Abercrombie v. Commissioner , 7 T.C. 120 ( 1946 )

J. S. Abercrombie Co., Petitioner, v. Commissioner of Internal Revenue, Respondent

Abercrombie v. Commissioner

Docket No. 6168

United States Tax Court

7 T.C. 120; 1946 U.S. Tax Ct. LEXIS 157;

June 12, 1946, Promulgated

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">*157 Decision will be entered that there is a deficiency of $ 36,640.04.

Petitioner and H corporation were the operators of certain oil and gas properties under an agreement with A and C corporations. At one time the four corporations owned equal interests in the leases. In 1937 A and C corporations transferred to petitioner and H corporation a portion of their interests in consideration of a cash bonus and a reserved oil payment, but reserved to themselves as a "carried working interest" an undivided one-sixteenth of the working interest in all minerals. Under the agreement one-sixteenth of the proceeds of all oil and gas sales was to be credited to the carried interest and one-sixteenth of all expenditures, including capital expenditures, was to be charged to it. Petitioner and H corporation were to have the management of the properties and the right and obligation to sell, together with their own, the oil and gas accruing to the carried interest. When the proceeds should exceed the chargeable expenditures, regular distributions of the excess were to be made to A and C corporations. Not until after the taxable year did the proceeds exceed the chargeable expenditures. Held">*158 , A and C corporations retained a capital investment to the extent of a one-sixteenth interest in the oil and gas in place. Under the agreement the income and expenditures attributable to the carried working interest belonged to A and C corporations and petitioner is not taxable on that income.

G. Kibby Munson, Esq., for the petitioner.

Frank B. Schlosser, Esq., and L. R. Van Burgh, Esq., for the respondent.

Arundell, Judge.

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ARUNDELL

">*121 Respondent has determined a deficiency of $ 43,097.44 in petitioner's income tax liability for the calendar year 1941. In that year petitioner was engaged in developing and operating oil and gas leases known as the Old Ocean Field Prospect, and the only question for decision is whether it is entitled to eliminate, in computing its tax liability, a share of income and corresponding deductions attributable to a "carried working interest" of two other oil companies. If it is held that the income and expenditures attributable to the said "carried working interest" belonged to the other companies, then the parties have agreed that the proper deficiency is $ 36,640.04; otherwise, that the deficiency asserted by the Commissioner is">*159 correct.

All the facts have been stipulated and will be summarized herein.

FINDINGS OF FACT.

Petitioner is a corporation, organized and existing under the laws of Texas, with its principal place of business at Houston, Texas. Its income tax return for the year 1941 was filed with the collector for the first district of Texas.

Prior to November 1, 1937, petitioner and three other corporations, Harrison Oil Corporation, Atlatl Royalty Corporation, and Coronado Exploration Corporation (hereinafter referred to as Harrison, Atlatl, and Coronado, respectively) jointly owned and operated a number of oil and gas leases covering lands in Brazoria County, Texas, known as the Old Ocean Field Prospect, the four sharing equally in all expenses and profits.

During November of that year the four corporations were negotiating for a transfer of a portion of Atlatl's and Coronado's interests to Harrison and petitioner. The negotiations culminated in an agreement, effective as of November 1, 1937, which recited that in a contemporaneously executed instrument, incorporated by reference, Atlatl and ">*122 Coronado, as assignors, were assigning their interests in the oil and gas leases to Harrison">*160 and petitioner, as assignees, subject to the reservations and conditions stated in the agreement. The instrument of assignment provided that "subject to the reservations, and on the terms and conditions stated in [the] agreement * * * Atlatl * * * and Coronado * * * do * * * hereby grant, bargain, sell, convey, transfer and assign unto Harrison * * * and J. S. Abercrombie Company [petitioner] * * * all of the undivided one-half (1/2) interest of assignors in and to the oil and gas leases * * * and in and to certain personal property * * *."

Item I of the agreement provided for the payment of $ 600,000 in cash by petitioner and Harrison to Atlatl and Coronado.

In item II of the agreement the assignors reserved to themselves, as a limited overriding royalty, an oil payment of $ 2,250,000, payable out of one-fourth of the first oil, gas, etc., produced, saved, and marketed.

Item III of the agreement reads in part as follows:

In addition to, and independently of, the interest hereinabove reserved, Assignors do also hereby reserve unto themselves, their heirs, successors, representatives and assigns as a carried working interest that shall be and remain the property of Assignors, one-eighth">*161 (1/8) of the present interest of Assignors, being one-sixteenth (1/16) interest, in and to all of the oil and gas leases, during their lives or during the life of any extension or reacquisition thereof, in their entirety described in Exhibit "A" [the assignment] hereto attached, together with a like one-sixteenth (1/16) interest in personal property now or hereafter placed on the lands covered thereby. In consequence of this reservation, Assignees shall account to Assignors from time to time for one-sixteenth (1/16) of the operating profits as hereinafter defined (if any) that are realized from the development and operation of said oil and gas leases, if, as and when realized and collected.

Assignees, their successors and assigns, shall have and are hereby granted, the sole and exclusive superintendence, direction and management of said properties, * * * it being the understanding and intention of the parties hereto that Assignees shall have unrestricted freedom in the development and operation of said properties.

Assignees are hereby given the right, and on them is imposed the obligation to care for, in the same manner as their own, the oil, gas, casinghead gas and other minerals">*162 accruing to the carried working interest herein reserved and to sell the same proportionately with their own to purchasers of their selection and at the time and price deemed best by Assignees for their interest therein. In the event Assignees desire to refine or have refined said oil they shall have the right to purchase same themselves at the wells at the average posted field price in the Gulf Coast area for oil of like grade and quality.

* * * *

It was further provided that the assignees should pay all chargeable expenditures in connection with the properties, keep accurate books of account in accordance with a procedure of accounting set out in an attached document, and make quarterly reports to the assignors of the status of operations and remittances in payment of the interest of the ">*123 assignors in the operating profits, if any, earned during the quarter. The assignors were to be under no obligation to reimburse the assignees for any remittances made to them on an accounting for one-sixteenth of the operating profits, but it was agreed that all unliquidated expenses incurred by the assignees should be carried forward and charged against future receipts in the course">*163 of accounting to the assignors. The terms "gross proceeds," "chargeable expenditures," and "operating profits" were defined in the agreement and in the attached document relating to accounting procedure. Operating profits were said to be the amount by which the gross proceeds exceed the chargeable expenditures.

The following provision appears in item IV of the agreement:

The relation of the parties under this agreement shall be deemed and considered to be that of independent contractors and nothing herein shall be construed to constitute a partnership between the parties hereto. It is expressly understood and agreed that Assignors shall personally never be liable for any loss (except Assignors' proportion in the case of the recovery by judgments by third parties of the value of oil title to which fails) or cost or expense incurred in connection with the development, operation and maintenance of said properties; and against liability therefor, Assignees for themselves and their respective successors, assigns and representatives do hereby agree to indemnify and save harmless, Assignors and their representatives, successors and assigns.

With reference to the reserved one-sixteenth">*164 interest, the subject matter of item III of the agreement, the letter of transmittal accompanying the agreement, from Atlatl and Coronado to Harrison and petitioner, stated:

We do not agree to sell, but are to reserve and retain in us, as a carried ownership and interest, an undivided one-sixteenth (1/16) of the working interest in all minerals. Our respective rights and obligations with reference to the reservation and handling of, and accounting for, this reserved and carried interest are set out in copy of proposed agreement hereto attached.

Since November 1, 1937, the four corporations have operated under the terms of the agreement and assignment. Until July 1942 the expenses chargeable under the terms of the agreement against the carried working interest retained by Atlatl and Coronado exceeded the gross proceeds accruing to the interest from the sale of oil, gas, and other minerals. Since that time, however, the gross proceeds have exceeded the chargeable expenditures each month, and sums representing the net proceeds accruing to the carried working interests have been and are being paid quarterly to Atlatl and Coronado.

In his notice of deficiency respondent, in explaining">*165 the adjustments, made the following statement:

In the development of Old Ocean, you have been "carrying" Atlatl Royalty Company and Coronado Oil Company for their part of the expenses. You have accounted for these operations as though the "carried" partners or joint operators ">*124 were the owners of that interest and all income and expenditures attributable thereto have been treated as belonging to the Atlatl and Coronado Companies.

It is held this treatment of operations was incorrect. It is further held you realized taxable income from this carried interest * * *.

OPINION.

The theory underlying respondent's treatment of the "carried working interest" is that Atlatl and Coronado transferred to Harrison and petitioner all their interests in the oil and gas leases, that they retained nothing more than a right to share in net profits, and that therefore they had no economic interest in oil and gas in place. In that we think respondent is in error.

From the agreement and the assignment it is clear that Atlatl and Coronado reserved a one-sixteenth interest, a capital investment, in the minerals. The formal assignment was expressly made "subject to the reservations, and on the">*166 terms and conditions" of the agreement, one of which was that "Assignors do also hereby reserve unto themselves * * * as a carried working interest that shall be and remain the property of Assignors * * * one-sixteenth (1/16) interest, in and to all of the oil and gas leases."

With respect to the operation of the properties, the agreement provided that Harrison and petitioner were to have management and control and were obliged to sell, together with their own, the oil and gas accruing to the one-sixteenth carried interest. They were also to advance and pay all expenditures in connection with the properties. Under the detailed accounting procedure agreed upon, however, they were to recoup one-sixteenth of these expenditures by charging them against the proceeds of the oil and gas sales credited to the carried interest of the assignors.

In ; certiorari denied, ; and , both of which involved carried interests and operating agreements of the same general character that we have before us, the taxpayers, ">*167 who were the nonoperators, were held taxable on the income from oil production accruing to their carried interests, notwithstanding that they received no distribution in the taxable year because the operator was reimbursed from their shares for expenditures advanced on their behalf in connection with the properties. It is an immaterial distinction between those cases and this that here, in addition to the operating agreement, there was also a transfer of a portion of the interests of the nonoperators to the operators. So far as the retained one-sixteenth interest and the operating arrangement relating thereto are concerned, the principle is exactly the same. The income from oil production is ">*125 taxable to the owner of the capital investment which produces it. . Under the contract here, one-sixteenth of the proceeds from oil production -- that part attributable to the reserved interest of Atlatl and Coronado -- belonged to those companies, as did the expenditures chargeable to the carried interest. The income attributable to their interest is not taxable to petitioner.

As for respondent's point that what">*168 Atlatl and Coronado retained amounted to nothing more than a share in the net profits, we would observe that, even if that were so, the reservation of a share in or percentage of net profits does not of itself mean that a lessor or assignor has disposed of his entire interest and retains no capital investment in the oil in place. ; .

The parties have stipulated the amount of the deficiency in the event we should hold that the income and expenditures attributable to the "carried working interest" belonged to Atlatl and Coronado. We have so held. Therefore,

Decision will be entered that there is a deficiency of $ 36,640.04.