Opinion ID: 312230
Heading Depth: 1
Heading Rank: 1

Heading: Water Rights

Text: 2 The Vests owned certain acreage in Winkler County, Texas including the water and mineral rights incident to that property. Prior to April 1963, Shell Oil Company approached them with a proposal to purchase their water rights together with a right of way to facilitate their development. Shell's chief reason for seeking this agreement was to obtain sufficient reserves to provide water for use in the secondary recovery of oil by means of waterflooding. 1 3 On April 29, 1963 a final contract was executed. The Vests transferred to Shell by warranty deed the rights to all water between the depths of 3,000 and 6,500 feet beneath certain described land in Winkler County, Texas save that quantity of water needed by the Vests for their own exploration and production of minerals. Also transferred to Shell was a right of way over the Vests' land for the purpose of developing the acquired water rights and the construction, operation and maintenance of a trunk pipeline to be used to transport and distribute the water. 2 4 Shell, in turn, agreed to make payments in monthly installments extending over a 75 year period although it was not required to pay any fixed amount. See Earl Vest, 57 T.C. 128 (1971). These payments, when they became due, were computed according to Shell's receipts from the sale of purchase price water. 3 Purchase price water was defined as water produced from the water rights transferred to Shell or from other water rights acquired by Shell from others in Winkler, Ward and Ector Counties, Texas, during April 1963, or from other specified areas of Winkler County that might be brought under the agreement at a later time, or any water, not otherwise covered by the agreement, transported through pipelines constructed pursuant to the agreement. Shell had the option of being relieved of any further liability under the agreement if the quantity of purchase price water fell below an average of 50,000 barrels per day for six months. In that event, Shell could transfer the acquired water rights back to the Vests and be relieved of any further obligation. However, even if this option were exercised, Shell still retained the right to utilize any pipeline which might have been laid on the Vests property, upon payment of an additional consideration, for the purpose of transporting substances other than water. 4 5 From the date of the execution of the agreement through the tax years now in dispute (1965-1967), Shell did not drill any water wells, remove any water directly from the Vests' land or lay any pipeline. Nevertheless, Shell did pay the Vests a total of $26,630.95 for water extracted and transported from the property of neighboring landowners. 5 The Vests reported this income as capital gain received from the sale of the water rights and the right of way. Rejecting this determination, the Commissioner found that the Vests' transaction with Shell was a lease giving rise to ordinary income. Deficiencies were assessed accordingly. 6 The Tax Court, reversing the Commissioner's determination, held that the income received by the Vests with respect to the water rights and the right of way was capital gain, not ordinary income. 6 Applying the economic interest test approved by this court in Wood v. United States, 377 F.2d 300, 303-304 (1967) it rejected the Commissioner's assertions that the payments were based on production and that the Vests possessed a reversionary interest in the property. 7 Although the Tax Court acknowledged the relevance of such factors as the Vests' reservation of water rights for mineral exploration and the absence of either a fixed sales price or a substantial down payment, it did not regard them as controlling. 8 On the contrary, it found that the agreement between the Vests and Shell constituted a sale of the water in place and a permanent interest in the property for a right of way. 9 The Commissioner appeals from this part of the Tax Court's ruling. 7 Before reaching the merits of this question, there is a threshold issue which we must discuss briefly. The Commissioner contends that the economic interest test, Palmer v. Bender, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489 (1933); Commissioner v. Southwest Explor. Co., 350 U.S. 308, 314, 76 S.Ct. 395, 100 L.Ed. 347, 354 (1956), does not govern the tax consequences of the Vests' transfer of the water rights and the right of way. It is argued that this test was originally conceived to determine who has the depletable interest in minerals with respect to which the percentage depletion allowance is available. As such, the test is said to be a term of art ill-adapted to application outside the depletion context. The Commissioner cites several cases for this position, Bryant v. Commissioner, 399 F.2d 800, 806 (5th Cir. 1968); Moberg v. Commissioner, 365 F.2d 337, 340 (5th Cir. 1966) (Brown, J. concurring), but otherwise gives no concrete economic or scientific reasons to support it. 8 The view in this circuit is firmly established that the economic interest test can be applied to cases outside the percentage depletion area. Although the 'economic interest' concept was developed and refined primarily in cases dealing with oil and gas law, we have observed that there is 'no apparent justification for a difference in approach depending on the nature of the mineral involved' . . . . Rutledge v. United States, 428 F.2d 347, 350 (5th Cir. 1970). See also Rhodes v. United States, 464 F.2d 1307, 1310 (5th Cir. 1972); Wood v. United States, 377 F.2d 300, 304 (5th Cir. 1967). In the same vein, it has also been recognized on several occasions that regardless of the original purpose of the economic interest test, it is substantially the same as the test employed to determine whether income is taxable as capital gain or ordinary income. Rutledge v. United States, 428 F.2d 347, 351 (5th Cir. 1970); Wood v. United States, 377 F.2d 300, 305 (5th Cir. 1967). See Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25, 35, 66 S.Ct. 861, 90 L.Ed. 1062, 1069 (1946). In view of these principles, it appears to us that the Commissioner's argument in this connection is based on semantical distinctions and not considerations of economic or legal substance. Hence, we conclude that the Tax Court's use of the economic interest test was not erroneous. 10 9 As is always true in cases of this nature, a careful analysis of the facts is necessary to bring out the essential character of the transaction involved. A finding that an economic interest has been retained by the taxpayer must be supported by a showing of the following facts: (1) the taxpayer must have acquired by investment an interest in the minerals in place and (2) he must look solely to the extraction of the mineral for the return of his capital. Commissioner v. Southwest Explor. Co., 350 U.S. 308, 314, 76 S.Ct. 395, 100 L.Ed. 347, 353 (1956); Rhodes v. United States, 464 F.2d 1307, 1310 (5th Cir. 1972). Since there can be no serious question about the Vests' pre-agreement investment interest in the water rights and right of way, our chief concern here will be to assess the Vest-Shell agreement in light of the second part of the economic interest test. 10 The case law relevant to this issue can be dichotomized into two broad yet distinct lines of authority: sales cases and lease cases. Rhodes v. United States, 464 F.2d 1307, 1310 (5th Cir. 1972); Wood v. United States, 377 F.2d 300 (5th Cir. 1967). As a general proposition, if a sale is consummated, the taxpayer divests himself of all economic interest in the minerals transferred and therefore is entitled to treat the proceeds as capital gain. By the same token, if the transaction is a lease or one where the taxpayer looks solely to the extraction of minerals for a return on his capital, then he must treat the proceeds as ordinary income. Rhodes v. United States, 464 F.2d 1307, 1310 (5th Cir. 1972); Rutledge v. United States, 428 F.2d 347, 351 (5th Cir. 1970). See also Commissioner v. Southwest Explor. Co., 350 U.S. 308, 314, 76 S.Ct. 395, 100 L.Ed. 347, 353 (1956). 11 An exhaustive review of the sales cases is not necessary in order to identify the factors which distinguish them from the lease decisions. While the presence of language of sale has always been considered relevant, it is well recognized in both lines of authority that the labels or words used by the parties in forming their contract are not controlling. In short, the substance of a contract's terms and provisions will prevail over its form. Rhodes v. United States, 464 F.2d 1307, 1311 n.4 (5th Cir. 1972); Rutledge v. United States, 429 F.2d 347, 352 (5th Cir. 1970) (lease case). Thus, since this court's decision in Crowell Land & Mineral Corp. v. Commissioner, 242 F.2d 864 (5th Cir. 1957), it has consistently been held that a sale results where an agreement purports to transfer within a prescribed time period all, Rhodes v. United States, 464 F.2d 1307 (5th Cir. 1972); Gowans v. Commissioner, 246 F.2d 448 (9th Cir. 1957); Day v. Commissioner, 54 T.C. 1417 (1970), or a specific, predetermined quantity of minerals in place, Rhodes, supra, Linehan v. Commissioner, 297 F.2d 276 (1st Cir. 1961); Gowans v. Commissioner, supra, in exchange for a fixed consideration. 11 Rhodes, supra; Day, supra. See also Bryant v. Commissioner, 399 F.2d 800, 806 (5th Cir. 1968); Commissioner v. Remer, 260 F.2d 337 (8th Cir. 1958). The economic effect of an agreement exhibiting these terms is abundantly clear. Not only does the transferor part completely with his interest in the minerals in place, he also acquires a right to receive payments which is not dependent upon extraction by the transferee. There is thus a cashing in of an investment interest and capital gain treatment of the proceeds is appropriate. 12 The Vest-Shell agreement, despite its language of sale, does not lend itself to easy categorization. It is a borderline transaction for tax purposes reflecting in varying degrees both sale and lease characteristics. Nevertheless, after an analysis of its terms and provisions as a whole, Albritton v. Commissioner, 248 F.2d 49, 51 (5th Cir. 1957), we cannot conclude that this agreement is controlled by Crowell and subsequent sales decisions. In our opinion the Vest-Shell agreement differs significantly from the transactions involved in those cases. Because of these critical differences we find that the Vests retained an economic interest in the water rights and right of way transferred to Shell. 13 Under the terms of the agreement, the Vests did not transfer to Shell all of the water in place or a specific quantity thereof. Though this fact alone represents a key difference from the sales cases, it takes on increased importance in light of other provisions in the agreement. These provisions indicate that Shell had no intention of making an outright purchase of water payable in any event. On the contrary, Shell acquired the water rights primarily for use when needed to provide sufficient reserves for the secondary recovery by oil by means of waterflooding. 12 While Shell was obligated to make payments to the Vests in monthly installments over a 75 year period, it is important that Shell controlled the conditions under which this obligation arose. Shell was under no duty to extract any purchase price water at all and if it did not, the Vests would receive nothing. We do not think that these terms are equivalent to the quid pro quo that has traditionally been associated with a bona fide sales transaction or a cashing in of one's investment interest in property. 13 14 But having found that the Vest-Shell agreement is fundamentally unlike the transactions in the Crowell line of decisions involving what were determined to be sales, it does not automatically follow that the Vests retained an economic interest in the water rights. We still must inquire whether the Vests looked to the extraction of the water for a return on their capital. Palmer v. Bender, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489 (1933); Commissioner v. Southwest Explor. Co., 350 U.S. 308, 76 S.Ct. 395, 100 L.Ed. 347 (1956); Rutledge v. United States, 428 F.2d 347 (5th Cir. 1970); Wood v. United States, 377 F.2d 300 (5th Cir. 1967); Albritton v. United States, 248 F.2d 49 (5th Cir. 1957). See also, United States v. White, 401 F.2d 610 (10th Cir. 1968) (en banc). This is the critical determination. The language of the contract relevant to this point is clear and unambiguous. The Vests possessed the right to be paid a percentage of the proceeds received by Shell from the sale of all purchase price water which by definition included but was not limited to water actually extracted from wells situated on the Vests' property. 14 15 We recognize that a bare right measured by production does not constitute an economic interest, Commissioner v. Remer, 260 F.2d 337, 340 (8th Cir. 1958); Rutledge v. United States, 428 F.2d 347, 351 (5th Cir. 1970). But it is also true that the question in all cases is what is owned by whom, or more exactly, what is the source of the right pursuant to which payments are received. Bryant v. Commissioner, 399 F.2d 800, 806 (5th Cir. 1968). Here we need only to emphasize what was pointed out earlier. The Vests' right to receive payments was linked inextricably to Shell's withdrawal of water or use of the pipelines. Without the occurrence of one or both of those eventualities, Shell incurred no liability whatever. This symbiotic relationship-between payments and production-is the kind of retained interest which makes the Vest-Shell agreement incompatible with a sale and more in the nature of a lease. Hence, we think the conclusion is escapable that the Vests retained an economic interest in the water rights transferred to Shell. It follows that the proceeds from this transaction were ordinary income and that the Tax Court's conclusion to the contrary was error. 15