TURNER & GIVRAY
3300 First Place Tower
Tulsa, Oklahoma 74103
(918) 582-3311
*Counsel of Record
September 17, 1997 Attorneys for Petitioner
ry
QUESTION PRESENTED
Did the Tenth Circuit Court of Appeals violate
this Court’s rulings, reaffirmed most recently in
Commissioner v. Schleier, 115 S.Ct. 2159 (1995) and
United States v. Burke, 112 S.Ct. 1867 (1992), that
exclusions from gross income are available only if
specifically stated and that such exclusions must be
narrowly construed, when the Tenth Circuit ruled that
the lifting costs of an oil and gas business are excluded
from its gross income because such lifting costs are
analogous to costs of goods sold which are excluded
from the gross income of a manufacturing,
merchandising, or mining business under 26 C.F.R.
§1.61-3(a)?
-ii-
LIST OF PARTIES
Petitioner and Respondent are named in the
caption and were the only parties to this case before both
the Tenth Circuit Court of Appeals and the United States
District Court for the Northern District of Oklahoma.
RULE 29.6 STATEMENT
As required by Rule 29.6 of this Court, Petitioner,
which is a Delaware corporation, states that it has no
parent company or nonwholly owned subsidiaries.
-lll-
TABLE OF CONTENTS
Page
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RO GERLS vk o e es ili
RPM PE PPADS ks oc ee es v
Se ME ee ee le 2
NN gs eee si ye 2
STATUTES AND REGULATIONS .......... 3
-jV-
TABLE OF CONTENTS (continued)
REASONS FOR GRANTING CERTIORARI .... 6
The Tenth Circuit’s opinion broadly
construing the exclusion from _ gross
income contained at 26 C.F.R. §1.61-3(a)
to apply by analogy to the lifting costs of
an oil and gas business violates a line of
cases from this Court that began over
forty years ago with Jacobson and
Glenshaw Glass and has continued to the
recent decisions in Schleier and Burke,
all of which consistently and uniformly
hold that the only exclusions from gross
income are those which are specifically
stated, and that those exclusions which
are specifically stated must be narrowly
CI ss Oe ee a es 8
RELIEF REQUESTED AND CONCLUSION ... 18
ATER 6 ea eee Er Oe es es A-1
Yo
TABLE OF AUTHORITIES
CASES
Commissioner v. Glenshaw Glass Co.,
Wot iP EAM ek ee eae ok passim
Commissioner v. Jacobson,
GF Bite. cae, OP we es passim
Commissioner v. Schleier,
ERD Ok Rt 8 ee passim
Laguna Royalty Co. v. Commissioner,
27 T.C.M. (CCH) 164 (1968),
aff'd 406 F.2d 703 (Sth Cir. 1969) ...... iz, 13
Max Sobel Wholesale Liquors v. Commissioner,
630 F.2d 670, 673-4 (9th Cir. 1980) ........ 14
All-Steel Equipment, Inc. v. Commissioner,
54 T.C. 1749, 1751 (1970),
aff'd in part and rev'd in part
on the grounds, 467 F.2d 1184
FR Ee ia ee ee ee 17
O’Gilvie v. United States,
eit ve Oe 2 eee 7
United States v. Burke,
BER ee TO OEE ooo eee ek passim
United States v. Centennial Savings Bank,
BES Wie Sot ROAR CEE ke ek ce ig 11
is ce ee eee reer
III I
-vi-
TABLE OF AUTHORITIES (continued)
STATUTES
Paes Wt ORE a iW a's me a kk we ele 9
ee Rea Ok a a ln ee eS oe wee es 13
Be es OER ok es PR eee 17
Se Shan Ek Ase WS Peo ae 4
eS a ak EER Oe Rees 3, 15
OR PER a oe oe OR YS eR oe eS 16
REGULATIONS
BSS EE 6 a We Ek Cw eee en 10
ce ee ED os gk x ak ee passim
Ee Ge a RE. VN aOR TS OG en 17
ee as SE 6 eck be eee ReeD 18
Se ee Oa» oN oS en OR 16
aes enn, ©) oo 6 6 eS ELAS 16
PT BOO i Pe CERES Cee Oe 16
-Vii-
TABLE OF AUTHORITIES (continued)
SUPREME COURT RULES
pene Sc ONEt Meltre £0, AO) gc oc ee we es 7
I UE EE ekg ws ce eke ow ews 2
PT GE UO A of Se ek hk ae ee ll
IN THE
SUPREME COURT OF THE UNITED STATES
OCTOBER TERM 1997
RHOADES OIL COMPANY
Petitioner,
THE UNITED STATES OF AMERICA
Respondent.
PETITION FOR A WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE TENTH CIRCUIT
Rhoades Oil Company ("Petitioner") asks this
Court for writ of certiorari to review the June 19, 1997,
Order and Judgment of the United States Court of
Appeals for the Tenth Circuit.
.%
OPINIONS BELOW
The Tenth Circuit’s opinion below is an
unreported Order and Judgment filed on June 19, 1997.
A-1.' In that opinion, the Tenth Circuit reversed an
Order of the United States District Court for the
Northern District of Oklahoma filed February 15, 1996.
A-4. The District Court had granted summary judgment
to Petitioner in a suit for refund to recover personal
holding company taxes and interest assessed against and
paid by Petitioner for the tax years 1988, 1989, and
1990. Pursuant to the February 15, 1996 Order,
Judgment was entered in favor of Petitioner and against
Respondent in the District Court on February 20, 1996.
A-26.
JURISDICTION
The Tenth Circuit Court of Appeals filed its Order
and Judgment on June 19, 1997. A-1. Jurisdiction lies
under 28 U.S.C. § 1254(1) for this Court to review the
final decision of the Tenth Circuit Court of Appeals.
This Petition for Certiorari is filed under Rule 13.1 of
this Court.
'The Appendix to this petition is cited as "A-
pm
STATUTES AND REGULATIONS
This case involves the following statutes and
regulations, all of the relevant portions of which are fully
reprinted in the Appendix due to their length: Statutes -
26 U.S.C. §§ 61(a)(2), 162, 471, 542(a), 543, and 613;
Regulations - 26 C.F.R. §§ 1.61-1(a), 1.61-3(a), 1.471-
7, 1.471-8, 1.613-3, 1.613-4(a) and (f), and 1.614-3(e).
STATEMENT OF THE CASE
This case concerns the amount of gross income of
an oil and gas business. This case is unusual in that the
usual roles of the taxpayer (Petitioner) and the
government (Respondent) are reversed: Petitioner asks
this Court to determine that its gross income is higher,
while Respondent seeks a ruling that Petitioner’s gross
income is lower. This is due to the fact that this case
involves personal holding company taxes, which are
assessed when a taxpayer’s "personal holding company
income" exceeds sixty percent of its "adjusted ordinary
gross income." 26 U.S.C. §543(a).
sil
Respondent calculated Petitioner’s gross income”
by excluding Petitioner’s "lifting costs," which are the
costs of labor, repair, maintenance, materials, supplies,
property taxes, insurance, and severance taxes incurred
to operate and maintain oil and gas wells.’ Using the
calculation of gross income put forth by Respondent,
Petitioner met the test under 26 U.S.C. §542(a)(1) and
was assessed personal holding company taxes.
sie dal anal Math 18) rere
Petitioner disputed Respondent’s calculation of its
gross income, and _ unsuccessfully appealed the
assessment under the Respondent’s internal procedures.
Petitioner then paid the taxes and filed suit for a refund
___in the United States District Court for the Northern
District of Oklahoma. Jurisdiction in the court of first
instance was pursuant to 28 U.S.C. §1346(a)(1).
The matter was submitted to the District Court on
cross motions for summary judgment based on stipulated
facts and upon the deposition testimony of one expert
witness sponsored by Petitioner. Petitioner’s expert
witness testified that an oil and gas business such as
1 le aa Ma EN ida ca bah
*Gross income is the starting point for the
determination of a taxpayer’s "adjusted ordinary gross
income." 26 U.S.C. §543(b)(1).
‘Lifting costs are also sometimes referred to as
"lease operating expenses." The terms are synonymous.
-5-
Petitioner does not have "costs of goods sold" and that
Petitioner’s lifting costs were not the same as or
comparable to costs of goods sold. This evidence was
not rebutted by Respondent. A-69 . The sole issue
presented to the District Court was whether lifting costs
should be excluded from Petitioner’s gross income in
determining if Petitioner was subject to personal holding
company taxes.
The District Court ruled in favor of Petitioner,
rejecting the argument of Respondent that 26 C.F.R. §
1.61-3(a) applied. A-4. The District Court held that 26
C.F.R. §1.61-3 on its face applies only to a
"manufacturing, merchandising, or mining business" and
that the Petitioner is an oil and gas business. The
District Court noted that the oil and gas business is not
within the meaning of "mining" under the Internal
Revenue Code. The District Court ruled that because
there is no statutory or regulatory exclusion from gross
income for the lifting costs of an oil and gas business,
Petitioner’s gross income must be calculated without such
an exclusion. With Petitioner’s gross income calculated
without the exclusion of lifting costs, Petitioner was not
subject to personal holding company taxes, and was
entitled to a refund of the taxes paid.
The Tenth Circuit Court of Appeals reversed the
District Court, stating that it was "persuaded that lifting
costs are analogous to costs of goods sold" and that
a.
therefore the reasoning of 26 C.F.R. §1.61-3(a) applied.
A-2. The Tenth Circuit stated that "the general rule is
that "“gross income’ means the total sales less the costs
of goods sold[,]" and then implied that 26 C.F.R. §1.61-
3(a) merely applied this general definition to
manufacturing, merchandising, or mining businesses. A-
2. However, the Tenth Circuit cited no authority for the
"general rule" on which it relied.
REASON FOR GRANTING CERTIORARI
This Court should grant certiorari because the
decision of Tenth Circuit Court of Appeals violates the
long line of cases in which this Court has consistently
held that an item is included in gross income unless there
is a specific exclusion available, and that all such
exclusions from gross income must be narrowly
construed. Commissioner v. Schleier, 115 S.Ct. 2159,
2163 (1995); United States v. Burke, 112 S.Ct. 1867,
1870, 1878 (SOUTER, J. Concurring at 1878) (1992);
Commissioner v. Glenshaw Glass Co., 75 S.Ct. 483,
475, 477-78 (1955); Commissioner v. Jacobson, 69
S.Ct. 358, 369 (1949). Instead, the Tenth Circuit
broadly construed the exclusion from the gross income
of a manufacturing, mining, or merchandising business
for costs of goods sold, contained at 26 C.F.R. § 1.61-
3(a), to apply by analogy to exclude the lifting costs of
an oil and gas business from its gross income. There is
no specific exclusion stated anywhere in the Internal
7. a
Revenue Code or the Internal Revenue Regulations that
requires the exclusion of lifting costs from the gross
income of an oil and gas business. The Tenth Circuit
opinion decided this federal question in a way that is in
conflict with applicable decisions of this Court. See, S.
Ct. Rule 10.1(c).
The writ of certiorari is needed to safeguard the
integrity of this Court’s holdings that the only exclusions
from gross income available are those that are
specifically stated, and that the exclusions that are
available must be narrowly construed. This Court has
repeatedly emphasized these principles in a line of cases
that spans over forty years, including the Jacobson case
in 1949 and the Glenshaw Glass case in 1955. The
Respondent has successfully argued before this Court on
three occasions in the last five years that exclusions from
gross income must be narrowly construed. O’Gilvie v.
United States, 117 S.Ct. 452 (1996); Schleier; Burke.
However, in this case, the United States instead
convinced the Tenth Circuit to broadly construe 26
C.F.R. §1.61-3(a) to exclude lifting costs from
Petitioner’s gross income. The United States did so only
because a broad construction of the exclusion happened
to result in higher taxes for Petitioner in this case, due to
the unusual nature of personal holding company taxes.
The United States is bound by this Court’s holdings on
the required specificity and narrow scope of exclusions
from gross income, even in the unusual case such as this
-8-
one in which the application of the rule results in lower
taxes. The Tenth Circuit’s opinion is in irreconcilable
conflict with this Court’s decisions in Glenshaw Glass,
Jacobson, Schleier, and Burke. Only certiorari relief
from this Court will correct the wrong that has been
committed.
The Tenth Circuit’s opinion broadly
construing the exclusion from gross
income contained at 26 C.F.R. §1.61-3(a)
to apply by analogy to the lifting costs of
an oil and gas business violates a line of
cases from this Court that began over
forty years ago with Jacobson and
Glenshaw Glass and has continued to the
recent decisions in Schleier and Burke,
all of which consistently and uniformly
hold that the only exclusions from gross
income are those which are specifically
stated, and that those exclusions which
are specifically stated must be narrowly
construed.
The error committed by the Tenth Circuit is
simple. In direct violation of the fundamental principles
laid down by this Court governing the availability and
construction of exclusions from gross income, the Tenth
Circuit broadly construed 26 C.F.R. §1.61-3(a) to apply
by analogy to exclude the lifting costs of an oil and gas
ot Aion catches aaa cali
-9-
business from its gross income. The plain language of
26 C.F.R. §1.61-3(a) defines the gross income of a
"manufacturing, merchandising, or mining business" as
"total sales less the cost of goods sold[.]". The Tenth
Circuit extended the regulation to apply to the lifting
costs of an oil and gas business. In doing so, the Tenth
Circuit narrowly construed the definition of gross income
under 26 U.S.C. §61 and broadly construed the
exclusion from gross income contained in 26 C.F.R.
§1.61-3(a), in direct conflict with Glenshaw Glass,
Schleier, and Burke. The result is a new exclusion from
gross income which is not specifically stated in the
Internal Revenue Code or Regulations, in violation of
Jacobson.
The definition of gross income under the Internal
Revenue Code is found at 26 U.S.C. §61(a)(2):
"(a) GENERAL DEFINITION.-- Except as
otherwise provided in this subtitle, gross
income means all income from whatever
source derived, including, but not limited
to, the following items:
(2) Gross income derived from
business|[.]}"
-10-
Although renumbered, this statute has been essentially
unchanged since well before the Jacobson and Glenshaw
Glass cases.
In Glenshaw Glass, this Court held that the
definition of gross income under the Internal Revenue
Code has a "sweeping scope" intended to bring the
taxing power to bear on all constitutionally taxable
receipts. 75 S.Ct. at 475, 477-8. Since that time, this
Court has "repeatedly emphasized" the sweeping scope
of the definition of gross income under the Internal
Revenue Code. Schleier, 115 S.Ct. at 2163; Burke, 112
S.Ct. at 1870.
This Court has "also emphasized the corollary to
§61(a)’s broad construction, namely the ‘default rule of
statutory construction that exclusions from income must
be narrowly construed.’"Schleier, 115 S.Ct. at 2163,
quoting Burke, 112 S.Ct. at 1878 (SOUTER, J.,
concurring).
The rule is also emphasized in the 26 C.F.P.
§1.61-1(a), issued by the Internal Revenue Service under
26 U.S.C. §61(a), which provides that:
"Gross income means all income from
whatever source derived, unless excluded
by law."
<i
The rule that an item is included in gross income
unless there is a specifically stated exclusion that applies
has also been upheld by this Court on more than one
occasion:
"The income taxed is described in
sweeping terms and should be broadly
construed in accordance with an obvious
purpose to tax income comprehensively.
The exemptions, on the other hand, are
specifically stated and should be construed
in the light of the same policy."
Jacobson, 69 S.Ct. at 369 (1949); See also, United
States v. Centennial Savings Bank, 111 S.Ct. 1512, 1518
(1991).
The statute, cases from this Court, and the
regulations are all clear that an item is included in gross
income unless there is a specific exclusion available.
There is no exclusion anywhere in the Internal Revenue
Code or in the regulations issued by the Internal Revenue
Service that excludes the lifting costs of an oil and gas
business from its gross income. Only by broadly
construing 26 C.F.R. §1.61-3(a) did the Tenth Circuit
reach a contrary result, in violation of the principles that
this Court has "repeatedly emphasized" for more than
forty years. Schleier, 115 S.Ct. at 2163.
1%.
In its opinion, the Tenth Circuit stated that the
"general rule is that ‘gross income’ means ‘the total
sales less the costs of goods sold.”" The Tenth Circuit
went on to state that 26 C.F.R. §1.61-3(a) applies this
“general definition" to manufacturing, merchandising, or
mining businesses. A-2. However: there simply is no
such general rule. To the contrary, the general rule, as
repeatedly emphasized by this Court is that an item is
included in gross income unless a specific exclusion
applies, and that any such exclusions from gross income
must be narrowly construed. Jacobson; Centennial
Savings Bank.
The error of the Tenth Circuit results from its
reliance on Laguna Royalty Co. v. Commissioner, 27
T.C.M. (CCH) 164 (1968), aff'd 406 F.2d 703 (Sth Cir.
1969), which in turn relied on Rev. Rul. 60-344, 1960-2
C.B. 186. The error in Laguna Royalty and Rev. Rul.
60-344 springs from the use of the undefined term "cost
of operations" as an exclusion to determine the gross
income of any business, in place of the clearly defined
term "cost of goods sold" which is excluded to determine
the gross income of a manufacturing, merchandising, or
mining business under 26 C.F.R. §1.61-3(a). This was
apparently done to fill a perceived void in the
determination of the gross income from businesses other
than manufacturing, merchandising, or mining for
something akin to cost of goods sold. Such an analysis,
however, is directly contrary to the holdings announced
«13
repeatedly by this Court -- that the only exclusions from
gross income are those that are specifically stated, and
that even those must be narrowly construed. Jacobson,
Schleier. Conspicuously, the Tenth Circuit did not
mention Schleier or Burke in its opinion, nor did either
the Fifth Circuit or the Tax Court in Laguna Royalty
mention Glenshaw Glass or Jacobson.
The error of the use of "cost of operations” as a
substitute for "cost of goods sold" to determine the gross
income of a business is also clear in light of the fact that
under 26 U.S.C. §162(a) "the ordinary and necessary
expenses paid or incurred during the taxable year in
carrying on any trade or business" are deducted from
gross income to determine taxable income. The broad
and ambiguous term "cost of operations" easily fits
within the "ordinary and necessary" expenses of carrying
on a business. Therefore, under the theory of the Tenth
Circuit below and of Laguna Royalty, almost any item
classified as an “ordinary and necessary" business
expense could just as easily be reclassified as a "cost of
operation" and excluded from gross income in the first
instance, instead of being deducted from gross income to
determine taxable income. This distinction is significant.
There are numerous restrictions on the deductibility of
expenses under 26 U.S.C. §162(a). If instead cost of
operations can (or must) be excluded in determining
gross income, any restrictions on deductions would be
meaningless, because the taxpayer would simply exclude
-14-
the disputed items from gross income as "costs of
operations." See, Max Sobel Wholesale Liquors v.
Commissioner, 630 F.2d 670, 673-4 (9th Cir.
1980)(limitation on deductibility of certain illegal
payments as business expense did not apply where the
payments were part of cost of goods sold and as such
were excluded from gross income). Indeed, to use the
language chosen by the Tenth Circuit, many if not most
ordinary and necessary business expenses are also
"analogous to costs of goods sold" and thus could be
"properly excluded in arriving at gross income." The
failure to follow Schleier, Burke, Jacobson, and
Glenshaw Glass would thus allow a taxpayer to avoid
many if not most of the restrictions on the deduction of
business expenses contained in the Internal Revenue
Code.
To arrive at its decision below, the Tenth Circuit
had to broadly construe 26 C.F.R. §1.61-3(a) and
analogize lifting costs to costs of goods sold, because
there is no question that under the Internal Revenue Code
the word "mining" does not include oil and gas
production, and the term "costs of goods sold" does not
include lifting costs.
The oil and gas business is not within the
definition of mining under the Internal Revenue Code.
Although Respondent argued below that there is no
reason for distinguishing between mining and oil and gas
a,
production for purposes of determining gross income,
Respondent has offered no legal authority whatsoever
that oil and gas production is within the definition of
mining for purposes of the Internal Revenue Code, as
noted by the District Court, A-22.
The Internal Revenue Code and the Internal
Revenue Regulations consistently distinguish mining from
oil and gas production. The word mining is not used
interchangeably for oil and gas production anywhere in
the Internal Revenue Code or the Internal Revenue
Regulations. Instead, numerous provisions of both the
Code and the Regulations use mining and oil and gas
production in ways that leave no doubt that the two terms
are not interchangeable.
The personal holding company tax provisions
which are the subject of this case explicitly distinguish
between mining and oil and gas production. 26 U.S.C.
§543 consistently uses the phrase "mineral, oil, and gas
royalties" throughout. 26 U.S.C. §543(b)(2)(B)
distinguishes oil and gas exploration from mining. The
adjustments in subparts (i) through (iv) of that section are
made to royalty income both from minerals and from oil
and gas, but are only made to working interest income
from "an oil and gas well."
Mining is also distinguished from oil and gas
production in the depletion provisions of the Internal
-16-
Revenue Code. 26 U.S.C. § 613(a) states that depletion
is allowed in the case of "mines, wells, and other natural
deposits" as listed in 26 U.S.C. § 613(b), which again
refers to "mines, wells, and other natural deposits." 26
U.S.C. § 613(c)(1) defines "gross income from the
property" for property other than an oil or gas well as
the "gross income from mining." 26 U.S.C. § 613(c)(2)
and (3) define "mining," and do not include references
to extraction of oil and gas. 26 U.S.C. §613(c)(4)(H)
lists certain oil shale, but not oil well, treatment
processes as within the definition of mining. 26 U.S.C.
§613(d) specifies that depletion of oil and gas wells must
comply with 26 U.S.C. §613A in order to be allowed,
while depletion from mining does not.
The regulations concerning depletion also
explicitly distinguish between oil and gas production and
mining. 26 C.F.R. §1-613-4(a) states that gross income
from the property for all minerals except oil and gas
means “gross income from mining.” 26 C.F.R. §1.613-3
separately defines "gross income from the property" for
oil and gas wells. 26 C.F.R. §1.613-4(f) defines
"mining," and the definition clearly does not include oil
and gas production from wells. 26 C.F.R. §1-614-3(e)
defines "mine" as:
"any excavation or other workings or series
of related excavations or related workings,
as the case may be, for the purpose of
m, »
extracting any known mineral deposit
except oil and gas deposits. For the
purpose of the proceeding sentence, the
term "excavations" or "workings" includes
quarries, pits, shafts, and wells (except oil
and gas wells)."
The Tenth Circuit’s finding that lifting costs are
analogous to costs of goods sold is totally unsupported by
the record or by the law. Petitioner presented unrebutted
evidence in the form of expert testimony to the District
Court that lifting costs for an oil and gas business are not
the same as or comparable to costs of goods sold. A-69.
A taxpayer’s cost of goods sold is calculated by
subtracting the cost of inventory on hand at the end of
the year from the sum of the cost of inventory on hand
at the beginning of the year plus the cost incurred during
the year in acquiring new inventory. All-Steel
Equipment, Inc. v. Commissioner, 54 T.C. 1749, 1751
(1970), aff'd in part and rev'd in part on the grounds,
467 F.2d 1184 (7th Cir. 1972).
26 U.S.C. §471, and the regulations issued under
it, deal with calculating cost of goods sold through the
calculation of inventories. There is a specific regulation
setting forth the calculation of inventories of miners and
manufacturers, 26 C.F.R. §1.471-7, and another
regulation setting forth the calculation of inventories of
-18-
retail merchants, 26 C.F.R. §1.471-8. There is no
regulation setting forth the calculation of inventories for
oil and gas businesses.
The one constant factor in the calculation of cost
of goods sold is the "cost" must be tied to some specific
"goods sold." The last sentence of 26 C.F.R. §1.61-3(a)
specifically recognizes this, because it requires that an
amount cannot be included as part of cost of goods sold
before the tax year in which economic performance
occurs with respect to the amount -- the tax year in
which the goods are sold. Thus, calculation of cost of
goods sold requires that an inventory be kept. However,
oil and gas exploration and production companies as such
Petitioner do not keep an inventory of the oil and gas
they sell in a year. Without inventory, it is impossible
to calculate cost of goods sold. A-69.
In order to apply 26 C.F.R. §1.61-3(a) to
Petitioner, the Tenth Circuit thus had to go outside of the
plain language of the regulation. It did so by analogizing
"lifting costs" to "costs of goods sold." However, in
doing so the Tenth Circuit violated Jacobson, Glenshaw
Glass, Schleier, and Burke.
RELIEF REQUESTED AND CONCLUSION
Petitioner asks this Court to grant certiorari to
correct the Tenth Circuit’s error in violating this Court’s
-19-
cases holding that exclusions from gross income are only
available if specifically stated that such exclusions must
be narrowly construed, by reversing the decision of the
Tenth Circuit and reinstating the Judgment entered by the
District Court.
Respectfully submitted,
JOHN B. TURNER *
CHARLES GREENOUGH
STUART, BIOLCHINI,
TURNER & GIVRAY
3300 First Place Tower
Tulsa, Oklahoma 74103
(918) 582-3311
* Counsel of Record
Attorneys for Petitioner
a
=
2
APPENDIX
RS ee eT ee Oe eS ea SEM eR Fe Hot
APPENDIX CONTENTS
Page
Order and Judgment of the United States
Court of Appeals for the Tenth Circuit,
ORG Te BOE oa SWE 6 heen es A-1
Order of the United States District Court
for the Northern District of Oklahoma,
PORES 55. 19h ok Ak ee es A-4
Judgment of the United States District Court
for the Northern District of Oklahoma,
PRE DR a oe Si alee eee es A-26
STATUTES AND REGULATIONS
meat a, EAE ok a ens eee eS A-27
ee eS 6 on sk a ee SS A-27
ey ee a ee ae ew A-28
te i le eR A-29
Oe Oe a rk he ee ES A-29
Oe St RE Gas iw hs as CREO A-36
ee ee Er ae bs ee eS A-44
ee ee LkOM) 66s eo eS A-44
Be EE oe Pee oes SS A-45
Oe a TO ke ke ee ws ee A-45
re Bd oo Ee eee aw A-48
«Pie ek oe oe St re are A-48
Be 4.8 es BAGS) 6 ee ee A-60
APPENDIX CONTENTS (continued)
Page
Complaint for Refund in
Rhoades Oil Company vs.
United States of America, January 14, 1993 . A-61
Answer to Complaint for
Refund in Rhoades Oil Company vs.
United States of America, March 16, 1993 . A-66
Excerpts from Appellee’s Supplemental
Appendix on Appeal to the United
States Court of Appeals for the
Tenth Circuit -Excerpts of
Deposition of James M. Downs ........ A-69
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UNITED STATES COURT OF APPEALS
TENTH CIRCUIT
No. 96-5101
(D.C. No. 93-C-0036-B)
(N.D. Okla.)
[File Stamped 6/19/97]
RHOADES OIL COMPANY,
Plaintiff-Appellee
vs.
UNITED STATES OF AMERICA,
Defendant-Appellant.
ORDER AND JUDGMENT
Before BALDOCK, BRORBY, and MURPHY, Circuit
Judges.
Plaintiff-Appellee Rhoades Oil Company (taxpayer) is
engaged in the exploration for and production of oil and gas.
On audit, the Internal Revenue Service (IRS) determined that
taxpayer was subject to personal holding company tax under
26 U.S.C. § 541 for the years 1988, 1989, and 1990, in the
amounts of $101,053, $163,188, and $144,392 respectively.
“This order and judgment is not binding precedent, except under
the doctrines of law of the case, res judicata, and collateral estoppel. The
court generally disfavors the citation of orders and judgments;
nevertheless, an order and judgment may be cited under the terms and
conditions of 10th Cir. R. 36.3.
-A-2.
Taxpayer paid the additional tax and filed a claim for refund.
The IRS failed to act on the refund and taxpayer brought suit
in federal district court and prevailed. The government
appeals from summary judgment granted in favor of taxpayer.
Our jurisdiction arises under 28 U.S.C. § 1291 and we
reverse.
The facts are stipulated and undisputed. The narrow
issue Of law before us is whether lifting or production costs
incurred by an oil producer are properly excluded from gross
income in calculating "adjusted ordinary gross income" for
personal holding company tax purposes. See 26 U.S.C. §
542(a)(1); 543(b)(2)(B). If so, more than 60% of the
taxpayer's adjusted ordinary gross income is "personal
holding company income,” 26 U.S.C. § 543(a), and the tax
is properly imposed in this case. The taxpayer concedes that
the other requirement for imposition of the tax, namely the
stock ownership requirement of 26 U.S.C. § 542(a)(2) is met.
We have carefully reviewed the submissions of the
parties, and we are persuaded that lifting costs are analogous
to costs of goods sold and properly excluded in arriving at
gross income, and hence adjusted ordinary gross income, for
purposes of the personal holding company tax. See Laguna
Royalty Co. v. Commissioner, 27 T.C.M. (CCH) 164
(1968), aff'd 406 F.2d 703 (Sth Cir. 1969); Rev. Rul. 60-
344, 1960-2 C.B. 186. "Gross income" includes "[g]ross
income derived from business,” 26 U.S.C. § 61(a)(2), and
the general rule is that "gross income means "the total sales
less the costs of goods sold." 26 C.F.R. § 1.61-3(a)(applying
general definition to manufacturing, merchandising or mining
business). See also § 1.542-2 (cross referencing 26 U.S.C.
§ 61 and 26 C.F.R. § 1.61.1 to 1.61-14 in defining gross
ee ee eee
eS
income for personal holding company tax purposes and
Stating "[uJnder such provisions gross income is not
necessarily synonymous with gross receipts"). The fact that
"gross income from the property" may be defined in a
different fashion elsewhere in the Code or Treasury
Regulations for purposes of depletion, see 26 C.F.R. §
1.613-3 (definition for purposes of 26 U.S.C. § 613(c)), does
not address the issue before us. See Laguna Royalty Co., 27
T.C.M. (CCH) at _, 1968 WL 1158 at *3-4. We conclude
that the IRS’s position is supported by the regulations relied
upon and is reasonable; hence, we may not disregard it.
National Muffler Dealers Ass'n v. United States, 440 U.S.
472, 484 (1979).
REVERSED.
Entered for the Court.
Bobby R. Baldock
Circuit Judge
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IN THE UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF OKLAHOMA
Case No. 93-C-0036-H
[File Stamped 2/15/96]
RHOADES OIL COMPANY,
Plaintiff,
VS.
UNITED STATES OF AMERICA,
Defendant.
ORDER
This matter comes before the Court on a Motion for
Summary Judgment by Plaintiff Rhoades Oil Company, Inc.
("Rhoades Oil") and a Cross-Motion for Summary Judgment
by Defendant United States. For the reasons expressed
herein, the Court grants Plaintiff's Motion for Summary
Judgment and denies Defendant’s Cross-Motion.
Plaintiff commenced this civil tax action suit pursuant
to 26 U.S.C. § 7422 to recover alleged overpayments made
to the United States in connection with personal holding
company taxes and interest thereon assessed against Plaintiff
for taxable years 1988, 1989, and 1990, in the total amount
of $503,689.00. The assessment stemmed from the
determination by the Internal Revenue Service (the "Service")
that Plaintiff is a "personal holding company” within the
meaning of the Internal Revenue Code (the "Code") §§ 541-
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543, and therefore subject to the personal holding company
tax.
I
The basic facts of this case are set forth in the
Stipulation of Facts filed with the Court on November 9,
1993 and supplemented on May 31, 1994.
Rhoades Oil was founded in 1945 by Sam J. Rhoades,
Sr. for the purpose of exploring and producing oil and gas.
Since its inception, Rhoades Oil has been an oil and gas
company, and its only activities have been the exploration and
production of oil and gas reserves. These activities include
purchasing oil and gas leases, drilling wells, and acting as the
operator for producing wells.
Rhoades Oil is a closely-held Delaware corporation
with its principal place of business in Tulsa, Oklahoma. The
stock of the company is owned as follows:
Pre-9/89 Post-9/89
Common Stock (No Par)
Sam J. Rhoades 50% 305.0 66.7% 305.0
Nona M. Rhoades 25% 147.5 33.3% 146.5
Sam J. Rhoades, Jr. 25% 147.5 0.0% 0.0
Total Shares (Common)
Outstanding 600.0 452.5
Preferred Stock (Par $ 100)
Sam J. Rhoades, Trust 50% 100.0 66.7% 100.0
Nona M. Rhoades, Trust 25% 50.0 33.3% 50.0
Sam J. Rhoades, Trust 25% 50.0 0.0% 0.0
Total Shares (Preferred)
Outstanding 200.0 150.00
Rhoades Oil redeemed the shares of Sam J. Rhoades
following his death in 1989. During the last half of each of
the taxable years at issue more than 50 percent of the
outstanding stock of Rhoades Oil was owned by no more than
5 individuals.
The income of Rhoades Oil from its oil and gas
business is derived from working interests, overrides, and
royalty interests. A working interest is ownership of an oil
and gas lease. The owner receives the gross receipts from
the sale of oil and gas, less royalty payments and severance
taxes, and bears the drilling and operating expenses of the
well. The overrides of Rhoades Oil were created when the
company owned a working interest in certain wells, but
converted the working interest into an override. The
overrides do not bear any expenses of drilling or operations.
A royalty interest also bears no drilling or operating
expenses. In 1988 through 1990, Rhoades Oil received the
following revenues from working interests, overrides, and
royalty interests:
1988 1989 1990
Working Interests $1,162,000 $1,211,000 $1,316,000
Overrides and Royalties $ 56,000 $ 46,000 $ 56,000
As of January 1, 1988, January 1, 1989, and January
1, 1990, Rhoades Oil had retained earnings of $17,710,020,
$18,977,833, and $14,273,523, respectively. The investment
income of Rhoades Oil is derived from the investment of the
company’s retained earnings, mostly in Treasury Bills and
publicly-traded stocks.
- oo
The original Forms 1120 - U.S. Corporation Income
Tax Returns filed by Rhoades Oil for taxable years 1988,
1989, and 1990 did not reflect a liability for any personal
holding company tax.
On or about July 31, 1991, Rhoades Oil received a
letter from the Service notifying Rhoades Oil of proposed
federal income tax deficiencies under Section 541 et seq. of
the Code, the personal holding company tax provisions. This
Notice of Deficiency proposed deficiencies as follows:
Taxable Year Additional Tax
1988 $101,053.00
1989 $163,188.00
1990 $144,392.00
On April 16, 1992, Plaintiff executed IRS Form 870,
Waiver of Restrictions on Assessment and Collection of Tax
and Acceptance of Overassessment, and on May 24, 1992,
made advance payments of the deficiencies in the following
amounts:
Year Tax Interest
1988 $101,053.00 $ 39,895.85
1989 $163,188.00 $ 39,701.06
1990 $144,392.00 $ 15,459.48
Total $503,689.39
These deficiencies were subsequently assessed on July 6,
1992.
On or about May 22, 1992, Rhoades Oil filed three
separate Forms 1120X - Amended U.S. Corporation Income
Tax Returns for taxable years 1988, 1989. and 1990, which
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served as its claims for refund.“ In these Amended Returns,
Rhoades Oil sought a refund of all personal holding company
tax paid for taxable years 1988, 1989, and 1990, plus
interest. The Service neither approved nor denied these
claims within the six-month period following the filing of
these claims.
In calculating its personal holding company income for
taxable years 1988, 1989, and 1990, Rhoades Oil did not
deduct "lifting costs""” from gross income when determining
its adjusted ordinary gross income from working interests
under Section 542(a)(1). Using this method, Rhoades Oil’s
personal holding company income did not exceed 60 percent
of its adjusted ordinary gross income and, accordingly, it was
not treated as a personal holding company under Section 542.
On its tax returns, Rhoades Oil treated Lease
Operating Expenses (lifting costs) as part of its "Cost of
Goods Sold." For non-tax accounting purposes, Rhoades Oil
treated Lease Operating Expenses as part of its "Cost of
Operations" which is subtracted from Gross Receipts in
arriving at Gross Profits.
On audit, the Service followed Revenue Ruling 60-
**Pursuant to the Joint Stipulation of Facts, the United States
does not admit any facts set forth in the 1988, 1989, and 1990 Forms
1120X, except as expressly stated.
***The term "lifting costs” when used in the oil and gas industry
is usually considered to be synonymous with “operating costs,” and
consists of those deductible costs incurred in the production of oil and gas
after the completion of drilling and before its removal from the property
for sale or transportation, e.g. labor, superintendence, supplies, repairs,
and assets having a life not in excess of one year, maintenance, and
applicable overhead costs. See Rev. Rul. 60-344, 1960-2 C.B. 186.
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344, 1960-2 C.B. 186, and deducted lifting costs from gross
sales of oil and gas to calculate "gross income" for purposes
of the personal holding company test. Using this calculation
of "gross income," the Service determined that Rhoades Oil
was a personal holding company under Section 542 and was
therefore subject to the tax on undistributed personal holding
company income under Section 541.
II
Summary judgment is appropriate where "there is no
genuine issue as to any material fact," Celotex Corp. _v.
Catrett, 477 U.S. 317, 322 (1986); Windon Third Oil & Gas
Drilling Partnership v. Federal Deposit Insurance Corp., 805
F.2d 342, 345 (10th Cir. 1986), cert. denied, 480 U.S. 947
(1987), and "the moving party is entitled to judgment as a
matter of law," Fed. R. Civ. P. 56(c). In Celotex, the
Supreme Court stated:
[t]he plain language of Rule 56 (c) mandates the
entry of summary judgment, after adequate time
for discovery and upon motion, against a party
who fails to make a showing sufficient to establish
the existence of an element essential to that party’s
case, and on which that party will bear the burden
of proof at trial.
477 U.S. at 322.
A party opposing a properly supported motion for
summary judgment must offer evidence. in admissible form,
of specific facts, Fed. R. Civ. P. 56(e), sufficient to raise a
"genuine issue of material fact." Anderson v. Liberty Lobby,
Inc., 477 U.S. 242, 247-48 (1986) ("[T]he mere existence of
some alleged factual dispute between the parties will not
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defeat an otherwise properly supported motion for summary
judgment."). "Factual disputes that are irrelevant or
unnecessary will not be counted." Id. at 248.
Summary judgment is only appropriate if "there is
[not] sufficient evidence favoring the nonmoving party for a
jury to return a verdict for that party." Id. at 250. The
Supreme Court stated:
{t]he mere existence of a scintilla of evidence in
support of the plaintiffs position will be
insufficient; there must be evidence on which the
jury could reasonably find for the plaintiff.
Id. at 252. Thus, to defeat a summary judgment motion, the
nonmovant "must do more than simply show that there is
some metaphysical doubt as to the material facts."
Matsushita Elec. Indus. Co. v. Zenith Radio Corp., 475 U.S.
574, 585-86 (1986); Anderson, 477 U.S. at 250 ("[T]here is
no issue for trial unless there is sufficient evidence favoring
the nonmoving party for a jury to return a verdict for that
party. If the evidence is merely colorable, or is not
significantly probative, summary judgment may be granted."
(citations omitted)).
In essence, the inquiry for the Court is "whether the
evidence presents a sufficient disagreement to require
submission to a jury or whether it is so one-sided that one
party must prevail as a matter of law." Anderson, 477 U.S.
at 250. In its review, the Court construes the record in the
light most favorable to the party opposing summary
judgment. Boren v. Southwestern Bell Tel. Co., 933 F.2d
891, 892 (10th Cir. 1991).
Il
The language of the statute and the legislative history
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of the personal holding company tax provisions make clear
that any corporation that falls within the technical provisions
of the statute will be deemed a "personal holding company."
H.R. Rep. No. 704, 73d Cong., 2d Sess. 11-12 (1934).°**"
"The provision is designed so that there is no necessity to
prove a purpose to avoid surtaxes [on wealthy individuals],
and it has been considerably strengthened and improved by
the Revenue Act of 1937." H.R. Rep. No. 1860, 75th Cong.,
3d Sess. 3 (1938). See American Package Corp. v.
Commissioner, 125 F.2d 413, 416-17 (4th Cir. 1942) (noting
that, unlike the accumulated earnings tax, the personal
holding company tax must be applied regardless of whether
there is a legitimate business purpose); Investors Ins. Agency
vy. Commissioner, 72 T.C. 1027, 1032-33 (1979), aff'd, 677
F.2d 1328 (9th Cir. 1982) (applying personal holding
company tax despite being a trap for the unwary);
Montgomery Coca-Cola Bottling Co. v United States, 615
F.2d 1318, 1323 (Cl. Ct. 1980) (tax is "automatic upon
qualification under the objective criteria of sections 541 et
seq., and . . . does not turn on a tax avoidance motive").
A "personal holding company" is defined in Section
542(a) of the Code as follows:
**
""As Defendant stated in its brief, the goal of Congress in
enacting the personal holding company tax was to prevent the use of
"incorporated pocketbooks” by high-bracket individual taxpayers to shield
their investment income from tax at the steeply graduated individual tax
rates while retaining control over the underlying portfolio securities
through their control of the personal holding company. To accomplish this
goal, Congress established a set of mechanical tests for determining
whether a company was a personal holding company. Def.’s Resp. Br. at
8.
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(a) | GENERAL RULE.- For purposes of this subtitle, the
term "personal holding company" means any
corporation * * * if--
(1) ADJUSTED ORDINARY GROSS INCOME
REQUIREMENTS. At least 60 percent of its
adjusted ordinary gross income (as defined in
section 543(b)(2)) for the taxable year is
personal holding company income (as defined
in section 543(a), and
(2) STOCK OWNERSHIP REQUIREMENT. At
any time during the last half of the taxable
year more than 50 percent in value of its
outstanding stock is owned, directly or
indirectly, by or for not more than 5
individuals. * * *
The parties have stipulated that during the last half of
each taxable year at issue, more than 50 percent of the
outstanding stock of Rhoades Oil was owned by no more than
5 individuals. Plaintiff therefore has satisfied the stock
ownership test set forth in Section 542(a)(2).
If a corporation meets the stock ownership test of
Section 542(a)(2), under the terms of Section 542(a)(1) it will
be subject to the 28 percent tax on its undistributed personal
holding company income if its personal holding company
income comprises 60 percent or more of its "adjusted
ordinary gross income," as that term is defined in Section
543(b). Because the amount of Rhoades Oil’s personal
holding company income is not in dispute, the sole issue is
the proper method for determining its "adjusted ordinary
gross income".
The term "ordinary gross income” is defined in
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Section 543(b)(1) as:
(b) DEFINITIONS - For purposes of this part -
(1) ORDINARY GROSS INCOME. - The term
“ordinary gross income" means the gross income determined
by excluding -
(A) all gains from the sale or other
disposition of capital assets,
(B) all gains (other than those referred to in
subparagraph (A)) from the sale or other disposition
of property described in section 1231(b), and
(C) in the case of a foreign corporation...
The term "adjusted ordinary gross income" is defined in
Section 543(b)(2) as:
(2) ADJUSTED ORDINARY GROSS INCOME.
The term "adjusted Ordinary gross income" means the
ordinary gross income adjusted as follows:
baad ok *
(B) MINERAL ROYALTIES, ETC - From
the gross income from mineral, oil, and gas royalties
described in paragraph (4), and from the gross income
from working interests in an oil or gas well, subtract
the amount allowable as deductions for -
(i) exhaustion, wear and tear,
obsolescence, amortization, and
depletion,
(ii) property and severance taxes,
(ili) interest, and
(iv) rent,
to the extent allocable, under regulations prescribed
by the Secretary, to such gross income from royalties
or such gross income from working interests in oil or
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gas wells. The amount subtracted under this
subparagraph with respect to royalties shall not exceed
the gross income from such royalties, and the amount
subtracted under this subparagraph with respect to
working interests shall not exceed gross income from
such working interests.
As Defendant stated in its brief, the determination of
"adjusted ordinary gross income" may be illustrated as
follows:
Gross Income
less: Items described in Section 543(b)(1)(A)-(C)
equals: Ordinary Gross Income
and
Ordinary Gross Income
less: Items described in Section 543(b)(2)(B)(I)-(iv)
equals: Adjusted Ordinary Gross Income
The parties do not dispute the amounts of the
adjustments to be made under Section 543(b)(1)(A)-(C) to
reduce "gross income" to "ordinary gross income", or under
Section 543(b)(2)(B)(i)-(iv) to arrive at “adjusted ordinary
gross income." The parties disagree, however, as to the
proper definition of "gross income" under Section 543(b)(1),
the starting point of the calculation. The question for the
Court, therefore, is what constitutes "gross income" for
purposes of Section 543(b)(1) and the applicable regulations
in effect and pertinent to the taxable years at issue.
IV
Defendant claims that under Section 543 and the
applicable regulations "gross income" means gross sales (or
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receipts or revenues) reduced by "lifting costs." In support of
this view, Defendant relies almost exclusively on Revenue
Ruling 60-344, 1960-2 C.B. 186 and Laguna Royalty Co. v.
Commissioner, 406 F.2d 703 (5th Cir. 1969), aff’g, 27
T.C.M. (CCH) 164 (1968). Based on these authorities, and
using this method of calculating "gross income," Defendant
argues that Rhoades Oil should be classified as a personal
holding company for the taxable years in question. The
Court, however, believes that Defendant’s reliance upon these
authorities is misplaced.
In Revenue Ruling 60-344, the taxpayer sought advice
as to whether "lifting costs" constitute a part of production
costs in the determination of "gross income" from oil
production under the provisions of Section 61 (a) of the Code
relating to the definition of gross income, and Section 542(a)
of the Code relating to the definition of a personal holding
company.
At the time of Revenue Ruling 60-344, Section 61(a)
provided that "gross income means all income from whatever
source derived, including (but not limited to) . . . (2) Gross
income derived from business...." These provisions remained
in effect through taxable years 1988, 1989. and 1990. By
contrast, however, Section 542 and Section 543, which were
subsequently amended in 1964, were materially different
prior to the taxable years at issue here, Stating in applicable
part:
Section 542 [1954 Code]. (a) GENERAL
RULE. - For purposes of this subtitle, the term
"personal holding company" means any Corporation .
. if-
ii) @EREOSS INCOME
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REQUIREMENT. - At least 80 percent of its
gross income for the taxable year is personal
holding company income as defined in section
FES ks
Section 543 [1954 Code]. (a) GENERAL
RULE. - For purposes of this subtitle, the term
"personal holding company income" means _ the
portion of the gross income which consists of:
(1) DIVIDENDS * * *
(2) STOCK AND SECURITIES TRANSACTIONS * * *
(3) COMMODITIES TRANSACTIONS * * *
(4) ESTATES AND TRUSTS * * *
(5) PERSONAL SERVICE CONTRACTS * * *
(6) USE OF CORPORATION PROPERTY BY
SHAREHOLDERS * * *
(7) RENTS ***
(8) MINERAL, OIL AND GAS ROYALTIES * * *
Therefore, the question presented to the Service in Revenue
Ruling 60-344 was the meaning of the term "gross income"
as used in these pre-1964 provisions of the Code.
Moreover, without reasoning or justification, Revenue
Ruling 60-344 declared that Treas. Reg. § 1.61 -3,°°°™” which
*eee%
Treas. Reg. § 1.61-3(a) provides in applicable part:
(a) Jn general. In a manufacturing, merchandising, or mining
business, "gross income” means the total sales, less the cost of goods
sold, plus any income from investments and from incidental or outside
operations or sources. Gross income is determined without subtraction
of depletion allowances based on a percentage of income to the extent that
it exceeds cost depletion which may be required to be included in the
amount of inventoriable costs as provided in Section 1.471-11 and without
subtraction of selling expenses, losses or other items not ordinarily used
in computing costs of goods sold or amounts which are a type for which
i i lili on si an ie,
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by its terms pertains to "a manufacturing, merchandising, or
mining business", applied equally to an oil and gas business
for purposes of Section 542, and proceeded to analyze the
treatment of "lifting costs" under this provision of the
regulations. ******
Revenue Ruling 60-344 concluded that:
. . . in the case of oil and gas producing properties, "lifting
costs" constitute a portion of the cost of producing oil and
gas and must be subtracted from gross sales in computing
gross income for the purpose of determining whether
personal holding company income, as defined in section
543 of the Code, is at least 80 percent of the corporation’s
gross income for a taxable year.
In Laguna Royalty Co., the Fifth Circuit adopted
a deduction would be disallowed under Section 162(c), (f), or (g) in the
case of a business expense. The costs of goods sold should be determined
in accordance with the method of accounting consistently used by the
taxpayer.
“***Revenue Ruling 60-344 expressly relied upon Treas. Reg.
§ 1.61 -3 stating:
Section 61(a) of the Code provides, in part, that gross income
includes gross income derived from business. Section 1.61 -3 of the
regulations defines gross income in the case of manufacturing,
merchandising, or mining business as total sales, less the cost of goods
sold, plus any income from investments and from incidental or outside
operations or sources. In determining gross income, a subtraction should
not be made for depletion allowances based on a percentage of income,
selling expenses, losses, or other items not ordinarily used in computing
cost of goods sold. However, a taxpayer may elect to subtract for
depreciation or depletion based on cost incurred in connection with the
production of goods or materials in determining gross income. See Rev.
Rul. 141, C.B. 1953-2, 101.
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without discussion the findings and conclusions of the Tax
Court memorandum opinion. 406 F.2d 703. In turn, the
memorandum opinion, without informative analysis, adopted
Revenue Ruling 60-344 and determined that the issue should
be decided under I.R.C. § 61(a)(2) and Treas. Reg. § 1.61-
3.°°°""""" The Tax Court concluded:
We agree with respondent that, in the instant case, the term
gross income” means the gross sales in the amount for
which the oil and gas was sold in the immediate vicinity of
the wells, less “lifting costs." This position, as set forth in
Rev. Rul. 60344, 1960-2 C.B. 186 is that:
[ijn the case of oil and gas producing properties,
"lifting costs" constitute a portion of the cost of
producing the oil and gas and must be subtracted
from gross sales in computing gross income for the
purpose of determining whether personal holding
company income, as defined in section 543 of the
eeTeSee
The Court observes that in Laguna Royalty Co., as here,
the taxpayer argued that the treatment of “lifting costs" should be
determined by applying the definition of "gross income” contained in
Section 613 of the Code. 406 F.2d 703 (Sth Cir. 1969), aff'g 27 T.C.M.
(CCH) 164 (1968). The Tax Court properly rejected the taxpayer’s
argument and analyzed that case under Section 61, stating in part, "[t]he
term ‘gross income from the property’, as used in Section 613 for the
purposes of measuring the depletion or exhaustion of the natural resource,
is not the same as ‘gross income’ as used in Section 542(a)(1) for the
purpose of determining personal holding company tax liability." Id.
Similarly, in the instant case, this Court finds that Section 61, and not
Section 613, controls the definition of "gross income,” and thus Rhoades
Oil’s argument to the contrary is without merit. Accord Treas. Reg. §
1.542-2. As discussed more fuily below, the Court departs from Laguna
Royalty Co. by concluding that Treas. Reg. § 1.61-3, which refers to
“mining,” does not also apply to “oil and gas” under the statute as it
existed following the 1964 amendments.
ee ee eee ee ee
s og Oe ee PP ee ap ee eT ee
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Internal Revenue Code of 1954, is at least 80
percent of the corporation’s total gross income for
a taxable year.
In our opinion this is a correct statement of the rule
applicable herein.
With respect to Treas. Reg. § 1.61-3, the Tax Court stated:
Section 61 provides, in pertinent part, that gross
income includes "gross income derived from
business," and section 1.61-3 of the Regulations
defines gross income in the case of a manufacturing,
merchandising or mining business as total sales, less
cost of goods sold.
V
The authorities cited by Defendant all rely upon Treas. Reg.
§ 1.61-3 in deciding that "lifting costs" must be subtracted
from gross receipts to determine "gross income" under
Section 543(b)(1). These decisions apparently are based on
the view that the oil and gas business is included in the
phrase "manufacturing, merchandising, or mining business"
contained in the regulation.
Whether these authorities, which construed the term
"gross income" for purposes of Section 542(a)(1) of the pre-
1964 statute, were correctly decided, need not be determined
here. Indeed, nothing in the pre-1964 statute is presently
before this Court. What is before the Court is the law in
effect and applicable to taxable years 1988,1989, and 1990.
The Court finds that Revenue Ruling 60-344 and the case law
cited by Defendant in its brief all pertain to the pre-1964
Statute and thus are not binding in deciding the instant case.
Accordingly, the Court must look to the plain language of the
Code and the regulations in effect during the taxable years at
ee
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issue.
Two of the relevant provisions of the Code provide as
follows:
SECTION 541. IMPOSITION OF PERSONAL HOLDING
COMPANY TAX. In addition to other taxes imposed by
this chapter, there is hereby imposed for each taxable year
on the undistributed personal holding company income (as
defined in section 545) of every personal holding company
(as defined in section 542) a personal holding company tax
equal to 39.6 percent of the undistributed personal holding
company income.
SECTION 542. DEFINITION OF PERSONAL HOLDING
COMPANY. (a) GENERAL RULE - For purposes of this
subtitle, the term "personal holding company" means any
corporation (other than a corporation described in
subsection (c)) if-
(1) ADJUSTED ORDINARY GROSS INCOME
REQUIREMENT. - At least 60 percent of its
adjusted ordinary gross income (as defined in
section 543(b)(2)) for the taxable year is personal
holding company income (as defined in section
543(a)) ....
Revenue Ruling 60-344 construed the term "gross
income" as set forth in Section 542 as it existed prior to
1964. Clearly, however, following the 1964 amendments,
Section 542 no longer contained the term "gross income."
Rather, the section used the term “adjusted ordinary gross
income" instead of "gross income" and expressly stated that
the term is defined in Section 543(b)(2).
The language in Section 543(b) is illuminating for at
least two reasons. First, this is a new definition section
added by the 1964 amendments to set forth a determination
—— ee
-A-21-
of "adjusted ordinary gross income" step-by-step from "gross
income" to "ordinary gross income," I.R.C. § 543(b)(1), and
from "ordinary gross income" to "adjusted ordinary gross
income," I.R.C. § 543(b)(2). Second, the provision sets
forth the proper treatment of oil and gas royalties and
working interests in oil and gas wells, and expressly
distinguishes such royalties and interests from mineral
royalties, which are also specifically addressed. I.R.C. §
543(b)(2)(B).
The question for this Court is the meaning of "gross
income" as that term is used in Section 543(a)(1), the starting
point of the relevant valculation. Defendant first contends that
the Court should defer to Revenue Ruling 60-344, citing
Dunn v. United States, 468 F. Supp. 991, 993 (S.D.N.Y.
1979) (holding that revenue rulings have "the power of legal
precedents unless unreasonable or inconsistent with the
provisions of the Internal Revenue Code.") This revenue
ruling, however, construed the term "gross income"
contained in Section 542 prior to the 1964 amendments. As
a result of these amendments, Section 542 no longer contains
the term "gross income." Instead, "gross income" is used as
the starting point of the new definition section in Section
543(b), which definition section sets forth certain adjustments
and other calculations including specific subtractions to arrive
at the "gross income" both "from mineral, oil and gas
royalties" and "from working interests in an oil and gas
well." These adjustments and calculations were not in the
pre-1964 statute. In light of the material changes in the
statute, the Court rejects Defendant’s contention that Revenue
Ruling 60-344 and case law adopting its rationale control the
instant case.
-A-22-
Defendant next contends that, even if Revenue Ruling
60-344 and the cases that follow this ruling are no longer
controlling, the reasoning of such authorities should be
followed. Under this theory, for the reasons described above,
the Court would be required to apply Treas. Reg. § 1.61-3. |
As noted above, Treas. Reg. § 1.61-3 applies to "a
manufacturing, merchandising or mining business."
Defendant, however, has identified no authority whatsoever
to support its claim that "oil and gas" is synonymous with
"mining". Moreover, anyone familiar with the history of
Oklahoma is fully aware of the distinct contributions that the
oil industry and the mining industry have each made to the
State and, to date, the Court is unaware of any instance in
which anyone. has confused one industry with the other.
The assertion by Defendant that "oil and gas"
constitutes "mining" is even more incredible in the context of
the statute itself. As noted above, Section 543(b)(2) expressly
distinguishes between "oil," "gas," and "minerals." Thus, the
drafters of Section 543(b)(2) were clearly aware of the
#—<Hifferences between minerals, oil, and gas. Therefore, the
Court assumes that the drafters of Section 543(b)(1) were also
aware of this distinction. The Court finds that, for purposes
of defining "gross income" as the starting point of the
calculation in Section 543(b)(1), the drafters did not intend
the term "mining" to encompass "oil and gas".
Although ignoring the plain language of both the
statute and Treas. Reg. § 1.61-3, Defendant asserts further
that "mining" must include “oil and gas," because each
endeavor involves "the extraction of natural resources from
the earth." In its brief, Defendant states that:
[t}here is nothing to suggest that the activities of
-A-23-
Rhoades Oil should be treated differently than any
mining activity for purposes of Treas. Reg. § 1.61-
3(a) - both involve the extraction of natural
resources from the earth. And for purposes of the
personal holding company test, there can certainly
be no rationale for distinguishing them.
As noted above, however, this statute is technical in nature
and must be strictly applied according to its plain language.
See Montgomery Coca-Cola Bottling Co., 615 F.2d at 1323.
Strict statutory construction forbids substituting the term "oil
and gas" for "mining" simply because they both involve the
"extraction of natural resources from the earth." If the
Commissioner and the Secretary of the Treasury had intended
to apply Treas. Reg. § 1.61 -3 to "oil and gas” as well as to
"mining", then this provision of the regulations should have
referred to “the extraction of natural resources from the
earth.""""""""" See e.g. Granquist v. Hackleman, 264 F.2d 9.
16 (9th Cir. 1959) (stating "[a] Treasury Regulation has the
force and effect of law only if it is consistent with and
Defendant argues that the fact that Congress "made no
changes to the definition of "gross income’ in the Revenue Act of 1964
counsels that Congress acquiesced in the IRS’s interpretation of Revenue
Ruling 60-344. It is long-established that *[a]dministrative’ construction
must be deemed to have received legislative approval by the re-enactment
of the statutory provision, without material change." This argument is
wholly without merit. As noted herein, the 1964 amendments contained
material changes to the statute, including a detailed definitional section
that expressly distinguished between minerals and oil and gas. A more
reasonable conclusion is that if the Service and the Department of
Treasury had intended to continue to treat “oil and gas” in the same
fashion as "mining," then the Commissioner and the Secretary would have
amended the regulations to reflect the changes in the statute.
-A-24-
reasonably adapted to the enforcement of a revenue statute.")
In summary, the Court concludes that for purposes of
determining “gross income" under Section 542, the
controlling authority is Section 61. Section 1.61-3 of the
regulations, however, does not apply to "oil and gas,"
because it only refers to "mining" and the statute specifically
distinguishes between "minerals" and "oil and gas." I.R.C.
§ 543(b)(2)(B). The authorities cited by Defendant to the
contrary are inapposite because this provision of the Code
was materially amended in 1964, and the delineation between
"minerals" and "oil and gas" was reflected in a new
definitional section added by the 1964 amendments. Under
general principles, "gross income" refers to "gross income
derived from business." I.R.C. § 61(a)(2). Absent an express
statement to the contrary in the statute or applicable
regulations, "lifting costs" should be treated as operating
costs under general principles and therefore should not be
subtracted from gross profits to determine "gross income."
Applying these principles to the instant case, Rhoades
Oil is not a personal holding company as that term is defined
in Sections 541 through 543 of the Code for taxable years
1988, 1989, and 1990. Therefore, summary judgment is
hereby granted for the Plaintiff.“*""*""”
Stseesese
Treas. Reg. § 1.61-3 provides that the "cost of goods
sold should be determined in accordance with the method of accounting
consistently used by the taxpayer." Accordingly, Plaintiff argues that the
method of accounting consistently used by Rhodes Oil reflects "lifting
costs” in the category "Operating Expenses" rather than in the category
"Cost of Sales," and that this treatment should be respected under the
regulations. Because the Court has determined that, for the reasons
discussed herein, this regulation does not apply to “oil and gas,” it is
-A-25-
IT IS SO ORDERED.
This 14th day of February, 1996.
/s/ Sven Erik Holmes
Sven Erik Holmes
United States District Judge
unnecessary to reach this issue.
-A-26-
IN THE UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF OKLAHOMA
Case No. 93-C-0036-H
[File Stamped 2/20/96]
RHOADES OIL COMPANY,
Plaintiff,
vs.
UNITED STATES OF AMERICA,
Defendant.
JUDGMENT
The Court duly considered the issues and rendered a
decision in accordance with the order filed on February 15,
1996.
IT IS THEREFORE ORDERED, ADJUDGED AND
DECREED that judgment is hereby entered for the Plaintiff
and against the Defendant for taxes and interest paid in the
amount of $503,689.00, plus interest as allowed by law.
IT IS SO ORDERED.
This 19th day of February, 1996.
/s/ Sven Erik Holmes
Sven Erik Holmes
United States District Judge
“Att?
STATUTES AND REGULATIONS
Title 26, United State Code
§ 61. Gross income defined.
(a) General definition.--Except as otherwise provided
in this subtitle, gross income means all income from whatever
source derived, including (but not limited to) the following
items:
(2) Gross income derived from business;
* k %
§ 162. Trade or business expenses.
(a) In general.--There shall be allowed as a deduction
all the ordinary and necessary expenses paid or incurred
during the taxable year in carrying on any trade or business,
including--
(1) a reasonable allowance for Salaries or
other compensation for personal services actually
rendered;
(2) traveling expenses (including amounts
expended for meals and lodging other than amounts
which are lavish or extravagant under the
Circumstances) while away from home in the pursuit
of a trade or business; and
(3) rentals or other payments required to be
made as a condition to the continued use or
possession, for purposes of the trade or business, of
-A-28-
property to which the taxpayer has not taken or is not
taking title or in which he has no equity.
For purposes of the preceding sentence, the place of
residence of a Member of Congress (including any Delegate
and Resident Commissioner) within the State, congressional
district, or possession which he represents in Congress shall
be considered his home, but amounts expended by such
Members within each taxable year for living expenses shall
not be deductible for income tax purposes in excess of
$3,000. For purposes of paragraph (2), the taxpayer shall
not be treated as being temporarily away from home during
any period of employment if such period exceeds 1 year.
* * *
§ 471. General rule for inventories.
(a) General rule.--Whenever in the opinion of the
Secretary the use of inventories is necessary in order clearly
to determine the income of any taxpayer, inventories shall be
taken by such taxpayer on such basis as the Secretary may
prescribe as conforming as nearly as may be to the best
accounting practice in the trade or business and as most
clearly reflecting the income.
(b) Cross reference.-- For rules relating to
capitalization of direct and indirect costs of property, see
section 263A.
-A-29-
§ 542. Definition of personal holding company.
(a) General rule.--For purposes of this subtitle, the
term "personal holding company" means any corporation
(other than a corporation described in subsection (c)) if--
(1) Adjusted ordinary gross income
requirement.--At least 60 percent of its adjusted
ordinary gross income (as defined in section
543(b)(2)) for the taxable year is personal holding
company income (as defined in section 543(a)), and
(2) Stock ownership requirement.--At any time
during the last half of the taxable year more than 50
percent in value of its outstanding stock is owned,
directly or indirectly, by or for not more than 5
individuals. For purposes of this paragraph, an
organization described in section 401(a), 501(c)(17),
or 509(a) or a portion of a trust permanently set aside
or to be used exclusively for the purposes described
in section 642(c) or a corresponding provision of a
prior income tax law shall be considered an
individual.
§ 543 Personal holding company income.
(a) General rule.--For purposes of this subtitle, the
term "personal holding company income" means the portion
of the adjusted ordinary gross income which consists of:
(1) Dividends, etc.--Dividends, _ interest,
royalties (other than mineral, oil, or gas royalties or
-A-30-
copyright royalties), and annuities.
(2) Rents.--The adjusted income from rents;
except that such adjusted income shall not be included
if--
(A) such adjusted income constitutes 50
percent or more of the adjusted ordinary gross
income, and
(B) the sum of--
(i) the dividends paid during the
taxable year (determined under section
562),
(ii) the dividends considered as
paid on the last day of the taxable year
under section 563(d) (as limited by the
second sentence of section 563(b)),
and
(iii) the consent dividends for
the taxable year (determined under
section 565), equals or exceeds the
amount, if any, by which the personal
holding company income for the
taxable year (computed without regard
to this paragraph and paragraph (6),
and computed by including as personal
holding company income copyright
royalties and the adjusted income from
mineral, oil, and gas royalties) exceeds
10 percent of the ordinary gross
income.
(3) Mineral, oil, and gas royalties.--The
-A-31-
adjusted income from mineral, oil, and gas royalties;
except that such adjusted income shall not be included
if--
(A) such adjusted income constitutes 50
percent or more of the adjusted ordinary gross
income,
(B) the personal holding company
income for the taxable year (computed without
regard to this paragraph, and computed by
including as personal holding company income
copyright royalties and the adjusted income
from rents) is not more than 10 percent of the
ordinary gross income, and
(C) the sum of the deductions which
are allowable under section 162 (relating to
trade or business expenses) other than--
(i) deductions for compensation
for personal services rendered by the
shareholders, and
(ii) deductions which are
specifically allowable under sections
other than section 162, equals or
exceeds 15 percent of the adjusted
ordinary gross income.
(4) Copyright royalties.--Copyright royalties;
except that copyright royalties shall not be included
if--
(A) such royalties (exclusive of
royalties received for the use of, or right to
use, copyrights or interests in copyrights on
works created in whole, or in part, by any
-A-32-
shareholder) constitute 50 percent or more of
the ordinary gross income,
(B) the personal holding company
income for the taxable year computed--
(i) without regard to copyright
royalties, other than royalties received
for the use of, or right to use,
copyrights or interests in copyrights in
works created in whole, or in part, by
any shareholder owning more than 10
percent of the total outstanding capital
stock of the corporation,
(ii) without regard to dividends
from any corporation in which the
taxpayer owns at least 50 percent of all
classes of stock entitled to vote and at
least 50 percent of the total value of all
classes of stock and which corporation
meets the requirements of this
subparagraph and subparagraphs (A)
and (C), and
(iii) by including as personal
holding company income the adjusted
income from rents and the adjusted
income from mineral, oil, and gas
royalties, is not more than 10 percent
of the ordinary gross income, and
(6) Use of corporate property by shareholder. --
-A-33-
(A) Amounts received as compensation
(however designated and from whomever
received) for the use of, or the right to use,
tangible property of the corporation in any
case where, at any time during the taxable :
year, 25 percent or more in value of the
outstanding stock of the corporation is owned,
directly or indirectly, by or for an individual
entitled to the use of the property (whether
such right is obtained directly from the
corporation or by means of a sublease or other
arrangement).
(B) Subparagraph (A) shall apply only
to a corporation which has personal holding
company income in excess of 10 percent of its
ordinary gross income.
(C) For purposes of the limitation in
subparagraph (B), personal holding company
income shall be computed--
(i) without regard to
subparagraph (A) or paragraph (2),
(ii) by excluding amounts
received as compensation for the use of
(or right to use) intangible property
(other than mineral, oil, or gas
royalties or copyright royalties) if a
substantial part of the tangible property
used in connection with such intangible
property is owned by the corporation
and all such tangible and intangible
property is used in the active conduct
-A-34-
of a trade or business by an individual
a individuals described in subparagraph
(A), and
(iii) by including copyright
royalties and adjusted income from
mineral, oil, and gas royalties.
(b) Definitions.--For purposes of this part--
(1) Ordinary gross income.--The term
"ordinary gross income" means the gross income
determined by excluding--
(A) all gains from the sale or other
disposition of capital assets,
(B) all gains (other than those referred
to in subparagraph (A)) from the sale or other
disposition of property described in section
1231(b), and
(2) Adjusted ordinary gross income.--The term
"adjusted ordinary gross income" means the ordinary
gross income adjusted as follows:
(B) Mineral royalties, etc.--From the
gross income from mineral, oil, and gas
-A-35-
royalties described in paragraph (4), and from
the gross income from working interests in an
oil or gas well, subtract the amount allowable
as deductions for--
(i) exhaustion, wear and tear,
obsolescence, amortization, and
depletion,
(ii) property and severance
taxes,
(ili) interest, and
(iv) rent, to the extent allocable,
under regulations prescribed by the
Secretary, to such gross income from
royalties or such gross income from
working interests in oil or gas wells.
The amount subtracted under this
subparagraph with respect to royalties
Shall not exceed the gross income from
such royalties, and the amount
subtracted under this subparagraph with
respect to working interests shall not
exceed the gross income from such
working interests.
(4) Adjusted income from mineral, oil, and gas
royalties.--The term "adjusted income from mineral,
oil, and gas royalties" means the gross income from
mineral, oil, and gas royalties (including production
payments and overriding royalties), reduced by the
-A-36-
amount subtracted under paragraph (2) (B) of this
subsection in respect of such royalties.
§613 Percentage depletion.
(a) General rule.--In the case of the mines, wells, and
other natural deposits listed in subsection (b), the allowance
for depletion under section 611 shall be the percentage,
specified in subsection (b), of the gross income from the
property excluding from such gross income an amount equal
to any rents or royalties paid or incurred by the taxpayer in
respect of the property. Such allowance shall not exceed 50
percent (100 percent in the case of oil and gas properties) of
the taxpayer’s taxable income from the property (computed
without allowance for depletion). For purposes of the
preceding sentence, the allowable deductions taken into
account with respect to expenses of mining in computing the
taxable income from the property shall be decreased by an
amount equal to so much of any gain which (1) is treated
under section 1245 (relating to gain from disposition of
certain depreciable property) as ordinary income, and (2) is
properly allocable to the property. In no case shall the
allowance for depletion under section 611 be less than it
would be if computed without reference to this section.
-A-37-
(b) Percentage depletion rates.--The mines, wells, and
other natural deposits, and the percentages, referred to in
subsection (a)
States--
are as follows:
(1) 22 percent--
(A) sulphur and uranium; and
(B) if from deposits in the United
States--anorthosite, clay, laterite, and nephelite
syenite (to the extent that alumina and
aluminum compounds are extracted
therefrom), asbestos, bauxite, celestite.
chromite, corundum, fluorspar, graphite,
ilmenite, kyanite, mica, olivine. quartz crystals
(radio grade), rutile, block steatite talc, and
zircon, and ores of the following metals:
antimony, beryllium, bismuth, cadmium.
cobalt, columbium, lead, lithium, manganese,
mercury, molybdenum, nickel, platinum and
platinum group metals, tantalum, thorium, tin,
titanium, tungsten, vanadium, and zinc.
(2) 15 percent--If from deposits in the United
(A) gold, silver, copper, and iron ore.
and
(B) oil shale (except shale described in
paragraph (5)).
(3) 14 percent--
(A) metal mines (if paragraph (1)(B) or
(2A) does not apply), rock asphalt, and
vermiculite; and
(B) if paragraph (1)(B), (5), or (6)(B)
does not apply, ball clay, bentonite, china
-A-38-
clay, sagger clay, and clay used or sold for
use for purposes dependent on its refractory
-_properties.
(4) 10 percent--asbestos (if paragraph (1)(B)
does not apply), brucite, coal, lignite, perlite, sodium
chloride, and wollastonite.
(5) 7 1/2 percent--clay and shale used or sold
for use in the manufacture of sewer pipe or brick, and
clay, shale, and slate used or sold for use as sintered
or burned lightweight aggregates.
(6) 5 percent--
(A) gravel, peat, pumice, sand, scoria,
shale (except shale described in paragraph
(2)(B) or (5)), and stone [FN1] except stone
described in paragraph (7));
(B) clay used, or sold for use, in the
manufacture of drainage and roofing tile,
flower pots, and kindred products; and
(C) if from brine wells--bromine,
calcium chloride, and magnesium chloride.
(7) 14 percent--all other minerals, including,
but not limited to, aplite, barite, borax, calcium
carbonates, diatomaceous earth, dolomite, feldspar,
fullers earth, garnet, gilsonite, granite, limestone,
magnesite, magnesium carbonates, marble, mollusk
Shells (including clam shells and oyster shells),
phosphate rock, potash, quartzite, slate, soapstone,
stone (used or sold for use by the mine owner or
operator as dimension stone or ornamental stone),
thenardite, tripoli, trona, and (if paragraph (1)(B) does
not apply) bauxite, flake graphite, fluorspar,
-A-39-
lepidolite, mica, spodumene, and talc (including
Pyrophyllite), except that, unless sold on bid in direct
competition with a bona fide bid to sell a mineral
listed in paragraph (3), the percentage shall be 5
percent for any such other mineral (other than slate to
which paragraph (5) applies) when used, or sold for
use, by the mine owner or operator as rip rap, ballast,
road material, rubble, concrete aggregates, or for
similar purposes. For purposes of this paragraph, the
term “all other minerals" does not include--
(A) soil, sod, dirt, turf. water, or
mosses;
(B) minerals from sea water, the air, or
similar inexhaustible sources: or
(C) oil and gas wells.
For the purposes of this subsection, minerals (other
than sodium chloride) extracted from brines pumped
from a saline perennial lake within the United States
Shall not be considered minerals from an inexhaustible
source.
(c) Definition of gross income from property .--For
purposes of this section--
(1) Gross income from the property .--The term
"gross income from the property" means, in the case
of a property other than-an oil or gas well and other
than a geothermal deposit, the gross income from
mining.
(2) Mining.--The term "mining" includes not
merely the extraction of the ores or minerals from the
ground but also the treatment processes considered as
mining described in paragraph (4) (and the treatment
-A-40-
processes necessary or incidental thereto), and so
much of the transportation of ores or minerals
(whether or not by common carrier) from the point of
extraction from the ground to the plants or mills in
which such treatment processes are applied thereto as
is not in excess of 50 miles unless the Secretary finds
that the physical and other requirements are such that
the ore or mineral must be transported a greater
distance to such plants or mills.
(3) Extraction of the ores or minerals from the
ground.--The term "extraction of the ores or minerals
from the ground" includes the extraction by mine
owners or operators of ores or minerals from the
waste or residue of prior mining. The preceding
sentence shall not apply to any such extraction of the
mineral or ore by a purchaser of such waste or
residue or of the rights to extract ores or minerals
therefrom.
(4) Treatment processes considered as
mining.--The following treatment processes where
applied by the mine owner or operator shall be
considered as mining to the extent they are applied to
the ore or mineral in respect of which he is entitled to
a deduction for depletion under section 611:
(A) In [FN2] the case of
coal--cleaning, breaking, sizing, dust allaying,
treating to prevent freezing, and loading for
shipment;
(B) in the case of sulfur recovered by
the Frasch process--cleaning, pumping to vats,
cooling, breaking, and loading for shipment;
-A-41-
(C) in the case of iron ore, bauxite,
ball and sagger clay, rock asphalt, and ores or
minerals which are customarily sold in the
form of a crude mineral product--sorting,
concentrating, sintering, and substantially
equivalent processes to bring to shipping grade
and form, and loading for shipment:
(D) in the case of lead, zinc, copper,
gold, silver, uranium, or fluorspar ores,
potash, and ores or minerals which are not
customarily sold in the form of the crude
mineral product--crushing, grinding, and
beneficiation by concentration (gravity,
flotation, amalgamation, electrostatic. or
Magnetic), cyanidation, leaching,
crystallization, precipitation (but not including
electrolytic deposition, roasting, thermal or
electric smelting, or refining), or by
substantially equivalent processes or
combination of processes used in the
Separation or extraction of the product or
products from the ore or the mineral or
minerals from other material from the mine or
other natural deposit;
(E) the pulverization of talc, the
burning of magnesite, the sintering and
nodulizing of phosphate rock, the
decarbonation of trona, and the furnacing of
quicksilver ores;
(F) in the case of calcium carbonates
and other minerals when used in making
-A-42-
cement--all processes (other than preheating of
the kiln feed) applied prior to the introduction
of the kiln feed into the kiln, but not including
any subsequent process;
(G) in the case of clay to which
paragraph (5) or (6)(B) of subsection (b)
applies--crushing, grinding, and separating the
mineral from waste, but not including any
subsequent process;
(H) in the case of oil shale--extraction
from the ground, crushing, loading into the
retort, and retorting, but not hydrogenation,
refining, or any other process subsequent to
retorting; and
(I) any other treatment process
provided for by regulations prescribed by the
Secretary which, with respect to the particular
ore or mineral, is not inconsistent with the
preceding provisions of this paragraph.
(5) Treatment processes not considered as
mining.--Unless such processes are otherwise
provided for in paragraph (4) (or are necessary or
incidental to processes so provided for), the following
treatment processes shall not be considered as
"mining": electrolytic deposition, roasting, calcining,
thermal or electric smelting, refining, polishing, fine
pulverization, blending with other materials, treatment
effecting a chemical change, thermal action, and
molding or shaping.
(d) Denial of percentage depletion in case of oil and
gas wells.--Except as provided in section 613A, in the case
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of any oil or gas well, the allowance for depletion shall be
computed without reference to this section.
(e) Percentage depletion for geothermal deposits. --
(1) In general.--In the case of geothermal
deposits located in the United States or in a possession
of the United States, for purposes of subsection (a)--
(A) such deposits shall be treated as
listed in subsection (b), and
(B) 15 percent shall be deemed to be
the percentage specified in subsection (b).
(2) Geothermal deposit defined.--For purposes
of paragraph (1), the term "geothermal deposit"
means a geothermal reservoir consisting of natural
heat which is stored in rocks or in an aqueous liquid
Or vapor (whether or not under pressure). Such a
deposit shall in no case be treated as a gas well for
purposes of this section or section 613A, and this
section shall not apply to a geothermal deposit which
is located outside the United States or its possessions.
(3) Percentage depletion not to include lease
bonuses, etc.--In the case of any geothermal deposit,
the term "gross income from the property" shall, for
purposes of this section, not include any amount
described in section 613A(d)(5).
[(4) Redesignated (3)]
* k
-A-44-
Title 26 Code of Federal Regulations
§1.61-1 Gross Income.
(a) General Definition. Gross income means all
income from whatever source derived, unless excluded by
law. Gross income includes income realized in any form,
whether in money, property, or services. Income may be
realized, therefore, in the form of services, meals,
accommodations, stock, or other property, as well as in cash.
Section 61 lists the more common items of gross income for
purposes of illustration. For purposes of further illustration,
§1.61-14 mentions several miscellaneous items of gross
income not listed specifically in section 61. Gross income,
however, is not limited to the items so enumerated.
§ 1.61-3 Gross income derived from business.
(a) In general. In a manufacturing, merchandising,
or mining business, "gross income" means the total sales, less
the cost of goods sold, plus any income from investments and
from incidental or outside operations or sources. Gross
income is determined without subtraction of depletion
allowances based on a percentage of income to the extent that
it exceeds cost depletion which may be required to be
included in the amount of inventoriable costs as provided in
§ 1.471-11 and without subtraction of selling expenses, losses
or other items not ordinarily used in computing costs of
goods sold or amounts which are of a type for which a
TS
-A-45-
deduction would be disallowed under section 162(c), (f), or
(g) in the case of a business expense. The cost of goods sold
should be determined in accordance with the method of
accounting consistently used by the taxpayer. Thus, for
example, an amount cannot be taken into account in the
computation of cost of goods sold any earlier than the taxable
year in which economic performance occurs with respect to
the amount (see § 1.446-1(c)(1)(ii)).
* *
§ 1.471-7 Inventories of miners and manufacturers.
A taxpayer engaged in mining or manufacturing who
by a single process or uniform series of processes derives a
product of two or more kinds, sizes, or grades, the unit cost
of which is substantially alike, and who in conformity to a
recognized trade practice allocates an amount of cost to each
kind, size, or grade of product, which in the aggregate will
absorb the total cost of production, may, with the consent of
the Commissioner, use such allocated cost as a basis for
pricing inventories, provided such allocation bears a
reasonable relation to the respective selling values of the
different kinds, sizes, or grades of product. See section 472
as to last-in, first-out inventories.
§ 1.471-8 Inventories of retail merchants.
(a) Retail merchants who employ what is known as the
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"retail method" of pricing inventories may make their returns
upon that method, provided that the use of such method is
designated upon the return, that accurate accounts are kept,
and that such method is consistently adhered to unless a
change is authorized by the Commissioner as provided in
paragraph (e) of § 1.446-1. Under the retail method the total
of the retail selling prices of the goods on hand at the end of
the year in each department or of each class of goods is
reduced to approximate cost by deducting therefrom an
amount which bears the same ratio to such total as--
(1) The total of the retail selling prices of the
goods included in the opening inventory plus the retail
selling prices of the goods purchased during the year,
with proper adjustment to such selling prices for all
mark-ups and mark-downs, less
(2) The cost of the goods included in the
opening inventory plus the cost of the goods
purchased during the year, bears to (1).
The result should represent as accurately as may be
the amounts added to the cost price of the goods to
cover selling and other expenses of doing business and
for the margin of profit. See §§ 1.263A-1 and
1.263A-3 for rules regarding the computation of costs
with respect to property acquired for resale.
(b) For further adjustments to be made in the case of
a retail merchant using the last-in, first-out inventory method
authorized by section 472, see paragraph (k) of § 1.472-1.
(c) A taxpayer maintaining more than one department
in his store or dealing in classes of goods carrying different
percentages of gross profit should not use a percentage of
profit based upon an average of his entire business, but
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should compute and use in valuing his inventory the proper
percentages for the respective departments or classes of
goods.
(d) A taxpayer (other than one using the last-in,
first-out inventory method) who previously has determined
inventories in accordance with the retail method, except that,
to obtain a basis of approximate cost or market, whichever is
lower, has consistently and uniformly followed the practice
of adjusting the retail selling prices of the goods included in
the opening inventory and purchased during the taxable year
for mark-ups but not for mark-downs, may continue such
practice subject to the conditions prescribed in this section.
The adjustments must be bona fide and consistent and
uniform. Where mark-downs are not included in the
adjustments, mark-ups made to cancel or correct mark-
downs shall not be included; and the mark-ups included must
be reduced by the mark-downs made to cancel or correct such
mark-ups.
(¢) In no event shall mark-downs not based on actual
reduction of retail sale prices, such as mark-downs based on
depreciation and obsolescence, be recognized in determining
the retail selling prices of the goods on hand at the end of the
taxable year.
(f) A taxpayer (other than one using the last-in,
first-out inventory method) who previously has determined
inventories without following the practice of eliminating
mark-downs in making adjustments to retail selling prices
may adopt such practice, provided permission to do so is
obtained in accordance with, and subject to the terms
provided by, paragraph (e) of § 1.446-1. A taxpayer filing
a first return of income may adopt such practice subject to
-A-48-
approval by the district director upon examination of the
return.
(g) A taxpayer using the last-in, first-out inventory
method in conjunction with retail computations must adjust
retail selling prices for mark-downs as well as mark-ups, in
order that there may be reflected the approximate cost of the
goods on hand at the end of the taxable year regardless of
market values.
§ 1.613-3 Gross income from the property.
In the case of oil and gas wells, gross income from
the property, as used in section 613(c)(1), means the amount
for which the taxpayer sells the oil or gas in the immediate
vicinity of the well. If the oil or gas is not sold on the
premises but is manufactured or converted into a refined
product prior to sale, or is transported from the premises
prior to sale, the gross income from the property shall be
assumed to be equivalent to the representative market or filed
price of the oil or gas before conversion or transportation.
* * *
§ 1.613-4 Gross income from the property in the case of
minerals other than oil and gas.
(a) In general. The rules contained in this section are
applicable to the determination of gross income from the
property in the case of minerals other than oil and gas and the
-A-49-
rules contained in § 1.613-3 are not applicable to such
determination, notwithstanding provisions to the contrary in
§ 1.613-3. The term "gross income from the property," as
used in section 613(c)(1), means, in the case of a mineral
property other than an oil or gas property, gross income from
mining. "Gross income from mining" is that amount of
income which is attributable to the extraction of the ores or
minerals from the ground and the application of mining
processes, including mining transportation. For the purpose
of this section, "ordinary treatment processes" (applicable to
the taxable years beginning before January 1, 1961) and
"treatment processes considered as mining" (applicable to the
taxable years beginning after December 31, 1960) will be
referred to as "mining processes." Processes, including
packaging and transportation, which do not qualify as mining
will be referred to as "nonmining processes." Also for the
purpose of this section, transportation which qualifies as
"mining" will be referred to as "mining transportation" and
transportation which does not qualify as "mining" will be
referred to as "nonmining transportation." See paragraph (f)
of this section for the definition of the term "mining" and
paragraph (g) of this section for rules relating to nonmining
processes.
(f) Definition of mining--
(1) In general. The term "mining" includes
only--
(i) The extraction of ores or minerals
from the ground;
-A-50-
(ii) Mining processes, as described in
subparagraphs (2) through (6) of this
paragraph; and
(iii) So much of the transportation
(whether or not by common carrier) of ores or
minerals from the point of extraction of the
ores or minerals from the ground to the plants
or mills in which the processes referred to in
subdivision (ii) of this subparagraph are
applied thereto as is not in excess of 50 miles,
and, if the Commissioner finds that both the
physical and other requirements are such that
the ores or minerals must be transported a
greater distance to such plants or mills, the
transportation over such greater distance as the
Commissioner authorizes. See paragraph (h)
of this section for rules relating to the filing of
applications to treat as mining = any
transportation in excess of 50 miles.
(2) Definition of mining processes.
(i) As used in subparagraph (1)(ii) of
this paragraph, the term "mining processes"
means, for taxable years beginning before
January 1, 1961, the ordinary treatment
processes normally applied by mine owners or
operators in order to obtain the commercially
marketable mineral product or products,
including the following processes (and the
processes necessary or incidental thereto), and,
for taxable years beginning after December
31, 1960, the following processes (and the
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processes necessary or incidental thereto):
(a) In the case of coal--cleaning,
breaking, sizing, dust allaying, treating
to prevent freezing, and loading for
shipment;
(b) In the case of sulfur
recovered by the _ Frasch
process--cleaning, pumping to vats,
cooling, breaking, and loading for
shipment;
(c) In the case of iron ore,
bauxite, ball and sagger clay, rock
asphalt, and ores or minerals which are
customarily sold in the form of a crude
mineral product (as defined in
subparagraph (3)(iv) of this
paragraph)--
(1) Where applied for
the purpose of bringing to
shipping grade and form (as
defined in subparagraph (3)(iii)
of this paragraph)--sorting,
concentrating, sintering, and
substantially equivalent
processes, and
(2) Loading for
shipment.
(d) In the case of lead, zinc.
copper, gold, silver, uranium, or
fluorspar ores, potash, and ores or
minerals which are not customarily
-A-52-
sold in the form of the crude mineral
product--crushing, grinding, and
beneficiation by concentration (gravity,
flotation, amalgamation, electrostatic,
or magnetic), cyanidation, leaching,
crystallization, precipitation (but not
including electrolytic deposition,
roasting, thermal or electric smelting,
or refining), or by _ substantially
equivalent processes or combination of
processes used in the separation or
extraction of the product or products
from the ore or the mineral or minerals
from other material from the mine or
other natural deposit; and
(e) In the case of the following
ores Or minerals--
(1) The furnacing of
quicksilver ores,
(2) The pulverization of
a Ye a ee Se” ey ee ee, ee
talc,
(3) The burning of
magnesite, and
(4) The sintering and
nodulizing of phosphate rock.
(ii) The term "mining processes" also
includes the following processes (and, except
as otherwise provided in this subdivision, the
processes necessary or incidental thereto):
(a) For taxable years beginning
‘
oe ee ek no a ee Te
-A-53-
after December 31, 1960, in the case
of calcium carbonates and other
minerals when used in making
cement--all processes (other than
preheating the kiln feed) applied prior
to the introduction of the kiln feed into
the kiln, but not including any
subsequent process;
(b) For taxable years beginning
after December 31, 1960, and before
November 14, 1966, in the case of
clay to which former section
613(b)(5)(B) applied, and for taxable
years beginning after November 13,
1966, in the case of clay to which
section 613(b)(5) or (6)(B)
applies--crushing, grinding, and
separating the clay from waste, but not
including any subsequent process;
(c) For taxable years beginning
after October 9, 1969, in the case of
minerals (other than sodium chloride)
extracted from brines pumped from a
saline perennial lake (as defined in
paragraph (b) of § 1.613-2)--the
extraction of such minerals from the
brines, but in no case including any
further processing or refining of such
extracted minerals; and
(d) For taxable years beginning
after December 30, 1969, in the case
-A-54-
of oil shale (as defined in paragraph (b)
of § 1.613-2)--extraction from the
ground, crushing, loading into the
retort, and retorting, but in no case
hydrogenation, refining, or any other
process subsequent to retorting.
(iti) A process is "necessary" to another
related process if it is prerequisite to the
performance of the other process. For
example, if the concentrating of low-grade
iron ores to bring to shipping grade and form
cannot be effectively accomplished without
fine pulverization, such pulverization shall be
treated as a process which is "necessary" to
the concentration process. Accordingly,
because concentration is a mining process,
such pulverization is also a mining process.
Furthermore, if mining processes cannot be
effectively applied to a mineral without storage
of the mineral while awaiting the application
of such processes, such storage shall be treated
as a process which is "necessary" to the
accomplishment of such mining processes. A
process is "incidental" to another related
process if the cost thereof is insubstantial in
relation to the cost of the other process, or if
the process is merely the coincidental result of
the application of the other process. For
example, the sprinkling of coal, prior to
loading for shipment, with dots of paper to
identify the coal for trade-name purposes will
-A-55-
be considered incidental to the loading where
the cost of that sprinkling is insubstantial in
relation to the cost of the loading process.
Also, where crushing of a crude mineral is
treated as a mining process, the production of
fines as a byproduct is ordinarily the
coincidental result of the application of a
mining process. If a taxpayer demonstrates
that, as a factual matter, a particular process is
necessary or incidental to a process named as
a mining process in section 613(c)(4) of this
paragraph, the necessary or incidental process
will also be considered a mining process.
(iv) The term "mining" does not
include purchasing minerals from another.
Accordingly, the processes listed in this
paragraph shall be considered as mining
processes only to the extent that they are
applied by a mine owner or operator to an ore
or mineral in respect of which he is entitled to
a deduction for depletion under section 611.
The application of these processes to
purchased ores, minerals, or materials does
not constitute mining.
(3) Processes recognized as mining for ores or
minerals covered by section 613(c)(4)(C).
(i) As used in section 613(c)(4)(C) and
subparagraph (2)(i)(c) of this paragraph, the
terms "sorting" and "concentrating" mean the
process of eliminating substantial amounts of
the impurities or foreign matter associated
-A-56-
with the ores or minerals in their natural state,
or of separating two or more valuable minerals
or ores, without changing the physical or
chemical identity of the ores or minerals.
Examples of sorting and _ concentrating
processes are hand or mechanical sorting,
magnetic separation, gravity concentration,
jigging, the use of shaking or concentrating
tables, the use of spiral concentrators, the use
of sluices or sluice boxes, sink-and-float
processes, classifiers, hydrotators and flotation
processes. Under section 613(c)(4)(C), sorting
and concentration will be considered mining
processes only where they are applied to bring
an ore or mineral to shipping grade and form.
(ii) As used in section 613(c)(4)(C) and
subparagraph (2)(i)(c) of this paragraph, the
term "sintering" means the agglomeration of
fine particles by heating to a temperature at
which incipient, but not complete, fusion
occurs. Sintering will be considered a mining
process only where it is applied to an ore or
mineral, or a concentrate of an ore or mineral,
as an auxiliary process necessary to bring the
ore or mineral to shipping form. A thermal
action which is applied in the manufacture of
a finished product will not be considered to be
a mining process even though such thermal
action may cause the agglomeration of fine
particles by incipient fusion, and even though
such action does not cause a chemical change
-A-57-
in the agglomerated particles. For example,
the sintering of finely ground iron ore
concentrate, prior to shipment from the
concentration plant, for the purpose of
preventing the risk of loss of the finely divided
particles during shipment is considered a
mining process. On the other hand, for
example, a heating process applied to expand
or harden clay, shale, perlite, vermiculite, or
other materials in the course of the
manufacture of lightweight aggregate or other
building materials is not considered to be a
mining process.
(iii) As used in section 613(c)(4)(C)
and this section, to “bring to shipping grade
and form" means, with respect to taxable years
beginning after December 31, 1960, to bring
(by the application of mining processes at the
mine or concentration plant) the quality or size
of an ore or mineral to the stage or Stages at
which the ore or mineral is shipped to
customers or used in nonmining processes (as
defined in paragraph (g) of this section) by the
taxpayer.
(iv) An ore or mineral is "customarily
sold in the form of a crude mineral product",
within the meaning of section 613(c)(4)(C), if
a significant portion of the production thereof
is sold or used in a nonmining process prior to
the alteration of its inherent mineral content by
some form of beneficiation, concentration, or
-A-58-
ore dressing. An ore or mineral does not lose
its classification as a crude mineral product by
reason of the fact that, before sale or use in a
nonmining process, the ore or mineral may be
crushed or subjected to other processes which
do not alter its inherent mineral content.
Whether the portion of production sold or used
in the form of a crude mineral product is a
significant portion of the total production of an
ore Or mineral is a question of fact.
(4) Type of processes recognized as mining for
ores Or minerals covered by section 613(c)(4)(D).
Cyanidation, leaching, crystallization, and
precipitation, which are listed in section 613(c)(4)(D)
as treatment processes considered as mining, and the
processes (or combination of processes) which are
substantially equivalent thereto, will be recognized as
mining only to the extent that they are applied to the
taxpayer's ore or mineral for the purpose of
separation or extraction of the valuable mineral
product or products from the ore, or for the purpose
of separation or extraction of the mineral or minerals
from other material extracted from the mine or other
natural deposit. A process, no matter how
denominated, will not be recognized as mining if the
process beneficiates the ore or mineral to the degree
that such process, in effect, constitutes smelting,
refining, or any other nonmining process within the
meaning of paragraph (g) of this section. As used in
section 613(c)(4)(D) and subparagraph (2)(i)(d) of this
paragraph, the term "concentration" has the meaning
-A-59-
set forth in the first two sentences of subparagraph
(3)(i) of this paragraph.
(5) Processes recognized as mining under
section 613(c)(4)(I). Under the authority granted the
Secretary or his delegate in section 613(c)(4)(I), the
processes which are described in subdivisions (i)
through (iv) of this subparagraph, and the processes
necessary or incidental thereto, are recognized as
mining processes for taxable years beginning after
December 31, 1960. The processes described in
subdivisions (i) through (iv) of this subparagraph are
in addition to the specific processes recognized as
mining under section 613(c)(4). Such additional
processes are:
(i) Crushing and grinding, but not fine
pulverization (as defined in paragraph (g)(6)(v)
of this section);
(ii) Size classification processes applied
to the products of an allowable mining
process;
(iii) Drying to remove free water,
provided that such drying does not change the
physical or chemical identity or composition of
the mineral; and
(iv) Washing or cleaning the surface of
mineral particles (including the washing of
sand and gravel and the treatment of kaolin
particles to remove surface stains), provided
that such washing or cleaning does not activate
or otherwise change the physical or chemical
-A-60-
structure of the mineral particles.
(6) In the case of a process applied subsequent
to a nonmining process, see paragraph (g)(2) of this
section.
* *
§1.614-3 Rules relating to separate operating mineral
interests in the case of mines.
..(e) Mine Defined. For purposes of this section, the
term "mine" means any excavation or other workings or
series or related excavations or related workings, as the case
may be, for the purpose of extracting any known mineral
deposit, except oil and gas deposits. For the purpose of the
proceeding sentence, the term "excavations" or "workings"
includes quarries, pits, shafts, and wells (except oil and gas
wells). The number of excavations or workings that
constitute a mine is to be determined upon the basis of the
facts and circumstances of the particular case such as the
nature and position of the mineral deposit or deposits, the
method of mining the mineral, the location of the excavations
or other workings in relation to the mineral deposit or
deposits, and the topography of the area. The determination
of the taxpayer as to the composition of a mine is to be
accepted unless there is a clear and convincing basis for
change in such determination.
-A-61-
IN THE UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF OKLAHOMA
Case No. 93-C-0036B
[File Stamped 1/14/93]
RHOADES OIL COMPANY,
Plaintiff,
VS.
UNITED STATES OF AMERICA,
Defendant.
COMPLAINT FOR REFUND
1. Plaintiff is Rhoades Oil Company (the
“Taxpayer"), an Delaware corporation with its principal place
of business in Tulsa, Oklahoma.
2. Defendant is the United States of America.
3. Plaintiff brings this action against the United States
of America for recovery of United States income taxes
illegally and erroneously assessed against and collected from
the Taxpayer. Taxpayer is an Oklahoma _ resident.
Jurisdiction is conferred upon this Court by 28 U.S.C. §
1346(a)(1). Venue for this action is the Northern District of
Oklahoma as provided by 28 U.S.C. § 1396.
4. Taxpayer is a working oil and gas company, and
has been since it was founded in 1945. Taxpayer is presently
the operator of approximately sixty oil and gas wells.
5. Taxpayer employs twenty people, including a full-
-A-62-
time geologist and a full-time land man. With the exception
of a single employee who spends time monitoring the
Taxpayer’s invested funds, all of these employees are
engaged in the Taxpayer’s business of exploration for and
exploitation of oil and gas reserves. Between 1988 and 1991,
Taxpayer drilled thirteen wells. Taxpayer owns substantial
percentages of sixty working interests, and is the operator of
most of these wells.
6. Because drilling for oil and gas is an expensive
and risky proposition, Taxpayer needs to build up and retain
substantial cash reserves. These cash reserves allow
Taxpayer to pay for drilling wells and absorb the losses of a
dry hole.
7. In addition to drilling and operating wells,
Taxpayer is the owner of both working and royalty interests
in wells. A working interest is one that shares in the risk and
cost of exploration and operation of a well. A royalty
interest is one that receives a portion of gross revenues from
oil and gas production, regardless of costs. Many of the
royalty interests owned by Taxpayer were obtained in
transactions whereby previously held working interests were
converted into royalty interests.
8. On July 31, 1991, Taxpayer received a letter from
the United States Internal Revenue Service ("IRS") notifying
the Taxpayer of proposed federal income tax deficiencies
under § 541 and § 542 of the Internal Revenue Code. These
sections impose, under certain circumstances, an additional
tax known as the personal holding company tax. The
personal holding company tax is designed to attack
"incorporated pocketbooks" in which an individual places
liquid assets, and then uses the assets to pay for expenses.
-A-63-
The key characteristic of a personal holding company is the
presence of substantial liquid assets that generate income, and
very little actual operations. The Taxpayer is not such an
incorporated pocketbook. It is an active oil and gas
company, which has substantial assets only because it has
been successfui and profitable in its business through the
years.
9. The notice of deficiency proposed assessments of
additional tax as follows:
TAX YEAR ADDITIONAL TAX
1988 $101,053.00
1989 $163,188.00
1990 $144,392.00
10. The-reason that the IRS claimed these additional
taxes were due was a change in the method by which the IRS
determines whether Taxpayer was a personal holding
company. In general, this test measures the income derived
from investments against that derived from operations. This
change was the deduction of "lifting costs" (the costs
associated with producing oil and gas after a well has been
drilled) from revenues generated by operations. If the
treatment of lifting costs had not changed, Taxpayer would
not have been found by the IRS to be a personal holding
company, and the tax would not have applied. This change
in the personal holding company test is contrary to the plain
language of § 542 of the Internal Revenue Code, under which
only depreciation, depletion, taxes, and interest are deducted
from oil and gas revenues.
11. Taxpayer attempted to resolve the dispute with
the IRS through a protest. This resulted in an admission by
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the IRS of an error in its calculations. Accordingly, the
amount of the proposed deficiency for tax year 1990 was
reduced to $144,392.00. However, the IRS denied
Taxpayer’s protest as to the merits on the issue of whether
the personal holding company tax should be assessed.
Taxpayer executed and delivered to the IRS a Form 870,
Waiver of Restrictions on Assessment and Collection of
Deficiency in Tax and Acceptance of Over Assessment,
whereby Taxpayer accepted the correct assessment amounts
as follows:
TAX YEAR ADDITIONAL TAX
1988 $101,053.00
1989 $163,188.00
1990 $144,392.00
12. Taxpayer has consented to assessment of the
corrected deficiencies, and has paid all additional tax and
interest contained in such assessment.
13. On or about May 22, 1992, Taxpayer filed a
Form 1120X - Amended U.S. Corporation Income Tax
Return for each of the tax years in question, in which
Taxpayer claimed refunds for all of the deficiencies assessed
by the IRS against Taxpayer and paid by Taxpayer, together
with all interest as allowed by law.
14. As of December 24, 1992, a date more than six
(6) months after the filing of the Taxpayer’s claims for
refund, Taxpayer has received no notice that such claims
have been approved or denied. Under § 6532 of the Internal
Revenue Code, the Taxpayer’s claims for refund are thus
deemed to be denied.
15. The attempt by the IRS to deduct lifting costs in
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calculating whether Taxpayer is a personal holding company
was improper, and is contrary to the plain wording of the
statute. Taxpayer is not a personal holding company, and the
personal holding company taxes assessed against Taxpayer for
1988, 1989, and 1990 were illegally and improperly assessed
and collected, and were contrary to law.
16. Taxpayer is the sole owner of the claims for
refund described above, and has made no assignment of such
claims.
WHEREFORE, Plaintiff Rhoades Oil Company prays
that this Court enter judgment in its favor and against
Defendant United States of America for taxes and interest
paid in the amount of $503,689.00, plus interest as allowed
by law.
DOERNER, STUART, SAUNDERS,
DANIEL & ANDERSON
By:__/s/ Charles Greenough
John B. Turner (OBA #9132)
Charles Greenough (OBA #12311)
320 South Boston, Suite 500
Tulsa, Oklahoma 74103
(918) 582-1211
Attorneys for the Plaintiff
Rhoades Oil Company
-A-66-
IN THE UNITED STATES DISTRICT COURT FOR
FOR THE NORTHERN DISTRICT OF OKLAHOMA
Case No. 93-C-0036B
[File Stamped 3/16/93]
RHOADES OIL COMPANY,
Plaintiff,
VS.
UNITED STATES OF AMERICA,
Defendant.
ANSWER TO COMPLAINT FOR REFUND
The United States hereby answers the Complaint as follows:
1. The United States lacks knowledge sufficient to
form a belief as to the truth of the allegations contained in
paragraph 1 of the Complaint.
2. The United States admits the allegations contained
in paragraph 2 of the Complaint.
3. The United States avers that if jurisdiction exists,
it exists by virtue of 28 U.S.C. Section 1346(a)(1), but denies
that the federal income tax in issue were illegally or
erroneously assessed or collected. The United States admits
that venue is proper in the Northern District of Oklahoma.
4. The United States lacks knowledge sufficient to
form a belief as to the truth of the allegations contained in
paragraph 4 of the Complaint.
5. The United States lacks knowledge sufficient to
-A-67-
form a belief as to the truth of the allegations contained in
paragraph 5 of the Complaint.
6. The United States lacks knowledge sufficient to
form a belief as to the truth of the allegations contained in
paragraph 6 of the Complaint.
7. The United States lacks knowledge sufficient to
form a belief as to the truth of the allegations contained in
paragraph 7 of the Complaint.
8. The United States admits the allegations contained
in the first sentence of paragraph 8, but avers that the
remainder of paragraph 8 contains legal argument and
conclusions requiring no response. To the extent the
remaining allegations require a response, the United States
lacks knowledge sufficient to form a belief as to the truth of
those allegations.
9. The United States admits the allegations contained
in paragraph 9 of the Complaint.
10. The United States avers that paragraph 10
contains legal argument and conclusions requiring no
response. To the extent the allegations require a response,
the United States lacks knowledge sufficient to form a belief
as to the truth of those allegations.
11. The United States lacks knowledge sufficient to
form a belief as to the truth of the allegations contained in the
first and second sentence of paragraph 11 of the complaint,
but admits the allegations contained in the remainder of
paragraph 11.
12. The United States admits the allegations contained
in paragraph 12 of the Complaint.
13. The United States admits that on June 1, 1992,
plaintiff filed a Form 1120X - Amended U.S. Corporation
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Income Tax Return for 1989 and 1990, but lacks knowledge
sufficient to form a belief as to whether such form was filed
with respect to 1988.
14. The United States lacks knowledge sufficient to
form a belief as to the truth of the allegations contained in
paragraph 14 of the Complaint.
15. The United States denies the allegations contained
in paragraph 15 of the Complaint.
16. The United States lacks knowledge sufficient to
form a belief as to the truth of the allegations contained in
paragraph 16 of the Complaint.
WHEREFORE, the United States prays that this Court
dismiss the Complaint with prejudice, and the this Court
grant such further relief as it deems proper.
TONY M. GRAHAM
United States Attorney
/s/ Christopher H. Grigorian
CHRISTOPHER H. GRIGORIAN
Trial Attorney
Tax Division
U.S. Department of Justice
P.O. Box 7238
Ben Franklin Station
Washington, D.C. 20044
Telephone: (202) 514-6520
-A-69-
96-5101
IN THE UNITED STATES COURT OF APPEALS
FOR THE TENTH CIRCUIT
RHOADES OIL COMPANY,
Plaintiff - Appellee
[File-Stamped
August 13, 1996]
UNITED STATES OF AMERICA,
Defendant - Appellant
ORAL ARGUMENT REQUESTED
ON APPEAL FROM THE JUDGMENT OF THE
UNITED STATES DISTRICT COURT FOR THE
NORTHERN DISTRICT OF OKLAHOMA
APPELLEE’S SUPPLEMENTAL APPENDIX
JOHN B. TURNER
CHARLES GREENOUGH
STUART, BIOLCHINI,
TURNER & GIVRAY
15 East Fifth Street, Suite 3300
First Place Tower
Tulsa, Oklahoma 74103
(918) 582-3311
Attorneys for Rhoades Oil
Company
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TABLE OF CONTENTS
-
7
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PAGES
|
Transcript of Deposition of Page 1-47
James M. Downs taken on
May 10, 1994, submitted to
District Court as Exhibit A of
Appendix to Brief of Rhoades Oil
Company filed May 31, 1994
IN THE UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF OKLAHOMA
Case No. 93-C-0036-B
[COPY]
RHOADES OIL COMPANY,
Plaintiff,
VS.
UNITED STATES OF AMERICA
Defendant.
THE DEPOSITION OF JAMES M. DOWNS,
taken on behalf of the Plaintiff, pursuant to the Federal Rules
of Civil Procedure, this 10th day of May, 1994, commencing
at the hour of 3:42 p.m., at the offices of Doerner, Stuart,
-A-71-
Saunders, Daniel, Anderson & Biolchini, 320 South Boston
Avenue, Suite 500, Tulsa, Oklahoma, before Cathleen E.
Marquardt, Certified Shorthand Reporter in and for the State
of Oklahoma.
JAMES M. DOWNS,
after having been first duly sworn to testify the truth, the
whole truth, and nothing but the truth, testified as follows:
DIRECT EXAMINATION
BY MR. GREENOUGH:
[PAGE 13, LINE 13]
Q
>O >
>
In your expert opinion for companies that are involved
solely in oil and gas exploration, do generally
accepted accounting principles require classification of
any costs as costs of goods sold?
No, they do not.
No issued financial accounting standard requires that?
No. That terminology has not been used as a cost
description, if you will, in FAS 19 or 69.
Is that classification used in customary industry
practice?
For companies involved exclusively in exploration and
production?
O>f
OO} >
QO >
-A-72-
Correct.
No, it is not.
For companies that are involved exclusively in oil and
gas exploration, does FAS 19 specify a classification
of the cost to operate and maintain wells and related
equipment and to the other costs of operating and
maintaining wells?
Yes, it does.
And what is that?
Operating expenses or lease operation expenses.
Does that classification include labor costs, repairs,
maintenance, materials, supplies and fuels consumed,
supplies utilized in operating wells, property taxes,
insurance and severance taxes?
Yes, it does.
So all of those items would be classified as production
costs or lease operating expenses under generally
accepted accounting principles?
Yes, they are. Those terms are used interchangeably.
What is the reason behind that classification of costs?
MR. GRIGORIAN: | Even though we’re
reserving objections, I would just like to state an
objection to any testimony relating to reasoning
behind the GAAP principles unless he’s shown to
have been involved in their promulgation and would
know, or establish a foundation for where -- for why
he knows what the reasons are.
(by Mr. Greenough) Based on your -- let me rephrase
this question please. Based on your experience in the
industry, do you have a belief as to the reason behind
the classification that we just discussed?
> O >
> —
-A-73-
Yes, I do.
And what is that?
That’s the industry terminology for those classes of
costs. The accounting followed what was standard
terminology in the industry as related to those
expenses.
For a company that’s involved exclusively in oil an
gas exploration and not in the business of refinery or
chemically altering oil and gas products, is a
classification of the items of costs we just discussed as
costs of goods sold generally appropriate under
generally acceptable accounting principles?
Would it be generally appropriate to call those costs
cost of goods sold:
Correct.
No.
CROSS-EXAMINATION
BY MR. GRIGORIAN:
[PAGE 26, LINE 17]
So your opinion regarding the use of cost of goods
sold in the oil and gas industry was that it would be
an inappropriate form of classification on an income
statement or a statement of operations. Is that what
you stated earlier?
That’s correct.
Q
-A-74-
Q When you refer -- when you use the term
“inappropriate,” what -- is it about the use of the
phrase “cost of goods sold" that you find
inappropriate?
A It’s not descriptive in that it doesn’t convey what the
nature of those costs are. The nature of those costs
are not cost of goods sold.
[PAGE 40, LINE 11]
Q I asked you earlier about trying to compare what a
lifting cost is in an oil and gas company to what cost
of goods sold are in a manufacturing process, and I
believe it was your testimony that you can’t compare
them because, for one reason, you would incur lifting
costs whether or not you sold any oil and gas; is that
true? Is that one of the --
A That’s one of the reasons.
Q Okay. Let me ask you, are there elements of cost of
goods -- is there an element of cost of goods sold,
whether or not you call it a cost of goods sold, but an
expense incurred by the corporation which is
contained in the cost of goods sold figure, but which
would have otherwise been incurred whether or not
the corporation, the manufacturing corporation, sold
anything?
MR. GREENOUGH: I’ll object as to vague. I don’t
understand that question at all.
(2)
>
> ©
>OP> fA
-A-75-
(By Mr. Grigorian) Mr. Downs, do you understand
the question? |
Not really, but I think I’ve already answered that
question once.
Okay.
I think you are asking it a different way, but a
moment ago you asked me is there any -- if I took the
scenario of -- if I would agree that lifting costs were
somehow similar to cost of goods sold except they are
called that by industry practice, and the answer is no.
Lifting costs are a period cost for the operation of a
property which would be incurred regardless of the
level of production, regardless of the level of sales,
and regardless of the level of revenues.
Cost of goods sold are the assigned costs of
the inventory a company sold during the period, and
there’s no relationship between the two.
I understand that, but can you tell me what goes into
a cost of goods sold?
For a manufacturing company?
Yes.
Well, why don’t you ask me what goes into the cost
of inventory because what goes into the cost of goods
sold is merely an allocation of the inventory costs for
the products you sold in a period. What goes into the
cost of inventory depends upon your flow-of-cost
assumption as to what accounting method you want to
use, but it would include, in a manufacturing
environment, direct labor, raw materials, supplies,
and overhead, including depreciation.
If you didn’t sell anything, you wouldn’t have
-A-76-
any cost of goods sold that period. It would be zero.
What you sell is merely an allocation of what you’ve
accumulated as your inventory costs.
Lifting costs, on the other hand, they don’t
have any bearing to the level of sales. It’s the costs
you incur in the period to operate and maintain that
property, which might include an allocation of support
facilities for a group of properties which you would
incur. Whether you produced and sold one barrel or
a million barrels, you are going to incur some of
those costs. That is a major difference, in my opinion.
Okay. The costs of inventory that you described as
being elements of the cost of inventory, direct labor,
overhead, supplies, cost of goods sold aside, are those
expenses, would you agree, that are also often
incurred regardless of whether or not the
manufacturer sold any product?
Irrespective of whether or not they are charged to
expense and called cost of goods sold? There are costs
-- there are costs in inventory for the cost of the
products you manufactured during the period and
prior periods. If you don’t sell any of those, you don’t
incur any cost of goods sold.
Now, if you didn’t manufacture anything
either, you know, ignore the fact that you probably
can only do that one year, but if you neither
manufactured nor sold, there are costs that would
show up as expenses in your financial statements,
your statement of income. You’d have no revenues,
you’d have no cost of goods sold. You could still
have overhead, the administrative overhead called
-A-77-
general and administrative expenses. An oil company
incurs general and administrative expenses, too, but in
a manufacturing environment, the accounting rules
and the tax rules would require you to capitalize a
portion of those costs into inventory on an annual
basis if you manufactured some products that period,
but there’s a distinction there. One relates to the
capitalization in the inventory if they were
manufactured. Cost of goods sold relates to what was
the cost you’ve incurred for the products you sold that
period. That’s why it’s, you know, a very descriptive
term for refining and marketing and chemical
operations, very descriptive.
[PAGE 45, LINE 4]
/S/ JAMES M. DOWNS
JAMES M. DOWNS
Sworn to and subscribed before me
this 19th day of May 1994.
/S/ CHERYL M. RANK
Notary Public
My Commission expires Nov. 17, 1996
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.