Commissioner of Internal Revenue v. P. G. Lake, Inc.

PETITIONER:Commissioner of Internal Revenue
RESPONDENT:P. G. Lake, Inc.
LOCATION:Shotwell Manufacturing Co.

DOCKET NO.: 108
DECIDED BY: Warren Court (1957-1958)
LOWER COURT: United States Court of Appeals for the Fifth Circuit

CITATION: 356 US 260 (1958)
ARGUED: Mar 11, 1958
DECIDED: Apr 14, 1958

Facts of the case

Question

  • Oral Argument – March 11, 1958 (Part 1)
  • Audio Transcription for Oral Argument – March 11, 1958 (Part 1) in Commissioner of Internal Revenue v. P. G. Lake, Inc.

    Audio Transcription for Oral Argument – March 11, 1958 (Part 2) in Commissioner of Internal Revenue v. P. G. Lake, Inc.

    Earl Warren:

    Mr. Stull, you may proceed.

    John N. Stull:

    May it please the Court.

    Where I stopped I — in this hypothetical example of mine, I was sitting back with my royalty receiving $300 a year taxable to me as ordinary income with 27.5% — percentage depletion tax free to me off the top.

    Of course the capital gain was a lot better because instead of deducting 27.5% off the top, they deduct 50% and the highest tax rate is only 25%.

    Now, I could have realized a capital gain by getting out of this deal completely and selling out my interest but I don’t want to because this interest maybe more valuable than even the engineers say now that maybe that through these new methods of gas injection, and water flooding, and so on, that instead of a thousand barrels, that royalty may produce actually before the field is exhausted perhaps 1500 barrels.

    Furthermore, Texas is a prolific state and it may be that when this field is about exhausted, somebody will come along and draw much deeper and hit a whole new oil bearing sand.

    In that case I might discover that I’ve got 10,000 additional barrels applicable to this royalty.

    So I’m in a dilemma.

    I want a capital gain but I want to stay in.

    I want to get out but only out enough to get a capital gain.

    So what I do is use this device called the carved out oil payment.

    Now to return to my example, I think I’ll get $300 a year every year for 10 years.

    I go around to X who is financially responsible or otherwise men.

    If he’s not responsible, he can probably borrow the money because this is a good field and I tell him that for $580 cash that he’ll give me $580 cash, I will assign to you X an oil payment which means that the — while this oil payment is in effect, the pipeline company that is purchasing the oil and was sending those checks to me, monthly checks, as this oil was being produced, we’ll now send those checks to you.

    I’ve got $580 cash.

    You will receive those checks until you’ve received enough — enough checks to make $600 plus interest of 4%, we say.

    I’m certainly sure — I’m reasonably sure that this will pay out on a little over two years, $600 plus whatever the interest is.

    Now the mechanics of this, the assignment is carried out by a formidable looking document by which I grant bargain, sell, transfer, assign, and convert my royalty interest to X until he has received $600 plus 4% interest.

    Thereafter, that assigned interest — interest according to this instrument, terminates and the royalty reverts and revests in me.

    Its sign, sealed, delivered, and recorded.

    Because it’s recorded, the pipeline company purchasing the oil stopped sending me the checks and sends them to my friend X until this temporary assignment terminates.

    William O. Douglas:

    You make it — you make it sound rather transparent that —

    John N. Stull:

    Well, Your Honor —

    William O. Douglas:

    Are those the facts of these cases?

    John N. Stull:

    Your Honor, I’m honestly not exaggerating.

    William O. Douglas:

    What I’m getting at is this.

    Is — are there — do we have here involved a complete sell — sale of — of a one quarter interest or a —

    John N. Stull:

    Well, Your Honor let me — may I give you the facts (Voice Overlap) —

    William O. Douglas:

    — transfers for pledges for notes or mortgages?

    John N. Stull:

    No, sir.

    William O. Douglas:

    What — what we have is just what you said.

    John N. Stull:

    That is, in essence, these transactions.

    Now it maybe that X will give his note to a bank and go out and borrow the money, but all he has done is pay me cash and I assigned to him this oil payment.

    And I would like to — I don’t want to go into the facts of all these cases because they’re pretty much the same.

    What I would like to go into, two of them, to illustrate that I’m not exaggerating this particular transaction.

    Let’s take the O’Connor case.

    This came up from the District Court.

    In that case, the estate owned eight royalty interests.

    It was reasonably estimated that the reserves of oil applicable to those eight interests were 23,150,000 barrels.

    The estate transferred to one Blackburn a $10 million oil payment carved out of this — these royalty interests.

    The consideration paid for this $10 million oil payment was $9,990,350 plus 4% interest.

    Apparently, Mr. Blackburn didn’t have that much money so he borrowed it from the Chase Bank in New York.

    They sent their engineers down and decided to have plenty of reserves to cover the pay out of this.

    He borrowed a 3.5% interest.

    So everybody was happy on this transfer.

    Mr. Blackburn got $9650 which was the difference between the $10 million oil payment and the amount he paid $9,990,350, and he also got a half of percent interest which was during this pay out, which was the difference between what he paid the Chase Bank and what the estate paid him.

    Now at the time of that transfer, it could be reasonably estimated and it shows in the record, that about 4 million barrels would be required to pay out that oil payment.

    That is about 17% of the reserves and after he paid out, there would be $19,150,000 barrels left.

    That oil payment paid out in three years.

    After the three-year pay out, the pipeline company again started sending those checks to the estate or to the beneficiaries if they were distributed just as they had been sending them to the estate before this assignment was made.

    The Court of Appeals tells what?

    (Inaudible)

    John N. Stull:

    As a capital gain, yes, sir.

    As a capital gain?

    John N. Stull:

    Yes, sir.

    The Commissioner said that — that $9,990,000 was taxable as ordinary income subject to depletion.

    The depletion deduction allowed on that was $2,750,000 of barrels or a little less than that.

    And the rest was taxed at ordinary income rates.

    The tax levied by the Commissioner was about $5,600,000.

    A claim for refund was made and the District Court and the Fifth Circuit held that that was a capital gains transaction and the $2,000,000 odd difference in tax was refunded.

    William O. Douglas:

    Is that prorated over a period of years or was it payable in one year?

    John N. Stull:

    The consideration sir?

    William O. Douglas:

    No, the tax.

    John N. Stull:

    Well, the tax was paid and collected in one year.

    Yes, sir.

    Because this transaction was a one year transaction.

    It was an assignment then they got the money.

    It was theirs to do whatever they wanted to so there’s just one transaction.

    Charles E. Whittaker:

    (Inaudible)

    John N. Stull:

    Yes, sir.

    Charles E. Whittaker:

    (Inaudible)

    John N. Stull:

    Yes, sir.

    They can.

    Charles E. Whittaker:

    (Inaudible)

    John N. Stull:

    I think all of these are cash, sir.

    Charles E. Whittaker:

    All in cash?

    John N. Stull:

    Yes, sir.

    Yes sir.

    The money is some sort of —

    Charles E. Whittaker:

    (Inaudible)

    John N. Stull:

    Yes, sir.

    Now the facts on the P.G. Lake case are their corporation, P.G. Lake, Inc. was indebted to its President, P.G. Lake for $600,000.

    This corporation was engaged in a business of producing oil and gas, developing oil and gas property from which it realized ordinary income subject to depletion and on the seven-eighths working interest on producing leases.

    Now the usual way of paying back that debt would be that this ordinary income would come in, depletion at 27.5% would be taken off the top, corporate tax paid on the remainder, and use the depletion tax free plus what’s left over after the tax and the rest of it can pay off the note.

    But P.G. Lake, Inc. assigned to P.G. Lake an oil payment for $600,000 plus 3% interest.

    Now, since this was a working interest that the corporation owned, they could not assign as the O’Connor estate did the complete royalties.

    Because that, the working interest has to pay the expenses of production.

    And furthermore, I suppose that they didn’t want to assign too much because they didn’t want to run into the limitation on percentage depletion.

    Percentage depletion is 27.5% of the gross but it’s limited to 50% of the net.

    And if they cut off too much of their income, they might have their expenses come up and cut down the percentage depletion.

    John N. Stull:

    So what they did was make this oil payment payable out of only 25% of the seven-eighths working interest.

    In other words, they kept the other 75% of the working interest, got all the income from it but they assigned for this oil payment — carved out oil payment transaction 25% of that working interest.

    Now, at the time of that assignment if it would be reasonably estimated that the oil payment would pay out in about three years, and it did pay out in about three years.

    Now, it seems to us that the taxpayers claim here that this lump sum consideration received for these assignments qualifies for the preferred treatment of 117 of the Internal Revenue Code just won’t stand analysis.

    Under the ordinary principles of income tax law without putting aside for the moment some of the peculiarities of the tax law of oil and gas interests, we think that this was merely anticipating income that what the transaction was that the taxpayers own these mineral interests.

    They were receiving the checks.

    They had been receiving them from the pipeline companies.

    They had been reporting them as ordinary income for a good many years for some of these cases.

    They were doing it at that time and they could reasonably expect that that would happen in the future.

    William J. Brennan, Jr.:

    Mr. Stull, on your — on your theory, would the entire payment be taxable under your receipt?

    John N. Stull:

    Yes, sir.

    There was a question on the (Inaudible) cases about that Your Honor, but that wasn’t argued there and it’s not being argued here.

    And I believe on the O’Connor brief, that was admitted (Inaudible) —

    You cite the case wrong.

    John N. Stull:

    On that point.

    Felix Frankfurter:

    (Inaudible) case?

    John N. Stull:

    (Inaudible)

    Felix Frankfurter:

    (Inaudible)

    John N. Stull:

    (Inaudible) yes, sir.

    Now it seems to us that the result of this is that for a short period of time, transferee (Inaudible) these rights, became entitled to collect the ordinary income which otherwise the transferor would have collected.

    And that merely because of these temporary assignments, a capital gain is not realized.

    This is not the type of transaction that comes within Section 117.

    Section 117 does not cover assignments of income.

    Now —

    (Inaudible)

    John N. Stull:

    I’d say on that — on that situation, sir, it would be out of luck but when you borrow nine — almost $10,000,000 from the Chase Bank, they send their engineers down there and they don’t make the loan unless they’re doing well as the estimates are under conservative side.

    So I don’t — I’ve never heard of any of these oil payments running out.

    Maybe some of the taxpayers, counsel here from taxes know more about it than I do.

    Know about it.

    Now we think that under the decisions of this Court that this is nothing but an assignment of income.

    John N. Stull:

    For instance, in the Horst case, decided by this Court in 1941, the taxpayer leased a building and the lease had eight years to run.

    In consideration for cancellation of that lease, he received a lump sum.

    He claimed it was a capital gain.

    This Court said no.

    That that was merely in lieu of the ordinary rent which he would have collected year after year over the rest of the term of the lease.

    We think that’s just the same thing here, that this lump sum cash payment is just the same thing.

    It’s in lieu of the ordinary royalty income subject to depletion.

    And I want to emphasize that on these payments, the Commissioner does consider, thus get depletion deduction of all these taxes of the oil payment assignments.

    Now, another analogy in the regular law without going to the oil and gas law, it seems to us, is the Watson case where this Court held that in 1953 that the sale of an orchard, an orange grove with unmatured crops on the trees.

    In that situation, part of that sales price had to be allocated to the crops.

    And therefore, it was taxable as ordinary income just as if the seller had kept the groves a little longer, picked the fruit, and sold it in one lump sum for over a period time himself.

    Well the taxpayers here say that that type of case doesn’t apply here because they’ve got oil, oils of peculiar animal.

    Oil is both capital and its income.

    Well, we can’t say that that’s a valid distinction because oil, when it’s sold, you get a depletion allowance on it.

    That takes care of you capital.

    The only thing left is income.

    The Commissioner has given these taxpayers their depletion allowance.

    They’re not being taxed on their capital.

    All they did was assign their income.

    Now I would like for a minute to turn to some of these oil cases.

    Going back to that original leasing transaction I discuss at the outset, if you remember we had the landowner entering into a lease.

    He retained the one-eighth royalty, seven-eighth of it was working interest and he received a cash bonus.

    Now that exact situation was before this Court in 1932 in Burnet against Harmel.

    The question there was whether there had been a sale of the oil and gas in place to the purchaser, the lessee in that case.

    If there had been a sale, this bonus, this cash bonus would have been taxed as capital gain, but this Court held otherwise.

    They said that, “Yes, we can look to the law of the State of Texas,” and under the law of the State of Texas, we admit that this — this leasing transaction actually convey title to all the minerals in place to the lessee.

    That this Circuit, just as they did in this case, held in Harmel that because under state law, all right, title and interest to the minerals went to the lessee.

    It was therefore a capital transaction for federal income tax purposes and the bonus was taxed as capital gain.

    This Court disagreed.

    It said that we have to look to state law to determine the interest to the party but we look to the federal income tax statutes and the statute there was a predecessor of Section 117 with which we’re concerned here.

    John N. Stull:

    And they said that under that it was not intended by Congress that a transaction such as this should result in capital gain.

    Further decisions of this Court such as Palmer against Bender which involved a bonus in a subleasing transaction, pointed out that this lump sum bonus consideration was merely a substitute for and in lieu of ordinary income, ordinary royalty income which would be received by the taxpayers over a period of years, it was really an anticipation of that income.

    Therefore, it was of exactly the same type of that income and taxable exactly of that income would have been taxed when it was received.

    The Court specifically stated that the bonus was a return pro tanto of the plaintiff’s capital investment in the oil in anticipation of its extraction.

    Now, we think that exactly the same thing applied here.

    What we have is a taxpayer within continuing economic interest in the minerals in place, a royalty, overriding royalty, a working interest whatever it is.

    What he does is sell in anticipation that is in anticipation of what he will receive as ordinary income.

    Part of that ordinary income for a lump sum consideration just as the lessor in Harmel did.

    We think that those principles are exactly applicable here.

    We can’t find any distinction between those two cases at all.

    (Inaudible)

    John N. Stull:

    Well, Your Honor, I — let me put it this way.

    If it is just selling — if my reserves are thousand barrels, and I sell hundred barrels instead of making an assignment for $300, if I just transfer hundred barrels and he’s got to go to the well and get it up and sell rather than collect the pipe — the checks from the pipeline, I don’t see that there’s any possible difference.

    (Inaudible)

    John N. Stull:

    That is entirely different, sir, and I think that that was the capital gains transaction, because as to that part, I’m completely out.

    I chopped that part off.

    It isn’t one of these — I’m now out — I’m now completely back in situation.

    And I think that the depletion cases that have been decided by this Court all the way up to the Burton-Sutton Oil Company in 1945 show that — that when you keep a continuing economic interest in that property, then it is not a capital transaction, it is merely a sublease or Burton-Sutton was net profit.

    I don’t know what you call that type of arrangement.

    Do you think then in pursuit of the hundred barrels, other than that would be (Inaudible)?

    John N. Stull:

    Yes, sir.

    I — I don’t see that it makes any difference whether it’s in cash or in-kind because when I sell it in cash it just means that somebody else is lifting the oil, but if I sell it in-kind, it means that this fellow has to go out and lifted himself, and of course there would be expenses allocable to that and I would assume that he would be given some sort of a consideration for the estimated cost of lifting that oil.

    So we probably wouldn’t tax — tax him on the complete amount which —

    Tom C. Clark:

    Suppose I have (Inaudible)

    John N. Stull:

    Pardon me sir?

    Tom C. Clark:

    Suppose I own the row — the one-eighths, so my lifting (Inaudible)

    John N. Stull:

    Yes.

    Tom C. Clark:

    — percent and so I have heard of and I want to get some money and I figured all was going down and so I want to sell in (Inaudible) let say, so I sold a hundred barrels.

    John N. Stull:

    Out of that royalty interest.

    Tom C. Clark:

    Yes.

    Tom C. Clark:

    And the work and interest to pay the expenses of course, namely, you would get a — I suppose the pipeline company will give you a check for the first hundred barrels that came out of my one-eighth.

    Would that be or should that be kept it in?

    John N. Stull:

    Well, it says, as long as there is — it’s just a temporary assignment as long as it isn’t a part, fractional part of your royalty for the rest of the life of the properties, we say it’s just a temporary assignment of income.

    Tom C. Clark:

    Well, suppose that leaves 500 barrels under we’d have to make under a system that you’ve just described.

    If I signed one-fifth of that then it would not — it would be a capital gain you say —

    John N. Stull:

    No, sir, because you’ve limited it.

    If you assign one-fifth of your entire interest in whatever maybe down there because as I pointed out before, there maybe a lot more down there than the best engineers know right now.

    Tom C. Clark:

    If I didn’t limit it, well, it wouldn’t be a capital gain.

    John N. Stull:

    Yes, sir.

    Tom C. Clark:

    Although we all might consider the facts whether there’s only 500 barrels there so I was calculating on the basis of him only getting 100 barrels under his one-fifth.

    You said that will be kept in.

    John N. Stull:

    I say that’d be ordinary —

    Tom C. Clark:

    You said what?

    John N. Stull:

    — ordinary income if I understand this correctly.

    If it’s an undivided interest that goes throughout the life of the property, maybe you think it’s a hundred — hundred barrels in there, it maybe more or less.

    But if you — if the risk is put on the person who purchases it as to how much is in there —

    Tom C. Clark:

    The capital gain?

    John N. Stull:

    Capital gain, yes sir.

    Now, finally, I think that it’s pretty clear that Section 117 requires the sale of property.

    We think that the only property that possibly had been sold here was either an assignment of income which obviously is in property, an anticipation of future income or an assignment of a mere contractual rate to collect from the pipeline company, income in the future which otherwise I would have collected.

    Neither of this we think is property under Section 117.

    We don’t believe that Congress ever intended that this type of transaction fall within Section 117.

    Now, the taxpayers here extraneously argue that this Court should take a different approach to this.

    They should look at it from the standpoint of whether it’s substantial or insubstantial.

    If one of these assignments is a substantial part of their interest, then, we should say capital gain.

    If it’s insubstantial, we should say ordinary income.

    O’Connor came up from the District Court and there’s a finding there that 17% of the reserves paying out in three years is substantial.

    We don’t agree that this is a correct approach but even if it is, we still think that the oil payments here are insubstantial.

    There is missing from the record in the Fleming case, the estimated reserves.

    So perhaps if it come — came down to a question of fact, we’d have to find out about those.

    John N. Stull:

    But we don’t think that the Court ever need reach this substantial business.

    We think our first two arguments completely answer any argument that the taxpayers made.

    Furthermore, if you get into the substantial versus insubstantial business, we think it’s almost impossible to administer because that oil is under the branch, you can’t get down and see it.

    You just have to take the best engineering estimates.

    They’re pretty accurate but they’re usually conservative.

    Furthermore, we may have hit another sand down there and get a lot more oil.

    So what’s insubstantial today or what is substantial today may very well be insubstantial tomorrow.

    William O. Douglas:

    I can see that the Tax Court (Inaudible)

    John N. Stull:

    Yes, sir.

    I think that the Tax Court in the Fifth Circuit looked at the state law and said, “This is a fine instrument, it’s been recorded, the title of the oil passed under Texas law,” and without analyzing Burnet against Harmel and the other depletion cases decided by this Court, they passed it off as a capital transaction.

    Is the Seventh Circuit the only one on your side?

    John N. Stull:

    Yes, sir.

    Most of these are just been litigated in the Tax Court.

    Charles E. Whittaker:

    The title to oil tax, I believe, is this the title to (Inaudible).

    John N. Stull:

    Well, I assume under these instruments, I think that an oil payment under Texas law and I can be corrected on this, it’s considered real estate under Texas law.

    Now, the taxpayers have a claim of a foul here.

    They say that the Commissioner applied this — these deficiencies retroactively.

    It seems to me we’ve been through all these, the Automobile Club case but some of them still seem to push it.

    All these transactions — the earliest of these transactions was in December of 1947.

    The first published ruling that I know about as to the taxation of these oil payments occurred in 1946 in which the general — the general counsel of this Treasury published a GCM in which he said that short lives oil payments were not qualified as capital assets.

    He said ordinarily these are one or two years.

    From this, these taxpayers argue that in the Weed case, this thing paid out in two years and four months.

    They say this GCM said one or two years so they didn’t catch us.

    Some of the others paid out in three years, others paid out in four and five.

    Of course, the payout period doesn’t mean very much because if you always sign a very small part of your interest, it will take a much longer time to pay out than if you’re in a position to assign your whole interest for a much shorter time.

    Anyway, that ruling on which they relied specifically stated, that no opinion is expressed with respect to the status of oil payments extending over a substantial portion of the depletable interest from which product.

    I think that any taxpayer who relied on that and now claims a foul was a little out of line on relying on that particular assignment.

    In 1950, the Commissioner again ruled that the experience from 46 to 50, it showed that there was no possible basis to figure out the difference between a short-lived and — and a long-lived oil payment.

    So therefore he was going to give up any idea and he had expressed from the first that there might be possibly later on come out with some idea of a distinction between them.

    Now I stated at the beginning that there is another question involved in the Fleming case.

    John N. Stull:

    In the Fleming case, these assignments were not laid for cash.

    They were made for real estate.

    We think that it’s impossible to distinguish between cash and real estate in this situation.

    But the taxpayers say that this is a tax-free exchange under Section 112 (b) (1) of the Internal Revenue Code which is quoted on pages 54 and 55 of our brief.

    That says that no gain or loss should be recognized if property held for productive use in the trade or business or for investment not including the stock and trade or other property held primarily for sale.

    It’s exchange solely for property of a light count to be held either for productive use and trade or business or for investment.

    Now we can’t see that this oil payment is that type of property in that statute anymore than its property under Section 117.

    We think that the oil payment is merely an assignment of income.

    It’s an anticipatory assignment of income.

    Therefore, it can’t be like property to an office building in Fort Worth or a ranch out in Texas somewhere.

    In conclusion, I just want to say that I think that these devices, while they maybe well recognized under the Law of Texas, I realize that there are other situations where the oil payment has a use in the oil industry.

    I won’t get in to that.

    We’re not attacking that particular type, we’re attacking a carved out oil payment which is carved out temporarily from a larger interest which interest is retained by the assignor whether he goes through the mechanics of assigning it to the assignee with the reversion back or whether he just carves out a partial interest in it and really keeps it himself.

    We don’t think that that makes any difference.

    Earl Warren:

    Mr. Weeks.

    Harry C. Weeks:

    May it please the Court.

    I represent P.G. Lake, Incorporated and William Fleming, et al.

    And Mr. Jackson will speak for it and others and I do not want to take over a half an hour if the Court could warn me at that time.

    Earl Warren:

    Then make your own arrangement.

    Harry C. Weeks:

    Yes, sir.

    Thank you.

    All right.

    As Mr. Stull had said in the Fleming case, there are two questions.

    And if I may, I will follow his lead although the question which he termed subsidiary was the question upon which we won below.

    That is that the exchange of these oil payments or other real estate was nontaxable under the expressed terms of Section 112 (b) (1) of the 1939 Code.

    As we see the matter, the Commissioner is trying to exercise what is clearly a legislative prerogative.

    There is much more to this question than counsel indicated.

    The capital gain provisions were introduced in 1921.

    As far as this question is concerned, there has been no change from 1921 down through the Internal Revenue Code of 1954.

    From 1921 until 1946, it was the consistent practice of the Internal Revenue Service to treat the carving out and sale of an oil payment as productive of capital gain if the holding period of the property was present.

    Harry C. Weeks:

    Counsel said that the first published ruling was in 1946.

    I call attention to one in 1941 which is quoted in my brief on page 111, the latter part of the italicized portion there, expressly holds that the carving out of an oil payment is a sale of an interest in the property as to which gain is calculated in the ordinary way.

    Not only was that the position of the Commissioner during which time we’ve had I’d say 20 reenactments of the — a capital gain provision.

    It was the position of the courts.

    The Fifth Circuit in the Ortiz Oil Company case expressly held that the carving out and sale of an oil payment and some properties in east Texas did — was a sale of an interest in the property that the seller was not entitled to depletion.

    That the depletion went to the oil payment purchaser and that the Ortiz Oil Company’s seller calculated its gain from the sale and said it was the sale of an interest in the profit just as any other profit from a sale is computed by subtracting selling price from — basis from selling price.

    William O. Douglas:

    I see that (Inaudible)

    Harry C. Weeks:

    39 I believe, Your Honor.

    William O. Douglas:

    On the Tax Court.

    Harry C. Weeks:

    The Tax Court.

    It was decided by the Fifth Circuit in 1939 and this Court refused certiorari as strenuously argued or the very thing that they argued –are arguing for here —

    William O. Douglas:

    It seems to (Voice Overlap) —

    Harry C. Weeks:

    I was — I was denied all the way down.

    William O. Douglas:

    I see you’re counsel before the Tax Court.

    Harry C. Weeks:

    Yes.

    All the way, I tried to get in this Court but I couldn’t.

    And it was expressly held, I believe, Judge McCord, I believe, wrote the opinion and in the Fifth Circuit.

    I’ve forgotten the author in the Tax Court.

    It was expressly held in that case that it was a sale of an interest in the property.

    Perhaps there are other cases to the same effect.

    In the reply brief that was handed to me just before the Court convened today, it stated, I believe, that there’s a difference in the Ortiz case because the proceeds from the sale of that oil payment were paid for the development.

    I — I do not believe the record supports that statement.

    With that long history before us — before the Bureau of Internal Revenue with the Ortiz case and perhaps other cases, and I would say an unlimited number of private rulings where they’ve held that the carving out and the sale of oil payments produced long-term capital gain other conditions being present.

    The general counsel of the Internal Revenue Service in 1946 ruled at a short-lived oil payment.

    One that ordinarily paid out in one or two years produced ordinary depletable income.

    Now although that was directly contrary to Ortiz and their previous practice, the only case that they cited there was a case where a man sold a declared dividend on stock and kept the stock.

    And they expressly said there that Horst and known other cases were not pertinent.

    The — this Court held in 1937 that where an oil lease or leases were assigned with an informal retention of an oil payment.

    A part of the lease was sold and a part of it retained, so that the assignee who was before the Court in that case, Thomas versus Perkins, so that the assignee could not be required to report as a part of his income.

    The oil applicable to that retained all payment interest.

    Harry C. Weeks:

    That was a very informal agreement as contrasted with the formality in which not barrels of oil, not a right to collect from the pipeline or so but an interest in an oil and gas lease which entitles them to a certain right in that and limits it by dollars when as and if produced.

    The — you take the Ortiz case and the Perkins case and the uniform holdings that whoever has an economic interest in property is entitled to depletion on the income from that property.

    That is the income relating to that depletion, to that interest and must be report it.

    And the definition frequently reiterated, I believe, the last was in Southwest Exploration case, that anyone who must look solely to oil or gas and same is true of any other members when as and if produced for the recovery of his investment as a depletable economic interest which is ownership in the Perkins case, in quoting from Palmer versus Bender, this Court said that ownership was essential.

    Now, counsel has not tried to tell this Court why it is that a retained oil payment is a different character of interest from a carved out oil payment.

    He hasn’t tried to tell the Court, although he very frankly and properly admits, that if the man in his original example that had the thousand barrel royalty, if he sold that entire royalty, Mr. Stull would have given him capital gain.

    If he sold an undivided tenth interest in it, he would have given him capital gain.

    If he sold the most minutes of fraction as long as it extended for the economic life of the property, he would have gotten capital gain.

    But the — in 1946, they discovered there was a difference in property pending on how you carved it out and how long it lasts and so forth in the hands of the purchaser rather than in the hands of the seller.

    Now in 19 — in 1948, I believe it was, to show what the practice was before, the Bureau ruled at this, I.T. 24 of the 1946 General Counsel Memorandum would not be applied retroactively to transactions before April 1, 1946.

    Just in the Leslie Salt case, I think that is conclusive.

    Referring to that date, the Commissioner recognized transactions as we say that he did.

    That situation went on until 1950 when the Commissioner said that he was no longer able to distinguish between the practical or legal effect of short-time or long-term oil payments.

    And therefore, again, without any further authority, they would all be treated as producing ordinary depletable income.

    William O. Douglas:

    What did the Tax Court say about those regulations or interpretations?

    Harry C. Weeks:

    I –I don’t think they expressly said they were unsound, Mr. Justice Douglas —

    William O. Douglas:

    They did (Voice Overlap) —

    Harry C. Weeks:

    — but they –they certainly cited and discussed and were not followed.

    What was the year of the change?

    Harry C. Weeks:

    The first as the short-live one was 1946, Mr. Justice Harlan.

    Then his intermediate ruling and they’re set out in — in the appendix to my brief in full, I’m sorry they were so long but I didn’t write them.

    The — it was in 1948, I believe, where he said he wouldn’t apply that retroactively.

    Then in 1950, he went all the way.

    Now, two of our transactions, one was 1948, and one 1949.

    Those were the transactions involved in the Fleming case.

    Now we say that under the Leslie Salt Company case, he had no right to change a position which had been repeatedly approved by reenactment of the statute which had been approved by the courts and which is entirely different from the Automobile Club of Michigan case where it was more or less of a private ruling which everybody admit it was wrong.

    The only person that’s ever said this was wrong is the Government since 1950.

    The (Inaudible) case on which their petition for certiorari was predicated, held that it was essentially alone so that the assignor of the oil payment was taxable as the oil was produced and applied to the oil payment.

    We don’t think that’s right but if it is right, may — and that’s what they got certiorari on the conflict.

    If it is right, then, most of these cases go out the window because the year of production is not before the Court or substantive time of the year of the production.

    Harry C. Weeks:

    I believe some of the Fleming oil payments and by the way some of them lasted or still lasting, they — they have an expected life for 10 or 12 years made in 1948.

    Judge Hutcheson in one of his opinions below said that perhaps the most startling example of the Commissioner’s prerogative — presumed prerogative to legislate was with respect to the depletion.

    Now this Court has held in Twin Bell Oil Syndicate that you can’t have a double depletion allowance.

    This Court has held that everyone who must look to oil when as and if produced is entitled to depletion on that oil when as and if produced.

    So this people who acquired these oil payments cannot be denied depletion with respect to their income during the lives of these oil payments, but the Commissioner in the face of his success in the Ortiz case where it was held that the carved or outer was not entitled to depletion said, “Oh yes, you’re entitled to it.”

    And he just changes the holding of this Court and holdings of every court that’s ever passed on it by saying out of where this depletion deduction on the sale of a capital asset.

    And it’s the only time in the history of depletion that it’s ever been done.

    And it — as I say, it thwarts the — the ruling of this Court in Helvering versus Twin Bell Oil Syndicate.

    Now, there’s a footnote from page 37 of the Government’s brief, Footnote 17, which says that — well the first thing you do you — the oil payment purchaser recovers his cost and then he gets depletion — percentage depletion on his excess.

    Well that is not now and has never been the practice of the Bureau of Internal Revenue.

    You just can’t get that.

    And if you could get it, it would be absolutely contrary because you’d be getting cost depletion isn’t plus — plus percentage depletion.

    You don’t get your capital back as oil is produced.

    You have no right to get your capital back as oil is produced.

    This Court held that under the 1913 Act.

    You only get what Congress says you can get and they say you can get either cost depletion, they say now that you can only get cost depletion or percentage depletion but you cannot get both.

    The necessary effect of their contention, the — nobody in the Internal Revenue Service or no court would or could deny the oil payment holder depletion on its proceeds is to allow the forbidden double deduction for depletion.

    Now those aims are very closely connected because depletion and income go together and income and ownership go together.

    This people did contest, didn’t get an order on the pipeline, they got a deed.

    And they had the right to have that oil delivered to them at the top — on top of the ground without expense.

    They could sell it.

    They could give it away or do anything they wanted to with it.

    And if it — well, it didn’t happen to be present and Mr. Stull’s geology is a little better than a lot of people because he says you can’t tell all about it.

    The people to finance McCarthy, the Bank Insurance Company will be glad to have had him at the appropriate time.

    But they had to take over all these properties because they couldn’t quite — quite figure it out accurately.

    (Inaudible)

    Harry C. Weeks:

    But they — they answered the lowest would fall on the oil payment holder if the property is destroyed or non-existing.

    The oil payment holder can sell that or dispose of it if he sees fit without accountability to anyone.

    It’s liable to his debts and for not — the debt — not with the debt of another.

    If that doesn’t comply with all of the requirements of complete ownership and they’re not ownership of oil after it gets at the top of the ground.

    Harry C. Weeks:

    If so, an oil payment holder wouldn’t have any right to depletion, because this Court held in bank line that when it gets to the top of the ground and you deal with it there as an article of commerce, it’s not a depletable property anymore.

    Charles E. Whittaker:

    (Inaudible)

    Harry C. Weeks:

    Yes, sir.

    I — I think so.

    Now, Mr. Jackson represents Mr. — and I — I don’t think I’ve ever read that instrument but it’s different from all I ever saw if he didn’t.

    Charles E. Whittaker:

    (Inaudible)

    Harry C. Weeks:

    Oh yes, sir.

    Yes, sir.

    And in the Lake case while it wasn’t printed in this record.

    Mr. Lake signed a division order saying I’m the owner of an interest in — of a certain specified interest in these two leases, and I certify that and the — from now on, beginning at 7:00 a.m. on January 1, 1951, you’ll pay me for this fraction of the oil.

    Now, he could have changed its pipeline connection, he could have gone after and done anything he wanted to with that oil.

    The obligation of his assignor terminated when it was delivered in the ordinary way that oil is delivered.

    Charles E. Whittaker:

    (Inaudible)

    Harry C. Weeks:

    Well they do.

    They — they convey the oil with the accompanying right to receive.

    It — it’s — the dollar is limited, Mr. Justice Whittaker.

    When — when you got an oil of a certain value, what we call the face amount plus the amount equal to interest which is really just more oil, then your — your right is terminated

    Charles E. Whittaker:

    (Inaudible)

    Harry C. Weeks:

    Well may I — may I read a sample instrument in the Fleming case.

    They are all substantially the same.

    I’m reading from page 171 of the record.

    It is said William Fleming does hereby sell, assign, and convey under the said Mrs. Marie (Inaudible).

    Her heir had assigned.

    The following describe real property to wit an overriding royalty or mineral interest carved hereby out of the interest owned by William Fleming in each and all of the oil and gas leases described above amounting to a certain fraction in and to all of the oil in, under or that maybe produce, saved, and marketed from the above described practice of land under the terms of the oil and gas leases.

    Then it goes ahead with governance until they’ve received there from oil of the net value of $73,500.

    Charles E. Whittaker:

    (Inaudible)

    Harry C. Weeks:

    It — it merely measures the interest of the assignee in the oil in place just as frequently we have fluctuating royalty interest.

    Ordinarily, in most cases of royalty is an eight.

    There are numerous cases where they say well, if a daily production is 50 barrels or more then the oil would be three-sixteenth or one-fourth and so forth.

    And it goes up and down and fluctuates when the — as the situation varies from day to day.

    Harry C. Weeks:

    Now, if I may, I think I’d better get to the question.

    Felix Frankfurter:

    As a practical matter then, they don’t ship in the barrel of royalties (Inaudible)

    Harry C. Weeks:

    That’s true of everybody that has an oil interest unless he has his own refinery and pipeline and runs it to — refines and market it.

    Everybody gets their pipeline checked.

    That’s the customary way except quite recently we’ve had trouble getting pipeline connections.

    But if they can get a pipeline connection, that’s what they do.

    Everybody!

    Now, we don’t think in the Fleming —

    Charles E. Whittaker:

    Mr. Weeks, do I understand you to say that since 1950 that the (Inaudible)

    Harry C. Weeks:

    It has finally changed.

    Yes, sir.

    Charles E. Whittaker:

    (Inaudible)

    Harry C. Weeks:

    Ordinary depletable income.

    That would be his contention.

    Charles E. Whittaker:

    Your real case here (Inaudible)

    Harry C. Weeks:

    Mr. — Mr. Justice Whittaker, our kick on the Fleming case is that, because they were 48 and 49, our kick on the Lake case because we didn’t think the Commissioner was right.

    We thought what the Fifth Circuit had told us in the Ortiz case was right and that he had no right to change his position so we went right on the face of this thing there.

    And that is exactly the situation unless it’s sold.

    You will recall that General Motors Acceptance case was decided in 1947.

    But you made a — you made a (Inaudible)

    Harry C. Weeks:

    [Laughs] Well, I’ll have to wait a few weeks to say — to answer that.

    I hope it wouldn’t have to go to Court.[Laughs]

    That’s all I’m asking you to show me (Inaudible)

    Harry C. Weeks:

    Oh, yes.

    I — I think — I think we sold just exactly what Section 117 said.

    We sold property.

    We didn’t held — sell property held primarily for sale and it is — comes within the expressed terms of it.

    The Watson case or the fruit case, Mr. Justice Clark was very careful to distinguish between an annual recurring crop and an irreplaceable substance like oil and even one that takes a long time to replace like timber.

    So you’re retroactive that you (Inaudible) just an added strength to your (Inaudible) of these cases.

    Harry C. Weeks:

    Yes, sir.

    Harry C. Weeks:

    And as I was trying to get — and that applies as far as I’m concerned only to the Fleming case.

    And I don’t think we should get to it in the Fleming case because under Section 112 (b) (1) of the 1939 Code, we think these were nontaxable exchanges as the court below held.

    Hugo L. Black:

    Suppose General Motors mixed contract with that kind to the seal of cars that it produces, would that be a capital transaction?

    Harry C. Weeks:

    No, sir, because those cars are its stock and trade.

    They make them primarily for sale.

    What’s oil?

    Harry C. Weeks:

    Oil in the ground is capital.

    When it gets on top of the ground, it’s an entirely different thing.

    This Court told us in Harmel that you couldn’t sell oil in the ground.

    We — you sell a right to go in there and see — and see what you can do.

    But now, you take — you take Mr. Stull’s position.

    He says you sell your royalty interest, you get capital gain.

    You sell 10% of your royal interest, you get capital gain.

    He said that if –if you sell your royalty interest and retain that oil payment — retain an oil payment and then sell that oil payment to get capital gain.

    But they say this carving out.

    This cesarean creation of — of this interest distinguishes it and makes a future income.

    Well now, it’s not nearest future if you sold all of it.

    Hugo L. Black:

    Well, if General Motors will sell one-tenth of it — assets it had —

    Harry C. Weeks:

    If it’s sold (Voice Overlap) —

    Hugo L. Black:

    — that — that would be a capital transaction wasn’t it?

    Harry C. Weeks:

    If it’s a whole one-tenth of its factories.

    Yes, sir.

    Now, the — the —

    Hugo L. Black:

    You draw a distinction between General Motors selling cars.

    Its manufacturers could view at a certain time and would be delivered at a certain time and pleaded a certain time and the oil company making the same kind of contract with the oil that it has and expected to (Inaudible).

    Harry C. Weeks:

    I make the distinction and the statute makes the distinction.

    The statute accepts from the application of capital gain, personal property held primarily for sale to customers.

    We are not in the business of selling oil payments or oil in the ground.

    Hugo L. Black:

    Would you sell oil?

    Harry C. Weeks:

    We sell oil after it’s produced.

    Harry C. Weeks:

    And if we were, if I may say this, Mr. Justice Black, if your distinction was sound then Mr. Stull’s original statement that selling your entire royalty interest or his statement that selling an undivided interest in the lease to last for the economic life of it would be absolutely unsound but it is not.

    Hugo L. Black:

    Suppose you went into contract differently and told us you sell oil for the future instead of the language you used and made exactly the same kind of contract and get exactly the same kind of payment.

    Harry C. Weeks:

    Well, Your Honor, I don’t think you can do that.

    Hugo L. Black:

    Lawyers are pretty good on those areas.[Laughter]

    Harry C. Weeks:

    Well, you can make a contract to sell oil when — after it’s produced.

    I don’t know what would happen if you didn’t produce it.

    I imagine your purchaser, if you sold him a thousand barrels of oil to be produced next month and delivered into his tanks and you didn’t produced it, I’m imagining he’s going to take his money back.

    Well we can’t get our money back on these things.

    Hugo L. Black:

    Have you tried to?

    Harry C. Weeks:

    We expressly —

    Hugo L. Black:

    Have you had to?

    Harry C. Weeks:

    Oh, there are many oil payments —

    Hugo L. Black:

    In these cases.

    Harry C. Weeks:

    Oh, no.

    This — fortunately these things paid out.

    I say — the Lake paid out.

    Most of the Fleming paid out whether their — the 10 to 12-year wouldn’t pay out or neither.

    I don’t know.

    I think it will.

    But if you take the Lake payment at the time that proper — that payment was sold, we were allowed to produce 20 days a month.

    Today we’re allowed to produce nine days a month.

    It would have taken seven or eight years without a change in price or change in allowance.

    The Fleming payments under the same standard would last through 30 or 40 years.

    Hugo L. Black:

    Suppose you just had a plain contract for sale — sell after it’s produced, well the statement, I think, that if you didn’t produce it, they wouldn’t get it.

    What would have been the difference in the result there and here?

    Harry C. Weeks:

    I refer the — to the Court’s opinion in Thomas versus Perkins, where it was expressed easily.

    Hugo L. Black:

    Practically, what would be the difference?

    Harry C. Weeks:

    I think — I think the Bureau would hold that was an oil payment and — and the industry would hold it was an oil payment.

    And I’m infringing on Mr. Jackson’s time.

    Earl Warren:

    May I ask you just one more question?

    Earl Warren:

    What would be the difference between this and selling an interest in the crop, percentage interest in a crop yet to be grown?

    Harry C. Weeks:

    Well, your crop is an annual recurring thing.

    It’s not — it’s not capital.

    Oil in the ground is capital.

    If it is not, then the whole — whole treatment of it from — by the Bureau of Internal Revenue and the courts for 40 years is absolutely wrong.

    Earl Warren:

    The orange trees would be capital before they — before they have their crops.

    Harry C. Weeks:

    Yes, and nobody has ever said that selling orange tress didn’t produce capital gain.

    Earl Warren:

    No.

    Harry C. Weeks:

    It’s the crop.

    Now, we don’t have an oil crop.

    If they can go down in the ground and say here are a certain number of barrels that are income, here are a certain number of barrels that are capital.

    Well, there might be some to their theory but it is all capital down there.

    Hugo L. Black:

    Who went down on the ground?

    Harry C. Weeks:

    Nobody.

    Hugo L. Black:

    Well who got the oil out of the ground?

    Harry C. Weeks:

    The — in our cases the lessee, that man that had the working interest continued to produce, paid the expenses, and deliver this oil to the pipeline.

    That —

    Hugo L. Black:

    That would be a (Inaudible)

    Harry C. Weeks:

    Yes, sir.

    Yes.

    You — you deliver to one pipeline and you can — first found a particular lease.

    Thank you, Your Honor.

    Earl Warren:

    Mr. Jackson.

    J. Paul Jackson:

    May it please the Court.

    As I see it, the Court has three courses open to it.

    That is based upon the prior administrative history of sale to carved out oil payments.

    Now to run over briefly, this legislative history to fill a few gaps that were omitted by Mr. Weeks.

    It is entirely true as he has said that for 25 years following the enactment of the capital gain provisions in 1921, it was the consistent practice of the Treasury Department to recognize that the sale of carved out oil payments, whether they’d be long or be short, would be entitled to capital gain treatment under 1921 Act.

    There are rulings to that effect and many private rulings wish to that effect and that was the position affirmatively taken by the Government in several cases.

    In 1946, as Mr. Weeks has said, detecting what was conceived to be a defect in the law.

    J. Paul Jackson:

    And instead of going to Congress, they sought to cure this defect administratively.

    And that 1946 ruling provided that as to short term oil payment or short-lived oil payments as distinguishable on long-lived oil payments, that is oil payment stated to be one or two years in length.

    They should be treated as assignments of income and taxed at normal rates and denied capital gain treatment.

    That ruling was made prospective in its operation because it represented a change of existing policy.

    In 1949, that same ruling was extended to donative assignments.

    That is when one gave an oil payment to a member of his family.

    If the oil payment was short-lived, as distinguished from long-lived, that was held to be an assignment of income and not a donation of property producing income.

    That again was made prospective in its operation in the Nail case which had involved the donation of an oil payment and which had been held to be, by the Tax Court or the Tax Appeals then to be a gift of property and not a gift of income and which the Treasury had acquiesced.

    That acquiescence was withdrawn and not a ruling.

    Thereafter, it was made prospecting.

    Now in 1950 for the first time they extended these two prior rulings to cover all oil payments no matter how long in duration or no matter how short in duration.

    All oil payments, oil due to large interest, if sold, were held to be sales of income and if given away were held to be gifts of ordinary income.

    When the Fifth Circuit in the Caldwell case refused to accept I.T. 4003, that’s the 1950 ruling, the Government then receded from this extreme position.

    And in the Hawn case and again in the cases below, went back to its original ruling.

    Their position was that the Caldwell case was right that I.T. 4003 the extreme rule was wrong and they urged for the insubstantial transfer rule.

    That is, if the transfer was insubstantial in relation to the reversion, it would be held to be an assignment of income.

    If it were substantial, it was deemed to be a sale of property.

    Here, they take the alternative position.

    First they are going back for the I.T. 4003 and holding that all oil payments, carved out of a large increase no matter how long in duration should be treated as assignments of income as anticipations of income and tax to normal rates.

    That will include the 12-year oil payment in the Fleming case the 13-year oil payment in the Caldwell case.

    (Inaudible) say, if the oil payment is insubstantial in relation to this reversion, then, the — an insubstantial one should be taxed as an assignment of income and the substantial one at capital gain.

    Now, there are three courses open to the courts.

    First, you can take the extreme view published first in 1950.

    Since repudiated below, review of I.T. 4003 which is, that all oil payments, no matter how long in duration shall be treated as assignments of income and taxed at normal rates.

    Secondly, you can go back to the other extreme and you can contend a whole, that all oil payments, when sold, no matter how short in duration or sales of property, sales of real property, when Congress intended such to enjoy, the capital gain benefits.

    That would be the rule in effect for 25 years until the change was made in 1946, or you can take the middle ground and hold the insubstantial oil payments.

    Those that are insubstantial in relation to the reversion or interest or to the interest kept, or truly, by applying some extension of the Horst principle, or truly assignments of income but those that are substantial shall be treated as sales of durable substantial property rights and to be given capital gain treatments.

    That is the Government’s alternative view at least the alternative view set forth from its brief and it’s a view that it urged below.

    Now, first, is the extreme view of I.T. 4003 right?

    We submit on any basis that view which is the Government’s primary view is clearly wrong.

    J. Paul Jackson:

    That view would hold that every oil payment, no matter how long its life or how substantial, is to be treated as an assignment of income.

    Now, first, I think we should look to the committee reports and those ways and means of the Senate Finance Committee Report in connection with the enactment of the capital gain provisions in 1921.

    Those committee reports stated clearly that sales of farms, mineral properties, I repeat, mineral properties, and other capital assets have been recorded by virtue of the high surtax rates applicable to such sales.

    Such sales have been deterred and the purpose of the capital gain rates was to omit such transactions, sales have been on properties including others to go forward without the payment of tax are represented by the surtax rates.

    Now, an oil payment, as Mr. Weeks has said and as the case has hold, an oil payment is a creature of the Texas oil men, men from the oil states which was an interest in property long before we had a capital gain provision.

    The uses of oil payments as set forth in our brief and I mean for the Court with that now.

    But they are mineral property.

    To tax a long-term oil payment, a 12-year oil payment would be to create the very hardship at what — at which the capital gain sections of the law were directed.

    Namely, it would produce an excessive surtax on the profits of a number of years, the bunching of income of 10, 12, 15 years in a single year which the very hardship that Congress was aiming at when it enacted the capital gain provisions.

    The Government itself admits that an oil payment is a mineral property and moreover, that an oil payment is a capital asset.

    The I.T. 4003, which is the basis of their case or their primary contention, says specifically that if a taxpayer owns an oil payment and sells it in its entirety or sells the fraction of it extending over the life of the property, he has sold the capital asset.

    Now —

    Earl Warren:

    Mr. Jackson, what is the difference — real difference between that situation and the man signing an interest in his real property through the extent of so much rent that you might get offer to a building that is his — where they’re entitled to amortization on the building.

    J. Paul Jackson:

    Let’s — let me get to that question now, if Your Honor please.

    I would concede to the said argument although in this general neighborhood is not well developed.

    That he sale by me to a third party, well first, a prepayment of rent is clearly ordinary income to me by prepay — if you prepay me two years rent, I must take up those two years in a single year and tax at normal rates.

    It’s not a capital gain transaction, I admit.

    If I should sell rents in the future to a third party or if I should sell dividends on stock that I own to a third party for cash, if I should sell one or two years coupons on a bond, I think my own belief is, all the cases are not clear on this, that I have sold income.

    I have anticipated income and what I get is simply a substitution of what I would have gotten, had I not sold the coupon or sold the future rent, or sold the dividends?

    I think I have normal income and not capital gain.

    Conceded that, however, does not mean and here we get to a very important point.

    It does not mean that an oil payment for that oil property or that oil income for that matter is like income from other property, income by way of dividends from stock or interest on a coupon or found on a bond or rent from real estate.

    When oil in the ground is real property, each barrel of oil in the ground is real property.

    When that barrel of oil is lifted to the surface, it is transmuted under our state law into personal property but still — it’s still a tangible property.

    When that barrel of oil is sold, there is a profit on the sale of that barrel of oil.

    The profit is the difference between its cost and its selling price.

    Its cost is determined by taking the cost of the entire mineral content and dividing it by the estimated number of barrels in place in order to find a unit cost for that barrel of oil.

    That’s what we call cost depletion.

    Each barrel of oil has its own cost.

    Now when that barrel of oil is sold, the difference between that cost and its selling price is profit.

    J. Paul Jackson:

    The sale or the profit on the sale of that barrel ofoil is normal income is normally income under the Harmel decision.

    It’s normal income because it is a recurring day to day time consuming operation similar to a manufacturing operation, this Court said in the Harmel case.

    But it’s not income in the sense of a dividend from a stock or the interest from a bond.

    It’s profit from the sale of property.

    Earl Warren:

    Or the rental of the building?

    J. Paul Jackson:

    Or the rental of a building.

    It’s not the sale of derivative income from a non-consuming corpus.

    It’s a small sale of a small piece, to use (Inaudible) illustration of the tree itself.

    It’s not the sale of fruits from a tree.

    It’s a small sale of the tree itself.

    The sale of an oil payment represents the sale in bulk of a number of barrels all in place.It’s not — again not the sale of fruits and property.

    It’s a sale of a large part of the corpus itself.

    When an oil payment is carved out and sold and there is an interest retained, the oil payment is not the fruit of that which is kept nor is that which is kept the reversion or interest, the corpus that produces that which is sold — that which is sold representing these barrels in place.

    They sold to the purchaser who consumes that in the process.

    And in that consumptive process, that part of the property never comes back.

    Now they —

    Earl Warren:

    This part of the building becomes — it’s less to come back?

    J. Paul Jackson:

    No.

    No, I think not.

    Earl Warren:

    Why isn’t that (Inaudible)?

    J. Paul Jackson:

    I haven’t considered that depreciation on a building would be comparable to the sale of oil in the ground or maybe there’s an analogy there, Your Honor but —

    Earl Warren:

    What was the difference?

    That’s the thing that I want.

    They’re both properties.

    J. Paul Jackson:

    Let me — let me see if I can lead — if I can get it this way.

    While the sale of an oil payment is not the sale of the fruits of property in that sense, it is clear that it is to an anticipation of income.

    It’s an anticipation of income in the sense that had you not sold it but had you kept it and produced it on a barrel by barrel basis.

    All of it would have been normal income to you.

    That’s the unique characteristics of any natural resource.

    It is depletable in nature.

    J. Paul Jackson:

    It’s relatively short-lived.

    And because of its depletable nature, it carries within it both the concept of a true property right which it is a mineral property and at the same time, the concept of an oil being income.

    In the oil property, if kept to its ultimate life, is all income.

    Any oil property, if sold at once is all capital.

    It’s all capital and yet all income.

    Now, if we are going to say that when you sell an oil payment, you would be taxed at normal rates because you have simply anticipated income then that means that on the sale of any mineral property whether it would be a royalty, whether it would be a lease, or whether it would be a working interest, or an oil payment, and you sell any property outright or fractional interest in it.

    In a sense, you by virtue of that sale, anticipating income, you are getting today a price for that which had you not made the sale would have all been income to you.

    And yet since 1921, the cases all hold and the Bureau’s position and the Treasury position is solid that when you sell an entire interest or a fractional interest, you have sold the capital asset.

    As the Court said in the America case, if that were not true, then, the language of the committee report is meaningless.

    The committee report of the 1921 Act said that the purpose of the capital gain was to enable sales of mineral properties to go forward without the oppressive surtax rates.

    Now, if — if this thing is not the assignment of the fruit from a tree, what if it is an anticipation of income in the same sense that the sale of any oil property is a sale of income.

    We conceive then that this oil payment is like a coin — a coin.

    On one side, we see the inscription.

    This gives you the right to future production.

    This is the anticipation, if you will, of future income.

    And on the other side, it’s clearly inscription that this is indeed a mineral property.

    It is a mineral property under state law and for federal purposes.

    It’s a depletable property, and it’s this dual characteristic that causes us the problem here.

    Now, if we’re to meet that problem by saying every sale, every carved out oil payment irrespective of life, is to be treated as assignment of income.

    We get into some absurdities.

    Take for example the 12-year life oil payment against which there is remaining two-year life in the form of a reversion or interest.

    Can it be said that when that oil payment is covered up for the 12-year life representing perhaps 90% of the oil in place which you have anticipated income that — that is the sale of the fruits from a tree, that the Horst case has got any application whatever, that the — that the corpus that produces this income is the two-year remaining residual life of this property the 10% that’s left.

    Isn’t it clear that what you have done is that you’ve sold a substantial — a large part of your mineral property and you’ve anticipated income only in the sense that any sale, any mineral property is an anticipation of income.

    If the Bureau is right and the service is right that the sale of an oil payment is a capital asset if you sell it all, you sell your entire interest in it, we have this anomaly.

    I have a two-year oil payment as a two-year life.

    I sell it all.

    I get capital gain.

    I carved out an oil payment with the 12-year life and I’m taxed with normal rates.

    I sell a short-lived oil payment representing a thousand barrel to oil in place.

    If I sell it all, I get capital gain.

    J. Paul Jackson:

    But if I sell a million barrel of oil in place in the form of a carved out oil payment, I’m taxed to normal rates because for suit, I hold back one single barrel of oil.

    Now, clearly Congress didn’t intend results of that nature.

    Another one.

    I sell an undivided tenth —

    Earl Warren:

    Don’t you have the same situation whether you — with other real property whether you choose to sell it or use it through the years.

    If you sell it, you’ll take a capital gain and if you use it and if (Inaudible) income, you have to pay an income tax (Inaudible).

    Is that it?

    J. Paul Jackson:

    Yes, if I use it and if I can take the income from day to day.

    Earl Warren:

    What’s the difference between — between the two?

    That’s what I’m trying to get at the basic difference — the legal difference between the two.

    J. Paul Jackson:

    The legal difference between the two as I see it Your Honor are these.

    In the case of real estate, you have an eternal perpetual life.In the case of real estate, rents were paid to you.

    Those rents are paid from year to year.

    They had arrived from a non-depleting corpus.

    And if you sell two years, for example, of your rents or give away two years of your rent assignment, you still have your real property left.

    You still have your corpus left capable of reproducing income forever.

    But if I sell an oil payment out of my property, my property to begin with is relatively short-lived.

    It’s not eternal or perpetual such as real estate generally is.

    Being a mineral property, it has a relatively short life.

    That’s one big difference.

    Earl Warren:

    Exactly —

    J. Paul Jackson:

    The other is —

    Earl Warren:

    — exactly just give me an example as to that during the war, the Government granted short-term amortizations, did they not, on lot of buildings seven — as low as seven years.

    J. Paul Jackson:

    Five years (Voice Overlap) yes.

    Earl Warren:

    Five — five years.

    Now suppose — suppose the great income from that property was the — the building was on it but not the land itself and the person did exactly what you did, would he be entitled to treat it as — as capital gain rather than — than income because it was only a five-year building — only had a five-year value?

    J. Paul Jackson:

    Well, if I sold the building, there’s no question that I would get capital gain.

    You’re selling five years of rents from the building.

    Earl Warren:

    Yes, that’s all.

    J. Paul Jackson:

    If I’m selling five years rent from the building —

    Earl Warren:

    Yes.

    J. Paul Jackson:

    — in advance, there is no case saying that I’m denied capital gain treatment that I know of.

    But I would suspect that I would be denied capital gain treatment certainly under the Treasury practice.

    This area of — to what extent you can sell future income indefinitely, to what extent that certainly becomes capital, we don’t know.

    For example we wouldn’t know if you took all of it — the coupons from a 20-year bond and sold it whether you’re selling capital or you’re selling future income.

    A good argument could be made on either side, if Your Honor please.

    But your difference here is that in terms of relationship between what you have sold and what you have left, when you sell five years of rents from your building and the five years go by, you still have your — your property unimpaired except for depreciation of course.

    Earl Warren:

    What you have after your oil is sold.

    J. Paul Jackson:

    Now, when you sell —

    Earl Warren:

    You have your property with the oil.

    J. Paul Jackson:

    No.

    But when you sell a piece of property, an oil property, we’ll say they have a 10-year life and you sell five years of it.

    You’ve sold half of the property itself.

    You see the difference?

    That when you sell an oil payment, you are not only anticipating income but you are selling the corpus because that is the essential nature of these natural resources is that they deplete.

    Felix Frankfurter:

    Does your depletion allowance (Inaudible) —

    J. Paul Jackson:

    Not — not hardly, Your Honor.

    Not hardly.

    When you have a greater rate up to 91% and you punch as in the O’Connor case, $10,000,000 of income in one year.

    Your effective rate after you take 27.5% off of 91%, you have an effective tax rate of about 66%.

    We contend that Congress intended that we should have a 25% rate.

    The depletion does not take the place from the mathematical point of view but when you sell property, Your Honor, when you sell a mineral property or a fractional interest in the mineral property, the rule is that you do not get depletion.

    The rule is and has always been that you get capital gain.

    The rule always has been that you cannot have both depletion and capital gain.

    You must have one or the other.

    In the case of normal income you take depletion.

    In the case of a capital transaction, you take capital gain

    That depletion figure is of a compromised figure (Inaudible).

    J. Paul Jackson:

    Your Honor, we couldn’t spend a more enjoyable evening talking about the pros and cons of a depletion allowance.

    The 27.5% was given in 1926 to the oil people as a substitute for discover depletion, right or wrong.

    J. Paul Jackson:

    It was given as a — as a matter of grace shall we say to the oil people because of the risk of the enterprise and so on.

    But it was given as against normal income — against the current production to replace a diminishing capital asset taken into account the — the nature of this oil property.

    But when you are selling a large part of your property, I’ll go back to my illustration again.

    Is it — could it be true that Congress intended that I could sell an undivided 10% interest in my royalty representing a thousand barrels of oil in place and it would be clear that I have capital gain as the Government admits.

    And yet, if I sell 90% of my property in the form of a carved out oil payment representing a million barrels of oil in place and I’m denied a capital gain treatment because I kept the last 10%, does it make this much difference that the — that the transaction is horizontal rents have been vertical.

    Charles E. Whittaker:

    (Inaudible)

    J. Paul Jackson:

    I don’t think it quite concedes that but let me — let me clarify one thing in Your Honor’s mind.

    I think you’ve been disturbed about the money part of this, the — the dollar amount the dollar sign on these oil payments.

    Let’s clear that up.

    The — an oil payment represents the ownership of a certain quantity of oil in place that is limited in amount that is the number of barrels in place is limited.

    It therefore called a limited overriding royalty, more properly known.

    Now, if I grant you an oil payment giving you the right to the first 9000 barrels of oil in place, there’s no question but that you have ownership of 9000 barrels in place and you become the owner of it when it’s produced.

    Now instead of making it in form of barrels, I grant to you an oil payment which carries with it ownership in the ground of a number of barrels in place that will equal in dollars when and as produced $27,000.

    That gives you 9000 barrels in place if the oil produces $3 a barrel when produced.

    The dollar sign on the oil payment and unfortunately when you have this word payment, it doesn’t really mean payment.

    The dollar sign, the dollar amount in an oil payment is simply the measuring sticks, the dollar amount that identifies or measures the quantity of oil in ground that you own.

    The — the — there is also in these oil payments a grant of a sufficient amount of oil in place which when produced, saved and sold that will not only produce these dollars but that will produce an amount equal to ad valorem taxes and production taxes.

    Charles E. Whittaker:

    Does the amount of oil (Inaudible)

    J. Paul Jackson:

    Exactly so.

    Charles E. Whittaker:

    I have (Inaudible)

    J. Paul Jackson:

    Oh, yes.

    You have title to — it’s like fungible goods.

    You have title to the first amount of oil whatever amount that maybe that will produce you $27,000.

    Charles E. Whittaker:

    (Inaudible)

    J. Paul Jackson:

    Well, that oil is — is yours in place.

    It sends to you as — as real property would be sent in the law of Texas.

    It’s conveyed as real — real property is conveyed.

    It’s subject to the statute of fraud as real property is subject.

    It is real property in every sense of the word.

    Hugo L. Black:

    May I ask you?

    J. Paul Jackson:

    Yes.

    Hugo L. Black:

    I don’t quite understand —

    J. Paul Jackson:

    I’m sorry, I haven’t answered you correctly but it’s — the dollars are measuring sticks for oil in place.

    Hugo L. Black:

    I don’t quite understand (Inaudible).

    Does the man buys it from you under this contract and you say he is the owner?Does he get a depletion allowance?

    J. Paul Jackson:

    If — yes, sir.

    He gets a cost depletion allowance.

    Hugo L. Black:

    He gets a depletion allowance on the oil he bought from you and you get a 25% allowance.

    J. Paul Jackson:

    I get a capital gain.

    Hugo L. Black:

    What do the Government get?

    J. Paul Jackson:

    The Government gets a good deal, Your Honor.

    The Government gets 25% from me and if — and not too much from you if you have paid a price about equal to the discounted value of the expected recovery.

    Yes.

    Hugo L. Black:

    (Inaudible)

    J. Paul Jackson:

    That would be true.

    Hugo L. Black:

    — specific interest by the man who gets depletion (Inaudible) —

    J. Paul Jackson:

    If — if I own a two-year oil payment which I bought and I sell it to you at a discount, I get capital gain on it.

    You would set up your cost as the cost of that oil payment which would give you cost depletion which should mean that there would be very small income to you, an interest element only in you.

    How much time I have —

    Earl Warren:

    Your time is up.

    J. Paul Jackson:

    My time is up.

    Well, I — I haven’t had chance to get into the other two possibilities for this Court.

    I refer to our briefs for those possibilities.

    Thank you.

    Earl Warren:

    Mr. Stull.

    John N. Stull:

    May it please the Court.

    I seem to have had a failure of memory.

    We’re not quite as badly off in the lower courts as I led the Court to believe.

    The first time we were down there recently in the Hawn case, we want to — apparently even the Fifth Circuit wouldn’t go along with the transfer of an oil payment as a capital gain transaction where it was given to somebody to build the owner a house.

    Then when we went down in the Caldwell case, we had the Hawn case distinguished away but Judge Reeves is on our side.

    John N. Stull:

    The Tax Court has gone along with Caldwell rather than Hawn in any of those cases.

    Is there a dissent in the Tax Court?

    John N. Stull:

    I don’t recall, Your Honor.

    William O. Douglas:

    Six —

    John N. Stull:

    Six?

    William O. Douglas:

    (Inaudible)

    John N. Stull:

    That oil — the only other thing I have to say is that I haven’t heard any answer to our Harmel argument that this is just exactly like the Harmel case.

    This depletion argument — depletion, the Southwest Exploration decision of this Court said that the depletion was to take care of returning to the owner of one of these economic interests as capital investment.

    We’re not trying to tax depletion, to tax that capital investment.That’s exactly what this allowance is for.

    As far as the oil in kind goes, I — I had not experience with these oil deals to know that every oil deal allows every participant to get his oil in kind if he wants it.

    I don’t think anybody ever gets.

    A barrel of crude oil in New York is pretty hard to dispose of.

    What happened here is whether there’s a right to the oil in kind or whether it’s a cash.

    It is that there was a cash came in and cash was paid to the pipeline.

    And the Harmel case said that the Texas oil lease conveyed the right to the oil and gas.

    That’s true.

    But they said that is not a capital gains transaction.

    Well that right is conveyed at the wellhead or was conveyed in the grounds and not a capital gains transaction.

    And therefore, they said that that bonus was taxable as ordinary income.

    It wasn’t a capital transaction.

    Sir —