Commissioner of Internal Revenue v. Southwest Exploration Company – Oral Argument – January 24, 1956

Media for Commissioner of Internal Revenue v. Southwest Exploration Company

Audio Transcription for Oral Argument – January 23, 1956 in Commissioner of Internal Revenue v. Southwest Exploration Company

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Earl Warren:

Number 287, United States versus Huntington Beach Company.

Mr. Zarky.

Hilbert P. Zarky:

If the Court please, this is the companion case to the Southwest Exploration Company argument.

The taxpayer in this case is one of the upland owners, Huntington Beach Company.

And the Court of Claims held that it was entitled to depletion on the income payments which Southwest Company had made to it.

Just to clarify what the situation is with respect to the division of the allowance the year here involved was 1948 and in that year the gross income, which Southwest had obtained from the leases, was approximately $20,000,000.

After deducting it, its expenses, it had a net income of some $7,300,000 of which it had paid to Huntington Beach, $1,300,000, maybe it share of the net profits.

Now, if the Ninth Circuit were correct in the Southwest case, Southwest would be entitled to a deduction based on the entire $20,000,000 of income it obtained from the property.

So that its actual depletion deduction would be about $5,500,000.

Now, if the Court of Claims is correct, then out of the Southwest $20,000,000, it must exclude the $1,300,000 it paid to the upland owner here.

So that its depletion base would be $18,700,000 instead of $20,000,000 and the depletion base of Huntington Beach would be $1,300,000, the net profit payments which it received.

The Court of Claims in holding that Huntington Beach had a depletable interest followed what is our first alternative argument, namely, that under the peculiar circumstances of this case, the upland owners had contributed valuable rights which enabled production to take place and that they have received a depletable interest in the form of net profit payments which became within the rationality of Burton-Sutton and Kirby.

That I — the Court of Claims gave a practical example, which I think is very persuasive, it posed this hypothetical situation that imagine that the owner of land had given an easement for a golf course permitting it to use the surface of the land, so that the golf club had complete rights with respect to that surface.

And that thereafter, minerals were discovered to underlie the surface and the owner of the property had given a mineral deed to a third party.

But that third party cannot exploit the minerals without digging through the surface of the land and so he must turn to the golf club to obtain the necessary property rights to permit that to take place.

So, the Court of Claims says, suppose that the owner of the mineral rights now deals with the owner of the surface or the person who has an easement with the surface and obtains the right to break through the surface and will pay for the life of mineral lease a portion of the net profits from production.

Court of Claims assumed that that would be an easy case that the owner of the surface ought to have the deduction for depletion.

“And,” said the Court of Claims and we agree with the Court of Claims, “This case should be no different that the upland owners do not have their property immediately and physically above the mineral deposits and that the physical mineral deposit lies at an angle.”

The important thing is that their property is being used and their property is enabling the production to take place.

Harold Burton:

Mr. Zarky, Mr. Wilson just got through reading to us and commenting on the two sentences of the regulations.

Would you mind commenting on those and related to this —

Hilbert P. Zarky:

Yes, sir.

Harold Burton:

— situation?

Hilbert P. Zarky:

I was just going to that, Mr. Justice Burton.

As a background, I must talk about three cases, which have preceded Kirby and Burton-Sutton, and which the Court of Claims and we distinguished on the particular facts of this case.

That was a trilogy of cases all reported in the 303 U.S.

One case is Helvering v. O’Donnell.

The taxpayer in that case own one-third of the stock in a corporation that had oil and gas leases.

He sold his stock to another corporation which undertook to acquire the oil properties from the first corporation and as consideration for the stock which it acquired was going to pay Mr. O’Donnell one-third of the net profits from its production after it acquired the oil properties.

This Court held that the net profit payments received by the selling stockholder were not depletable.

Hilbert P. Zarky:

The next case is Elbe Oil Land.

There, the owner of oil-bearing property had transferred it for a large dated consideration, partly payable immediately and partly payable in installments in the future if the transferee elected not to abandon the transaction.

In addition, the transferee undertook to pay to the transferor a percentage of its net profits after it had recouped its entire investment including this purchase price which it had paid for the property.

And the issue in that case was whether the installment payments were themselves subject to depletion or whether they were sales profits.

There having been no net profits paid in that case.

And the third case is Helvering v. Bankline Oil Company where the taxpayer had a contract with a lessee of the wells to buy the gas as it float in the wells and to process it making natural gas and gasoline.

And in Bankline, the taxpayer claimed that it was buying under its contract, the gas at a favorable price less than market price and then it should be entitled to depletion on the difference between the price that paid under the contract and the price which it would have paid and had it been buying at market price.

Now, we distinguish those three cases on the ground that, and none of them as here, was the party receiving the net profit payments, doing anything essential to the production of oil and gas.

When the stockholders sold his stock in O’Donnell, he wasn’t like the upland owners here enabling the lessee to get to the property, except in a more — most indirect sense.

Elbe itself is peculiar because you were trying to test whether there was a sale measured by the fact that the net profit payments had been retained and this Court said that interest was not one which qualify the sale in anyway.

And indeed in Burton-Sutton, the Court indicated that Elbe should not be extended beyond its facts.

And Bankline represented nearly a favorable contract to purchase.

Now, to get more to the answer to your question, Mr. Justice Burton, for those trilogy of cases, the Treasury amended its regulations immediately thereafter to provide that a favorable contract and interest in net profits is not a depletable interest.

And the Government so thought that’s what the three cases stood for.

And that’s why when Kirby and Burton-Sutton was here, the Government relying on those regulations contented very rigorously that nothing short of an interest in gross production could be depletable and that an interest in net production or net profits could not be depletable.

This Court, of course, held to the contrary in both cases.

So that this Court in effect did not feel that the regulations was a correct interpretation of the statute.

In other words, to the extent that the regulations say that an interest in net profits is not a depletable or economic interest in the property.

The regulations are in contradiction to what Kirby and Burton-Sutton held.

And my understanding is that under the new Code, the proposed Treasury Regulations contemplate omitting that particular sentence in order to have the regulations conform to the Kirby and Burton-Sutton cases.

So that actually to the extent that the argument rests here on the regulations is the very same argument which the Government twice advanced unsuccessfully in this very tribunal.

So that we do not feel that the regulations at all point to the fact that the upland owners cannot have a depletable interest.

I think it might be helpful if I ran down some of the arguments, which the Ninth Circuit accepted, to indicate why we think they are wrong.

To a large extent, the —

Stanley Reed:

But before — before you leave the regulation, isn’t — isn’t there a difference between the interest in the — in the Burton-Sutton and the — the — what’s the other case, Kirby?

Hilbert P. Zarky:

Kirby.

Stanley Reed:

— different interests of what we have here?

Hilbert P. Zarky:

I think not in Burton-Sutton, Your Honor.

I say this for this reason, prior to the transfer in Kirby and Burton-Sutton, there was a difference because the transferor stood in a position where they could exploit the minerals.

But after the transfer in Burton-Sutton, Gulf, the assignor, had no further interest, any further legal interest, in the minerals in place.

Hilbert P. Zarky:

So far as Gulf was concerned, it was as much a stranger to what was taking place after the less — after the assignment than the upland owners here.

But Gulf did have an interest and that’s what this Court held was important.

It maintained an interest by having reserved the share of the net profits of the operator and it was that economic interest which this Court said having them retained by Gulf.

It meant that Gulf must look to the depletion allowance to recover whatever capital investment it had in the minerals in place.

So we feel that this case stands just like Burton-Sutton.

There have been arguments made which indicate that authorities, that Burton-Sutton is different because, for example, there was a covenant there to reconvey to the assignor if the assignee didn’t develop the property.

There have been arguments in here that this is not a rent or royalty.

This is a personal covenant of Southwest.

But the Fifth Circuit, you will recall, decided Burton-Sutton in the Government’s favor.

It had held that — and that profit payments were not depletable and the Fifth Circuit did so on the very philosophy that that was a personal covenant that the assignor had no interest in the minerals and this had followed the previous decisions of the Fifth Circuit.

So that so far as the legal interest is concerned, it seems to us that the upland owners here stand in the same — almost the same situation if the assignor did in Burton-Sutton after the assignment.

Stanley Reed:

Well, do you — do you interpret the regulation where it says thus an economic that it does not possess an economic interest merely because the factual relation with the owner that that’s an economic offense?

Hilbert P. Zarky:

Well, I think that those regulations —

Stanley Reed:

That’s solely as a contract entirely apart from many power that the landowner has to — to give access to or not to give access to the owner, is it — is that what distinguishes —

Hilbert P. Zarky:

That —

Stanley Reed:

— cases from the others?

Hilbert P. Zarky:

That’s how I would distinguish the present peculiar situation from Helvering and O’Donnell, Elbe Oil Land and Bankline.

Stanley Reed:

But I’m —

Hilbert P. Zarky:

But I — I’m sorry.

Stanley Reed:

And to recognize by — and this regulation itself.

Hilbert P. Zarky:

Well, I think that the regulations and I’m puzzled by just what they can mean today after Burton-Sutton and Kirby.

Treasury thought that the trilogy O’Donnell, Elbe and the Bankline stood flattened for the proposition that no interests in their profits could ever be depletable whether reserved by the lessor, reserved by an assignor or acquired by stranger.

Now, we know that that isn’t so that at least in the lessor and the — and the assignor —

Stanley Reed:

Which profits, comes from a — from a power over the land itself and over the way to get to the oil, will that distinguish it?

Hilbert P. Zarky:

Well, the upland owners here.

Stanley Reed:

I’m speaking now with the regulations.

Hilbert P. Zarky:

Yes.

Well, the regulations were not written with that in mind.

They were written in — in mind that there was a flat rule of law, net profits, no depletion, no matter how you acquire it.

And they were written, of course, before the —

Stanley Reed:

(Inaudible)

Hilbert P. Zarky:

— Kirby and Burton-Sutton so that they must be regarded as — to a large extent distinguished by what Kirby and Burton-Sutton held.

So that to the extent, the arguments here are based on the fact that there was no legal title for the minerals, that there were no reversionary interest, no right to drill in the upland owners, that there was a personal covenant that the regulations governed it.

All those are arguments which the Government had advanced and which this Court rejected in Kirby and Burton-Sutton.

And we think that the same arguments are really being resurrected here today to achieve the result which this Court said is not the law in those two cases.

Hugo L. Black:

If those regulations were denied by the court opinion, why have they’d been left standing?

Hilbert P. Zarky:

I’m a little puzzled by that too, Justice Black.

But there are many instances where the administrator just have too many things to do and don’t get around to it fast enough.

But the position, which we take here today, is taken advisably with the Commissioner’s acquiescence so that this — does reflect the present position of the Internal Revenue Service.

Hugo L. Black:

How long does it take him to take into regulation back here?

Hilbert P. Zarky:

Well, I suppose that one had nothing else to do, it would be very fast.

Hugo L. Black:

Well, what I meant was, they’ve evidently taking it up to you.

Hilbert P. Zarky:

Well, they didn’t take it up with me.

That was —

Hugo L. Black:

Why didn’t you take up with them?

Have you taken up with them?

Hilbert P. Zarky:

Well, when we’re through litigating for the — for the client, then we’re through with it.

We have no authority to — to change the regulations —

Hugo L. Black:

Yes, you have nothing to do with it, but I wondered why when you call — when their attention was called to it that some steps were not taken and you changed it —

Hilbert P. Zarky:

The thought may well have been that Kirby and Burton-Sutton spoke for themselves and that exactly where the line should be drawn was not too clear, but —

Hugo L. Black:

Well, which part of this regulation do you consider is out by reason of Kirby and Sutton?

Hilbert P. Zarky:

Well, to the extent that the regulations make the flat blunt statement.

Hugo L. Black:

The part that Justice Reed read?

Hilbert P. Zarky:

This part here, “Thus, an agreement between the owner of an economic interest —

Hugo L. Black:

In the brief, where is that on?

Hilbert P. Zarky:

That’s on page 48 of the Government’s brief in Southwest.

I’m not sure we reproduced it in Huntington Beach.

“Thus, an agreement between the owner of an economic interest and another entitling the latter to purchase the product upon production.”

That part we think is good law.

Hugo L. Black:

Thus, where is that now, page 48?

Hilbert P. Zarky:

“Thus, an agreement between the owner of an economic interest, and another at the last final paragraph, entitling the latter to purchase the product upon production.”

We think that that is good law under Bankline.

“Or to share in the net income derived from the interests of such owner does not convey a depletable economic interest.”

That we think is bad law under Kirby and Burton-Sutton.

Hugo L. Black:

The last quote?

Hilbert P. Zarky:

That’s right.

Harold Burton:

Do you say, Mr. Zarky, that there were some pending legislation that it reflect the change?

Hilbert P. Zarky:

Well, the Bureau — the Internal Revenue Service is now preparing regulations under the new 1954 Code which didn’t change the basic statute from the 39 Code.

And it’s a long time consuming process to get out all the details.

They are far from being ready for approval.

But my understanding is that Internal Revenue Service intends to delete that last part of the sentence.

I would like, if I may, to pass to our alternative argument, which is that without regard to whether or how the upland owners acquired this interest in net profits.

We ask the Court to hold that it had an economic interest.

Now, we recognized, we’re asking the Court to go beyond what was decided in Kirby and Burton-Sutton.

Now, we think we’re asking for a sensible logical extension of those cases to make a workable rule.

An interest in gross production is obtained by the life of the lease like a gross royalty.

That’s depletable no matter who has it or how he obtained it.

And its common in the industry for the lessor to fragment his reserved royalty and sell it to others and its common for the lessee to fragment his interest by granting overriding royalty.

And as a matter of fact, by — in many situation, you will find hundreds of people having minute fraction of the right to — every barrel of oil produced or the proceeds from their sale.

And no one doubts that those interests are depletable so long as they’re (Inaudible) with the lease no matter how they go, whether by sale, assignment, by inheritance just so long as the party who has the interest has an interest in gross production that is depletable.

Now, the question we pose is, if as Kirby and Burton-Sutton hold an interest in net profits is so like an interest in gross production as to be depletable in the circumstances of those cases, should not the same rule apply to an interest in net profits no matter how its conveyed or to whom its conveyed or how its obtained.

That is if the lessor or assignor and Kirby and Burton-Sutton having retained an interest in net profits is entitled to depletion.

Shouldn’t a transferee for cash consideration, donation by gift, by inheritance, shouldn’t the transferee stand in the same position that the transferor did?

And if that interest can be carved out by the lessor, why shouldn’t the lessee be able to carve it out, just as the lessee can grant an interest in gross production by an overwriting royalty, why shouldn’t the lessee be able to sell an in interest in net profits and convey depletable interest even if it’s for a cash consideration.

This would be a simple rule.

It would be a workable rule.

Everyone would know precisely where everyone stands.

If you didn’t have to concern yourself with whether the peculiar circumstances of this case or another case fitted in to the rationality of Kirby and Burton-Sutton.

If the Court agrees with us, then it makes no difference that the upland owners obtained this interest by conveying an interest in their property.

It could be consider just as though the upland owners had bought for cash from Southwest the right to receive 24.5% of its net profits for the term of the lease.

Hilbert P. Zarky:

And that ought to be as depletable in the hands of the upland owners as if for cash, they had bought the right to receive one-eighth of gross production from the leases.

In other words, if this Court will put them both on the same basis so that an interest in net profits which stand precisely as an interest in gross production, we think that we have a logical extension in the two case and would have a rule which would make for more uniform results and would be administratively a lot more workable and taxpayers would be able to predict where they stand rather than having to worry about whether particular circumstances do or do not fall within the share or reliance of Kirby and Burton-Sutton.

Earl Warren:

Mr. Horrow.

Harry R. Horrow:

May it please the Court.

The respondent, Huntington Beach Company, is one of the upland owners on whose land, the oil wells — oil wells were located which were drilled under the ocean and into the tidelands.

The respondent received 17.75% of the net profits from the production of that oil and gas.

The respondent claimed depletion on those net profits payments and depletion was allowed by the court below.

The respondent contends that in accordance with the opinion of the court below that the depletion deduction should be a portioned to those who share in the income from production in accordance with their shares.

That is to say, in the case of the respondent, depletion should be allowed on its net profits payments.

In the case of Southwest, depletion should be allowed only on the portion of the income which it is entitled to keep and depletion should be allowed on the portion of the income from production which it is required to pay over, the royalties to the State and the net profits payments to the upland owners.

Of course, these net profit payments are taxable to the upland owners and, of course, the royalties and the net profits payments that are paid by Southwest would not be taxable to Southwest.

The facts in — in this case differ in no material respect from those in the companion case, 286.

They have been stated by the government counsel, but I would like to emphasize the steps involved in bringing about the production of oil and gas on the state lands.

The first step was a call for bids on the state lease.

Under that call, the only persons eligible to bid for the state lease were the upland owners or those to whom the upland owners were willing to sell their property or grant the use of their property.

They were not compelled under the state law to grant the use of their property to anybody, certainly not to Southwest.

Southwest at that time had been an inactive corporation.

It own no property, controlled no property in the area and had no — no right to insist that Huntington Beach or the other upland owners convey to it the right to use the property in order to make it eligible for the bid.

The upland owners chose not to bid for the state lease.

They chose not to sell their property.

They chose instead to grant the use of their property to Southwest and make Southwest eligible to bid on the state lease.

Southwest, thereby, become the only eligible bidder.

And, of course, the state lease was granted to Southwest, but that lease was not unconditional.

Southwest had no right under that lease to enter upon the tidelands and produce upon the tidelands.

The lease required that Southwest use the property of the upland owners and drill its wells through the upland owners’ property.

So that the grant by the State of the right to extract the oil from the — the submerged lands was not effective.

It was not complete without the grant that was made by the upland owners.

Both grants were necessary in order to permit Southwest to enter upon the production of oil and gas in the tidelands.

In consideration of the grant of the use of their property, Southwest agreed to pay the upland owners 24.5% of the net profits, in the case of the respondent, 17.75% of the net profits from all of the operation on the state lands.

The upland owners were not limited to a share in the net profits from the wells that were located on their lands.

Harry R. Horrow:

It is true that the lease required that the wells be located on their lands.

But if the lease should be modified so as to permit vertical drilling into the tidelands, the upland owners will share in the net profits from those wells as well as the producing wells that are now located on their property.

The grant of the use of a property, the agreement covering the share in net profits were inseparably apart of the state lease.The state lease was not operated without the grant that was made by the upland owners.

No production could have taken place without that grant and the grant of the use of a property, the right to share in the profits were coextensive with the lease.

The lease was for a term of 20 years or so long thereafter as oil and gas might be produced and the same was true of the grant to the upland owners for the use of their property as well as their share in the profits.

Now, the respondent contends that under those arrangements, it had an economic interest in the production of the oil and gas in the tidelands.

I say economic interest because that is the term that the Supreme Court, this Court, has used in all of its decisions relating to a depletable interest.

But this Court has used the term economic interest in describing a depletable interest because it has repeatedly said that it is the economic relation of the taxpayer to the oil and gas production, not the legal relation that control his right to depletion.

It doesn’t make any difference what the concepts of property law are under the — the applicable state jurisdiction, the niceties of conveyancing are ignored, the sole question in determining whether the taxpayer has a depletable interest is whether he has a capital investment in the oil and gas in place and must look solely to the production, the income from the production for a return of his capital.

The respondent —

Harold Burton:

Was the resource of your client’s property is being depleted?

Harry R. Horrow:

Your Honor, the resource which is depleted is our property right which is our right to share in the income from production, our net profits.

As the income rises or falls, our property interest will produce more or less income and when the oil is exhausted, when the mineral content has been entirely removed, our property is exhausted.

The depletion allowance —

Harold Burton:

Your property remained just the same, doesn’t it?

Harry R. Horrow:

Our property, if Your Honor please, is the right to share in the profits.

The property that we owned, the surface and the right to use the subsurface in drilling the wells that was property which we had — in which we had a capital investment.We invested that in the production that was taking place under the state lease, entitle — entitled to the oil or to the oil deposit is not necessary for depletion.

I might add that Southwest had no title to the mineral deposit because —

Harold Burton:

Suppose the State had allowed them to drill out in the water, right over the — the tidelands.

Harry R. Horrow:

Under the —

Harold Burton:

You wouldn’t had anything depleted in, would you?

Harry R. Horrow:

If the wells had — had been permitted to be drilled in the tidelands and no agreement had been made between the upland owners and Southwest, the upland owners will have no share in the income from production.

Harold Burton:

It would have anything to plead it either, wouldn’t it?

Harry R. Horrow:

That is correct.

But the state law required that the wells be drilled through our property.

Sherman Minton:

But the State can change that.

Harry R. Horrow:

The State can change that but the State cannot change our agreement, Your Honor.

Our agreement provides that we are entitled to the net profits from all the operations on the state lands whether or not those operations take place through slant drilled wells or whether they take place through vertical wells.

We have a continuing right to share in the income from production of the oil and gas under that lease as long as that lease is in effect or any renewal or extension of that lease.

Harold Burton:

Mr. Horrow, do you join the Government in — in the second alternative?

Harry R. Horrow:

Yes, Your Honor.

And if I may take that up, I’d like to — now, I’d like to discuss the — the theory of the Government in which we confer.

The Government’s theory is predicated on its interpretation of the Burton-Sutton case.

That case involved a right to share in the net profits under a lease which the Gulf Refining Company had obtained and then in turn assigned to an operator.

The operator agreed to pay Gulf 50% of the net profits and this Court held that that net profits interest standing alone was depletable.

We found no difference between a net profits payment and the situation in Kirby where there was a royalty interest together with a share in the net profits.

The Government had contended in Burton-Sutton that a net profits interest standing alone was not depletable.

If the taxpayer had to own something else to give him his economic interest, a royalty or other interest, then this Court held that that was not true, that the net profits interest standing alone was depletable because the mark of an economic interest was a share in the income from production and sole dependency on production for that income.

The Burton-Sutton case left open this question, if the Gulf Refining Company which held a share in the net profits sold that net profits interest for cash or if the operator turned around and sold another portion of the net profits to a third party when the purchaser of that net profits interest be entitled to depletion.

And the Government contends that it would be because the taxpayer would have a capital investment in the production of the oil and gas, it could look solely to the production for a return of its capital or the possibility of profit.

We conquer in that view.

But the respondent does not rest its case on that point.

There are additional factors here which attached to — to our net profits interest which we believe require the recognition of an economic interest on the part of respondent without regard to the acceptance to the government’s theory.

Now, there are four factors that we think are present here.

One, the upland owners had control over the right to produce.

Two, there was required and continuing use of their property and production.

Three, the operator, Southwest, in order to acquire its economic interest had as a condition precedent to pay the upland owners a share in the net profits.

And — and the fourth factor is the continuing control which the upland owners exercised over the production.I’d like to take up each one of those points briefly.

Earl Warren:

Suppose Mr. Horrow, in order to make this oil merchantable it was necessary to have a pipeline from the well and, let’s say, three or four miles in place it was convenient for — for handling the oil and Southwest acquired an easement over — over the land for that pipeline and paid for it by a percentage of the — of the net profits.

Would the owners of that land have a depletion allowance?

Harry R. Horrow:

Under the —

Earl Warren:

(Voice Overlap) have to it?

Harry R. Horrow:

Your Honor, under the broad theory of Burton-Sutton, it would.

But under the particular facts of our case, that situation would be different from ours because the property, the use of which is granted for the net profits interest is not used in production.

It’s not used in the extraction of the oil and gas.

The owner of the property does not have any control over the right to produce.

The acquisition of the economic interest of the operator is not — does not take place as a result of being required to pay a portion of the net profits and there is not the continuing control over production that is present here in our situation.

Earl Warren:

I don’t see how — how these things apply because it — its just by position of your land that — with relation to the state pool that you claim to be entitled to this depletion allowance.Now — and we could also say that it’s because of the relationship of this — of this land that you get an easement over is in the similar relation to your land that is necessary for you to — necessary for them to have that in order to produce.

Now, why wouldn’t that produce the same effect so far as depletion is concerned?

Harry R. Horrow:

Your Honor, I’d like to suggest this important difference.

Harry R. Horrow:

In order to get the right to produce, Southwest had to pay the upland owners, the share of the profits, just as it had to pay the State of California royalty.

In our opinion, there is no difference in substance or effect between the royalty that Southwest had to pay to the State to acquire the right to produce and the share in the net profits that it had to pay to the upland owners in order to acquire the right to produce.

In both cases, those payments diminished the economic interest of Southwest because to the extent that Southwest is required to pay these amounts out of income from production.

It does not have that much income from production on which it could claim or should — should get depletion.

Well, if I may, I’d like to take up these four points that I think represent factors applicable here requiring the recognition of our interest, economic interest whether or not the broad rule of Burton-Sutton or the broad interpretation of Burton-Sutton is accepted.

The first one, is matter of control over the right to produce just as in Burton-Sutton, the upland owners have the choice of operating the property themselves taking and bidding on the state lease and they are the only ones eligible if they chose to.

They chose not to grant the use of their property to Southwest or permitting someone else to operate the property.

In Burton-Sutton, Gulf shows not to operate the property.

It assigned the lease to an operator for sharing the net profits.

And we contend that our position is identical in effect with the situation that Gulf had in Burton-Sutton.

On the second point, the use of our property in production.

The key to depletion is an economic interest.

If more is needed unless — then — then a share in the net income is not our economic interest confirmed by the fact that our property must be used both under the law and — and the easement, the state lease, to produce that oil and gas.

I’ve discussed the third point, the matter of — of the — the payment by Southwest of the net profits as a condition precedent to acquiring its — its right to produce.

The fourth element is the continuing control that the upland owners hand over the production.

At the time, the use of the uplands was granted to Southwest, an agreement was entered into which prescribed in detail how Southwest was to conduct its operations.

It had to conform the good drilling practice.

It had to give complete information on the pumps, mechanical condition.

It had to conform to any conservation program that a majority of the producers should agree to.

And in extracting the oil, it had to agree to follow good engineering practice and those requirements were essentially the same as the requirements that were laid down in the state lease.

And they both reflect the concern that one who has an interest in production exercises or expresses in seeing to it that there is maximum economic recovery from the oil and gas to assure maximum income on its share of the — the income from production.

Stanley Reed:

Mr. Horrow, are you going to discuss the regulations (Inaudible)

Harry R. Horrow:

Yes, sir.

I think Mr. Zarky has stated that insofar as the regulations express the view that a net profits interest is not depletable.

That position has been squarely rejected by this Court in Kirby and Burton Sutton.

Stanley Reed:

Well, do you — are you familiar when those regulations were issued?

Harry R. Horrow:

The regulations were issued, Your Honor, following Elbe and O’Donnell and Bankline Oil.

Stanley Reed:

Well, the reason I was asking that was because the Government brief says, Treasury Regulations (Inaudible) were promulgated under Internal Revenue Code of 1939.

Harry R. Horrow:

Those regulations conformed to the regulations that were in effect following Elbe and O’Donnell, which I believe were decided in 1939.

Stanley Reed:

But in — in Burton-Sutton, the Treasury Regulation referred to, regular — Treasury Regulations of 1994.

Harry R. Horrow:

There — there has been no — no substantial change in this portion of the regulations since Elbe, O’Donnell and Bankline Oil.

In these —

Stanley Reed:

But were they — what in the preceding regulations was — was this the same regulation in the preceding regulation?

Harry R. Horrow:

Well, these regulations, Your Honor, were before this Court in the Kirby and Burton-Sutton cases.Regulations in this form were before this Court in those two decisions.

Stanley Reed:

They’re — they may have been but they — if — if the Government is correct in saying the petitioner promulgated under the Internal Revenue Code of 1939, if I take it what they are, then they didn’t cover the years 1936, 1937 and 1938 which Burton-Sutton covers.

So that — if — if I’m — if that is correct, I don’t know whether it is not, I merely notice that these regulations weren’t referred to in Burton-Sutton so far as I can see it (Inaudible)

Harry R. Horrow:

Well, that’s correct, Your Honor.

Stanley Reed:

And — and when — and when these were promulgated in 1939, Burton-Sutton covered 1936, 1937 and 1938 and we would have the issuance of these regulations after Burton-Sutton.

Harry R. Horrow:

The Burton-Sutton case, Your — Your Honor knows, it was decided in 1946.

Stanley Reed:

Yes.

Harry R. Horrow:

The years —

Stanley Reed:

And also, it covers fiscal year’s ending in 1936, 1937 and 1938.

Perhaps, Mr. Zarky knows about the plaintiff — the economics of the later years.

Harry R. Horrow:

At any rate, insofar as they express the view that a net profits payment is not depletable, they are squarely contrary and inconsistent with the Burton-Sutton decision in —

Stanley Reed:

Yes, I — I was assuming you answered the question.

Harry R. Horrow:

— in the Kirby case.

And, Your Honor, I believe we referred to the portion of the regulations dealing with the contractual relation clause in the preceding sentence on page 48.

That statement does not reach this situation because that regulation pertains to a taxpayer who has no capital investment in the mineral deposit.

It is our contention that we had a capital investment in the mineral deposit represented by the dedication of our property to the production of the oil and gas.

Stanley Reed:

As supported by the California legislation.

Harry R. Horrow:

Made possible by the California legislation, but once those agreements —

Stanley Reed:

Made — made necessary with California.

Harry R. Horrow:

Made necessary, yes, Your Honor.

But once those agreements had been entered into whereby we — we stipulate it for a share in the profits, the legislation could not deprive us the benefit of that agreement.

Stanley Reed:

Perhaps you’ll —

Harry R. Horrow:

I’d like to close it with this — with this point.

The Court has repeatedly said that economic realities control depletion.

The economic realities of this situation are these.

There are three interests that share in the income from production.

One, mistake through its royalties.

Harry R. Horrow:

Secondly, Southwest as the operator of the property.

And the third is the — the upland owners who share in the net profits.

If depletion is allowed to the upland owners, recognition will be given of the economic realities of this situation and the deduction will be apportioned on the basis of the economic interest as they appear, namely, on the basis in which the parties share in the income from production.

Hilbert P. Zarky:

All right.

May I just comment on the regulations?

The existing regulations were amended by a treasury decision as I recall in the early part of 1940 to reflect the O’Donnell, Elbe and Bankline cases.

Now, Your Honor is correct that those regulations were not applicable in Burton-Sutton but they were the regulations applicable in Kirby, and you will find it in Footnote 4 of the Kirby opinion, a quotation from the regulations which include that disputed sentence.

Now, of course, in both Burton-Sutton and in Kirby, we were contending that the regulations were a correct interpretation of the statute which had all along remained unchanged so that our position had been calling that the applicable regulation were governing in Kirby and that what they stated was the correct rule of law not only because they governed those particular years, but because there were a correct interpretation of the statute which has remained unchanged all the way through.

And as, Your Honor, may recall in Burton-Sutton, the Court, in speaking of the regulations, broadly said that they’re not very helpful.

They tell us what to do once you decided what is a rent or royalty but they don’t tell us what is a rent or royalty.And in — the net profit payment regulation was intended to be specific.

After Kirby and Burton-Sutton, we think they are equally unhelpful in deciding the issue posed by this case because, had the regulations been applied literally.

I think the Government should have prevailed in both Kirby and Burton-Sutton because to the extent that they say that an interest in net profits is not an economic interest.That was precisely what the Court held was not true in both Kirby and Burton-Sutton.

Harold Burton:

Do you report what happened here before the Court of Claims, aren’t you?

Hilbert P. Zarky:

Sorry, sir?

Harold Burton:

The Government’s for what happened in the Court of Claims.

Hilbert P. Zarky:

No, no, we took the opposite side in the Court of Claims.

We argued very — as rigorously as we could by the same contention which Southwest makes in this case.

In other words, we took one position in Ninth Circuit.

We took the opposite position in the Court of Claims and lost both of them.

Harold Burton:

(Voice Overlap) —

Hilbert P. Zarky:

We — we were persuasive no matter which — which side we argue that.

[Laughs]

Harold Burton:

You — you agree with the Court of Claims now, don’t you?

Hilbert P. Zarky:

Yes, that’s before we took a tactical inconsistent position because we had to.

But now —

Harold Burton:

Would you — you’d like to, the present case, to be affirmed.

Hilbert P. Zarky:

The Court of Claims, we believe, should be affirmed to the Ninth Circuit reversed.

Harold Burton:

Otherwise, you would — anybody wouldn’t get depletion.

Hilbert P. Zarky:

That’s right and we agreed that one of the two parties must get it and we also contend that both of them can have it.

Sherman Minton:

Moved it’s depletion —