[328 U.S. 25, 26] Mr. Norman F. Anderson, of Lake Charles, La., for petitioner.
Mr. J. Howard McGrath, Sol. Gen., of Washington, D.C., and Sewall Key, Acting Asst. Atty. Gen., and Miss Helen R. Carloss and Mr. Hilbert P. Zarky, both of Washington, D.C., for respondent.
Mr. Justice REED delivered the opinion of the Court.
The taxpayer, the petitioner here, is the operating company for the production of oil from Louisiana lands. The taxpayer acquired a contract from J. G. Sutton, grantee in the contract, that imposed upon the grantee the obligation to develop the oil land. For that purpose the contract transfe red to the grantee all oil rights previously obtained by S. W. Sweeney by a lease from the owners of the land, the Cameron Parish School Board. Through another transaction the grantor in the Sutton contract, the Gulf Refining Company of Louisiana, acquired these rights from Sweeney. An underlying oil royalty was retained by the School Board and an overriding oil royalty by Sweeney. The contract between Gulf and Sutton required the grantee-operator, who is now this taxpayer, to pay to the grantor, Gulf, 50% of the proceeds of the oil produced and sold from the land, deducting from the proceeds certain itemized expenses of the producer. Those expenses are so general in character that it may be said fairly that Gulf was to receive 50% of the net from operations.
The issue here is the correctness of the taxpayer's manner of handling this 50% net from operations, paid to Gulf, in its return for federal income tax for its fiscal years ending during 1936, 1937 and 1938 under the Revenue [328 U.S. 25, 27] Acts of 1934 and 1936. The taxpayer deducted these payments of 50% of net income from its income for each of the years from the oil sold from the property. It claimed that Gulf retained an economic interest in the oil in place to the extent of this 50% payment. The Tax Court upheld the Commissioner's inclusion of an amount equal to these 50% payments in the taxpayer's gross income. They were included by the Commissioner in the income on the theory that the 50% payments represented capital investment by the taxpayer. That is, they were a part of the cost of the lease. 3 T.C. 1187. If this theory is correct, it is proper to add an equivalent sum, as the Commissioner did, to the taxpayer's gross income. 1 The Circuit Court of Appeals affirmed the Tax Court. Burton-Sutton Oil Co. v. Commissioner, 5 Cir., 150 F.2d 621, 160 A.L.R. 961.
A decision on the category of expenditures to which these 50% disbursements belong affects both the operators who make them and the owners, lessors, vendors, grantors, however they may be classed, who receive them. If they are capital investments to one, they are capital sales to the other. If they are rents or royalties paid out to one, they are rents or royalties received by the other. 2 The decision below conflicts in principle with Commissioner v. Felix Oil Co., 9 Cir., 144 F. 2d 276. Kirby Petroleum Co. v. Commissioner, 326 U.S. 599 , 66 S.Ct. 409, involved payments of a share of net income by a producer but differs from this case because the lessor there was a landowner who reserved a royalty as well as a share in the net profits. Consequently, we granted certiorari, 327 U.S. 771 , 66 S.Ct. 526.
The applicable provisions in the Revenue Acts for 1934 and 1936 and the Regulations thereunder are substan- [328 U.S. 25, 28] tially the same for the two Acts. We insert below those that seem pertinent. 3 The issue of the character of these 50% payments is not settled, however, by the statutes or regulations. These prescribe the federal income tax accounting procedure after a determination that an expendi- [328 U.S. 25, 29] ture of an operator is or is not a rent, a royalty or an ordinary business expense, but throw little light on what is a rent or royalty.
In the Kirby case, we held that a payment of a share of the net profits from oil production by the operator to the owner of the land was a rent or royalty and taxable to the landowner as income from the oil property. Therefore the owner could take from the payment the 27 1/2 per centum allowance for depletion provided by Section 114(b)(3). The reason given in the Kirby case for holding that the payment of a part of the net return from the property to the landowner was a royalty or rent,4 was that the owner had a capital investment-an economic interest-in the oil with a possibility of profit from that interest or investment solely from the extraction of the oil. As hereinbefore indicated, the landowner in the Kirby case had retained also a one-sixth oil royalty and had received a bonus. It was conceded that as both the bonus and the royalty represented a return for the sale in part of the lessor's investment in the oil in place, the lessor was entitled to depletion on both.