1. Under the Revenue Act of 1918, bonus and royalties received
by the lessor under an oil lease are taxable, after making the
allowed deductions, as income.
Burnet v. Harmel, ante, p.
103. P.
287 U. S.
301.
2. The bonus and royalties paid the lessor both may involve
return of capital investment in oil in the ground. P.
287 U. S.
302.
3. A distinction between royalty and bonus, which would allow a
depletion deduction on the former, but tax the latter in full as
income, when received, making no allowance for reasonably
anticipated production of oil on the leased premises, would deny
the "reasonable allowance for depletion" provided by § 234(a)(9) of
the Revenue Act of 1918. P.
287 U. S.
302.
4. Article 215 of Treasury Regulations 45, as amended November
13, 1926, provides that, when the lessor receives a bonus in
addition to royalties, under an oil lease, there shall be allowed
as a depletion deduction in respect cf the bonus an amount equal to
that proportion of the cost or value of the property on the basic
date which the amount of the bonus bears to the sum of the bonus
and the royalties expected to be received, and that such allowance
shall be deducted from the amount remaining to be recovered by the
lessor through depletion, and the remainder be recoverable through
depletion deductions on the basis of royalties thereafter received.
Held, a reasonable formula for allocating bonus to
anticipated depletion where the estimates involved in its
application are reasonable. P.
287 U. S.
303.
5. Where the facts do not justify a finding that bonus plus
expected royalties will exceed the invested capital, it is
consistent with the amended rule,
supra, and not
unreasonable, to allocate bonus paid in earlier years and not
returned for taxation entirely to depletion allowance, and thus
reduce proportionately the amount of depletion allowance per barrel
of royalty oil extracted in later years. P.
287 U. S.
306.
6. In view of the state of the record in this case, the Circuit
Court of Appeals did not abuse its discretion in not remanding the
case to the Board of Tax Appeals because of the Commissioner's
failure to find the "expected royalties." P.
287 U. S. 308.
Page 287 U. S. 300
7. Repeated reenactments of a taxing provision under which
Treasury Regulations had been adopted for its enforcement
held persuasive that the regulations conformed to the
statute, and were approved by Congress. P.
287 U. S.
307.
8.
Burnet v. Thompson Oil & Gas. Co., 283 U.
S. 301, distinguished. P.
287 U. S.
307.
55 F.2d 17 affirmed.
Certiorari to review the affirmance of a decision of the Board
of Tax Appeals, 15 B.T.A. 1195, sustaining income tax
assessments.
MR. JUSTICE STONE delivered the opinion of the Court.
This case is here on certiorari, 286 U.S. 541, to review a
judgment of the Court of Appeals for the Ninth Circuit, 55 F.2d 17,
which reversed an order of the Board of Tax Appeals, 15 B.T.A.
1195, and sustained a ruling of the Commissioner of Internal
Revenue fixing the amount of depletion to be allowed and deducted
from royalties received by petitioner in 1919 and 1920 as the
lessor of oil lands, in determining petitioner's taxable income for
those years.
In December, 1913, petitioner, the owner of two tracts of oil
lands, leased them for stipulated net bonus payments, aggregating
$5,173,595.18 and royalties of one-fourth of the oil produced by
the lessee. All the bonus payments were made before 1919. Whether
petitioner returned those payments as income or paid income tax
on
Page 287 U. S. 301
them for the years when received does not appear. During 1919
and 1920, petitioner received royalties from the leased lands. In
returning its income for those years, it sought to deduct from the
royalties received the entire original unit cost to it of the oil
extracted during the taxable period, without any diminution by
reason of the bonus payments which it had already received. Under
the applicable Revenue Act of 1918, c. 18, 40 Stat. 1057, bonus and
royalties received by the lessor of an oil lease, after deductions
allowed by the taxing act, are taxable income of the lessor.
See Burnet v. Harmel, ante, p.
287 U. S. 103. The
question to be decided is whether the Commissioner correctly
calculated the deduction for depletion for the years in question by
treating the bonus previously received by the petitioner as a
return of capital, and by reducing
pro tanto the depletion
allowed on the royalties received in later taxable years.
The court below sustained the Commissioner's treatment of the
bonus payments as advanced royalties for which depletion must be
allowed under § 234(a)(9), Revenue Act of 1918 (40 Stat. 1078), to
the extent that they represent a return of capital, and held
erroneous the conclusion of the Board of Tax Appeals that the
entire bonus was taxable income. The correctness of this decision
must first be determined, for, if the Board was right in ruling
that the bonus was not subject to a depletion allowance, the method
of computing the depletion to be allowed on the royalties received
during the taxable years in question would present no problem. The
taxpayer would be entitled to deduct the full capital investment
per barrel in the oil extracted during those years.
Section 234(a)(9) of the 1918 act includes in the authorized
deductions from gross income:
"(9) In the case of mines, oil and gas wells, . . . a reasonable
allowance for depletion and for depreciation of improvements,
according to the peculiar conditions in
Page 287 U. S. 302
each case, based upon cost including cost of development not
otherwise deducted: . . . Such reasonable allowance in all the
above cases to be made under rules and regulations to be prescribed
by the Commissioner with the approval of the Secretary. In the case
of leases the deductions allowed by this paragraph shall be
equitably apportioned between the lessor and lessee. . . ."
We think it no longer open to doubt that, when the execution of
an oil and gas lease is followed by production of oil, the bonus
and royalties paid to the lessor both involve at least some return
of his capital investment in oil in the ground, for which a
depletion allowance must be made under § 234.
See Burnet v.
Harmel, supra. This is obvious where royalties alone are
insufficient to return the capital investment. A distinction
between royalties and bonus, which would allow a depletion
deduction on the former, but tax the latter in full as income, when
received, making no provision for a reasonably anticipated
production of oil on the leased premises, would deny the
"reasonable allowance for depletion" which the statute provides.
The harsh operation of such a rule with respect to taxpayers
generally is apparent, and is emphasized by the opportunist
character of petitioner's argument here. The rule for which it
contends can operate to its advantage only if it fortuitously
escapes payment of any tax on the bonus payments, which it insists
shall be treated as income without the deduction of any depletion
allowance.
Doubts, if any, whether the statute authorizes depletion of
bonus payments, have been definitely set at rest by the repeated
reenactment, without substantial change, of the provisions of §
234(a)(9) [
Footnote 1], since
the promulgation
Page 287 U. S. 303
of treasury regulations providing for such depletion. [
Footnote 2]
See Burnet v. Thompson
Oil & Gas Co., 283 U. S. 301,
283 U. S.
307-308;
Brewster v. Gage, 280 U.
S. 327,
280 U. S. 337;
National Lead Co. v. United States, 252 U.
S. 140,
252 U. S.
146-147.
The question remains whether the method followed by the
Commissioner in this case in allocating depletion to bonus and
royalties failed to afford that "reasonable allowance" for
depletion which the statute provides.
Article 215, Treasury Regulations 45 (1920 ed.) provided:
"(a) Where a lessor receives a bonus or other sum in addition to
royalties, such bonus or other sum shall be regarded as a return of
capital to the lessor, but only to the extent of the capital
remaining to be recovered through depletion by the lessor at the
date of the lease. If the bonus exceeds the capital remaining to be
recovered, the excess and all the royalties thereafter received
will be income, and not depletable. If the bonus is less than the
capital remaining to be recovered by the lessor through depletion,
the difference may be recovered through depletion deductions based
on the royalties thereafter received. The bonus or other sum paid
by the lessee for a lease made on or after March 1, 1913, will be
his value for depletion as of date of acquisition."
This paragraph of the regulation was amended, November 13, 1926,
by Treasury Decision 3938, V-2, C.B. 117, to read as follows:
"(a) Where a lessor receives a bonus in addition to royalties,
there shall be allowed as a depletion deduction
Page 287 U. S. 304
in respect of the bonus an amount equal to that proportion of
the cost or value of the property on the basic date which the
amount of the bonus bears to the sum of the bonus and the royalties
expected to be received. Such allowance shall be deducted from the
amount remaining to be recovered by the lessor through depletion,
and the remainder is recoverable through depletion deductions on
the basis of royalties thereafter received."
The important difference in operation between the regulation
before its amendment and after is in the case where the
Commissioner properly finds that the sum of the bonus and expected
royalties exceeds the lessor's capital investment in the oil in the
ground. If, for example, the bonus were $1,000,000 and the
estimated royalties were $2,000,000 and the capital investment of
the lessor in the oil in the ground, to be depleted, were
$2,000,000, the allowed depletion for return of the capital
investment would be deducted, one-third from the bonus and
two-thirds from the royalties as received.
The regulation thus operates to distribute the lessor's
anticipated profit or the taxable net income to be derived from the
extraction of all the oil ratably between the bonus and royalties,
so that the estimated profit element in each will be taxed as
received, subject to such readjustments of capital account as are
authorized by paragraphs (c) and (d) of the amended regulation, in
the event of termination, abandonment, or expiration of the lease
before all the oil is extracted. But, if the bonus and expected
royalties together are not found to exceed the capital investment
of the lessor, the entire bonus received in advance of royalties
must be treated, after the amended regulation as well as before, as
a return of capital, since, in that case, the expected royalties
added to the bonus are, by hypothesis, sufficient to return no more
than the lessor's capital.
Page 287 U. S. 305
Such was the case here. In determining petitioner's depletion
allowance for the two years in question, the Commissioner made no
specific determination of the "expected royalties" from the leased
lands. But such a determination was of consequence in allocating
depletion to the bonus only in the event that the total of bonus
and expected royalties exceeded the invested capital of the tax
payer. No facts appear which would have justified such a finding,
and, without it, the requirements of the amended regulation were
satisfied by treating the whole bonus as a return of capital and
deducting from the depletion allowance on each barrel of the
royalty oil the proportion of the capital investment already
returned by the bonus. This is what the Commissioner did.
He determined, on the basis of engineers' reports, the total
amount of oil in the ground at the date of the lease, and its value
as of March 1, 1913. This he treated as petitioner's capital
investment, to be returned by the depletion allowance. The
computation necessarily revealed the per barrel capital investment
in oil in the ground at the date of the lease. By making certain
necessary capital investment adjustments, reflecting oil extraction
during the years before 1919, the detail of which is not now
important, he arrived at the per barrel capital investment of
petitioner in oil in the ground in 1919 and 1920, the figure which
would represent the actual amount of depletion of the capital
investment for each barrel of oil extracted during those years if
there had been no bonus payments. His method of bringing the bonus
into the computation amounted, in effect, to dividing the amount of
the bonus by the total number of barrels of royalty oil in the
ground, as indicated by the engineers' reports. The result
represented the amount to be deducted from the depletion allowance
per barrel of royalty oil which would otherwise have been made for
those years. Stated
Page 287 U. S. 306
in another way, the total amount of the bonus was deducted from
petitioner's total capital investment in oil in the ground
returnable by depletion allowances, with a corresponding reduction
in the per barrel capital investment in the oil reserve. Thus, the
Commissioner treated the whole of the bonus as a return, in advance
of abstraction of the oil, of a part of the petitioner's capital
investment in the oil in the ground, with which it would part, in a
technical legal sense, only upon abstraction. In consequence, the
deduction for depletion allowed on royalties received in 1919 and
1920 was reduced; it is of this reduction that petitioner
complains.
We think the Commissioner's method "reasonable" within the
meaning of the statute. The deduction for depletion from the bonus
payments, which the statute requires, must either be made after the
process of extracting the oil is complete, to the extent that the
royalties received have been insufficient to replace invested
capital, with the attendant inconvenience of indefinite
postponement of the allocation of the bonus to income and return of
capital, or a formula must be adopted by which the appropriate
allocation may be made as the two classes of gross income, bonus
and royalties, are received.
That formula the regulation purports to furnish. Where the
estimates are reasonable, the formula affords a fair and convenient
method of avoiding the present taxation of the bonus, when
received, as income, in the face of the probability that it will
ultimately prove not to be such. It will not fail to provide, with
reasonable certainty, for the restoration of capital to which the
taxpayer is entitled, if the oil extracted equals or exceeds the
amount originally estimated. If less than that amount, it does not
preclude revision and necessary adjustments, as errors appear
probable. In addition, provision is made by subdivisions (c) and
(d) of the regulation, as amended, for such necessary capital
readjustments as may be occasioned
Page 287 U. S. 307
by the termination, abandonment, or expiration of the lease
before all the oil is extracted.
The method of computation provided by the amended regulation
must be taken to have received the approval of Congress, for, as
already noted, the provisions of article 215(a), as amended, have
been continued in the Treasury Regulations since 1926, and those of
§ 234(a)(9) of the Revenue Act of 1918 (40 Stat. 1078) have been
reenacted without substantial change in the Revenue Acts of 1928
and 1932.
The problem here is different from that involved in
Burnet
v. Thompson Oil & Gas Co., supra. There, it was held,
interpreting § 234(a)(9), that the part of the depletion not
allowed by the 1913 statute in the year in which it occurred could
not be carried over and added to the depletable base used in
computing the tax for a later year under the 1918 Act, which
allowed depletion in full. Here, an anticipated depletion of
capital is to be returned from bonus and future royalties, to the
extent that the applicable statutes allow, and the problem is to
allocate such anticipated depletion to a payment made in advance of
its occurrence. This allocation is permitted by the statute.
Petitioner argues, nevertheless, that the regulation is
unreasonable because it requires the Commissioner to estimate
probable royalties which are dependent on the frequently
unforeseeable future market value of oil. But the regulation does
not require him to make estimates which are unreasonable, for,
where none can be made with reasonable accuracy, the Commissioner
cannot find that "the sum of the bonus and royalties expected to be
received" exceeds the capital investment. In that event, the whole
of the bonus will be treated, as in this case, as a return of
capital. We cannot say that such a result is unreasonable on its
face. The exigencies which "the peculiar conditions of each case"
may present we need not now consider. It is also unnecessary to
inquire under
Page 287 U. S. 308
what circumstances the application of the regulation may fail to
comply with the statute because the appraisals which are made are
extravagant or impossible. In the case before us, the accuracy of
every estimate of the Commissioner is unchallenged. It cannot be
said that the regulation, as applied here, was unauthorized by the
statute because inadequate for its purpose or inconvenient or
unjust in its operation.
Finally, petitioner urges that, as the Commissioner failed to
find the expected royalties to be received under the lease, the
court below should have exercised its discretion to remand the case
to the Board of Tax Appeals for a rehearing. Section 1003(b),
Revenue Act of 1926, 44 Stat. 9, 110. As we have said above, the
record does not disclose any facts from which the expected
royalties might be determined. Neither the petitioner nor the
Commissioner asked opportunity to supply such facts. It does not
appear whether such an estimate could be made, or that, if made,
the sum of the bonus and expected royalties would exceed the
petitioner's capital investment, returnable by depletion. Hence, no
case was made calling for the court below to exercise its
discretion in petitioner's favor.
Affirmed.
[
Footnote 1]
Section 234(a)(9), Revenue Act of 1921, 42 Stat. 227, 256; §
234(a)(8), Revenue Act of 1924, 43 Stat. 253, 284, and § 234(a)(8),
Revenue Act of 1926, 44 Stat. 9, 42; § 23(1), Revenue Act of 1928,
45 Stat. 791, 800; § 23(1), Revenue Act of 1932, 47 Stat. 173,
180.
[
Footnote 2]
Article 215(a), Treasury Regulations 45 (1920 ed.), Revenue Act
of 1918, continued intact in article 215(a), Treasury Regulations
62, Revenue Act of 1921; Art. 216(a), Treasury Regulations 65,
Revenue Act of 1924. The amendment of subdivision (a), November 13,
1926, by T.D. 3938, V-2, C.B. 117, appears in Art. 216(a), Treasury
Regulations 69, Revenue Act of 1926; article 236(a), Treasury
Regulations 74, Revenue Act of 1928.
See also the minimum
royalty provision in Art. 236(b), of Regulations 74.