DocketNumber： No. 12-75
Citation Numbers： 217 Ct. Cl. 431, 582 F.2d 604
Judges： Cowen, Davis, Kunzig
Filed Date： 7/14/1978
Status： Precedential
Modified Date： 1/13/2023
delivered the opinion of the court:
This is a corporate income tax dispute whether certain business expenditures should be deducted as ordinary and necessary expenses or should be capitalized. Taxpayer Southland Royalty Company ("Southland”) is engaged in the oil and gas business. It keeps its books and reports its income and expenses for federal income tax purposes on the calendar year and accrual bases. The controversy revolves around the deductibility of legal expenses which Southland accrued during 1966, 1967, and 1968 in connection with litigation, and of expenses which it accrued during 1968 for a study of petroleum reserves. Senior Trial
I.
Southland contends that each of the three items of expense involved in this suit was deductible for income tax purposes under I.R.C. § 162(a),
(a) In general. — There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business ....
I.R.C. § 263(a)(1), on the other hand, declares that:
(a) General Rule. — No deduction shall be allowed for—
(1) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate ....
It is familiar law that I.R.C. § 263 (if applicable) takes precedence over I.R.C. § 162. I.R.C. §§ 161, 261.
For each of the items in controversy, defendant argues on the basis of the regulations that the expenditure must be capitalized because it was incurred: (1) in defending or perfecting title to property (Treas. Reg. § 1.263(a)-2(c)); (2) in the acquisition of property having a useful life substantially beyond the end of the taxable year (Treas. Reg. § 1.263(a)-2(a)); and/or (3) in adding to the value of, or substantially prolonging the life of, property owned by the taxpayer (Treas. Reg. § 1.263(a)-l(a)(l), -1(b)).
The 1966 Litigation Expenses
At the times pertinent to this litigation, Southland owned a fraction of the royalty interest in a certain 480-acre parcel of land located in Winkler County, Texas; two other companies, Avoca Corporation ("Avoca”) and Socony Mobil Oil Company ("Mobil”), owned the remaining fractions of the royalty interest in the 480 acres; and Pan American Petroleum Corporation ("Pan Am”) and West-brook-Thompson Holding Corporation ("Westbrook”) were the holders of a mineral lease on the land, authorizing them to mine and operate for oil, gas, potash, and other minerals.
The mineral lease referred to in the preceding paragraph contained three numbered royalty provisions, as follows:
(1) The first royalty provision required the lessee to deliver to the credit of the lessor (i.e., to Southland, Avoca, and Mobil, as successors to the original lessor insofar as the royalty interest was concerned), free of cost, "the equal one-eighth part of all oil produced and saved from the leased premises and % of the net proceeds of potash and other minerals at the mine.”
(2) The second royalty provision required the lessee to pay the lessor $100 per year "for the gas from each well where gas only is found, while the same is being used off the premises * * *.”
(3) The third royalty provision required the lessee to pay the lessor $50 per year "for gas produced from any oil well and used off the premises * * *.”
In 1956, Pan Am and Westbrook drilled a deep well on the 480-acre parcel, and this well produced only gas. They began selling gas from this well in 1958. Two other deep gas wells were completed on the 480-acre parcel, one in 1958 and one in early 1959; and Pan Am and Westbrook began selling gas from these wells. Sales of gas from the
As of 1959, Pan Am and Westbrook were paying Southland and the other royalty owners, in connection with the production and sale of gas from the three deep wells referred to in the preceding paragraph, at the rate of $100 per well per year, under the second royalty provision previously mentioned.
In 1959, Southland, Avoca, and Mobil filed suit against Pan Am and Westbrook in a Texas district court, seeking additional royalty payments on the gas produced and sold from the three wells mentioned in the two immediately preceding paragraphs of this opinion. Southland et al. contended in the litigation that they had the right to have their payments calculated on the basis of one-eighth of the net proceeds from the sale of the gas, under the phrase in the first royalty provision of the mineral lease requiring the payment of of the net proceeds of potash and other minerals at the mine” (emphasis supplied); and that the second and third royalty provisions relative to lump-sum payments per well per year in connection with gas were applicable only to gas used by Pan Am and Westbrook off the leased land.
On motions for summary judgment by all parties (there being no dispute as to any material fact), the state district court sustained the position of Pan Am and Westbrook; and this judgment was later affirmed by the Texas Court of Civil Appeals.
The case was then taken to the Texas Supreme Court by Southland et al. The Texas Supreme Court first decided the case in favor of Pan Am and Westbrook on June 26, 1963. On motion for rehearing, however, the Texas Supreme
The district court, on remand, entered a final judgment on June 29, 1964, determining the respective amounts due Southland et al. in accordance with the Texas Supreme Court’s decision of January 29, 1964. Pan Am and Westbrook took an appeal; and on October 27, 1965, the Texas Court of Civil Appeals affirmed the district court’s decision of June 29, 1964.
After Pan Am and Westbrook filed with the Texas Supreme Court an application for writ of error to review the Texas Court of Civil Appeals’ decision of October 27, 1965, but before any action was taken by the Texas Supreme Court on the application, the parties entered into a settlement agreement which concluded the litigation. Under the settlement agreement, Southland on or about March 30, 1966, collected a lump sum of $168,990.78 representing royalties that had accrued to Southland’s account through December 31, 1965, plus interest thereon in the amount of $26,247.81. In addition, the settlement provided for Southland to receive, from and after January 1, 1966, its proportionate share of royalty payments calculated on the basis of one-eighth of the net proceeds received by Pan Am and Westbrook from the sale of gas, as provided for in the first royalty provision of the lease dated March 27, 1925.
On May 16, 1966, Southland paid to the law firm of Jackson, Walker, Winstead, Cantwell and Miller the sum of $75,276.18, being a fee of $75,000 and related expenses of $276.18, for the law firm’s services in connection with the litigation and settlement proceedings mentioned above.
Subsequently, Southland filed with the Internal Revenue Service a timely claim for the refund of the $44,067.38, plus statutory interest. This claim was denied by the IRS on January 26, 1973.
The principal question is whether this Pan Am-West-brook litigation of Southland’s must be regarded as the defense or perfection of taxpayer’s title to property within Treas. Reg. 1.263(a)-2(c) {supra, note 5). Capitalization of expenditures incurred for the purpose of defending or quieting title is a rule of long standing, "virtually as old as the federal income tax itself.” Spangler v. Commissioner, 323 F.2d 913, 919 (9th Cir. 1963). There is, however, no hard-and-fast demarcation between expenditures that must be capitalized under the rule and those that may be deducted currently. Manufacturers Hanover Trust Co. v. United States, 160 Ct. Cl. 582, 589, 312 F.2d 785, 788-89, cert. denied, 375 U.S. 880 (1963); Morgan’s Estate v. Commissioner, 332 F.2d 144, 150 (5th Cir. 1964). The individual facts must almost always be weighed and taken into account. Manufacturers Hanover Trust Co., ibid; see also Southern Natural Gas Co. v. United States, 188 Ct. Cl. 302, 370, 412 F.2d 1222, 1263 (1969); Connecticut Light & Power Co. v. United States, 177 Ct. Cl. 395, 407, 368 F.2d 233, 240 (1966).
In the past, the main gauge for determining the character of legal fees has been to examine the "primary purpose” of the litigation; if the main objective was the defense or perfection of title, the expenditures had to be capitalized, but if title was only incidental to the litigation
That uncertain and difficult test may be the best that can be devised to determine the tax treatment of costs incurred in litigation that may affect a taxpayer’s title to a property more or less indirectly, and that thus calls for judgment whether the taxpayer can fairly be said to be "defending or perfecting title.” Such uncertainty is not called for in applying the regulation [Treas. Reg. § 1.263(a)-2(a)] that makes the "cost of acquisition” of a capital asset a capital expense. In our view application of the latter regulation to litigation expenses involves the simpler inquiry whether the origin of the claim litigated is in the process of acquisition itself.
Neither party contends that there would be any difference here if the "origin of the claim” test were to be used instead of the "primary purpose” standard; neither do we, on these facts, see that there would be any difference. Although some courts have held that "primary purpose” has been supplanted by "origin of the claim” in suits involving defense of title (see Anchor Coupling Co. v. United States, 427 F.2d 429, 432-33 (7th Cir. 1970), cert. denied, 401 U.S. 908 (1971); Reed v. Commissioner, 55 T.C. 32, 38-40 (1970)) we need not reach that point.
For this item, the crucial circumstances, under either standard, are, first, that Southland, on the one hand, and Pan Am-Westbrook, on the other, both agreed that the latter had the full right to take gas from the leasehold; second, that Pan Am-Westbrook conceded that Southland was entitled to be paid for the gas taken; and, third, that the only disputed issue was the amount Pan Am-Westbrook was to pay Southland for the gas (i.e., under which provision of the lease were the gas royalties to be calculated). These facts demonstrate that defense or perfection of Southland’s basic title to the gas was in no way involved in the litigation. No one contested that basic title, nor was there any disagreement that Pan Am-Westbrook had the right to acquire title to the gas from
This case is measurably stronger for the taxpayer on this item than Pierce Estates, Inc. v. Commissioner, 3 T.C. 875 (1944). That taxpayer had brought suit against the lessee of gas and oil rights, who, in addition to questioning the manner of computing any royalties due, urged that no payments were due the plaintiff — the wells had produced gas, but no oil; the assignment required payments to be paid out of "all oil and other minerals produced”; and gas was not a mineral. The trial court disposed of this contention by noting that "the word 'minerals’ in Texas, included gas, as a matter of law.” 3 T.C. at 892. The Tax Court found that the litigation expenditures had been made for the sole purpose of collecting income due under the assignments,
Boagni v. Commissioner, 59 T.C. 708 (1973), the main precedent cited by the defendant, dealt with a different situation. That taxpayer’s group had entered into a mineral lease, under which the taxpayer’s group and the Susan-Alice group were to receive royalties equal to one-eighth of all production; an overriding royalty interest in lieu of a cash bonus was also assigned by the lessee to the taxpayer’s group. Under the partition agreement bonuses,
Defendant’s secondary arguments — i.e. those additional to the defense-or-perfection-of-title point — must also be rejected. As we have pointed out, Southland acquired no new property interest as a result of the Pan Am-Westbrook litigation; its right to be paid for the gas under the lease was unquestioned. Of course, the fact that the suit resulted in benefits to the taxpayer beyond the close of the taxable year is not in itself dispositive. The "one-year” rule is a "mere guidepost.” Colorado Springs Nat’l Bank v. United
By the same token, we hold it inappropriate to characterize the Pan Am-Westbrook suit as adding to the value of taxpayer’s leasehold (within Treas. Reg. § 1.263(a)—
III.
The 1967 and 1968 Litigation Expenses
On July 14, 1925, W.N. Waddell and others, as the owners of 45,771 acres of land situated in Crane County, Texas, and commonly known as the "Waddell Ranch,” granted an oil and gas lease on such land to Gulf Production Company, corporate predecessor of Gulf Oil Corporation ("Gulf’). As successor to W. N. Waddell and others, Southland later became the owner of a fraction of the royalty interest in the Waddell Ranch and, therefore, of a fractional reversionary interest entitling Southland to participate in the further development of the minerals, or in the issuance of a new mineral lease on the property, following the expiration of the term of Gulfs oil and gas lease on the property.
The Gulf lease was for a term of 12 years from its date and for as long thereafter as oil or gas was produced from the land, but the term of the lease was limited by a provision expressly declaring "that this lease shall not remain in force longer than fifty (50) years from this date.”
Gulf successfully drilled many oil and gas wells on the Waddell Ranch; and, by 1967, Gulf was operating on that property approximately 900 wells that were producing oil and gas. Southland was entitled to (and presumably
The Texas Railroad Commission, in the exercise of authority conferred on it by the Texas legislature, ordered production of oil and gas from the wells on the Waddell Ranch to be stopped for 197 days between January 20, 1938, and March 23, 1940. Thereafter, the Commission issued monthly proration orders which restricted the amount of oil and gas that could be produced by Gulf from the wells on the Waddell Ranch.
On or about October 11, 1967, Gulf and others filed suit against Southland and others in a district court of the State of Texas, seeking a declaratory judgment to determine the longevity of the oil and gas lease on the Waddell Ranch. Gulf et al. contended in the litigation that delays in the production of oil and gas from the Waddell Ranch due to proration orders issued by the Texas Railroad Commission should not be counted in determining the date on which the 50-year term of the lease would expire; and that the termination of the lease should not occur until 1987. Southland et al., on the other hand, contended that Gulfs leasehold estate would expire on July 14, 1975, which would be exactly 50 years after the date of the execution of the lease.
The litigation proceeded through the state district court and the Texas Court of Civil Appeals, each of which rendered judgment in favor of Southland et al.; and it was finally concluded by the Texas Supreme Court in a decision dated May 30, 1973 (496 S.W. 2d 547). The Texas Supreme Court affirmed the judgments of the courts below, and declared that Gulfs oil and gas lease on the Waddell Ranch would terminate finally on July 14, 1975.
During 1967 and 1968, Southland accrued obligations in the amounts of $22,898.68 and $113,892.55, respectively, representing amounts payable to one law firm in 1967 and to two law firms in 1968 for legal services rendered in connection with the litigation instituted by Gulf et al. These respective amounts were deducted by Southland in computing its federal income taxes for the calendar years 1967 and 1968; the deductions were disallowed by the Internal Revenue Service, which assessed deficiencies; the amounts of the deficiencies, plus interest, were paid by Southland; and Southland now sues for refunds.
As might be expected, there is no precedent precisely in point, but there are decisions strongly suggesting the capitalization result, and none which (in our view) compels a conclusion favorable to plaintiff. In Reed v. Commissioner, supra, 55 T.C. 32, the taxpayer, in a prior suit, had attempted to have declared invalid an agreement which gave the defendants the opportunity to purchase a partnership interest owned by the taxpayer, for the book value of the underlying tangible assets plus ten percent, before the interest could be transferred to anybody else. The Tax Court noted that the right to dispose of property freely was an important attribute of ownership; moreover, the right to income was not then in issue. Since the origin of the suit was directly related to the capital asset underlying the partnership agreement and the income interest was not affected by the attempt to remove the restriction upon the sale of the interest, the litigation expenditures were held to be capital in nature. The Tax Court found (under the origin-of-the-claim test) that the expenses were incurred in
Taxpayer, in riposte, stresses three sorts of rulings, none of which seems to us applicable. The first group relates to trust litigation. In Herman A. Moore Trust v. Commissioner, 49 T.C. 430 (1968), acq. 1968-2 Cum. Bull. 2, a trust sought a deduction under I.R.C. § 212(2) and Treas. Reg. § 1.212-l(i), allowing a deduction for "expenses of litigation, which are ordinary and necessary in connection with the performance of the duties of administration . . . .” Two of the beneficiaries of the trust had brought suit for the activation of certain trusts in their favor; they argued that under the doctrine of acceleration of estates in remainder the renunciation of interest in some of the assets in the trust by their mother, the life income beneficiary, accelerated their interests. The Tax Court held that the trustee’s primary purpose in litigating that suit was not in defending his title to the assets, but to obtain a decision on the timing of the remaindermen’s rights as an aid to his administration of the trust.
Plaintiff also invokes Bliss v. Commissioner, 57 F.2d 984 (5th Cir. 1932), an early opinion which contains some broad language on the deductibility of expenses incurred to protect the owner’s right to undisturbed possession and enjoyment of his property. We read later decisions of the Fifth Circuit as limiting the Bliss dictum, at most, to the costs of ejecting a present trespasser or illegal occupant (see Jones’ Estate v. Commissioner, 127 F.2d 231, 232 (5th Cir. 1942); Morgan’s Estate v. Commissioner, 332 F.2d 144, 150 (5th Cir. 1964)), and as inapplicable to a suit like Gulfs restricted to a declaration of future rights to property.
Another type of case put forward by taxpayer is exemplified by Industrial Aggregate Co. v. United States, supra, 284 F.2d 639. Those are cases in which the prior litigation had mixed objectives — recovery of income or damages currently owed, plus some general defense of title — and in which the court passing on the tax question determined that the recovery of damages or income currently owed was the primary or dominant aim. In
As a last resort, taxpayer attacks the validity of the regulation on defense or perfection of title to property, but we consider this regulation so long and so well entrenched that it has become part of income tax law. See Industrial Aggregate Co. v. United States, supra, 284 F.2d at 644, note 7, and Parts I and II of this opinion, supra.
IV
The 1968 Oil and Gas Reserves Study Expenses
In September 1967, Southland engaged Clarke B. Gillespie, a petroleum engineer and consultant, to analyze and estimate the extent of the oil and gas reserves in the
This $31,297.27 was deducted by Southland in computing its federal income tax for the calendar year 1968; the deduction was disallowed by the Internal Revenue Service, which assessed a deficiency against Southland; the amount of the deficiency, plus interest, was paid; and Southland seeks a refund in the present litigation.
The evidence in the record shows that oil and gas companies, such as Southland, from time to time hire independent petroleum engineers to analyze and estimate the extent of their oil and gas reserves, and that the management of a company uses the information obtained in reserve studies to make income projections, develop short-term and long-term budgets, arrange financing, and make reports to shareholders and regulatory authorities.
The prior decisions on the tax treatment of the costs of producing surveys said to be comparable to the Gillespie report all seem to have gone off on the postulate of considering the survey as part of some underlying property. See Southern Natural Gas Co. v. United States, supra, 188 Ct. Cl. 302, 412 F.2d 1222 (1969); American Smelting & Refining Co. v. United States, 191 Ct. Cl. 307, 325, 423 F.2d 277, 288 (1970); Louisiana Land & Exploration Co. v. Commissioner, 7 T.C. 507 (1946), aff’d on other issues, 161 F.2d 842 (5th Cir. 1947); cf. Godfrey v. Commissioner, 335 F.2d 82, 85 (6th Cir. 1964), cert. denied, 379 U.S. 966 (1965). In this instance, however, the Government disavows that approach and asks us to treat the Gillespie report, by itself, as property having a useful life in taxpayer’s business lasting beyond the taxable year (1968).
Our difficulty with that line-of-reasoning is that the Gillespie report, if "property,” is not the kind of property which should be capitalized by itself, even if its usefulness happens to last beyond the year in which it is produced. Gillespie’s study was scarcely the sort of "separate and distinct asset” that the Court in Lincoln Savings & Loan
Decisive for the deductibility of the expenses incurred for the Gillespie report is that they are functionally part of, and indistinguishable from, expenditures for ordinary management planning. As the trial judge pointed out, the reserve study is similar to a balance sheet in a corporation; its estimates, subject to change at any time from ongoing developments, assist management in making income projections, short-term and long-term budgets, the arrangement of financing, and the preparation of reports to shareholders and regulatory authorities. Had Gillespie been an employee of the company rather than a consultant, when he prepared the study, there would have been no question as to the deductibility of his salary. To follow the defendant’s logic, much of the salaries and overhead incurred in the production and even use of all sorts of management studies should be capitalized; the time-period over which benefits would flow from such activities would presumably be longer than one taxable year. Obviously that is not the law as of now. It makes no difference, either, that the Gillespie report was held "confidential”; that could be true of many management plans reduced to written form.
[Expenditures made in connection with the defense or perfection of title to both tangible and intangible property (such as real estate, securities, chattels, etc.) can be taken into account in determining gain or loss, at the time the property is disposed of, by the simple course of adjusting the basis, or "tax cost,” of the property. By denying an immediate deduction for expenditures of a capital nature, but instead allowing an addition to the basis of the property, the tax benefit (from a decreased gain or an increased loss, as the case may be) is deferred until disposition of the property ....
California & Hawaiian Sugar Refining Corp. v. United States, 159 Ct. Cl. 561, 573, 311 F.2d 235, 242 (1962). By that means the accounting goal of matching expenditures to the income resulting from a capital transaction is achieved. Here the Government does not argue that there is some underlying tangible or intangible asset to which the survey costs may properly be added. See also note 20, supra. Neither is amortization appropriate. The useful life of the survey is very uncertain; as the trial judge found, the estimates in a reserve study are subject to change at any time and have to be updated every few years to take account of subsequent developments. In those circumstances, it is not compulsory to amortize such a recurring item over a fixed time-interval. Neither is it appropriate to require capitalization without amortization; such a requirement would clearly distort Southland’s income.
The result on the whole case is that plaintiff-taxpayer is entitled to recover with respect to the items discussed in Parts II and IV of this opinion, and not entitled to recover with respect to the item treated in Part III. The case is remanded to the Trial Division for a determination of the plaintiffs recovery pursuant to Rule 131(c).
Neither party excepts to the trial judge’s findings of fact which we adopt. The issues before us are essentially “legal” problems or “mixed” questions in which the “legal” element predominates.
All references to the Internal Revenue Code are to the provisions as they were in force during the applicable tax years.
I.R.C. § 161 provides:
"In computing taxable income under section 63(a), there shall be allowed as deductions the items specified in this part, subject to the exceptions provided in part IX (sec. 261 and following, relating to items not deductible).”
I.R.C. § 261 provides:
"In computing taxable income no deduction shall in any case be allowed in respect of the items specified in this part.”
In Georator Corp. v. United States, 485 F.2d 283, 285 (4th Cir. 1973), cert. denied, 417 U.S. 945 (1974), the court noted that an expenditure does not have to be described as a capital asset in I.R.C. § 1221 in order to be classified as a capital expenditure.
Treas. Reg. § 1.263(a)-l, T.D. 6313, 1958-2 C.B. 117, reads in pertinent part as follows:
"§ 1.263(a)-l CAPITAL EXPENDITURES; IN GENERAL. — (a) Except as otherwise provided in chapter 1 of the Internal Revenue Code of 1954, no deduction shall be allowed for—
“(1) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate ....
"(b) In general, the amounts referred to in paragraph (a) of this section include amounts paid or incurred (1) to add to the value, or substantially prolong the useful life, of property owned by the taxpayer, such as plant or equipment, or (2) to adapt property to a new or different use. Amounts paid or incurred for incidental repairs and maintenance of property are not capital expenditures within the meaning of subparagraphs (1) and (2) of this paragraph. See sections 162 and § 1.162-4.”
Treas. Reg. § 1.263(a)-2 provides (in relevant part):
§ 1.263(a)-2 "EXAMPLES OF CAPITAL EXPENDITURES. — The following para*436 graphs include examples of capital expenditures:
"(a) The cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year.
"(c) The cost of defending or perfecting title to property.”
The lease granted Pan Am and Westbrook "the right to use, free of cost, gas, oil and water produced on said land for all operations thereon * *
In this court, defendant concedes that taxpayer is entitled to deduct the litigation-cost of collecting back royalties owed by Pan Am-Westbrook. Defendant puts this figure at $18,819.05 (of $75,276.18 total litigation expenses) — the amount said by plaintiffs former counsel to be attributable to the proceedings after remand from the Texas Supreme Court’s decision in favor of Southland.
Although the Tax Court did not expressly discuss the case in terms of income already accrued versus future income, the order of the trial court construing the royalty provisions of the assignment required "such payments to be out of all minerals that have been or may be produced from the land covered by the said leases . ...” 3 T.C. at 885. It seems clear that the decision resulting from the litigation for which the expenses were incurred affected not only past but also future income.
Pierce Estates, Inc. can usefully be contrasted with Reed u. Commissioner, supra, 55 T.C. 32. There, a partnership interest had been sold to the Robilio family by the estate of the late father of the taxpayer; the taxpayer brought suit against the Robilios and the executors of her father’s estate, alleging a breach of fiduciary duty. She requested that a constructive trust be imposed on the partnership interest and that it be reconveyed to the estate along with an accounting for all profits from the purchase. The court (applying the origin-of-the-claim test) found that the accounting request was merely incidental to the request for title; the litigation expenses had to be capitalized, since the taxpayer’s success in obtaining an accounting was "wholly dependent upon her procuring title.” 55 T.C. at 41.
Defendant seems to say that the second and third royalty provisions should be disregarded because the payments under them were relatively so small ($100 per year and $50 per year per well), but we cannot obliterate lease provisions which the parties to the lease deliberately inserted in good faith and over which they had a long and costly litigation. There is no suggestion that the lease was drawn up in that way for federal tax purposes or with federal tax consequences in mind. See, also, note 12, infra.
I.R.C. § 212, though not directly involved in this litigation, pertains to the defendant’s contention that litigation expenses are not deductible to the extent they are allocable to the collection of future income; the predecessor of I.R.C. § 212 was added to allow taxpayers to treat expenses incurred in income-producing activities other than trade or business or in the conservation of property held for the production of income in the same manner as ordinary and necessary expenses incurred in trade or business under I.R.C. § 162. See United States v. Gilmore, 372, U.S. 39, 44-45 (1963); Trust of Bingham v. Commissioner, 325 U.S. 365, 373-74 (1945); Spangler, supra, 323 F.2d at 918. Treas. Reg. § 1.212-l(b), T.D. 6279,1957-2 C.B. 192, promulgated under I.R.C. § 212, is of interest:
The term "income” for the purpose of section 212 includes not merely income of the taxable year but also income which the taxpayer has realized in a prior taxable year or may realize in subsequent taxable years; and is not confined to recurring income but applies as well to gains from the disposition of property. For example, if defaulted bonds, the interest from which if received would be includible in income, are purchased with the expectation of realizing capital gain on their resale, even though no current yield thereon is anticipated, ordinary and necessary expenses thereafter paid or incurred in connection with such bonds are deductible. Similarly, ordinary and necessary expenses paid or incurred in the management, conservation, or maintenance of a building devoted to rental purposes are deductible notwithstanding that there is actually no income therefrom in the taxable year, and regardless of the manner in which or the purpose for which the property in question was acquired. Expenses paid or incurred in managing, conserving, or maintaining property held for investment may be deductible under section 212 even though the property is not currently productive and there is no likelihood that the property will be sold at a profit or will otherwise be productive of income and even though the property is held merely to minimize a loss with respect thereto.
I.R.C. §§ 162 and 212 are to be read in pari materia. Woodward, supra, 397 U.S. at 575 n.3. I.R.C. § 263 supersedes I.R.C. § 212 just as it does § 162. See I.R.C. §§ 211, 261.
Here, too, defendant appears to emphasize the disparity in income available to Southland under the first royalty provision of the lease as compared to that recoverable under the second and third provisions. See note 10, supra. But for the reasons already suggested we do not believe this case should be decided any differently than if the second and third provisions had required payments of $10,000 and $5,000 per well per annum. Bad faith and tax-oriented arrangements aside, it would unduly complicate and strain the enforcement of the capitalization provisions to make the result turn, solely or primarily, on the varying contrasts between the monetary benefits flowing to the owner if he won or lost the underlying substantive litigation.
Southland characterizes its purpose in defending the Gulf suit as "to permit it to make definitive plans for the operation of the Waddell property upon a confirmation of the July 14, 1975, expiration date and to collect the ordinary income to accrue to its reversionary interest.”
A number of courts have held that any litigation expenses must be capitalized, if they are incurred in the defense or perfection of title, regardless of the substantiality of the adverse claim. Galewitz v. Commissioner, 411 F.2d 1374 (2d Cir.), cert. denied, 396 U.S. 906 (1969); Estate of Baier v. Commissioner, 533 F.2d 117 (3d Cir. 1976); Safety Tube Corp. v. Commissioner, 168 F.2d 787 (6th Cir. 1948); Schwabacher v. Commissioner, 132 F.2d 516 (9th Cir. 1942). But see the comments of Judge Forrester, dissenting in Ruoff v. Commissioner, 30 T.C. 204, 226-27 (1958), rev’d, 277 F.2d 222 (3d Cir. 1960), he took the view that litigation costs should be capitalized only if the title was clouded at the time of acquisition, and the comments of Judge Wisdom, dissenting in Usry v. Price, 325 F.2d 657, 660-63 (5th Cir. 1963), against the holding that litigation costs were deductible in a suit that was a "re-hash” of issues in earlier title case; Zietz v. Commissioner, 34 T.C. 369, 382 (1960) (deduction allowed for litigation costs incurred in suit "wholly without merit and malicious,” since the petitions, which might have raised the title issue if allowed to stand, were dismissed). In this instance the issue in the reversionary interest litigation was substantial, so we need not reach the question of whether litigation costs arising from a frivolous claim need be capitalized.
In Farmer v. Commissioner, 126 F.2d 542, 544 (10th Cir. 1942), the court, in holding that the litigation expenses were incurred to defend title and therefore nondeductible, commented:
Petitioners did more than litigate the right to receive oil royalty payments. The title to the oil and gas lease under which they received these payments depended upon the title to the land. Without title to the land they had nothing. It was therefore necessary for them to defend and establish the title to the land in order to retain their interest in the oil and gas.
The taxpayer in its 1967 annual report characterized the litigation as involving the question whether it would continue to have a royalty interest in the subject property or whether its interest would be converted in 1975 to a "mineral fee”, and promised a "vigorous defense.” Parenthetically, we do not regard as decisive that the plaintiff would acquire a "mineral fee” at the expiration of the leasehold. Disputes over much less substantial property rights have been held to fall within the purview of the regulations relating to the defense or perfection of title. Reed, supra, 55 T.C. 32 (right of first refusal on sale of partnership interest); Boagni, supra, 59 T.C. 708 (interest in overriding royalties); Manufacturers Hanover Trust Co., supra, 160 Ct. Cl. 582, 312 F.2d 785 (trustee’s legal title).
In Manufacturer’s Hanover Trust Co., supra, 160 Ct. Cl. at 591-92, 312 F.2d at 789-90, we held that the litigation expenses had to be capitalized when the trustee’s title to the assets itself was challenged; the court noted that:
This situation is to be distinguished from that which would arise if a fiduciary sought to deduct expenses incurred in determining which of several potential beneficiaries was entitled to receive trust property. There the fiduciary’s title would not be at issue, and it would not be engaged in perfecting or defending title.
Campbell v. Fields, 229 F.2d 197 (5th Cir. 1956) and Southern Natural Gas Co. v. United States, 188 Ct. Cl. 302, 412 F.2d 1222 (1969), both involved the wholly non-title issues arising from unitization requirements leading to the more efficient recovery of oil and gas.
In Cruttenden v. Commissioner, 70 T.C. No. 18 (May 8, 1978) — cited by plaintiff as a decision in which legal fees paid to facilitate the return of property (securities) were held deductible — there was no hint of a challenge to any title or legal interests of those taxpayers (the Cruttendens) but merely a failure, for economic and financial reasons, to return the property on time. Moreover, the Cruttendens sought recovery of property to which they claimed an immediate, present right of possession — not a future right.
It is worth noting that the geophysical survey involved in Louisiana Land &
In contrast, the Gillespie report was not produced for the purpose of utilizing (or planning the utilizing of) particular oil-and-gas properties over their useful lifetime.
In Colorado Springs National Bank, supra, 505 F.2d at 1192, the court stated: "The start-up expenditures [for a bank credit card system] here challenged did not