Big Four Oil & Gas Co. v. Commissioner

The Big Four Oil & Gas Company, a Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent. Southwestern Oil and Gas Company, a Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent

Big Four Oil & Gas Co. v. Commissioner

Docket Nos. 57107, 57108

United States Tax Court

29 T.C. 31; 1957 U.S. Tax Ct. LEXIS 66; 8 Oil & Gas Rep. 119;

October 14, 1957, Filed

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Decisions will be entered for respondent.

Excess Profits Tax -- Net Abnormal Income Attributable to Prior Years -- Sec. 456 (a) (2) (B). -- A producing "discovery" oil well or wells having been completed in an oil pool covered by petitioners' leases less than a year after the beginning of "exploration, discovery, or prospecting" by petitioners relating to the area covered by such leases, petitioners have failed to show that the income from such pool claimed to be abnormal resulted from "exploration, discovery, or prospecting" extending over a period of more than 12 months as required by the provisions of section 456 (a) (2) (B), I. R. C. 1939. Therefore, the petitioners are not entitled to the relief accorded by section 456.

Robert A. Rundle, Esq., and J. Stanton Carson, Esq., for the petitioners.

George J. Rabil, Esq., for the respondent.

Kern, Judge.

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KERN

The respondent determined deficiencies in income and excess profits taxes of the petitioners for the taxable year ended December 31, 1950, as follows:

Petitioner	Docket No.	Deficiency
The Big Four Oil & Gas Company	57107	$ 22,992.84
Southwestern Oil and Gas Company	57108	20,983.12

The two cases were consolidated for trial on motion made at the hearing. The only question presented is whether the petitioners, for the taxable year 1950, are entitled to the relief claimed for abnormal income under the provisions of section 456 of the Internal Revenue Code of 1939.

FINDINGS OF FACT.

Some of the facts have been stipulated and are hereby found to be as stipulated.

The petitioners, Southwestern Oil and Gas Company, hereinafter referred to as Southwestern, and the Big Four Oil & Gas Company, hereinafter referred to as Big Four, are corporations organized in 1909 under the laws of the State of Delaware and with principal offices located in Pittsburgh, Pennsylvania. They are engaged in the production of crude petroleum in oil fields located in the State of Illinois. At all times material hereto the petitioners were conducting operations on leased properties located in Lukin Township, Lawrence County, Illinois. During the year 1950 Justin Lees was, and still is, the president of both Big Four and Southwestern. Each of the petitioners filed its corporation income tax return, together with a computation of corporation excess profits tax, for the calendar year 1950 with the collector of internal revenue for the twenty-third district of Pennsylvania.

Big Four and Southwestern deducted from their excess profits net income for the taxable year $ 188,501.97 and $ 190,222.45, respectively, as abnormal income attributable to other years (in the instant case to 1949) in accordance with the provisions of section 456 of the Internal Revenue Code of 1939. The respondent disallowed these deductions with the following explanation contained in the deficiency notices:

The amount of $ 188,501.97 [Big Four] [$ 190,222.45 -- Southwestern] excluded by you from excess profits net income under the provisions of Section 456 of the 1939 Internal Revenue Code relating to alleged abnormal income attributable to other years is restored to excess profits net income for the reason that the claimed relief under the provisions of Section 456 of the 1939 Internal Revenue Code is denied.

On or about June 1, 1949, G. R. Hayes, a partner in the Hayes Drilling Company, hereinafter referred to as Hayes Company, advised the petitioners that Hayes Company, which had been acting on its own behalf and not as an agent for the petitioners, had collected subsurface maps and various geological data covering sections 7, 8, 17, and 18, T. 2 N., R. 12 W., Lukin Township, Lawrence County, Illinois, and proposed an exchange of such data and information with the petitioners. Petitioners had secured two leases within this area in 1946 but no wells were drilled, and the terms of these leases were allowed by petitioners to expire at an undisclosed date in 1948. In connection with these two leases one of petitioners' employees did some ineffective surface prospecting. The petitioners' employees correlated and checked the information received from Hayes Company. The data compiled by the petitioners and obtained by them from prospecting activities carried on by them subsequent to March 1, 1949, and the information received from Hayes Company, plus additional studies and inspections of the area which were thereafter made by petitioners, indicated that oil and gas in commercial quantities might be found in the area.

On or about June 15, 1949, the petitioners and Hayes Company agreed to associate and act in concert with the above-mentioned sections by first obtaining a block of leases in said area and then drilling a test well or wells, with additional wells to be drilled if the test well or wells should result in the discovery of oil. They further agreed that each of the three should contribute one-third of the expenses and should be entitled to one-third of the profits.

During June, July, and early August 1949, representatives of the petitioners and Hayes Company, acting in the joint interest of all three, contacted the owners of the land in the selected area and explained to them the necessity of obtaining a solid block of leases as a prerequisite to their drilling of a test well or wells. The titles of the owners of the land required to be included in the drilling area were searched and thereafter verbal agreements were obtained from all of them. By the early part of August 1949, the commitments having been obtained as aforesaid for oil and gas leases from the respective owners of the properties of the proposed block, a tentative well location was made on a 20-acre tract known as the W. D. Milligan tract. A rotary drilling rig necessary for the drilling of such first or test well was moved to the property identified as the Horton tract in section 17 upon which a commitment for lease had been obtained. This was after the proposed location of the first or test well was changed from the W. D. Milligan tract to the tract known as the Horton tract.

On September 8, 1949, Southwestern, with Big Four and Hayes Company as colessees, entered into a written oil and gas lease with Roy C. Horton, et ux., as lessors. Thereafter similar leases to the petitioners and Hayes Company were entered into and dated as follows:

	Date of lease
Lessors	(1949)
Huntsinger, et al	Sept. 8
Beal, et ux	Sept. 12
Martin, et vir	Sept. 13
Young, et ux	Sept. 13
Allen, et ux	Sept. 13
Leighty, et ux	Sept. 14
Schrader, et al	Sept. 14
Moore, et ux	Sept. 15
Milligan, et al	Sept. 16
McConell, et al	Sept. 20
Putnam, et al	Sept. 20
Hardacre, et ux	Sept. 21
Kensler, et ux	Sept. 21
Hawkins, et ux	Sept. 21
King, et ux	Oct. 7
Spencer, et ux	Oct. 7
Combs, et vir	Oct. 15

On October 10, 1949, the petitioners began drilling a test well at the location in the leased area known as the Horton tract in section 17, which well was completed on October 14, 1949, and which produced oil in commercial quantities. It was drilled on this location because of the recommendation of a subsurface geologist employed by the Hayes Drilling Company. This was the discovery well of an oil pool which later became known as the Ruark Pool. The discovery well having proved successful, additional drilling operations were thereafter undertaken on this and the other leases constituting this block as hereinafter set forth:

		Date	Date
Well No.	Leasehold	commenced	completed	Result
2	Horton	10/17/49	10/21/49	Producer
3	King	10/22/49	10/26/49	Producer
4	Milligan	10/27/49	10/30/49	Producer
5	Cunningham, et al	11/ 2/49	11/ 5/49	Producer
6	Moore	11/ 6/49	11/10/49	Producer
7	Milligan	11/10/49	11/14/49	Dry
8	Beal	12/ 1/49	12/ 6/49	Dry
9	Cunningham, et al	12/ 7/49	12/10/49	Producer
10	Cunningham, et al	12/14/49	12/17/49	Producer
11	Young	12/18/49	1/ 7/50	Dry
12	Hawkins	3/ 7/50	3/11/50	Dry
13	Cunningham, et al	3/15/50	3/18/50	Producer
14	King	4/27/50	5/ 1/50	Producer
15	Hawkins	5/ 3/50	5/ 7/50	Producer
16	Young	5/ 8/50	5/12/50	Dry
17	Hardacre	5/15/50	5/18/50	Dry
18	King	6/ 2/50	6/ 6/50	Producer
19	Horton	6/ 8/50	6/11/50	Producer
20	Kensler	8/27/50	8/30/50	Dry

No effective exploration or prospecting leading to the discovery of the Ruark Pool or resulting in the income derived therefrom was done by petitioners prior to March 1, 1949. The existence of such a pool in substantial size was discovered not later than November 5, 1949, when the fifth producing well was completed on the property covered by petitioners' leases. The Kensler tract on which No. 20 was drilled was located at the extreme westerly end of the block of leases. On July 20, 1951, well No. 21 was commenced on the Martin lease and was completed as a dry hole on July 26, 1951. On July 28, 1951, well No. 22 was commenced on the Leighty lease and was completed as a dry hole on July 31, 1951. Both the Martin and Leighty tracts were located at the northerly end of the block of leases. The petitioners and their colessees thereupon terminated their drilling on further wells on the leases referred to above.

In developing the Ruark Pool the number of wells that were drilled was limited only by State regulations, property lines, pool limits, and locations where drilling was not expected to produce oil in commercial quantities. All the wells drilled from No. 1 through No. 19 by the petitioners were drilled in the field of the Ruark Pool. None of the wells drilled after the discovery well were either "wildcat" or "wildcat near" wells. They were drilled in that part of the Ruark Pool covered by petitioners' leases for the primary purpose of exploiting the oil and gas contained therein, and also for the secondary purpose of ascertaining the extent, size, and shape of the pool. After the discovery well was drilled in October 1949 there was a systematic, rapid, complete, and normal development of the oil pool covered by petitioners' leases by means of the drilling of the subsequent wells.

OPINION.

It is necessary to spell out with some particularity the issue in the instant case under the pleadings. The most specific allegation of error contained in the petitions is as follows (paragraph 4 (h)):

The Commissioner of Internal Revenue erred in determining that petitioner did not qualify for relief under Section 456 of the 1939 Internal Revenue Code with respect to abnormal income for 1950 resulting from exploration, discovery or prospecting, or any combination of the foregoing, extending over a period of more than 12 months.

Paragraphs 5 (b) and 5 (k) of each petition read as follows:

(b) Since March 1st, 1949, petitioner was engaged in exploring in an area in Lawrence County, Illinois designated as Sections 7, 8, 17 and 18 T. 2 N., R. 12 W., Lukin Township for indications favorable to the discovery of oil. During the course of these explorations, employees of the petitioner, acting in its behalf, compiled data, acquired geological information and explored the surface of the area for indications of potential oil and gas productivity.

(k) Operating personnel of the petitioner were engaged in exploratory and discovery work from March 1, 1949 when exploratory work was begun until July 31, 1951 when the completion of the twenty-third well determined the productive limits of the Lukin Township or Ruark Pool.

No date other than March 1, 1949, is alleged in the petitions as the beginning of the "period of more than 12 months" referred to in the allegations of error. Respondent's answers denied all of the allegations of paragraphs 4 and 5 in each petition.

At the trial herein petitioners' counsel inquired of witnesses concerning prospecting and exploration by petitioners in years prior to 1949 and beginning in 1946. ^{*76 counsel objected to such evidence on the ground that under the pleadings only testimony concerning exploration and prospecting beginning in 1949 would be relevant to the issues presented. The Court overruled the objections and remarked as follows:}

It may be that the only evidence which will be considered pertinent in the disposition of the case is the evidence covering the period alleged in the petition. However, the court is interested in knowing what the facts are; and if the exploration started at a different time, I think the court ought to know when it started.

It was implicit in the Court's ruling (although unfortunately not made explicit) that petitioners' counsel would move to amend the pleadings to conform to the proof during the course of the trial pursuant to Rule 17 (d) of the Tax Court's Rules of Practice, with which, it must be assumed, petitioners' counsel are familiar. However, no such motion was made either during the trial or at any time thereafter, and no amended pleadings were filed by petitioners. See M. C. Parrish & Co., 3 T. C. 119, 129, affd. 147 F. 2d 284; Louis Halle, 7 T.C. 245">7 T. C. 245.

Under the pleadings we would be justified in confining ourselves to a consideration of "the evidence covering the period alleged in the petition," and in making no findings with regard to any exploration or prospecting which may have been done by petitioners' agents prior to March 1, 1949. Samuel J. Rissman, 6 T.C. 1105">6 T. C. 1105.

However, since a careful consideration of the testimony objected to convinces us that petitioners have not thereby borne the burden of proving that there was effective exploration or prospecting by petitioners' agents relating to the property here in question, leading to the discovery of the Ruark Pool, and resulting in the income here claimed to be abnormal, which antedated March 1, 1949, we need not rest our conclusion as to the beginning of the period of exploration, discovery, and prospecting solely upon a resolution of the narrow question involving the pleadings herein.

Petitioners' production superintendent testified that in 1946, about the time petitioners acquired two leases in the area adjacent to the later discovered Ruark Pool, he did "surface prospecting in that area covering a considerable amount of territory." One of these leases was identified as the Leighty lease and the other as the Milligan lease. From other evidence in the record it appears that petitioners later acquired leases on two separate properties identified as "Milligan" and on property identified as "Leighty." On one of the Milligan properties no well was ever drilled. On the Leighty lease petitioners drilled one well completed July 31, 1951, and it was a dry hole. The two leases acquired in 1946 were allowed to expire at some undisclosed date in 1948. The type of exploration and prospecting done by the production superintendent, who was not a geologist, was to examine the surface of the area for "hydrocarbon balls," for unhealthy-looking timber and crops, and for "toadstools or growths on it which is supposed to be the result of escaping gases which does form hydrocarbon." If the "hydrocarbon balls," small globules about as big as a peppercorn, looked black the witness considered them as having a high hydrocarbon content and indicating the presence of oil in the locality. He made no chemical analysis of them, made no borings below the surface, no soil analyses, and caused no geophysical surveys or maps to be made. From the testimony of other witnesses, we are of the opinion that the type of exploration and prospecting done by this witness was not effective.

Furthermore, although this witness testified in a general way that he did this exploration and prospecting up to 1949, he stated that he "continued in the area covering different tracts of land. * * * This work was continued at different intervals from 1946 until we actually acquired the leases in 1949." The record does not show the specific work he did in connection with the leaseholds here in question, nor the amount of time spent by him in that specific work.

Finally the petitioners have not proved that any work done by this witness resulted in the discovery of the Ruark Pool and the realization of the income here in question. While petitioners' president testified that he accepted the recommendation of the production superintendent with regard to taking the two leases in 1946, he did not testify that the 1949 leases were taken or the wells were driven in reliance on any advice given by him or as a result of any prospecting or exploration made by him. When asked on cross-examination whether he accepted the hydrocarbon-deposit theory of the production superintendent, he gave the rather noncommittal answer: "I accepted his theory on everything to our benefit." It is significant that when the time came to drill the test well on the 1949 leases, its location was fixed according to the recommendation of a subsurface geologist employed by the Hayes Drilling Company.

Upon the entire record we conclude that no effective exploration or prospecting leading to the discovery of the property here involved, or resulting in the income here claimed to be abnormal, was done by petitioners for any ascertainable period of time prior to March 1, 1949.

Accordingly, the issue presented herein is whether the income here in question resulted from "exploration, discovery, or prospecting" extending over a period which began on March 1, 1949, and was terminated, as respondent contends, on or about October 14, 1949, when a producing oil well was completed on petitioners' leased premises and the existence of an oil pool was thereby established, or was terminated on July 31, 1951, when, as petitioners contend, "the completion of the twenty-third well determined the productive limits of the Lukin Township or Ruark Pool."

It should be pointed out in this connection that petitioners' claim to abnormal income, as defined in section 456 (a) (2) (B) of the Internal Revenue Code of 1939, *82 from "exploration, discovery, or prospecting" extending over a period which included the drilling of prior wells in the pool plus a period of exploration and prospecting beginning March 1, 1949.

As we have indicated, this case involves an interpretation of section 456 (a) (2) (B). This subsection was written into the Internal Revenue Code of 1939 by section 101 of the Excess Profits Tax Act of 1950. As stated by the Ways and Means Committee (H. Rept. No. 3142, 81st Cong., 2d Sess.), this section (456) in general "corresponds to section 721 as amended, in the World War II excess profits tax law." However, the report goes on to say that: "Subparagraph (C) of subsection (a) (2) of the prior law has been redefined and restricted as appears in subparagraphs (B) and (C) of subsection (a) (2) of" section 456. We set out in the margin section 721 (a) (2) (C) referred to above.

The petitioners' position, on the issue stated by us above, is that the period of "exploration, discovery, or prospecting" relating to a petroleum pool is not completed until its bounds and limits are definitely ascertained; that all of their drilling activities in connection with the Ruark Pool constituted a process of "exploration, discovery, or prospecting, or any combination of the foregoing," which continued until the drilling of the last well on July 31, 1951; that this lasted for a period of more than 12 months; and "that, therefore, they are entitled to the relief provided by Section 456 of the Internal Revenue Code of 1939 for abnormal income derived from such activities."

Respondent's position on brief is in effect a reiteration of the views expressed in Revenue Ruling 236, 1953-2 C. B. 236. Because there are no decided cases and no promulgated regulations of the Commissioner helpful in a solution of the question before us, and because this Revenue Ruling not only states the position of respondent but also outlines the complicated statutory background of the problem, we set forth the greater part of that ruling, as follows:

2. Exploration, discovery, or prospecting. -- Exploration or prospecting by a taxpayer begins with the first field work designed to determine whether to acquire or retain the acreage in the area in which a discovery is later made. (See I. T. 4006, C. B. 1950-1, 38.) It does not include the general research of published reports to determine where exploration might be profitable. Exploration is ended and discovery occurs for a pool when a well is completed that proves the presence of oil or gas in commercial quantities. Subsequent drilling in the pool, while it may contain a large element of risk, constitutes exploitation to reap the benefits of the discovery. To the extent that "development" is the equivalent of "exploration" or "discovery," it may result in abnormal income under section 456; to the extent that "development" is the equivalent of "exploitation," it will not result in any abnormal income within the meaning of section 456.

3. Period of exploration, discovery, or prospecting. -- To qualify under section 456 (a) (2) (B) income must result from exploration, discovery, or prospecting, or any combination of the foregoing, extending over a period of more than 12 months. This means that the elapsed time between the commencement of exploration or prospecting and the resulting discovery, as defined in paragraph 2, exclusive of any intervening periods of inactivity, must total more than 12 months. Only the actual time consumed from the initial steps in the exploration or prospecting to the final completion of the discovery well that proved the presence of oil or gas in commercial quantities is to be considered in measuring the time elapsed.

4. Class of income. -- The entire income of a taxpayer which results from exploration, discovery, or prospecting, or any combination of the foregoing, extending over a period of more than 12 months, constitutes a single class of income.

5. Determination of abnormal income. -- That part of the gross income from the sale of oil and/or gas from properties of the taxpayer which meets the other requirements of section 456 and which is attributable to the exploration, discovery, or prospecting of such properties constitutes abnormal income within the meaning of section 456 (a) (2) (B). That part of the gross income from the sale of oil and/or gas from the taxpayer's properties which is attributable to the exploitation of such properties, however, does not under any circumstances constitute abnormal income within the meaning of section 456 (a) (2) (B). Any method of allocation will be acceptable which reasonably determines the portions of income which are attributable to exploration, discovery, or prospecting of the properties and the portions of income which are attributable to the development or exploitation of the properties in view of the respective risks undertaken. * * *

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6. Items of abnormal income. -- An item of abnormal income consists of the abnormal income, as defined above, attributable to a single discovery. Thus, the amount of an item of abnormal income in any taxable year is equal to that portion of the income, attributable to the discovery, realized in such taxable year from a particular oil and/or gas pool which is proved by a single discovery well. For the purposes of this Revenue Ruling, a "pool" means any underground accumulation of crude petroleum or associated hydrocarbon substances including, but not limited to, natural gas, constituting a single and separate reservoir or source of supply within a field. The probable limits of such new pool, as determined by the best evidence available at the date of completion of the discovery well, thus define the area within which all leases or properties owned at the time by the discoverer would be included in the discovery. Later discoveries of new pools in the same area may be made in different sands or horizons, and again the income attributable to the discovery of the new pool would be determined by the facts known as of the date of discovery. No adjustments will be made because of any subsequent information.

The abnormal income of a taxpayer for any year, either the current taxable year or one of the 4 prior taxable years, consists of the sum of the items of abnormal income, as defined above, from all discovery units of the taxpayer yielding such income in the given year.

The income here in question must be considered as derived from the Ruark Pool (an assumption made by both parties in their approach to the problem). As we have pointed out, there is no contention based upon the segregation of the income as from individual wells drilled by petitioners.

Considering the income as derived from the pool, we are of the opinion that the exploration, discovery, and/or prospecting, which resulted in that income, necessarily must antedate and end with the discovery of the pool and the practical availability to petitioners of income therefrom, which would in this case be on or about October 14, 1949, and certainly not later than November 5, 1949, when the completion of the fifth producing well proved without doubt the existence of an oil pool covered by petitioners' leases. Petitioners' hope and purpose in drilling additional wells on their leases may well have been twofold, first and primarily to obtain more oil from the pool and thereby exploit and develop it, and, second, to ascertain the extent, size, and shape of the pool. Insofar as these drillings were intended to result and did result in the receipt of income by petitioners, they constituted an exploitation and a development of an oil pool discovered on or about October 14, 1949, as a result of exploration and prospecting carried on prior thereto. Webster's New Collegiate Dictionary defines "exploration" as "[act] of exploring, as for geographical discovery," and in discussing the word "discover" the same work says: "Discover presupposes exploration * * *." It also defines "discovery" as "1. Act of discovering," and the verb "prospect" as "[to] explore or examine for something." We consider that Congress in using the words "exploration, discovery, or prospecting" meant acts leading up to and antedating the finding of the thing discovered, which in this case, according to the hypothesis made by both parties, was the oil pool here in question. A factor leading us to this conclusion is the deliberate omission by Congress in enacting section 456 (a) (2) (B) of the word "development," which had appeared in the predecessor statute. We consider that Congress did not mean the words "exploration, discovery, or prospecting" to include acts seeking information about the thing already discovered, performed as incidents to its development and exploitation after it was discovered. This conclusion accords with the distinction made by the oil industry itself between discovery wells and development wells. Thus, in Williams & Meyers, Manual of Oil and Gas Terms (1957), p. 91, an exploratory or discovery well is defined as a well drilled "for the purpose of ascertaining the presence underground of a commercial petroleum deposit. * * *" In contrast, this Manual defines a development well as a "well drilled with the expectation of producing from a known productive formation, and which is located in accordance with spacing regulations and field development requirements [p. 91]." The Manual also defines development as the "drilling and bringing into production of wells in addition to the exploratory or discovery well on a lease * * * [p. 61]."

We are not unmindful of the testimony of petitioners' witnesses to the effect that the drilling of wells after the discovery well constituted exploration in that they served to ascertain the limits of the Ruark Pool. For the reasons stated, we do not consider that the drilling of the development wells, after the drilling of the discovery well or wells, was the "exploration" contemplated by Congress in the phrase under examination. However, even if we are mistaken in this conclusion, it seems obvious to us that the income from the Ruark Pool, claimed here to be abnormal, cannot be considered as having resulted from any exploration, as such, made after the discovery of the Ruark Pool and the start of its development.

Therefore, we conclude that the income here in question, claimed by petitioners to be abnormal income from the Ruark Pool, resulted from "exploration, discovery, or prospecting," which extended over a period which could not have been longer than from March 1, 1949, to November 5, 1949, and since this period was not "of more than 12 months" petitioners are not entitled with regard to this income to the relief accorded by section 456 of the Internal Revenue Code of 1939.

Decisions will be entered for respondent.

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Footnotes

• 1. The testimony elicited by these questions was to the effect that one of petitioners' agents did some unorthodox surface prospecting in the area incident to the taking of two leases by one of the petitioners, which leases were surrendered in 1948 before any drillings were made thereon.↩

• 2. SEC. 456. ABNORMALITIES IN INCOME IN TAXABLE PERIOD.

  (a) Definitions. -- For the purposes of this section --

  * * * *

  (2) Separate classes of income. -- Each of the following subparagraphs shall be held to describe a separate class of income:

  * * * *

  (B) Income resulting from exploration, discovery, or prospecting, or any combination of the foregoing, extending over a period of more than 12 months; * * *↩

• 3. Petitioners' excess profits tax returns break down the total receipts from the Ruark Pool to receipts from "Productive Leases." It is impossible to determine from these returns, or otherwise, the receipts from the individual wells.↩

• 4. SEC. 721. ABNORMALITIES IN INCOME IN TAXABLE PERIOD.

  (a) Definitions. -- For the purposes of this section --

  * * * *

  (2) Separate classes of income. -- Each of the following subparagraphs shall be held to describe a separate class of income:

  * * * *

  (C) Income resulting from exploration, discovery, prospecting, research, or development of tangible property, patents, formulae, or processes, or any combination of the foregoing, extending over a period of more than 12 months; * * *↩