Appeal from the United States Tax Court
Before Pell, Circuit Judge, Fairchild, Senior Circuit Judge, and Bauer, Circuit Judge.
Taxpayers Fred and Mary Engle appeal from a decision of the United States Tax Court upholding a determination by the Commissioner that they were not entitled to a percentage depletion allowance on two oil and gas leases for the year 1975. The Engles had received advance royalties as a result of their assigning the leases during the taxable year. No physical extraction of oil or gas from the depletable properties had occurred during 1975. The Tax Court held that 26 U.S.C. § 613A(c) (1976)*fn1 permits the percentage depletion deduction only if there is some physical extraction of oil or gas during the taxable year.
The sole issue on appeal is whether the Tax Court correctly interpreted section 613A(c) to preclude a taxpayer otherwise entitled to the percentage depletion allowance from claiming the deduction if there was no physical extraction of oil or gas from the depletable properties during the year for which the percentage depletion allowance is claimed.
The facts are undisputed. Fred and Mary Engle are husband and wife. They filed a joint federal income tax return for 1975. During that year, Fred Engle acquired two oil and gas leases covering a total of 240 acres of land in Wyoming. Both leases were assigned by Engle to different parties in October, 1975. Engle received advance royalties of $7,600 from the two assignments. This $7,600 was the only taxable income received from the properties during 1975. No discovery or exploratory work was done on the properties covered by the leases during the taxable year; no gas or oil was extracted from the properties that year.
The Engles claimed a 22% depletion deduction, pursuant to section 613A. The Commissioner determined that the Engles were not entitled to the deduction because there was no "average daily production." § 613A(c), of domestic crude oil or natural gas and no average daily secondary or tertiary production of domestic crude oil or natural gas during 1975. The Commissioner assessed a deficiency of $4,957.55.*fn2 A majority of the Tax Court upheld the Commissioner's interpretation in a majority and concurring opinion that together span forty-six pages.*fn3 Judge Fay strongly dissented from the conclusion that the "average daily production" language of section 613A(c) makes actual physical extraction of gas or oil a prerequisite to the percentage depletion deduction.
We note at the outset that the pertinent language of section 613A(c) has not previously been interpreted by a court of appeals. We must consider the statutory language, pertinent legislative history, and the judicial interpretation of the percentage depletion allowance as it existed prior to enactment of section 613A*fn4 in construing the challenged provision. We begin by setting forth the statutory scheme for percentage depletion allowances as it existed prior to enactment of the Tax Reduction Act of 1975, Pub.L. No. 94-12, 89 Stat. 26 (1975) (1975 Act).
A. Sections 611 and 613 of Title 26.
Prior to promulgation of the 1975 Act, percentage depletion allowances were governed solely by sections 611 and 613. Section 611(a) states, in relevant part, that "there shall be allowed as a deduction in computing taxable income a reasonable allowance for depletion ...." § 611(a). Section 613, entitled "Percentage Depletion," states in part: "In the case of the mines, wells, and other natural deposits listed in subsection (b), the allowance for depletion under section 611 shall be the percentage, specified in subsection (b), of the gross income from the property ...." § 613(a) (emphasis added).
The Supreme Court made clear that if the depletable properties resulted in gross income to the taxpayer, the percentage depletion allowance was applicable whether or not any physical extraction occurred during the taxable year. E.g., Herring v. Commissioner, 293 U.S. 322, 55 S. Ct. 179, 79 L. Ed. 389 (1934). The ruling in Herring was in response to the Commissioner's conclusion that section 214(a)(9) of the Revenue Act of 1926 contemplated actual production as a prerequisite to the percentage depletion allowance. The Commissioner had reasoned that no oil or gas well existed absent production and the statutory language permitted the "reasonable allowance for depletion" only "(i)n the case of mines, oil and gas wells ...." It is clear, therefore, that the Engles would have been entitled to the percentage depletion allowance on the basis of their advance royalties had this case arisen prior to promulgation of the 1975 Act.
It was also established, prior to the 1975 Act, that if no production of oil or gas occurred prior to cancellation of the lease, the taxpayer was required to restore the previously deducted depletion to income. Douglas v. Commissioner, 322 U.S. 275, 285, 64 S. Ct. 988, 994, 88 L. Ed. 1271 (1944); 26 C.F.R. §§ 1.612.3(a)(2) and (b)(2) (1981). As the Tax Court noted in the instant case, this rule constituted at least an implicit requirement of actual production of oil or gas at some point in time.
The 1975 Act essentially eliminated the percentage depletion allowance in the case of oil and gas wells except as to certain domestic gas wells and independent producers and royalty owners. See §§ 613A(a), (b), and (c). The latter exception is the ...