Island Petroleum Co. v. Commissioner , 17 B.T.A. 1 ( 1929 )

ISLAND PETROLEUM CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Island Petroleum Co. v. Commissioner

Docket No. 19970.

United States Board of Tax Appeals

17 B.T.A. 1; 1929 BTA LEXIS 2374;

July 26, 1929, Promulgated

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">*2374 1. Held, that the petitioner did not own or control substantially all of the stock of four other corporations and therefore was not affiliated with them.

2. Held, that the amount advanced by the petitioner during the taxable period to finance the operations of four other corporations represented payment for stock in such corporations and therefore was not an allowable deduction to the petitioner in determining net income.

3. Held, further, that such amount was not deductible as a loss sustained during the taxable year in determining net income.

J. Kemp Bartlett, Esq., and William M. Williams, Esq., for the petitioner.

Philip M. Clark, Esq., for the respondent.

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TRAMMELL

">*1 This is a proceeding for the redetermination of a deficiency in income and profits tax of $24,367 for the fiscal year ended April 30, 1920. The matters in controversy are (1) the action of the respondent in refusing to determine that the petitioner and four Texas corporations were affiliated during the taxable period, and (2) not allowing as a deduction from the consolidated net income losses in the amount of $106,416.98 sustained by the four Texas">*2375 corporations for the fiscal year here involved. As an alternative contention the petitioner urges that, in the event it and the four other corporations are found not to have been affiliated during the taxable period, it be allowed as a deduction the amount of $106,416.98, on the ground that it was either a loss actually sustained by the petitioner during the taxable period or an operating expense for the period.

FINDINGS OF FACT.

The petitioner is a Delaware corporation organized in 1901, and has its principal office at Baltimore, Md. Its oil refinery is located ">*2 at Neville Island, Pa., about six miles west of Pittsburgh. The petitioner's business is and was during the taxable year here involved that of gathering crude petroleum through pipe lines, or in other ways, refining such petroleum at its Neville Island refinery into various products of crude petroleum and selling such products. From its beginning, one of the petitioner's most important problems has been the obtaining of a sufficient amount of crude petroleum to supply its refinery on a profitable basis. From 1901 until about 1912, the principal source of its supply of crude petroleum was the Standard Oil">*2376 Co. or one of its subsidiaries. In 1903 the Standard Oil Co., which, through its affiliated pipe-line companies, supplied practically all of the refineries in Pennsylvania, limited the supply of oil and so curtailed the petitioner's supply that it was impossible for the petitioner to operate successfully because of overhead expenses. In an attempt to remedy the situation, the petitioner joined with the Pittsburgh Oil Refining Co. and formed a pipe-line company, which gathered crude petroleum from producing wells in Pennsylvania. In 1912 the petitioner and six other refineries were the owners of the stock of a pipe-line company which had built and was operating pipe lines into West Virginia and supplying the refineries with crude petroleum. This effort on the part of the petitioner and the other refineries to obtain crude petroleum was successful only for a period because of the declining production in the territory supplying the pipe lines. By 1917 the situation was such that the petitioner was unable to obtain from the above mentioned pipe-line companies an adequate supply of crude petroleum.

The foregoing was the situation in 1917, when C. B. Dutton, who was associated with">*2377 a Dr. Rittman at the United States Bureau of Mines, offered the petitioner what was believed to be an opportunity to obtain an adequate supply of crude petroleum from the Texas oil fields. Since 1914 Dutton had been known by William H. Fehsenfeld, president of the petitioner. In November, 1917, Dutton through an associate, E. T. Merritt, of Texas Had secured oil leases on between 250,000 and 300,000 acres of land in Texas, chiefly in Duval County of that State. Dutton's proposition contemplated having the petitioner associated with him in the development of the leases.

Fehsenfeld conferred with W. Champlin Robinson, president of the Pittsburgh Oil Refining Co., and as a result of the conference an agreement was reached with Dutton. After the proposition had been referred to the board of directors of the petitioner and they had authorized Fehsenfeld and the petitioner's general counsel to act in the matter, an instrument embodying the agreement of the parties was executed on December 8, 1917, by Fehsenfeld and Robinson and Dutton.

">*3 The instrument provides in part as follows:

WHEREAS, the parties of the first part [Fehsenfeld and Robinson] are desirous of joining">*2378 in the development of such leased lands for the purpose of producing therefrom crude petroleum in commercial quantities and of otherwise engaging in the various branches of the petroleum industry, including the production of natural petroleum gas and other mineral substances, to the extent that good business judgment warrants, taking into consideration the production and prospective production from such lands, and to that end, will furnish monies required for the initial development and drilling of such lands in consideration of the assignment of said leases to a corporation to be hereafter created, with such limitations, however, upon the obligation of the parties of the first part to furnish such monies, and with such limitations upon the assignment of said leases, as hereinafter is more particularly set forth.

* * *

1. The parties of the first part agree to cause to be promptly incorporated and organized, a corporation, under the laws of such State as the parties of the first part shall determine, for the purpose of taking title to the said leases and of conducting the drilling, producing and other operations herein contemplated and commonly associated with the production, ">*2379 transportation, marketing and manufacturing of crude petroleum and its products. If, however, it shall be mutually determined by the parties hereto that it will be advisable for two corporations to be formed, one to serve as a holding and operating corporation and the other as a corporation to conduct the business of drilling wells upon said properties, then, and in that event, the parties of the first part agree to cause two corporations to be formed, with all the corporate powers necessary for the conduct of the business of each of said corporations as may be permissible under the laws of the State of incorporation. As it is intended that such corporation or corporations shall conduct the business that they are created for the purpose of conducting, in the State of Texas, according to the laws of said State, they shall be so constituted as to be capable of doing business in said State,

2. If but one corporation is organized, as aforesaid, its entire common capital stock of the par value of One hundred thousand dollars ($100,000) shall be distributed among the parties hereto in the proportion of sixty percentum (60%) thereof to the parties of the first part, to be equally divided">*2380 between them, and forty percentum (40%) thereof to the party of the second part [Dutton], or and his nominee or nominees, and if two corporations shall be organized, as aforesaid, the entire common capital stock of the par value of One hundred thousand dollars ($100,000) of the holding and operating corporation shall be distributed as hereinabove provided, and the entire capital stock of the corporation organized for the purpose of drilling wells shall be held by the holding and operating corporation. In either case the aforesaid forty percentum (40%) of common capital stock to be issued to the party of the second part, or his nominee or nominees shall constitute, together with the sums of money hereinafter mentioned, the entire consideration moving to the party of the second part and his associate or associates for the transfer to said corporation, as hereinafter provided, of all the leases herein mentioned, and the sixty percentum (60%) of said common stock to be distributed to the parties of the first part shall be the entire consideration moving to them for the obligations herein, by them, assumed. Any further issue or issues of capital stock of said corporation shall be issued">*2381 at such price and upon such terms as the directors of said corporation shall, by resolution, determine, but no such shall be ">*4 made either to the parties of the first part or the party of the second part or his associate or associates based upon either the monies paid into the treasury of said corporation by the parties of the first part, as herein provided, or upon the transfer to said corporation by the party of the second part or his associate or associates of the leases herein mentioned.

3. Simultaneously with the execution of this agreement and with the payment of Eugene T. Merritt of the sum of Four thousand, two hundred and sixty-eight dollars and twenty cents ($4268.20), the party of the second part shall assign or cause to be assigned to the parties of the first part, as trustee, for the purpose hereinafter expressed, a certain lease, bearing date the 11th day of April, 1917, executed by a certain A. J. Ridder of Bexar County, State of Texas, to the said Eugene T. Merritt, which said lease covers twenty-nine thousand (29,000) acres, more or less, in what is known as the A. J. Ridder Ranch, lying some eleven (11) miles northwest of the City of San Diego, in Duval">*2382 County, in the State of Texas, the lands covered by said lease being more particularly identified and described in said lease, a true copy whereof is attached hereto for a more particular identification and description thereof; * * *.

* * * and the party of the second part further agrees to assign, or cause to be assigned, to the parties of the first part, as trustees as aforesaid, at the time of or before the starting of the drilling of the first well upon the said A. J. Ridder Ranch, and upon the payment by the parties of the first part of a further sum of to the party of the second part sufficient to pay the commission of a certain Harry Traylor, agent of J. B. Wilson, but which commission and payment shall not exceed the sum of Fifteen hundred dollars ($1500.00), a lease of what is known as the J. B. Wilson Ranch, said Wilson Ranch being contiguous to and approximately in the center of the tracts of land constituting the aforesaid A. J. Ridder ranch, the said Wilson ranch comprising a total acreage of twenty-six thousand (26,000) acres, more or less. The lease of the said J. B. Wilson ranch shall provide for the payment of a royalty of one-eighth (1/8) part of all petroleum">*2383 taken from said property and one-tenth (1/10) part of all petroleum gas taken therefrom, and shall further provide for the drilling of one well upon said property within a period of one year from the date of said lease, but shall contain no other drilling requirements, except that said property covered by said lease shall be developed with reasonable diligence consistent with the interest of both the lessee and the lessor thereunder, nor shall said lease provide for the payment of any other rental than is covered by the aforesaid royalties, and said lease shall be in all respects, subject to the approval, as to its form and substance, of the said parties of the first part. * * *

4. The aforesaid leases to be assigned to the parties of the first part as trustees, shall be assigned by the parties of the first part, as such trustee, without recourse upon them, to the corporation to be formed, as hereinbefore provided, in case it is determined to organize but one corporation; and in case it is decided to organize two corporations, then, and in that event said leases shall be assigned by the parties of the first part, as such trustees, without recourse upon them, to the corporation">*2384 formed for the purpose of holding and operating said property, and such assignment of said leases shall be made as soon as the corporation to receive said assignment shall have been duly chartered and organized and capable of taking title thereto, after which the trust created by the third paragraph of this agreement shall cease and determine.

5. The parties of the first part agree to pay into the treasury of the corporation to be formed, as hereinbefore provided, or if two corporations are formed, ">*5 then into the treasury of the holding and operating corporation, monies sufficient to enable such corporation to pay the actual cost of drilling the first test well to be drilled upon the said Ridder ranch, such cost to include the sum necessary to cover the purchase of rental (as the case may be), transportation and erection of a rig capable of drilling to a depth of three thousand (3,000) feet, but said drilling shall not be prosecuted beyond a depth of two thousand (2,000) feet, if the parties of the first part shall, in their combined judgment, determine not to have said well drilled to a greater depth; and the cost of drilling the first well shall also include incidental">*2385 expenses of employment of a geologist, an engineer or engineers, and other overhead expenses, the sum of one thousand dollars ($1,000); and the total cost of drilling the first well shall, in no event, exceed the sum of Fifteen thousand dollars ($15,000). The parties of the first part further agree to pay into the treasury of the aforesaid corporation, an additional sum of Four thousand, two hundred and twenty-eight dollars and twenty cents ($4,286.20) and further sums not to exceed Fifteen hundred dollars ($1500) and Five Hundred dollars ($500), as hereinbefore provided, which said sums shall be paid over by said corporation to the said Eugene T. Merritt, as and for the entire cash consideration, except as hereinafter provided, payable to him by said corporation for the transfer to it, as aforesaid, of all of the right, title and interest of the said Eugene T. Merritt and his associates, as lessee or lessees under all of the aforesaid leases covering the entire Ridder and Wilson ranches, and all other leases now held by him and his associates, or to be acquired by him or them, in Southeastern Texas, up to a total acreage of approximately three hundred thousand (300,000) acres. The">*2386 parties of the first part further agree to thereafter pay into the treasury of said corporation monies sufficient for the drilling of a second test well upon the said Ridder ranch after the completion of the first well, unless in their combined judgment, oil or natural gas has not been found or indicated to a sufficient extent to justify them, in their uncontrolled, combined judgment, in advancing further sums of money hereunder over and above the amount necessary to drill the first well, as aforesaid, and the aforesaid sums of money. The parties of the first part further agree to thereafter pay into the treasury of said corporation monies sufficient for the drilling of a third test well upon the completion of a second well, unless in their combined judgment oil or natural gas has not been found or indicated to a sufficient extent to justify them, in their uncontrolled, combined judgment, in advancing further sums of money hereunder, over and above the amount necessary to drill the first well, as aforesaid, the aforesaid sums of money and the amount necessary to drill the second test well.

* * *

9. The party of the second part further agrees, upon his own behalf and also upon">*2387 behalf of the said Eugene T. Merritt, that before offering any of the shares of stock of the aforesaid corporation, to be received by them, for sale they will offer said shares, if any, that they may desire to sell to the parties of the first part, at and for a price and terms as favorable to the parties of the first part as the said party of the second part or and his associate may be willing to offer to any other person, and an option is hereby given to the parties of the first part by the party of the second part and his associate, the said Eugene T. Merrit, to purchase said shares, or any of them, within fifteen (15) days after receipt of written notice from the party of the second part, or his associate, the said Eugene T. Merritt, of his or their desire to sell any or all of said shares.

">*6 As Merritt and Dutton had certain associates interested with them in their respective one-fifth shares of any oil that might be produced, it was decided that the interests of such parties could be provided for best by the formation of a corporation under the laws of the State of Texas. A corporation known as the Mar-Tex Oil Co. was chartered on January 8, 1918, with an authorized">*2388 capital stock of $20,000, divided into 2,000 shares of a par value of $10 per share. One-fifth of the stock of the company was issued to E. T. Merritt, one-fifth to Dutton and of the remainder, one-half was issued to Fehsenfeld for the petitioner and one-half to Robinson. Except for one lease, the Mar-Tex Oil Co. held and developed leases in Duval County. Robinson remained with the enterprise for only a few months and withdrew. At the time he withdrew he paid to the petitioner one-half of the amount expended by it up to that time in the development of the leases in Texas. Thereafter, Robinson had nothing to do with the corporation.

Thereafter, during 1918, three other corporations were formed to provide for the representation of the interests of other persons in oil leases that were turned in under the agreement of December 8, 1917. The Bee-Tex Oil Co. was chartered on July 25, 1918, with an authorized capital stock of $5,000, divided into 500 shares of a par value of $10 per share. This company was formed to take over and develop leases in Bee County, Texas. The Sierrita Petroleum Co. was chartered September 20, 1918, with an authorized capital stock of $10,000 consisting">*2389 of 1,000 shares of a par value of $10 each. This company was formed to take over and develop leases in Wilson County, Texas. The Rivera Oil Co. was chartered November 13, 1918, with an authorized capital stock of $5,000, consisting of 500 shares of a par value of $10 per share. This company was formed to develop leases around the Nueces River in San Patricio and Nueces Counties. Two-fifths of the stock of the foregoing three companies was issued to persons who turned over the leases and the remaining three-fifths went to the petitioner. The certificates for the petitioner's three-fifths interest were made out to Fehsenfeld. These certificates as well as those representing the petitioner's shares of stock of the Mar-Tex Oil Co. were endorsed by Fehsenfeld to the petitioner, and held in the petitioner's safe-deposit vault.

With the exception of the amount paid to the petitioner by Robinson at the time he withdrew from the Mar-tex Oil Co., the petitioner furnished all the money that went into the four Texas corporations, which were considered merely as agencies for disbursing the funds sent by the petitioner for developing the whole enterprise.

About the time the instrument">*2390 executed on December 8, 1917, was being prepared, the petitioner had an agreement or understanding with Robinson, Dutton and E. T. Merritt that Fehsenfeld, its president, ">*7 was to have the management and control of the Texas enterprise. Pursuant to this agreement, Fehsenfeld, on behalf of the petitioner, had full, complete, and unreserved control of each of the Texas corporations. He alone determined who should be the directors of the Texas corporations, when they should have meetings, and what should be done at such meetings. He determined who should be the officers of the corporations and what their compensation should be. Without exception be determined all questions of policy such as whether wells should be drilled and where they should be drilled, whether drilling equipment should be purchased or leased, and what materials should be purchased for drilling operations. When expenditures of more than trivial amounts were involved, Fehsenfeld always determined whether they should be made. He also determined when the Texas corporations should be dissolved.

At Feshenfeld's direction, monthly budgets of the requirements for expenditures were submitted to him from Texas. ">*2391 While the budgets were prepared to cover the requirements of the four corporations, generally they were made as if there was one budget instead of four. Well and camp reports showing the operations of the day were forwarded to Fehsenfeld daily. Weekly disbursement sheets accompanied by vouchers, receipts, pay-roll statements, etc. were also forwarded. While some memoranda were kept in Texas of the expenditures made there, the books of the Texas corporations were kept at the office of the petitioner in Baltimore by persons employed and paid by it.

Throughout the period of operations in Texas money passed frequently and constantly between the Texas companies, generally without cross charges and credits being made by the companies. Such action was based on the theory that the money was sent out to be used for all the operations and that the separate companies were disbursing agents for distributing the money. If cross charges or credits were made it was for the purpose of preparing analyses of expenditures made for the records of the Texas companies. E. T. Merritt and his son, Walle Merritt, were in direct charge of operations in Texas and for their services they received salaries">*2392 out of the funds furnished the Texas corporations by the petitioner. Neither Fehsenfeld nor any of the other officers or directors of the Texas corporations received salaries.

Although there were differences of opinion among the stockholders of the Texas corporations as to what was best to be done in the operation of these corporations, the stockholders acquiesced in the measures that Fehsenfeld took. The stockholders had confidence in Fehsenfeld's leadership. They were all anxious to have the undertaking in Texas result successfully, and knew that it could only be done by harmonious action. As Fehsenfeld and associates were putting up ">*8 all the money, the other stockholders knew that operations could not be continued if Fehsenfeld did not wish for them to continue.

For some time after the operations were begun, the Texas corporations had no established office and all the records in Texas and material in reference thereto were carried around by Walle Merritt in his suitcases. Later, a room was obtained in Corpus Christi, Tex., which served as an office for the four corporations.

For the fiscal year ending April 30, 1920, the total expenditures that were made by">*2393 the petitioner, both directly and through the agency of the Texas companies and Walle Merritt, amounted to the sum of $106,416.98. These expenditures were for the purpose of paying drilling expenses, lease rentals, salaries of petitioner's representatives in the Texas fields, rent of the Texas office, camp expenses, and other necessary and ordinary expenses connected with the exploration for oil and gas in the Texas field, but do not include any part of the salaries of W. H. Fehsenfeld, Louis K. High, or any other representative of petitioner operating outside of the Texas field.

Four wells were drilled on the Ridder lease in Duval County, and one well was drilled on the leases in Wilson County. These wells were from 3,000 to 4,000 feet deep. In only one of them was there any "showing" of oil, and the amount of oil in it was not enough to collect. A shallow gas well on the Ridder lease produced enough gas to fire the boilers for drilling operations and to heat the camp. As neither oil nor gas was found in paying quantities, the Texas enterprise was abandoned at Fehsenfeld's decision. He ordered Walle Merritt to secure an annulment of the charters of the Texas corporations">*2394 and to wind up their affairs. The corporations were dissolved on the following dates:

Sierrita Petroleum Co	January 27, 1922
Bee-Tex Oil Co	May 11, 1922
Rivera Oil Co	February 21, 1924
Mar-Tex Oil Co	February 21, 1924

The petitioner continued to advance funds to the Texas corporations up until the time of their dissolution. In winding up the affairs of the corporations, $3,000 or $4,000 was received from the sale of materials salvaged or left over from the drilling operations. Part of this money was used to meet the expenses incurred in winding up the affairs of the corporations and the remainder was forwarded to the petitioner.

The only cash receipts of any kind that came from the Texas operations consisted of money received through a sublease of the pasture rights upon one of the oil leases and of money received from the sale of some of the leases. The amounts so received were accounted for to Fehsenfeld, and on his instructions were used in the Texas operations.

">*9 In determining the petitioner's tax liability for the fiscal year ended April 30, 1920, the respondent determined that the petitioner and the four Texas corporations were not">*2395 affiliated during the taxable period.

OPINION.

TRAMMELL: The petitioner contends that during the fiscal year here involved it was affiliated with the four Texas corporations. In support of this contention the petitioner urges that it had not only complete management and direction of the business of the companies, but also complete control of the policies of all the companies not only as to the framing and dictation of the policies, but also control of the stock with respect to voting for or approving its policies.

The evidence shows that 600 shares of the stock of the Mar-Tex Oil Co. were issued to Robinson in 1918. It is not clear from the record, however, what arrangement was made as to the holding of this stock after he withdrew from the Texas enterprise. The evidence shows that for the taxable period here involved the stock still stood in his name, and that he continued to be a director of the company until January 13, 1921. Conceding for the sake of argument that he held this stock for the petitioner, this would indicate that the petitioner was the holder of three-fifths of the stock of that company, which is the same amount it had in the three other companies. The">*2396 petitioner through its president, Fehsenfeld, had complete management and control of the operations of the four Texas companies and determined all questions of policy relating to them. While there were differences of opinion among the stockholders of the Texas corporations as to what was the best to be done in the operation of the companies, the stockholders always acquiesced in the measures that Fehsenfeld took and the operation of the companies was harmoniously carried on. But the question is, Did the petitioner control the voting stock which it did not own? It is the control of the stock and not control of the business and policies which is the control referred to in the statute. . The fact that the minority stockholders acquiesced in the management of the business does not indicate that their stock was controlled within the meaning of the statute. . The record clearly shows that the minority stockholders of the Texas corporations were not stockholders in the petitioner.

It is also urged that by having an option to purchase the stock of the minority stockholders, ">*2397 the petitioner thus controlled such stock. In our opinion a mere option such as existed in the instant case to purchase stock when offered for sale does not constitute ">*10 control of the stock. ; .

From the evidence we can not find that the petitioner owned or controlled in excess of 60 per cent of the stock in each of the Texas corporations. This amount clearly does not represent substantially all of the stock. ; ; . See, also, , and

It is further urged that the petitioner and the Texas corporations were conducted as a commercial and economic business unit with respect to the Texas operations, which constituted the sole purpose for organizing the four Texas companies. Conceding but not deciding that this is true, there is clearly lacking that ownership or control">*2398 by the petitioner or by the same interests of substantially all of the stock of the Texas corporations as required by the statute.

In view of the foregoing, we are of the opinion that the action of the respondent in determining that the petitioner and the four Texas corporations were not affiliated within the meaning of the statute during the taxable period is correct and must be sustained.

The petitioner contends that, in event it and the Texas corporations are determined not to have been affiliated, it is entitled to a deduction of $106,416.98 as an ordinary and necessary business expense, representing an amount expended by it during the taxable period in connection with the operations of the Texas corporations. The petitioner also contends that the $106,416.98 was actually lost when expended and that it should be allowed that amount as a loss sustained during the taxable year. The respondent contends that the amount expended was in payment of 60 per cent of the stock of the Texas companies and, as further amounts were expended during subsequent years, no deductible loss was sustained during the taxable period.

The fact that Fehsenfeld, acting in behalf of the petitioner, ">*2399 in the exercise of his judgment decided to have other wells drilled and caused the petitioner to furnish the funds therefor, does not, in our opinion, serve to make such additional amounts any less payments for stock.

From the facts before us, we are of the opinion that the amount of $106,416.98 expended by the petitioner in connection with the operations of the Texas companies during the taxable period constituted a payment on the stock it had received under the contract, and therefore is not an allowable deduction for the taxable period.

The petitioner furnished additional money to the corporations during subsequent years and there is nothing to indicate that operations ">*11 were abandoned or that it was definitely determined during the taxable period that they would be abandoned, or that a loss had been or would be sustained. During the years here involved it is not shown that it was definitely known that the undertaking would not be successful.

The record does not show how many of the wells had been completed during the taxable period and there is a complete absence of evidence to indicate that conditions were so different during the taxable year from what they">*2400 were at the time of making the contract of December 8, 1917, as to justify the conclusion that the $106,416.98 constituted a loss sustained during the taxable year. .

Judgment will be entered for the respondent.