The Court briefly traced the history of its decisions in this area and, after quoting the formula from Palmer v. Bender, set out above, commented: "These two factors, usually considered together, constitute the requirement of `an economic interest.' This Court has found the requisite interest in the oil in place to have been retained by the assignor of an oil lease, Thomas v. Perkins, 301 U.S. 655, 57 S.Ct. 911, 81 L.Ed. 1324, * * * and the grantor of oil lands considered as an assignor of drilling rights, Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25, 66 S. Ct. 861, 90 L.Ed. 1062. The Court found no such interest in the case of a processor of natural gas who had only contracted to buy gas after extraction, Helvering v. Bankline Oil Co., 303 U.S. 362, 58 S.Ct. 616, 82 L.Ed. 897, and in the case of a former stockholder who had traded his shares in a corporation which owned oil leases for a share of net income from production of the leased wells, Helvering v. O'Donnell, 303 U.S. 370, 58 S.Ct. 619, 82 L.Ed. 903. "The second factor has been interpreted to mean that the taxpayer must look solely to the extraction of oil or gas for a return of his capital, and depletion has been denied where the payments were not dependent on production, Helvering v. Elbe Oil Land Development Co., 303 U.S. 372, 58 S.Ct. 621, 82 L.Ed. 904, or where payments might have been made from a sale of any part of the fee interest as well as from production.
" See also Burton-Sutton Oil Co. v. Commissioner, 1946, 328 U.S. 25, 32 et seq., 66 S.Ct. 861, 90 L.Ed. 1062; Palmer v. Bender, 1933, 287 U.S. 551, 557, 53 S.Ct. 225, 77 L.Ed. 489; Commissioner v. Southwest Exploration Co., 9 Cir., 1955, 220 F.2d 58, 60 et seq. Because of the high cost of exploiting and developing mineral deposits on a commercial basis, the practice in the extractive industry is for owners of mineral bearing lands to lease or grant mineral rights in their lands to professional exploiters who may operate the lease themselves or may sublease or grant mineral rights in their lands to professional exploiters who may operate the lease themselves or may sublease or assign it to others for actual production.
It is the taxpayer's position that the quarterly payments are deductible as lease rentals under § 23(a)(1)(A) of the Internal Revenue Code of 1939. In the alternative, the taxpayer contends that if these payments are to be construed as bonuses or advance royalties, as suggested by the Government, they are nevertheless deductible under the ruling of the Supreme Court in Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25, 66 S.Ct. 861, 90 L.Ed. 1062. The Government, on the other hand, contends that the quarterly payments are mere installments on the $300,000 originally paid for the lease and that as such they must be capitalized as leasehold costs.
Whether it owned the leasehold or royalty is beside the point. As stated in Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25, 32, 66 S.Ct. 861, 90 L.Ed. 1062 (1946): * * * We do not agree * * * that ownership of a royalty or other economic interest in addition to the right to net profits is essential to make the possessor of a right to a share of the net profit the owner of an economic interest in the oil in place.
This dominant purpose of the contract and this essential character make the classification of plaintiff's activities and payments under it much simpler than those which have perplexed the courts in similar tax cases and have brought about so many refinements and contrarieties of construction. See, e.g., the remarks of Mr. Justice Frankfurter in Burton-Sutton Oil Co., Inc., v. Commissioner, 1946, 328 U.S. 25, 37 and 38, 66 S.Ct. 861, 868, 90 L.Ed. 1062, where he refers to the decision in that case as a "tortuous process" and states, "It is suggested that the Tax Court makes differentiations from case to case which to the uninitiated look suspiciously like conflicting opinions"; and adverts to "the gossamer lines that have been drawn by this Court in tax cases [resulting in distinctions] which hardly can be held in the mind longer than it takes to state them". The decision here is made simpler also by the concessions which the Government makes.
One who acquires the latter through an agreement with one who possesses the former is not entitled to the depletion deduction. Some of these decisions are: Burton-Sutton Oil Co. v. Commissioner of Internal Revenue, 1946, 328 U.S. 25, 66 S.Ct. 861, 90 L.Ed. 1062; Kirby Petroleum Co. v. Commissioner of Internal Revenue, 1946, 326 U.S. 599, 66 S.Ct. 409, 90 L.Ed. 343; Anderson v. Helvering, 1940, 310 U.S. 404, 60 S.Ct. 952, 84 L.Ed. 1277; Palmer v. Bender, 1933, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489; Commissioner of Internal Revenue v. Gregory Run Coal Co., 4 Cir., 1954, 212 F.2d 52; M-B-K Drilling Co. v. Commissioner of Internal Revenue, 10 Cir., 1952, 194 F.2d 221; Dearing v. Commissioner of Internal Revenue, 5 Cir., 1939, 102 F.2d 91; Weirton Ice Coal Supply Co. v. Commissioner of Internal Revenue, 1955, 24 T.C. ___; Brown v. Commissioner of Internal Revenue, 1954, 22 T.C. 58; Morrisdale Coal Mining Co. v. Commissioner of Internal Revenue, 1952, 19 T.C. 208; Ruston v. Commissioner of Internal Revenue, 1952, 19 T.C. 284; C.A. Hughes Co., 1955, 14 T.C.M. 172; Hamill Coal Corp. v. Commissioner of Internal Revenue, 1955, 14 T.C.M. 218; Paul E. Barry, Inc. v. Commissioner of Internal Revenue, 1955, 14 T.C.M. 37; Winfield Mining Contracting C
We think the Tax Court correctly held that the only economic interest sufficient to justify depletion which taxpayer retained under the lease agreement was the right to receive a one-sixth royalty on all oil and gas produced and saved, excluding that used by The Texas Company for fuel, since the taxpayer retained no possibility of profit from the production of oil and gas so used for fuel. See Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25, 32, 34-35, 66 S.Ct. 861, 90 L.Ed. 1062. While it is true, as the Tax Court noted, that a lessor is entitled to a depletion allowance on royalties paid by the lessee, regardless of whether paid in cash or in oil, a taxpayer nevertheless may not claim percentage depletion on oil which, under the terms of the lease, is specifically excluded from any computation of its royalty interests.
The Commissioner relies heavily upon the cases involving a transfer of mineral interests, the transferor receiving a bonus and retaining a royalty or other interest in the mineral production. Burnet v. Harmel, 287 U.S. 103; Palmer v. Bender, 287 U.S. 551; Thomas v. Perkins, 301 U.S. 655; Kirby Petroleum Co. v. Commissioner, 326 U.S. 599; Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25; Commissioner v. Southwest Exploration Co., 350 U.S. 308. Thomas v. Perkins is deemed particularly pertinent. There a leasehold interest was transferred for a sum certain payable in oil as produced, and it was held that the amounts paid to the transferor were not includable in the income of the transferee but were income of the transferor.
Like the overriding royalty it is created from the working interest, and the net profits interest differs from other production-measured payments in that it represents a fractional share of the profit of the operating company, rather than a fractional share of the minerals themselves as produced. Comment, Sale or Lease: Capital Gain or Ordinary Income Subject to Depletion in Mineral Transactions, 32 La.L.Rev. 417, 424 n. 30 (1972). Eight years after Elbe, in Burton-Sutton Oil Co., Inc. v. Commissioner of Internal Revenue, 328 U.S. 25, 66 S.Ct. 861, 90 L.Ed. 1062 (1946), the Court concluded that where the assignor of certain oil rights retained an interest in the net operating profits, the transaction was not a sale but rather an assignment "with a reservation in the assignor of an economic interest in the oil." Id., at 37.
In subsequent cases, the economic interest concept was used to differentiate between capital and income transactions. If a transferer retains an "economic interest" in mineral rights, as a matter of federal tax law he has not made a sale of those rights regardless of how the transaction is classified under state law. Burton-Sutton Oil Co. v. Commissioner of Internal Revenue, 328 U.S. 25, 32-36, 66 S.Ct. 861, 90 L.Ed. 1062; see also Commissioner of Internal Revenue v. P. G. Lake, Inc., 356 U.S. 260, 264-265, 78 S.Ct. 691, 2 L.Ed.2d 743. In Anderson v. Helvering, 310 U.S. 404, 60 S.Ct. 952, 84 L.Ed. 1277, the transferee of certain royalty interests, fee interests, and deferred oil payments in property in Oklahoma contended that he had not made a purchase because the transferor had retained an economic interest in the property.