West v. Commissioner of Internal Revenue

150 F.2d 723, 34 A.F.T.R. (P-H) 81, 1945 U.S. App. LEXIS 3543

• Court: Court of Appeals for the Fifth Circuit
• Decided: July 24, 1945
• Docket: 11178-11181
• Status: Published

Opinions

HOLMES, Circuit Judge.

These consolidated proceedings involve income-tax deficiencies for the year 1938. By deed the petitioners transferred to the Humble Oil & Refining Company certain lands, improvements thereon, and minerals therein, subject to the terms of a contemporaneous collateral agreement. The Tax Court held that the profit from the sale of the surface of the land and improvements was a capital gain, but that such part of the consideration as was attributable to the mineral rights represented a bonus or advance royalties.

There is no question here with respect to the surface of the land or the improvements, or as to the proper method of taxing the gain from the surface estate. It is well settled in Texas that the surface of realty may be severed and held separately from the title to the minerals.¹ The only issue now presented is whether, for tax purposes, the transaction constituted a sale or a lease of the minerals, it being wholly neither, but having attributes of both; if a sale, then the cash so received was taxable under the capital-gains provision of the Revenue Act of 1938, Sec. 117, 26 U.S.C.A. Int.Rev.Acts, page 1061; if a lease, then such cash was taxable as depletable income under Section 22(a) and 23(m) of said act, 26 U.S.C.A. Int.Rev.Acts, pages 1008, 1014.

In determining the character of the contract, we are dealing with a deed and a contemporaneous written agreement. We may look not only to the language employed in both instruments, but to the circumstances surrounding the parties when the instruments were executed.² Prior to that time, J. M. West told Humble that he wanted to sell the properties. Humble was interested in the right to develop the lands for oil and gas; that was its business. It negotiated with West to acquire the properties for that purpose. Humble’s complete lack of interest in the surface was demonstrated by its leasing of the land to West for grazing and agricultural purposes. All this was shown by the evidence and found by the Tax Court.

Under the terms of the deed and agreement, the parties did not undertake to convey the entire interest of the grantors in the minerals. The granting, habendum, and general warranty clauses contained words of limitation excepting from the conveyance and retaining in the grantors specific mineral rights amounting in some instances to three-eighths thereof. The only language in the instruments that specifically referred to mineral interests acquired thereunder provided that Humble should be entitled to the conveyed percentage of all oil, gas, and other minerals produced from the property after seven o’clock a. m., December 28, 1938. On the date of the deed a division order was executed in which the parties certified that Humble was the owner of a five-eighths interest and West a three-eighths interest in all oil produced from the tract therein described. Similar division orders, where the interests varied, were executed by the parties covering other productive portions of the land involved. The situation here is distinguishable from Helvering v. Elbe Oil Land Company, 303 U.S. 372, 58 S.Ct. 621, 82 L.Ed. 904, where the contract provided for the absolute sale of all the property, including the oil and gas in place, without the retention by the taxpayer of any interest therein.

The Tax Court held that, from a practical standpoint, the provisions of the agreement weighed heavily in favor of a leasing arrangement; that one could not examine the terms of the agreement without realizing that its main purpose was to secure to the grantors the three-eighths royalty interest specifically excepted from the conveyance; that without operation of the properties they would receive no return on their interests; that, in order to be assured of a return, the grantors bound the grantee, an operating company, to operate with reasonable diligence not less than four drilling rigs, to drill offset wells, and to drill certain deep-test wells. It was further agreed that petitioners would sell and Humble would buy all royalty oil; that division orders would be executed and delivered; that the provision for free fuel for operating did not extend to certain leases owned by Humble; that an oil well meant a well capable of producing oil in paying quantities ; that the royalty and overriding royalty provisions should be applied in a certain manner where a particular sand in a certain field varied with respect to the 7500-foot depth; that petitioners had the right to be represented when gauges were made, and the right to be furnished with copies of the logs of wells drilled or being drilled. Also there were other provisions usually found in mineral leases.

The Tax Court decided that there were factors favoring the petitioners’ contention, but that they did not predominate; that the presence of so many provisions usually occurring in oil and gas leases supported the contention that the transaction in substance amounted to a lease of the minerals notwithstanding there was a sale of the balance of the land. We are in accord with this view. The absence from the deed and agreement of the words lease, let, lessor, and lessee, is not controlling. In the field of taxation we are concerned with realities, not formalities. The descriptive terminology that may be used in deeds, contracts, or other written instruments is ineffective to restrict the scope of the income-tax law. Technical niceties of the local law are not allowed to obscure the basic issue as to whether cash received is taxable under the capital-gains or the depletable-income provisions of the income-tax law.

The absence of a forfeiture clause has no special significance in the prevailing circumstances. The Wests relied upon their contractual right to recover damages for the failure of Humble to perform its drilling and other obligations, and probably upon the remedy of specific performance.³ The differences between the nature of the title that Humble took and what an ordinary lessee would have taken are immaterial for federal-income-tax purposes.⁴ The question for decision here does not turn upon recondite distinctions in the local law between determinable and indefeasible fees.⁵ The purpose of the transaction was the production of oil; and, to that end, the Wests retained the legal title to an undivided interest in the oil in place and contemporaneously stipulated for an income-producing operation “resembling a manufacturing business carried on by the use of the soil.” ⁶ These factors predominated to such an extent that the fact-finding tribunal held the transaction more nearly to resemble a lease than a sale. In Hogan v. Commissioner,⁷ the conveyance used the words “do hereby bargain, sell, assign and convey,” but this court held that the assignment, for tax purposes, was deemed a sublease rather than a sale, thereby disregarding technical distinctions of local law and applying uniformly the federal-income-tax statutes.⁸

In other words, the fact that the instruments of transfer passed only a fractional mineral interest, retaining the remaining portion thereof, is not controlling in determining the legal relationship created between the parties. It must also be considered that the properties conveyed were in part actual and in part probable producers of oil; that the transferee was engaged in the oil business, and was interested in the properties only for the purpose of developing the minerals; that one of the objects of the transferors was to secure full development of the minerals; that the transferee was contractually obligated to develop; and that the transferors, though securing to themselves so valuable a covenant, were chargeable with no part of the costs thereof.

What these taxpayers seek as liberal to them might prove harsh to others. The policy considerations underlying the capital-gains provision of the tax laws have no greater force than the considerations that underlie the depletion provision. The latter was intended as a tax-free return of the capital consumed in the production of gross income through severance.⁹ The depletion allowance was intended to encourage production, and may be regarded as a substitute for the capital-gains allowance where the taxpayer, instead of selling, leases or operates his own mineral holdings. The Tax Court is not a policy-making body; it is an administrative tribunal with quasi-judicial functions.¹⁰ It considers both law and facts, but review of its decisions is limited to questions of law.¹¹ As an independent agency in the executive branch of the Government, it differs from the old Court of Exchequer in England in that the latter was a judicial court of law and equity with exclusive jurisdiction in fiscal matters.¹²

All that has been said by the Supreme Court as to the finality of administrative determinations in other fields is applicable to decisions of the Tax Court.¹³ The judicial function is exhausted when, upon review, there is found to be a rational basis for its decisions; but its mistakes of law, clear-cut or rough-hewed, may be corrected on review.¹⁴ A rational basis for decision consists of a permissible finding of fact and a correct application of the law.¹⁵ A decision on any other basis is not in accordance with law and is subject to modification or reversal on review.¹⁶

Every tax decision is controlled by some principle of law, which arises out of the facts.¹⁷ The principle may be a part of the common law, or it may be defined in a statute, regulation, or constitutional provision. The rightfulness of the decision may depend upon the correct interpretation or the proper application of the governing principle. Often a question of law is presented as to whether there is substantial evidence to support the findings of fact. Jurisdiction to review decisions of the Tax Court is conferred by statute and is not affected by. the difficulties of distinguishing between legal and factual issues, but the decision under review must be affirmed if an error of law therein is not discernible from the record.¹⁸ The limitation upon the scope of the review is jurisdictional.¹⁹

In the instant case, the rational basis for the decision was substantial evidence in the record to support the finding of the Tax Court that the transaction amounted to a lease of the minerals and a sale of the remainder of the land. The fact that the minerals were leased having been established, it then became necessary for the Tax Court properly to apply the governing income-tax law to the transaction between the parties. This having been done correctly, the decision appealed from is affirmed.

1 Harris v. Currie, 142 Tex. 93, 176 S.W.2d 302.

2 Scott v. United States, 12 Wall. 443, 20 L.Ed. 438; United States v. Peck, 102 U.S. 64, 26 L.Ed. 46; Merriam v. United States, 107 U.S. 437, 2 S.Ct. 536, 27 L.Ed. 531; United States v. Gibbons, 109 U.S. 200, 3 S.Ct. 117, 27 L.Ed. 906; Sand Filtration Corporation v. Cowardin, 213 U.S. 360, 29 S.Ct. 509, 53 L.Ed. 833.

3 3 Summers Oil & Gas, Perm.Ed., 1927, § 462.

4 Palmer v. Bender, 287 U.S. 551, 557, 53 S.Ct. 225, 77 L.Ed. 489.

5 Cf. United States v. Joliet & Chicago R. Co., 315 U.S. 44, 62 S.Ct. 442, 86 L.Ed. 658, dealing with a so-called lease in perpetuity without a defeasance clause, which vested a full and indefeasible title in the grantee.

6 Anderson v. Helvering, 310 U.S. 404, pages 407, 408, 60 S.Ct. 952, 954, 84 L.Ed. 1277, wherein the court said: “Oil and gas reserves like other minerals in place, are recognized as wasting assets. The production of oil and gas, like the mining of ore, is treated as an income-producing operation, not as a conversion of capital investment as upon a sale, and is said to resemble a manufacturing business carried on by the use of the soil. * * * By an outright sale of his interest for cash, such an owner converts the form of his capital investment, severs his connection with the production of oil and gas and the income derived from production, and thus renders ■inapplicable to his situation the reasons for the depletion allowance.”

7 5 Cir., 141 F.2d 92, 93.

8 In Hervey v. R. I. Locomotive Works, 93 U.S. 664, 23 L.Ed. 1003, a contract in the form of a lease was held to be a sale. The court said, page 672 of 93 U.S., 23 L.Ed. 1003: “Nor is the transaction changed by the agreement assuming the form of a lease. In determining the real character of a contract, courts will always look to its purpose, rather than to the name given to it by the parties.”

9 Anderson v. Helvering, 310 U.S. 404, 408, 60 S.Ct. 952, 84 L.Ed. 1277.

10 Hutchings-Sealy Nat. Bank v. Commissioner, 5 Cir., 141 F.2d 422: 26 U.S.C.A. Int.Rev.Code, § 1100, 56 Stat. 957, 53 Stat. 158 et seq.

11 26 U.S.C.A. Int.Rev.Code, § 1141(c) (1).

12 15 C.J. p. 688; 3 Bla.Com. 44, 45.

13 Dobson v. Commissioner, 320 U.S. 489, 501, 64 S.Ct. 239, 88 L.Ed. 248, rehearing denied 321 U.S. 231, 64 S.Ct. 495, 88 L.Ed. 691.

14 Bingham’s Trust v. Commissioner, 65 S.Ct. 1232.

15 “In general, it is the function of the Board [the Tax Court] to determine the facts of a tax controversy on issues raised before it and to apply the law to those facts; and it is the function of the reviewing court to decide whether the Board has applied the correct rule of law.” Hormel v. Helvering, 312 U.S. 552, 556, 61 S.Ct. 719, 721, 85 L.Ed. 1037.

¹⁶

17 Ex facto jus oritur.

18 Omnia praesumuntur rite et son-niter esse acta donee probetur in contrarium.

¹⁹