Section 234(a)(8) of the Revenue Act of 1926, provides that, in
the case of oil wells, the taxpayer shall have, as a deduction from
gross income, "a reasonable allowance for depletion and for
depreciation of improvements, according to the peculiar conditions
of each case," to be made under departmental rules and regulations.
Section 204 permits the taxpayer to calculate depletion on the
basis of cost alone, or else to deduct an arbitrary allowance,
fixed by the statute, without reference to cost or discovery value
at 27% of gross income from the well.
Held, construing
these in the light of earlier provisions and administrative
construction, that the capitalized cost of drilling, as
distinguished from cost of physical property such as machinery,
tools, equipment, pipes, etc., is subject to depletion allowance,
and not to depreciation allowance. Pp.
288 U. S. 460,
288 U. S.
466.
59 F.2d 853, reversed.
Certiorari, 287 U.S. 591, to review a judgment against the
United States on a claim for money collected as income taxes.
Page 288 U. S. 460
MR. JUSTICE STONE delivered the opinion of the Court.
Respondent, a North Dakota corporation, in making its tax return
of income derived from its operation of oil wells in 1926, claimed
a deduction from gross income of a depreciation allowance on
account of the capitalized costs of preliminary development and
drilling. The Commissioner refused to allow the deduction claimed,
ruling that it was for depletion, not depreciation, and was
therefore included in the statutory depletion allowance of 27 1/2
percent of the gross income, which the respondent had also
deducted. §§ 204(c), 234(a)(8), Revenue Act of 1926, c. 27, 44
Stat. 9, 14, 16, 41. Having paid the correspondingly increased tax,
respondent brought this suit in the Court of Claims to recover the
excess. The court gave judgment for respondent, holding that the
development and drilling costs were the proper subjects of a
depreciation allowance which should have been made in addition to
that for depletion. 59 F.2d 853. This Court granted certiorari to
resolve a conflict of the decision below with that of the Circuit
Court of Appeals for the Fourth Circuit in
Burnet v. Petroleum
Exploration, 61 F.2d 273.
The Revenue Act of 1926, like earlier acts, [
Footnote 1] provided generally that "in the case
of . . . oil and gas wells," taxpayers should be allowed, as a
deduction from gross income, "a reasonable allowance for depletion
and for
Page 288 U. S. 461
depreciation of improvements, according to the peculiar
conditions in each case," such allowance "in all cases to be made
under rules and regulations to be prescribed by the Commissioner
with the approval of the Secretary." § 234(a)(8). The earlier acts
provided that depletion should be allowed on the basis of cost
unless the taxpayer was the discoverer of the well upon an unproven
tract, in which case the basis was the "value of the property" at
the time of the discovery or within 30 days thereafter. [
Footnote 2]
See Palmer v.
Bender, 287 U. S. 551. But
the "discovery value" provision was eliminated from the Act of
1926, which is applicable here, and the taxpayer was permitted to
calculate depletion on the basis of cost alone, § 204(c), or else
to deduct an arbitrary allowance, fixed by the statute, without
reference to cost or discovery value at 27 1/2 percent of gross
income from the well. [
Footnote
3]
Articles 223 and 225 of Treasury Regulations 69, under the
Revenue Act of 1926, were followed by the Commissioner in assessing
the present tax. Article 223 purports to permit the taxpayer to
choose whether to deduct costs of development and drilling as a
development expense in the year in which they occur or else to
charge them "to capital account returnable through depletion." In
the
Page 288 U. S. 462
latter event, which is the case here, "insofar as such expense
is represented by physical property, it may be taken into account
in determining a reasonable allowance for depreciation," which, if
the arbitrary deduction for depletion were claimed, would
constitute an additional allowance. Article 225 limits the
depreciation for which an allowance may be made to that of
"physical property, such as machinery, tools, equipment, pipes,"
etc. We do not doubt that the effect of this language is to require
the taxpayer to look to the depletion allowance, in this case 27
1/2 percent of gross income, for a return of the costs of
developing and drilling the well, which are involved here.
Respondent challenges the validity of the regulations thus
applied as in conflict with § 234(a)(8), which allows the deduction
of a reasonable allowance "for depreciation of improvements" in
addition to the deduction for depletion. It is urged that the drill
hole is an "improvement" of the taxpayer's oil land, and that no
logical distinction in accounting practice can be made between the
cost of this improvement and the cost of buildings and machinery
placed on the property for the operation of the well, for which
depreciation should admittedly be allowed.
The government argues that the well itself is not tangible
physical property which wears out with use so as properly to be the
subject of depreciation, and that, in any event, the regulations
are based upon the practices of the oil industry, and are within
the requirements of § 234(a)(8) that a reasonable allowance for
depletion and depreciation of improvements be made in all cases
under rules and regulations to be prescribed by the Treasury
Department.
We do not stop to inquire whether, under correct accounting
practice, an anticipated loss of a part of the capitalized cost of
developing and drilling an oil well because of decreased utility of
the well would be described or treated differently than wear and
tear of the machinery
Page 288 U. S. 463
used in production, or whether an allowance for the former
serves a purpose logically distinguishable from one for the latter.
For the issue before us, whether the statute requires the former to
be treated as depletion, is resolved by the history of the
legislation and the administrative practice under it.
The Revenue Act of 1916 permitted the deduction of a reasonable
allowance for the "exhaustion, wear and tear of property" used in a
business or trade, and, in the case of oil and gas wells, "a
reasonable allowance for actual reduction in flow and production."
§ 12(b) Second. The regulations authorized the deduction of an
annual allowance for "depreciation," and, in the case of oil and
gas wells, for "depletion" (Treasury Regulations 33, Arts. 159,
160, 162, 170), but ruled that no annual deduction for
"obsolescence" was authorized by the statute in any case; such a
loss, it was provided, might only be deducted in the year when it
became complete by abandonment of the property as no longer useful.
See Arts. 162, 178, 179 of Treasury Regulations 33;
Gambrinus Brewery Co. v. Anderson, 282 U.
S. 638,
282 U. S. 643.
In defining these terms, therefore, the Department was apparently
faced with the practical consequence that no annual deduction could
be made in anticipation of those losses which it regarded as
attributable to obsolescence, while such a deduction might be made
for those which it attributed to depreciation or depletion.
Depreciation was defined generally to include the wear and tear and
exhaustion of property by use, and obsolescence the loss in value
of property due to the fact that, because of changing conditions,
it has ceased to be useful.
Plainly, under these definitions, the loss in value of the drill
hole for an oil well because of the approaching exhaustion of the
oil in the ground was not to be treated as depreciation. Article
170 of Regulations 33 necessarily
Page 288 U. S. 464
ruled that it was not to be treated as obsolescence by declaring
that the purpose of the statutory provision relative to oil wells
was to return, through the aggregate of annual depletion
deductions, the taxpayer's capital investment in the oil, including
"the cost of development (other than the cost of physical property
incident to such development)." Article 170 thus contemplated that
an annual deduction should be made for costs of development by
including them in the cost of the oil in the ground for which a
depletion allowance was authorized by § 12(b), Second, "for actual
reduction in flow and production."
While the Revenue Acts which followed that of 1916 provided that
taxpayers generally might deduct "a reasonable allowance for
obsolescence" in addition to that "for the exhaustion, wear and
tear of property used in the trade or business," [
Footnote 4] in each of them, the section
expressly applicable to oil and gas wells [
Footnote 5] omitted the word "obsolescence" and
provided, in terms, only for the deduction of an allowance for
depletion and for depreciation of improvements. Whatever doubts
this omission may have suggested as to the propriety of an
allowance for obsolescence in the case of oil and gas wells,
raising the same problem as that, under the Act of 1916, the
question whether an allowance should be made for development and
drilling costs was set at rest, where cost was the basis of
depletion and depreciation of improvements, by the express language
of the Acts of 1918 and 1921, that the cost basis should include
"costs of development not otherwise deducted." But the questions
remained whether the allowance was to be treated as for
depreciation or depletion, and, more important, whether any
allowance could be made for development costs when the basis of
depletion
Page 288 U. S. 465
was discovery value, rather than cost. [
Footnote 6] In answering these questions, the
Department adhered to and made explicit the position taken by it
under the 1916 Act that development costs other than the cost of
physical property incident to the development must be returned
through the depletion allowance, but the regulations also provided
expressly that the cost of "physical property such as machinery,
tools, equipment, pipes, etc.," should be returned by an annual
allowance for depreciation. Articles 223, 225 of Treasury
Regulations 45 under the Revenue Act of 1918. The distinction thus
taken was continued in the regulations under the Revenue Acts of
1921, 1924, and 1926, [
Footnote
7] although, beginning with that of 1924, the express
declaration of the statute, already noted, that the cost basis for
depletion and depreciation of improvements should include costs of
development was eliminated, leaving the broad provision that a
reasonable allowance should in all cases be made under rules and
regulations to be prescribed by the Commissioner, with the approval
of the Secretary.
Doubts arising because of the silence of the Revenue Acts of
1918 and later years as to whether costs of development and
drilling were to be included in depletion when based on discovery
value were resolved by the regulations already noted and by the
addition of another. Article 220(a)(3) of Treasury Regulations 45
provided that
"the 'property' which may be valued after discovery is the
'well.' For the purposes of these sections, the 'well' is the drill
hole, the surface necessary for the
Page 288 U. S. 466
drilling and operation of the well, the oil or gas content of
the particular sand, zone or reservoir . . . in which the discovery
was made by the drilling, and from which the production is
drawn."
By including the drill hole in the property to be valued for
depletion under § 234(a)(9), this article necessarily carried
forward the distinction taken under the 1916 Act between drilling
costs, subject to depletion allowance, and costs of machinery,
tools, and equipment, subject to allowance for depreciation. §
234(a)(9) of the Revenue Act of 1921 and § 204(c) of the Revenue
Act of 1924 continued the provisions of the 1918 Act, and this
regulation remained unchanged. [
Footnote 8] It was eliminated under the 1926 Act, being no
longer necessary, as the statute omitted the "discovery value"
provision and substituted the arbitrary percentage allowance for
depletion. [
Footnote 9]
Thus, the Acts of 1918, 1921, and 1924 were consistently
construed by the regulations to permit a depletion, but not a
depreciation allowance for the costs of development work and
drilling, which were treated for this purpose either as a part of
the cost or an addition to the discovery value of the oil in the
ground. The administrative construction must be deemed to have
received legislative approval by the reenactment of the statutory
provision, without material change.
Murphy Oil Co. v.
Burnet, 287 U. S. 299;
Brewster v. Gage, 280 U. S. 327,
280 U. S.
337.
Respondent argues that whatever effect may be attributed to
earlier reenactments, that of 1926, which is applicable here, is
without force because § 204 of that Act abandoned discovery value
as the basis of depletion and permitted the taxpayer to abandon
cost and substitute a fixed allowance of 27 1/2 percent of gross
income from the well. We think the contention unfounded, and that,
on
Page 288 U. S. 467
the contrary, what was included in the reasonable allowance for
depletion by the established construction of the earlier acts gave
significant content to the word as used in the Act of 1926. There
is no ground for supposing that Congress, by providing a new method
for computing the allowance for depletion, intended to break with
the past and narrow the function of that allowance. The reasonable
inference is that it did not, and that depletion includes under the
1926 Act precisely what it included under the earlier acts. The
regulations under the 1926 Act so ruled, as has been shown, by
continuing the provisions of earlier regulations under which costs
of development and drilling were returnable by the depletion
allowance, and not by an additional allowance for depreciation.
[
Footnote 10]
It is true that the Board of Tax Appeals, in construing the 1924
and 1926 Acts, has held that capitalized drilling costs are subject
to a depreciation, rather than a depletion allowance. Jergins Trust
v. Commissioner, 22 B.T.A. 551; Ziegler v. Commissioner, 23 B.T.A.
1091; P-M-K Petroleum Co. v. Commissioner, 24 B.T.A. 360. But these
cases were all decided after the enactment of the 1926 Act, and did
not consider the administrative and legislative history, which we
think decisive.
Reversed.
[
Footnote 1]
§ 234(a)(9), Revenue Act of 1918; § 234(a)(9), Revenue Act of
1921; § 234(a)(8), Revenue Act of 1924.
[
Footnote 2]
§ 234(a)(9), Revenue Act of 1918; § 234(a)(3), Revenue Act of
1921; § 204(c), Revenue Act of 1924.
[
Footnote 3]
Sec. 204. (c) The basis upon which depletion, exhaustion, wear
and tear, and obsolescence are to be allowed in respect of any
property shall be the same as is provided in subdivision (a) or (b)
for the purpose of determining the gain or less upon the sale or
other disposition of such property, except that --
"
* * * *"
"(2) In the case of oil and gas wells, the allowance for
depletion shall be 27 1/2 percentum of the gross income from the
property during the taxable year. Such allowance shall not exceed
50 percentum of the net income of the taxpayer (computed without
allowance for depletion) from the property, except that in no case
shall the depletion allowance be less than it would be if computed
without reference to this paragraph."
[
Footnote 4]
§ 234(a)(7) of the Revenue Acts of 1918, 1921, 1924 and
1926.
[
Footnote 5]
See note 1
supra.
[
Footnote 6]
The discoverer of an oil well upon an unproven tract was
permitted for the first time by § 234(a)(9) of the Revenue Act of
1918 to calculate the allowance for depletion upon the basis of the
value of the "property" at the time of the discovery or within
thirty days thereafter.
See note 2 supra. The statute was silent as to the
inclusion of development costs.
[
Footnote 7]
Arts. 223, 225, of Treasury Regulations 62, 69; Arts. 225, 227,
of Treasury Regulations 65.
[
Footnote 8]
Articles 220(a)(3) of Treasury Regulations 62 and 222(3) of
Treasury Regulations 65.
[
Footnote 9]
See Senate Report No. 52, 69th Congress, 1st Session,
pp. 17, 18.
[
Footnote 10]
Compare also Treasury Decision 4333, Internal Revenue
Bulletin XI, April 11, 1932, No. 15, pp. 2, 3.