COMMISSIONER v. ENGLE
Legal provision: Internal Revenue Code
ORAL ARGUMENT OF CARTER G. PHILLIPS, ESQ., ON BEHALF OF THE PETITIONER, COMMISSIONER OF INTERNAL REVENUE AND THE RESPONDENT, UNITED STATES
Chief Justice Warren E. Burger: Mr. Phillips, I think you may proceed whenever you are ready.
Carter G. Phillips: Mr. Chief Justice, and may it please the Court:
The issue in these consolidated cases is whether Section 613A of the Internal Revenue Code permits a lessor of oil and gas property who receives an advance payment upon the execution of a lease, the advance payment either in the form of a lease bonus or an advance royalty, is entitled to a percentage depletion deduction against those royalties even though no oil or gas allocated to that income is produced during the taxable year.
The facts in both of these cases are not disputed.
In the Farmar case in 1976 taxpayers leased the mineral estate of lands they owned in Texas to two companies interested in oil and gas exploration.
Part of the compensation for that agreement was a substantial lease bonus to be paid in installments, and that was in no way dependent upon the actual production of oil or gas.
Instead, it was based on the acreage of the lease.
Taxpayers also included in that agreement a provision allowing them to receive royalties for any oil or gas actually produced.
During the 1976 tax year oil and gas was extracted from those properties, and a royalty was paid.
Taxpayers in their 1976 federal income tax returns claimed a 22 percent depletion deduction for both the lease bonus payment and the royalty.
In the Engle case in 1975 the taxpayers assigned a lease to properties they had in Wyoming to producers in return for an overriding royalty.
As part of the compensation scheme there the taxpayers in this case received an advance royalty of $7600.
During the 1975 tax year there was, however, no production.
Nevertheless, the taxpayers on their federal income tax returns for 1975 claimed a 22 percent depletion deduction for the advanced royalties that they had received.
In both of these cases the Commissioner assessed a deficiency by disallowing the percentage depletion deductions for payments that were received that had no relationship to any actual production during the taxable year.
The Farmars paid the deficiency and filed suit for return of the monies in the Court of Claims.
The Engles, on the other hand, brought a proceeding in the Tax Court.
The Court of Claims unanimously and the Tax Court by a vote of 14 to 1 upheld the Commissioner's decision and determined that Section 613A did not allow deductions in the absence of production during the taxable year.
The Engles appealed the judgment of the Tax Court to the Seventh Circuit which reversed.
Both the Commissioner and the Farmar's filed separate petitions to this Court.
They were granted and the case consolidated.
Prior to 1975 it was clear that the lease bonuses and advance royalties at issue in this case would have been subject to the percentage depletion deduction.
Prior to 1975 under Section 611 of the Internal Revenue Code which allows a deduction for a reasonable allowance for depreciation and Section 613 which allows a deduction for gross income from the oil or gas producing property this Court had concluded the only statutory condition for allowance of the depletion deduction was the existence of gross income, and since this Court had also concluded that advance payments either in the form of lease bonuses of advance royalties were gross income from the property the deduction was permitted.
Unidentified Justice: Mr. Phillips, even after 1975 are bonuses and advance royalties income from the property?
Carter G. Phillips: Yes, ma'am.
I believe they would still remain as income from the property.
Unidentified Justice: That would be consistent with our decision in Herring, the old decision.
Carter G. Phillips: Yes, Your Honor.
We do not dispute that decision in this case.
Unidentified Justice: Well, is there anything in the statute we are talking about here or the amendments that specifically changes the definition of gross income to exclude bonuses and advance royalties or that overrules Herring?
Carter G. Phillips: Nothing that expressly does that.
Congress did add Subsection D to Section 613 in 1975.
Subsection D says you do not start with Section 613 which is the provision that forces you to look at gross income.
Instead it says that you look first at Section 613A and only for so much of the production as you can demonstrate satisfies the requirements of Section 613A do you then come back into Section 613 and apply the gross income tests under Herring and for that matter all of the Commissioner's rulings regarding gross income.
Unidentified Justice: Well, Congress did not change the definition of gross income is what you are saying, but it did state that the deduction for percentage depletion had to be with respect to production.
Carter G. Phillips: That is right, Your Honor.
Unidentified Justice: Now is the statutory language not given better effect by allowing the deduction but just postponing it to the year of actual production?
Carter G. Phillips: Well, of course, that is not the issue in this case.
They are seeking to assert the deduction in this taxable year.
Unidentified Justice: Well, I am asking you if that is not a better application of this statutory language?
Carter G. Phillips: Well, I will concede that that is a reasonable interpretation of the statutory language.
The Commissioner's view is that the focus in Section 613A on production in the taxable year seems to expect that that is the taxable year that they focus on.
When the income is acquired prior to actual production the Commissioner has concluded that Congress simply did not intend for that to be subject to the depletion allowance.
As I said, Justice, I think in this case where the Seventh Circuit held that both interpretations are reasonable I submit that you could probably make a reasonable argument with regard to the hypothetical you set, but I think it important to make clear that regardless of how you decide your hypothetical you would still deny the deduction for the taxpayers in these cases.
Unidentified Justice: How about the converse?
What if you have a deduction in one year and no income until the next?
Carter G. Phillips: The Commissioner has taken the position at least with respect to the hypothetical he presented in his proposed regulations that if you have say $100,000 of production in one year and $85,000 of income in that year and $15,000 of income in the next year he will permit you the $15,000 deduction in--
Unidentified Justice: In the next year even if there is not any production.
So he does not apply the statute literally either.
Carter G. Phillips: --Not precisely.
I think the exception made for that... It is not clear that he would allow that if all of the income were derived in a separate year, only if a small portion is.
In addition, it is clear that that distinction that the Commissioner has drawn is fully consistent with the intention and purpose of Section 613A.
That is, Congress' dominant concern was to assure the production of oil and gas, the extraction of oil in hand and certainly under the hypothetical that the Commissioner has proposed you have production in hand so, therefore, he has decided to go ahead and allow that.
Certainly no taxpayers are likely to complain about the proposed regulation.
Unidentified Justice: Is it clear that he would not if you have advance royalties in one year and the next year you have production he would not allow the depletion of the royalties received in a prior year?
Carter G. Phillips: That seems clear, yes, Your Honor.
Unidentified Justice: He will not do that?
Carter G. Phillips: He will not do that.
He will be allowed cost depletion for the income that you have received in the prior year.
They will not allow the special advantage frankly that is afforded through percentage depletion.
Unidentified Justice: Mr. Phillips, let me just be sure I understood you correctly.
You said the dominant purpose of Congress in granting this exemption was to be sure there was some production of oil and gas unrelated to any particular time period.
Carter G. Phillips: During the taxable year.
I failed to say that, but I believe that Congress' dominant concern was some production prior to the income.
I think... I'm sorry.
Unidentified Justice: I am just wondering about whether there was this refinement of the general objective that there must be some production during the lease term which would be consistent with the old law and it really would not make much difference whether you had a year beginning or the end of the year lease where there was no production whereas there is a difference under the proposed regulations.
Carter G. Phillips: Well, of course, the proper result in this case does not really hang on whether or not the proposed regulations are consistent.
It seems to me we are still dealing with this particular case which is a situation where we have income and no production.
Unidentified Justice: If there is no production during the entire life of the lease even the taxpayer would agree he would have to give back the--
Carter G. Phillips: That is correct, but it seems perfectly consistent with the statute to expect that Congress may have preferred to have production as quickly as possible and not postpone it five to ten years.
Unidentified Justice: --One of the purposes of Congress was to discourage the practice of leasing with an advance royalty payment scheme?
Carter G. Phillips: Well, I think not to discourage it particularly but simply not to provide the extraordinary encouragement that percentage depletion would otherwise grant.
Unidentified Justice: It is correct, is it not, that the Commissioner's position will discourage this particular form of lease?
Carter G. Phillips: From the prior practice, yes, it will not be as readily adopted but of course--
Unidentified Justice: Which may in turn cause--
Carter G. Phillips: --Anybody other than a small producer would not be--
Unidentified Justice: --That is right.
We are only talking about small producers, but this may in turn make it more difficult for small producers to enter into advantageous leases.
Carter G. Phillips: --I do not think so, Your Honor.
The small producer retains the very substantial advantage that comes when there is production on the property.
Unidentified Justice: Right, but he loses the advantage if the lessee cannot assure him that there will be production in the year in which he is first receiving royalties.
Carter G. Phillips: That is correct.
But most royalty owners I would imagine would still realize that a small producer if there is reasonable likelihood of production will offer the advantages of percentage depletion that were not available if he used a large producer so that all this does is make the large producer small producer equal with regard to advance payments from which no oil is produced and for which Congress presumably had no real concern or interest in.
Chief Justice Warren E. Burger: We will resume at one o'clock.
Mr. Phillips, you may resume.
ORAL ARGUMENT OF CARTER G. PHILLIPS, ESQ., ON BEHALF OF THE PETITIONER, COMMISSIONER OF INTERNAL REVENUE AND THE RESPONDENT, UNITED STATES -- CONTINUED
Carter G. Phillips: Mr. Chief Justice, and may it please the Court:
In 1975 Congress in the Tax Reduction Act eliminated for the most part percentage depletion allowance for oil and gas.
After 1975 the existence of the percentage depletion allowance was no longer contingent exclusively on the existence of gross income.
Instead Congress added Subsection D to Section 613 which expressly requires the taxpayer to determine availability of any deduction, percentage deduction that is, under Section 613A first and then determine on the basis of whether you comply with the requirements of Section 613A how much of the deduction generally specified in Section 611 will be computed specifically under Section 613.
Congress in Section 613A permitted percentage depletion for a royalty owner such as the taxpayers in these cases who leased to an independent producer
"with respect to so much of the taxpayer's average daily production of domestic crude oil as does not exceed the taxpayer's depletable oil and natural gas quantity. "
Average daily production is determined by dividing the aggregate production for the year by the number of days in the taxable years.
The depletable quantity is an arbitrary number that the Congress had set in order to limit the maximum amount of production and the guarantee that the producers were in effect small producers.
As the majority of the Tax Court held, Section 613A places repeated emphasis on the concept of production, and production itself commonly means extraction from the ground and, therefore, it is fair to read the statutory language itself as requiring actual production during the taxable year, and accordingly the taxpayers in this case who cannot attribute any of their income to actual production during the taxable year are not entitled under the plain meaning of the language of Section 613A to a percentage depletion deduction.
Unidentified Justice: Mr. Phillips, what do you make of the language immediately preceding the critical section where it says "with respect to".
Are you familiar with that?
Carter G. Phillips: Yes.
Our view is that the 611 to be computed under Section 613.
The "with respect to" language is actually the pivotal language in our mind in determining that production is crucial because it is only with respect to so much production that you are allowed any kind of a depletion.
Unidentified Justice: I do not quite read it that way.
"except as provided in Subsection D the allowance for depletion under Section 611 shall be computed in accordance with Section 613 with respect to so much of the taxpayers average daily production of domestic crude oil as does not exceed the taxpayers depletable oil quantity. "
That suggests to me that there may be other instances of depletion allowance that are not embraced within that language.
Do you disagree with that?
Carter G. Phillips: No, I agree with that.
It is clear that it is with respect to both that you have to have some production and with respect to so much as does not exceed the depletable quantity.
So anything over 2000 barrels in 1975 will not be with respect to which you can deduct under the percentage depletion.
Just as if you do not have any production it is with respect to zero production that you are allowed the depletion.
So I would read that language as saying with respect to whatever number between 1 and 2000 barrels are produced by primary means of extraction.
Of course, the taxpayers are still entitled to cost depletion under Section 612, but in our reading of the plain meaning of the statute they are no longer entitled to percentage depletion simply as a simple arithmetic means.
That is, the numerator of aggregate production is zero divided by any number obviously equals zero, and so with respect to how much production is there a deduction the answer is zero.
Unidentified Justice: Mr. Phillips, does the Commissioner require the lessees to capitalize lease bonus and advance royalty payments that they make and to take a percentage depletion allowance against them in the year of actual production?
Carter G. Phillips: Well, he does not permit them... They have historically not been permitted to take the lease bonus and advance royalty and deplete that, use percentage depletion on that.
He does require them to capitalize it as a straight deduction.
He continues to take the view that the lease bonus and advance royalties are not subject to the percentage depletion allowance to the lessee.
That, by the way, is compelled I think in the House committee report in 1974.
We submit that the result compelled by the statutory language is equally supported by the only relevant legislative history in this case.
When the Tax Reduction Act was passed out of the House committee in 1975 it contained no provision with regard to oil and gas depletion, and an amendment on the House floor completely abolished oil and gas depletion which passed.
The bill then went to the Senate.
Again, the Senate Finance Committee reported out a bill that again contained no provision for oil and gas depletion, and on the floor of the Senate was the amendment added that conforms basically to Section 613A.
All of the courts that have considered this issue below have concluded that reading the legislative history in 1975 provides no useful insights into the solution of the problem presented by these cases.
That is, there is nothing in there that tells you how to treat lease bonus and advance royalties.
However, in 1974 during the prior Congress, indeed the last session of the prior Congress and merely four months prior to the date that the conference committee announced the final Section 613A compromise, the House considered legislation that had been proposed by Wilbur Mills then the Chairman of the Ways and Means Committee that is strikingly similar to Section 613A.
That legislation provided a percentage depletion deduction that was permissible again with respect to so much of the taxpayers average daily production of domestic crude oil as in that bill did not exceed 3000 barrels.
Average daily production in that legislation was defined precisely as it is defined in Section 613A.
When that bill was reported out of committee the House Ways and Means Committee made the only statement that is directly relevant to the appropriate disposition of this case, and the House committee's report states thus the deduction applies to gross income attributable to oil which is sold or removed from the premises and not to other types of depletable income.
Unidentified Justice: Mr. Phillips, does any of the history address covering the Commission?
Carter G. Phillips: Directly?
Unidentified Justice: Yes.
Carter G. Phillips: No, Your Honor, it does not.
Unidentified Justice: Your answer to the argument based on Herring is?
Carter G. Phillips: Is that it obviously did not require Congress to have considered the prior law in order to change that law.
If it adopts language in the statute that is just completely inconsistent with the basic ground rules that gave rise to the Herring decision which we submit it did, then Herring is just no longer appropriate as a basis for decision.
The House committee report says expressly, for example, a lease bonus paid to the lessor of mineral lands in a lump sum or in installments is independent of any actual production from the lease and thus would not be within any of the exemptions.
That is directly inconsistent with Herring, and it is clear that Congress meant to change the rules that income alone was no longer the basis for percentage depletion.
What was necessary now is actual production and that in the taxable year.
I take it as self-evident frankly that if that legislative statement had been included by the Senators who proposed the amendment in 1975 on the floor of the Senate that these cases would not be here today.
There is simply no way to mask the clear intent of the House Ways and Means Committee four months before this actual legislation was passed with regard to exactly what this language means, and it is the with respect to the taxpayers average daily production that is the pivotal language in the 1975 legislation, and under our theory that is precisely the same language that the House Ways and Means Committee was interpreting in 1974.
We submit there is simply no justification for doing as the Seventh Circuit did to disregard the only clearly relevant legislative history we have to tell us what that statute meant and intended in the cases we have before us today, nor indeed do we believe that such an extraordinary result as the Seventh Circuit reached can be justified simply on the basis that Congress failed to make reference to the prior law with regard to lease bonuses and advance royalties in 1975.
Unidentified Justice: Mr. Phillips, can I interrupt you one second.
In looking at the language from the 1974 legislative history you are relying on, say you had a five-year lease with a five-year lease bonus paid in five installments, equal installments, and there was production in the first four years of the lease but not in the fifth.
Would there be any depletion allowance on the fifth installment of the lease bonus under your view?
Carter G. Phillips: No, Your Honor.
There would not be any depletion allowance on any of the lease bonus under the interpretation of the House Ways and Means Committee in 1974 because they say that lease bonus is clearly not attributable to income from production.
It has nothing to do with production.
It is based on acreage and, therefore, it is not subject to the depletion allowance, percentage depletion allowance.
It is still subject to cost depletion but not percentage any longer.
Unidentified Justice: So that when we are looking at lease bonuses we do not care whether there is production or not.
Carter G. Phillips: That is correct, Your Honor.
I believe that is a fair interpretation of the House committee's report.
The Seventh Circuit believed that it could reach a contrary result.
The Seventh Circuit in reaching its decision first stated that under the statutory language the Commissioner's interpretation was perfectly reasonable.
Under the legislative history in 1975 the Commissioner's interpretation was perfectly reasonable.
That recognized that the 1974 legislative history if considered provided substantial support for the Commissioner's interpretation, and it blinded itself to all of that and decided the case on the basis of the failure of Congress in 1975 to expressly state that it was going to overturn prior law.
In the context of what Congress was doing in 1975 that simply ignores the reality of that congressional session.
Congress acted within six days between the time that the Senate proposed the amendment and the House committee... Excuse me, the House-Senate conference committee adopted the compromise solution to this proposal that that legislation came out.
In the context of eliminating almost all percentage depletion allowance it is just simply not reasonable to assume that anyone would have worried about this very small portion of the problem of percentage depletion.
The future of percentage depletion simply was in no way contingent on the treatment of the royalty owner's advance royalties and lease bonuses.
Therefore, it is not appropriate to rely on the failure to make comment in 1975 as the basis for deciding this case.
In 1975 Congress was reacting to a severe oil shortage which caused the price of deregulated oil to skyrocket.
It responded by eliminating the extraordinary tax advantages that percentage depletion had previously granted in most situations.
Congress decided to continue to give some depletion protection to independent producers, but it quite reasonably withheld the percentage depletion advantage to situations where oil was actually extracted during that taxable year and even then only so long as the amounts reflected a small producer.
In all other situations Congress simply relegated the taxpayer to the cost depletion that most other taxpayers are able to use in most of their industries.
Taxpayers here were entitled to the latter.
They were not entitled to the former.
The federal circuit correctly so held, and its judgment in Farmar should be affirmed.
The Seventh Circuit's holding should be reversed.
Unidentified Justice: May I ask another question?
I am just wondering how important the words "lease bonus" are and I guess we have expressly a lease bonus in one case and an advance royalty in the other case.
Is it conceivable that the two cases could be decided differently, the government win in one and lose in the other?
Carter G. Phillips: It is conceivable that we could.
I do not think the Congress intended to draw a distinction.
I think if--
Unidentified Justice: Well, to the extent that you rely on the lease bonus language in the '74 report, does that language apply with the same force to the advance royalty situation?
Carter G. Phillips: --Well, since the advance royalties and lease bonuses had historically been treated essentially the same I would say that there is no reason to draw a distinction between them simply because Congress in its example referred to lease bonus.
If you take the more general statement that proceeds the--
Unidentified Justice: So in effect in your argument the history really has changed, that the old law was changed, not just limited to a certain category of persons.
I do not remember the name of the case.
Carter G. Phillips: --The Herring?
Unidentified Justice: The Herring case.
Carter G. Phillips: Well, no.
I do not believe so because it seems to me that there is still the question of what is gross income and if you have gross income whether you are entitled to a depletion.
I do not think that has been modified at all.
It simply tells you that it has to have some production that goes with it.
That is just simply adding a precondition.
Once you satisfy the precondition Herring applies just as it always had.
I do not think Congress had intended to change that, nor would I expect them to have made reference to that portion of it.
The reason I think it inappropriate to distinguish between lease bonus and advance royalties is because the sentence that precedes this specific example talks generally about attributing income to production, and that is just as true in an advanced royalty as a lease bonus.
That is, an advance royalty with no production the income is just not attributable to any production.
Unidentified Justice: Well, not until there is production at least.
Carter G. Phillips: Right.
Unidentified Justice: Under their view once there is production it could be attributable.
Carter G. Phillips: Sure, but if that is not done in the taxable year then the statutory language itself makes clear that you ought not to be entitled to the percentage deduction in that year.
Unidentified Justice: The thing that troubles me about your emphasis on years are if I understand the papers correctly there are situations in which you would agree that in a fifth year of a lease there could be a depletion allowance based on production during earlier years in the lease, a fifth year in which there was no production in the fifth year.
Carter G. Phillips: If there were income.
Unidentified Justice: Yes.
Carter G. Phillips: And production.
The Commissioner's proposed regulation does suggest that that is true that he will accept at least some portion of income in a subsequent year although the production precedes it.
The facial inconsistency with the statutory language as we read it in this case is conceded, but it does seem to me that the notion of allowing the deduction in that situation is fully consistent with the purpose here.
That is, the purpose is to have oil and that purpose is fully served.
As I say, I doubt that any taxpayers will complain about the Commissioner's interpretation on that side.
They seem only to be complaining about the Commissioner's interpretation on this side.
Moreover, it does not seem to me that the tail of how you deal with that problem should wag the dog of how you deal with this essential problem here.
That is, we still have to decided this case first.
Unidentified Justice: Except that it will have an effect on the way in which people will negotiate their leases.
That is what I am trying to think through.
Carter G. Phillips: I think it will have some effect on the way they negotiate their leases, but I do not think it undermines the basic purpose which was to encourage independent producers to continue producing, that is, because they still have the basic advantage when you get to income when you have actual production and actual income you still get a significant advantage with percentage depletion that you simply do not get otherwise.
Unidentified Justice: Other people do not get that.
Carter G. Phillips: That is right.
Large producers do not get that so if you go to Amoco or Exxon or someone and ask them to drill your hole if you get a lot if income you are not going to--
Unidentified Justice: Could I ask did the Seventh Circuit believe that your suggestive interpretation and the interpretation submitted by your opponents both were reasonable?
Carter G. Phillips: --Yes, Your Honor.
That is precisely what they said.
The statutory language supports either interpretation.
Unidentified Justice: Yet they turned down your interpretation.
Carter G. Phillips: That is correct, Your Honor.
That is an extraordinary result in our view.
Unidentified Justice: Did they give an explanation for rejecting yours or for saying that they need not give you any deference at all?
Carter G. Phillips: They gave no explanation for why the Commissioner ought not to receive some deference in interpreting his statute or why the Tax Court should receive no deference in interpreting the statute.
They simply said that failure of Congress in 1975 to make express reference to prior law was the basis for deciding against the Commissioner.
We submit the Commissioner's interpretation should be upheld.
Unidentified Justice: Mr. Phillips, if you look at the conference committee report because this language was added in a floor amendment so we do not have a lot of history to go by and if you just look at the conference committee report for the language that was actually adopted, there is no indication that Congress intended to amend the definition of gross income from property.
Carter G. Phillips: I do not believe--
Unidentified Justice: Or to change the prior result.
It just is not there.
You cannot find it.
Carter G. Phillips: --It seems to me there are two answers to that.
First, we are not arguing that the definition of gross income from property has been changed or need be changed in order to support our interpretation.
Second of all it seems perfectly unreasonable to assume that the conference committee six days after the Senate amendment would be sitting down trying to sort out these problems.
The problems that the conference committee addressed itself to were twofold.
First, the conference said we are going to keep percentage depletion at 22 percent.
That is how we resolved the difference between the House and the Senate version.
Second of all, we are going to keep the depletable quantity at 2000 barrels.
That is the difference between the 3000 and the 1000 barrel proposals that were in the Senate.
You would expect that in the conference they are going to explain just what the differences were and how they were resolved, and that is all the conference report discusses.
That makes sense in context, but that is not basis for saying that our interpretation should not be adopted simply because Congress did not go further and explain every other problem that might exist.
Unidentified Justice: Well, it also indicated that it intended to retain the percentage depletion privilege for the independent producer.
That is what it intended to do.
Carter G. Phillips: Well, no it said it intended to retain the percentage depletion at 22 percent for 2000 barrels.
What it retained was the Senate's version of 22 percent and retained the Senate's version of 2000 barrels.
It does not say anything about intending to retain any more than that and even the Seventh Circuit in its decision in this case declined to read into retains in the context of that conference committee report anything other than it is out there and that it explained what the compromise in conference was about.
Chief Justice Warren E. Burger: Very well.
ORAL ARGUMENT OF THOMAS J. DONNELLY, ESQ., ON BEHALF OF THE RESPONDENT, ENGLE
Thomas J. Donnelly: Thank you, Mr. Chief Justice, and may it please the Court:
I represent the Engles who are the Respondents in No. 82-599.
The Engles received $7600 in advance royalties in 1975, a year in which there was no production in the sense of physical extraction from the oil and gas properties that were involved.
The Engles nevertheless claimed under the independent producer exemption Section 613A(c) of the Revenue Code which was added under the Tax Reduction Act of 1975 the percentage depletion allowance.
The Tax Court decided against the Engles' position finding that the statute had overruled the decision of the Herring case and required production, that is, that the payment must be directly related to production.
The Seventh Circuit reversed finding that there was no production requirement imposed by the statute but rather that the statute imposed a limitation only on the amount that would be eligible for the deduction in effect defining who is the small independent producer that was to have available to him a continuing percentage depletion allowance though Congress had intended to eliminate the depletion allowance for the large oil company.
It is the Engles' position that the language in Section 613A which requires the deduction to be computed in accordance with Section 613 requires that the deduction be based only on gross income from the property.
The advance royalties are gross income from the property.
There is nothing in Section 613A that says that the deduction is to be calculated on the value of production, and Mr. Phillips' position would suggest that the calculation is to be based on the value of production.
Since we contend that prior law was to be retained for the small independent producer, a brief summary of prior law would be in order.
Under the Herring case there was no production requirement.
Lease bonus and advance royalties were eligible for percentage depletion in the same manner as the proceeds of actual extraction.
There was a recapture rule I think that has been referred to before.
If by the termination of the lease there had not been production sufficient to justify the advance royalty or lease bonus, then under the tax benefit rule the amount of depletion previously claimed would be recaptured.
Unidentified Justice: Mr. Donnelly, would it not be a reasonable position for the Commissioner to require that the deduction... Even if you are right about the fact that bonuses and advance royalties are part of gross income, would it not be reasonable for the Commissioner to require that the deduction be taken in the year of actual production?
Thomas J. Donnelly: Well, I think that would be reasonable, but under the statute cannot be done.
The percentage depletion allowance can only be taken in the year in which the proceeds or the money is received.
It has to be based on the gross income from the property.
There is a limitation contained in Section 613 that it may not exceed 50 percent of the net income from the property so that the deduction, its calculation requires that it be taken in the year in which the money is received for cash basis taxpayers.
It would have been reasonable I think for Congress to have drafted the statute so that at the time there is production the depletion allowance be taken.
Unidentified Justice: Well then maybe that is what Congress did do.
Thomas J. Donnelly: Well, Congress... You see under the 1974 bill that Mr. Phillips referred to there was no requirement that the calculation be made in accordance with Section 613.
That, however, is in the 1975 bill.
The statute does not say compute the deduction with respect to the barrelage amount allowed under Section 613A(c)(1)(a).
It says the calculation is to be made in accordance with Section 613, that is, with respect to the gross income from the property on so much of the production as does not exceed the barrel limitation.
Our position, of course, all along has been zero production does not exceed 2000 barrels.
If we had zero production and we had gross income from the property, the calculation is simply to be based on the gross income from the property.
Only in the event that our production should exceed 2000 barrels a day would the limitation come into play.
We believe that we are indeed then what Congress intended to define as a small independent producer.
The statutory history, I think, has been given, and we believe that since the independent producers exemption was inserted into the law as a result of the Senate amendment that the Senate committee report is of particular relevance.
That report indicates that it was the intention to retain percentage depletion for the small independent producer.
We believe that this meant that prior law was to be retained as to the calculation of the exemption for the small independent producer, that the words 613> ["] fully reflect the intention of Congress to make the calculation in accordance with prior law.
Unidentified Justice: Mr. Donnelly, can I ask you a question?
Thomas J. Donnelly: Yes.
Unidentified Justice: It will reveal my ignorance, but is there another definition of the term "small independent producer" in the statute other than the--
Thomas J. Donnelly: No.
Unidentified Justice: --This is what defines it.
Thomas J. Donnelly: This is the definition.
The statute prevents large retailers and large refiners and large producers if you fall into any one of those categories from being eligible for the small independent producer exemption.
The intent was to eliminate percentage depletion for the large oil company.
Unidentified Justice: Explain this to me then.
Why would this language not permit one of the giant oil companies to take this deduction to the extent that their production did not exceed this limit?
Thomas J. Donnelly: Well, most of the giant oil companies are retailers and refiners or one of the two.
If you are a retailer or a refiner you cannot use the small independent producer exemption.
If you are a producer only the oil company would be eligible for the exemption within the limitations of the small independent producer exemption.
Unidentified Justice: So the only meaning of the word "small" is that if you are otherwise an independent producer then you may take depletion up to the maximum limits that year.
Thomas J. Donnelly: That is correct.
Unidentified Justice: I see.
Thomas J. Donnelly: If production limits do not exceed that total, you are considered a small producer and you are entitled to the full depletion--
Unidentified Justice: It seems to me that tends to support your view that this is a limit rather than a basic condition for eligibility.
Thomas J. Donnelly: --We believe that it does support that.
Unidentified Justice: I see.
Thomas J. Donnelly: In the case of our client, our client received $7600 in advance royalties based on the price of oil as it existed in 1975.
That would have been the equivalent of less than one barrel of oil per day as compared to the 2000 which the statute allows.
Unidentified Justice: But you do not say, do you, that if there is never any production that you can have percentage depletion on advance royalties or bonus payments?
Thomas J. Donnelly: Justice White, we recapture.
If by the termination of the lease the production had not--
Unidentified Justice: So there is a precondition to claiming percentage depletion on this income other than being a small producer?
Thomas J. Donnelly: --The precondition--
Unidentified Justice: There has to be some production.
Thomas J. Donnelly: --The precondition claiming percentage depletion on advance royalties has always been that ultimately--
Unidentified Justice: That may be be, but the answer is yes.
Thomas J. Donnelly: --So as to avoid recapture.
Unidentified Justice: Okay.
Thomas J. Donnelly: Right.
Unidentified Justice: Your answer is yes.
It is the same precondition that existed before 1975?
Thomas J. Donnelly: That is correct.
The effect of the government's position on us I think can be expressed by an example.
Let us assume that there were $7600 in advance royalties received in 1975, a 5 percent royalty rate and no physical extraction.
In 1976 $200,000 in value of oil is extracted from the property.
$10,000 then in royalty would have been earned, 5 percent of $200,000.
The $7600 advance would be offset against the $10,000 earned and the balance of $2400 would be owing.
Further assume the $2400 is paid in 1977.
The government's position would give us no percentage depletion deduction in 1975 because there was no physical extraction.
We would get no percentage depletion deduction in 1976 because there was no gross income from the property, and in 1977 I thought that under the government's position in this case we would get no percentage depletion during that year either; however, Mr. Phillips has said that the government would condescend in that year because there had been prior production to grant depletion on a reasonable quantity whatever that is, whatever he may mean by that, the gross income from the property which is paid during that year.
We think the statute does not work as to that.
The statute also does not work as to an extractor who, for example, receives $100,000 in advance in 1975 in anticipation of production in 1976.
He gets no percentage depletion deduction in 1975.
In 1976 let's assume there is $200,000 in production.
The $100,000 advance is offset.
It is previously paid.
The gross income from the property is only $100,000.
This is all he can take percentage depletion with respect to.
We think that the difficulty with the government's position is found in the first paragraph of the question presented in its original brief where the question presented is stated,
"Section 613A(2)(a)... Actually that is a misprint. "
"It should be A(1)(a)-- "
of the Internal Revenue Code of 1954 allows a percentage depletion deduction to be computed 613
", the significance of those words being that the deduction has to be calculated on the gross income from the property. "
"The government, however, eliminates those words when it paraphrases this section of the Code. "
They then go on, "with respect to"... eliminating the words "so much of the"...
"the average daily production of oil or gas. "
--eliminating the words "as does not exceed"...
"defined in terms of production for any taxable year. "
The government attempts to convert the statutory language which imposes merely a limitation into a production requirement.
This is the same thing the government attempted to do at the time of Herring some 50 years ago to impose a production requirement, but a production requirement does not work with a statute that bases the calculation on gross income from the property.
Chief Justice Warren E. Burger: Mr. Collie.
ORAL ARGUMENT OF MARVIN K. COLLIE, ESQ., ON BEHALF OF THE PETITIONERS, FARMAR, ET AL
Marvin K. Collie: Mr. Chief Justice, and may it please the Court:
We represent two taxpayer ranchholders in west Texas by the name of the Farmars and the Suggs.
They executed oil and gas leases in 1975 providing for installment bonuses.
They received a part of their installment in 1976.
In that same year they also received a royalty paid as a part of the actual production from their leases.
Not only is that a differentiation that one should note as a fact but also there is actual proof in this case that as the amount of the bonus goes up the amount of the percentage royalty goes down and vice versa.
As a matter of economic logic that must be.
May I digress from what I would otherwise say to perhaps address what Justice Stevens was asking about.
There is a very pertinent point to be realized that a person that does not have substantial economic means is going to take the bonus because of the certainty of income regardless of the depletion allowance because he must have those dollars in hand and he cannot afford to gamble on the royalty that might ultimately be greater if he said forget the bonus and I will take the greater royalty in the future.
Now with respect to the reply brief of the government which was filed just a week ago, we believe it would be profitable to spend a few moments on that reply brief, and in that connection we respectfully ask the Court if it should choose to do so to look at the copies of Section 613A and the bill in 1974.
We thought it might be more convenient for the Court if it could lay those two down side by side because what that shows one when it is done it... Section 613A, and it is unfortunate they put a cap "A" there because of a section reference.
It is not a small 613 cap A.
Unidentified Justice: Mr. Collie, are you referring to a particular point in the briefs here that you would like to have us look at?
Marvin K. Collie: Sir, Justice Rehnquist, what I am referring to is where the brief says there is remarkable similarity between the 1974 bill and the Act that came out as 613A.
If we could look at the Act for a moment then I would like to compare it to the other bill and show the difference.
Unidentified Justice: Where should we turn to look at the Act?
Marvin K. Collie: Sir, in the application for certiorari the last page, page 93, has that.
It actually starts at page 92.
Unidentified Justice: That is 93 in your case.
Marvin K. Collie: In application for certiorari in my case, yes, sir.
The point that we desire to make is that Section 613A says that without regard to Section 613, the old Act granting depletion, we will have two exceptions.
One is an exception for certain domestic gas wells and then it starts off with respect to the exception for certain gas wells with this very important language, this clinching language.
"The allowance for depletion under Section 611 shall be computed in accordance with Section 613 with respect to. "
and then it mentioned two types of natural gas that will still get percentage depletion.
Then it drops down in Subsection C to the exemption for independent producers and royalty owners, and it starts off the same way.
"except as provided in Subsection D. "
--which is irrelevant for our question...
"the allowance for depletion under Section 611 shall be computed under and in accordance with Section 613. "
Now why did Congress choose that cross-reference, this webb of cross-references that it has woven into the fabric of the Internal Revenue Code?
It is because Congress wanted to tell us that we wanted to go back to 613.
We want all of the law, the regulations, the baggage, the decisions of this Court including Herring in order that we can see when we go to the limitation that Congress meant for this Court to look and meant for the administration of the Internal Revenue Service to look at what it has said before over a period of 50 years with respect to Section 611 through Section 613.
That is the important thing.
When the legislative history of the prior bill in 1974 is referred to by the government and saying that there it said you cannot have the bonus, the depletion on the bonus, look what that bill says.
It does not have anything, not a word, about a cross-reference to Section 611, not a word about a cross-reference to Section 613.
There is the all-important difference between the bill that the IRS would have us look at and the actual enactment in 1975.
The legislative history may be different, but it is for a very good reason the statutory language is entirely different and without the vital, the all-important cross-references.
Now a moment more about legislative history if legislative history should be relevant here.
In the original briefs of the government they cited us three cases saying that we should look back from one Congress, the Congress in 1975 to a prior Congress in 1974.
They cited two cases.
In our briefs we showed that neither of those cases were applicable.
Now they come along with the Danlaheight case, the famous Texas City disaster case involving the Federal Tort Claims Act.
In that case this Court considered a prior legislative report to the Congress that enacted the Tort Claims Act.
It was because the statute, the bill in the prior Congress was exactly the same and the legislative report was exactly the same word for word.
The only reason they leaped forward back a year is because they wanted to pick up some testimony with respect to the prior bill because the bill that was actually enacted never had any legislative hearings.
Therefore, we respectfully submit that it had absolutely no support for going back into a prior Congress as to a bill that was never enacted.
Your Honors, in the situation the government would have us look at here we had a bill that came out of a committee.
Nothing further ever happened to it.
It was never referred to again in any place.
The danger as the Congressional Record shows is of doing such a thing as that aside from the vacuum that we are looking at the Ways and Means Committee changed 51 percent in those two years and changed in chairmanship from Chairman Mills to Chairman Ullman.
Next we would respectfully suggest--
Unidentified Justice: May I ask you one question?
Marvin K. Collie: --Yes, sir.
Unidentified Justice: Did the 1974 bill... What did that do with respect to regulated natural gas and natural gas sold under fixed contract?
Marvin K. Collie: They had a provision for it, yes, sir.
Unidentified Justice: For preserving or eliminating?
Marvin K. Collie: For preserving it.
Unidentified Justice: I see.
Marvin K. Collie: But... Excuse me, sir.
Unidentified Justice: So it was parallel in that regard?
Marvin K. Collie: In that regard, but again without the transitional or shall we say cross-referencing langauge that picks up 611 and picks up 613 in that manner.
Your Honor, it is to show that it is before this Court.
Now much has been made about the mechanical difficulties.
Principally this mechanical difficulties is found in the concurring opinions in the Tax Court and the dissenting opinions in the application of the statute.
We respectfully submit those mechanical difficulties are wholly illusory.
They are simply not there.
We would simply apply and why the IRS did it I cannot understand except they started it off wrong.
They would simply apply the same technique that the lessor does today with respect to cost depletion.
In other words, the lessor would have to do nothing more than he does today with respect to cost depletion in order to allocate this percentage depletion that he takes on his bonus over the actual production that he may receive in the future, and of course as Justice White pointed out if there is no production in the future the percentage depletion evaporates.
So the mechanical difficulties as all of the commentators have pointed out are simply not there.
May I add with respect to the some 11 or more commentators that have commented on the cases now before this Court I am pleased to report they all have come down in favor of the taxpayers' position.
Unidentified Justice: Do you feel that weighs heavily in your favor?
Marvin K. Collie: Sir?
Unidentified Justice: Do you feel that weighs heavily in your favor?
Marvin K. Collie: Justice Rehnquist, I would rather it be on our side than on the other side.
Unidentified Justice: Are you happy to report that none of them is a student?
Marvin K. Collie: Sir?
Unidentified Justice: Are you happy to report that none of them is a student?
Marvin K. Collie: No, sir.
I cannot say that.
I can say though to Your Honor that about half of them are practitioners and half of them are students.
But I would say the students' notes are very lucid and well done, and any practicing attorney would be delighted to have been associated with them.
Unidentified Justice: Unless he is on the other side of the case.
Marvin K. Collie: Lastly--
Unidentified Justice: Mr. Collie, before you go on do I understand that you think that it would be appropriate to require the deduction then to be taken in the year of the actual production?
Marvin K. Collie: --No, ma'am.
I think, Justice O'Connor, it would be appropriate to take the percentage depletion deduction in the time of the receipt of the dollar.
It is possible to devise a method to take the deduction at a later period of time, but I do not believe that is in accordance with the teaching of the Herring case which we believe is still vital and was not destroyed.
Unidentified Justice: Well would it not be consistent with it and be a reasonable interpretation that the Commissioner could make?
Marvin K. Collie: Yes, ma'am.
Unidentified Justice: So perhaps even if we agreed with you on the gross income issue it should be remanded to the court below to consider deference to the Commissioner on that?
Marvin K. Collie: With all deference, Justice O'Connor, to the Commissioner when the Commissioner has adopted a totally erroneous position he is not entitled to prevail.
Unidentified Justice: Well, maybe we could disabuse him of that position in the process.
Marvin K. Collie: I would hope, of course, the Court would, yes, Your Honor.
Lastly, we would respectfully call the attention of the Court to the fact that the Farmars and the Suggs had actual production during the year of the receipt of their bonus and so there is absolutely nothing in the statute that says that they cannot combine these two types of gross incomes from the property.
The gross income that is truly gross income from the property in the form of a bonus and the dollars they receive from the percentage royalty, I put the two together and take their percentage depletion upon that.
You can easily combine them and see whether or not the limitation had been violated.
So, therefore, we have an even, simplistic method of applying the statute.
What the taxpayers here are suggesting conform with all of the decisions, the mosaic, almost Grecian mosaic that this Court worked out with respect to percentage depletion on bonuses over a very long period of time.
It conforms with what Congress intended for the small producer.
It is simple.
It is logical, and the taxpayers should prevail.
Unidentified Justice: May I ask you a question about your position?
Supposing you had a lease with a very large producer.
Marvin K. Collie: A very large what, sir?
Unidentified Justice: A very large producer.
It is an independent producer so it is not a retailer and all that stuff, which produced ten barrels on December 31, or the last day of the taxable year and in the taxable year it got an advance royalty of $10 million and then it got very small payments but very large production thereafter.
Would it get the full deduction under your view in the first year?
Marvin K. Collie: Yes, sir, but then it would have to be spread over the large production if I understand the question correctly in the later years and it would immediately violate the 3000 or 2000 barrel limit and you would immediately in the next year restore a part of the depletion deduction to income.
In other words, you estimate your recoverable reserves, Your Honor, and then you spread that... Say you are going to get 1000 barrels... I mean a million since we are dealing with big figures a million barrels a year for the next ten years.
Unidentified Justice: Right.
Marvin K. Collie: So you spread your bonus over that ten years proportionately, and if you take your bonus and spread it to the next year and see how many dollars you are getting for that production you immediately are able to see that you have gone over in the second year your 2000 barrel limitation and so in the second year you immediately restore the depletion you took in the first year back to income.
Chief Justice Warren E. Burger: I think you have answered the question now.
Do you have anything further?
Carter G. Phillips: No.
Chief Justice Warren E. Burger: Thank you, gentlemen.
The case is submitted.