Carr Staley, Inc., Plaintiff-appellant, v. United States of America, Defendant-appellee, 496 F.2d 1366 (5th Cir. 1974)

Carr Staley, Inc., the taxpayer, appeals from the district court's judgment denying its claim for a refund of income taxes which it alleges were unconstitutionally imposed pursuant to 26 U.S.C.A. 636(b) (Supp.1974). It was taxpayer's position below, as here, that 636(b) is unconstitutional because it results in the taking of taxpayer's property without due process of law in contravention of the fifth amendment. After a careful review of the provisions of 636(b) and the Congressional purpose underlying its enactment, we concur with the district court's conclusion that the contested provision is a proper exercise of Congress's authority to 'lay and collect taxes on incomes, from whatever source derived.'¹

* A production payment may be defined as

'. . . a right to a specified share or production from a mineral property (or a sum of money in place of production) when that production occurs. The production payment is secured by an interest in the minerals, the right to the production is for a period of time shorter than the expected life of the property, and the production payment usually bears interest.' See Joseph, Recent Developments in Oil and Gas Taxation, 22 Oil & Gas Tax Q. 164, 172 (1974).

The retained production payment is a frequently used method for splitting property interests of minerals in place. Before the enactment of the Tax Reform Act of 1969, it was an effective technique for dividing the income which resulted from the extraction of oil or other minerals. Under common practice, the owner of an oil holding will convey his interest to another party for a sum certain. Conjointly he will retain the right to a production payment which entitles the assignor to future income from the oil produced. This payment will be paid out from the oil as it is extracted. The assignor looks to the oil in place as the source for the payment of his reserved interest. We have previously noted that:

'A fundamental characteristic of a production payment is that it is not burdened with any of the operating expenses of a lease. It is payable only out of production, and there is no personal liability on the part of the owner of the production payment. The production payment owner has no possessory interest, no right to drill, no right to the surface, and no claim to possession . . .. His interest is an incorporeal hereditament in the nature of an overriding royalty creating a present interest in land in the payee.' Brooks v. Commissioner, 424 F.2d 116, 122 (5th Cir. 1970).

Thus the assignee of mineral lands encumbered by a production payment assumes no personal liability for the payment of the retained production payment. The assignor is completely relegated to and dependent upon the oil in place as the generator of funds for retiring the payment.

On January 1, 1972, Alfred B. Guinn conveyed to the taxpayer an undivided 1/16th working interest in an oil and gas lease which Guinn owned. The record reveals that under the terms of this assignment, Guinn immediately received from taxpayer $2000. As additional consideration for the transfer, Guinn retained a production payment in the undivided 1/16th working interest. This retained production payment was made payable out of 70% Of all oil or other minerals produced from the 1/16th working interest until Guinn had received an additional $5,000. Further, the agreement provided that Guinn was to receive an amount of interest²  equal to the rate of 10% Per annum on the unliquidated balance owing under the retained production payment plus an amount equal to all the ad valorem taxes assessed against the property represented by the production payments.³ 

In this particular oil venture, the Medders Petroleum Corporation actually conducted the operation and extracted the oil from the leased premises and the Atlantic Richfield Company purchased the oil as it was removed from the ground. Atlantic Richfield paid Guinn and Carr Staley directly for the oil produced from the leased premises an amount which corresponded to Guinn's retained production payment and Carr Staley's right to production under the assignment. During the time period in question, January 1, 1972 to July 31, 1972, Atlantic Richfield paid the taxpayer $549.90 for its proportional interest in the leased premises. Additionally, taxpayer was charged $407.76 by Medders Petroleum for the operating expenses incurred in extracting the oil from its 1/16th working interest. More important to the problem here posed, Guinn received $1,283.09, which amount equaled his retained production payment in the 1/16th working interest. Under the proscriptions of 636(b) the taxpayer was compelled to include in its gross income the money paid to Guinn.

Several Supreme Court opinions have given favorable treatment to oil property apportioned in this manner. These cases invariably arose because both the assignor and assignee of oil property were seeking the oil depletion allowance on the same interest represented by the retained production payment. The Court held that where the assignor had retained such rights which amounted to 'an economic interest in the oil in place,' then he rather than the assignee was entitled to the depletion allowance. See Thomas v. Perkins, 301 U.S. 655, 57 S. Ct. 911, 81 L. Ed. 1324 (1937); Anderson v. Helvering, 310 U.S. 404, 60 S. Ct. 952, 84 L. Ed. 1277 (1940); Commissioner v. Southwest Exploration Co., 350 U.S. 308, 76 S. Ct. 395, 100 L. Ed. 347 (1956).

Relying on the property theories advanced by these cases and the unique features of the retained production payment, taxpayer asserts that it is being taxed for the income of another individual which it asserts is forbidden by the fifth amendment. Taxpayer contends that the income accruing to Guinn as a result of his retained production payment was his alone and any attempt to tax it for that income would be arbitrary and capricious and thus beyond the power of Congress.

Section 636(b) states that:

'A production payment retained on the sale of a mineral property shall be treated, for purposes of this subtitle, as if it were a purchase money mortgage loan and shall not qualify as an economic interest in the mineral property.'

By enactment of Section 636(b), Congress has repudiated 'the economic interest test' developed by the Supreme Court in determining whether income attributable to a retained production payment shall be taxed to the assignor or the assignee. Under the new standard, the retained production payment is treated as a purchase money mortgage and the income produced from that retained production payment is taxed to the mortgagor (assignee) as in other cases.⁴ 

The Senate Report issued in support of the new treatment that is given production payments leaves little doubt as to the impetus for the change.⁵  The Report noted that a retained production payment is the same thing a 'loan secured by a mortgage on property and the 'borrower' (Carr Staley, Inc.) not personally, liable for the loan.' See footnote 5, supra. Under previous law, the tax consequences of a retained production payment transaction are strikingly different from that accorded an ordinary sale of property with a purchase money mortgage to secure the unpaid balance of the purchase price. Where a retained production payment is utilized, the assignee-Mortgagor is permitted, to exclude from his income that amount necessary to 'pay out' the retained production payment. Thus, the assignee is granted in effect the right to acquire a valuable capital asset by using 'before-tax' dollars in payment for the asset. In contrast, assume that Guinn had sold taxpayer an apartment building. Conforming the facts established here to our hypothetical, Carr staley would pay Guinn $2,000 as a down payment with Guinn taking a $5,000 purchase money mortgage on the apartment building without any personal liability on Carr Staley's part in case of a default. In this similar economic exchange, Carr Staley would receive the income produced by the apartment building, take authorized deductions, pay taxes on the income received (the rentals from the individual apartment units), and use the 'after-tax' dollars to retire the outstanding purchase money mortgage. These two similar economic endeavors were previously accorded completely divergent-- and as Congress concluded unwarranted-- tax treatment.

Furthermore, the Senate Report observed the great loss of revenue to the treasury which had resulted from these favored mineral transactions. Continued differentiation between the retained production payment on the one hand and the normal mortgage situation on the other would result in the perennial loss of millions of dollars in revenue. Accordingly, Congress acted to eliminate what it considered the unjustness which was the inevitable consequence of the disparate treatment accorded these economically similar transactions. The legislative history emphasizes the fact that taxpayers involved in substantially similar business transactions are accorded very different treatment. In one case (mineral transaction) the purchaser pays for an asset with tax free dollars; whereas, another taxpayer (purchase money mortgage transaction) pays for an asset with tax paid dollars.⁶ 

This the taxpayer contends Congress may not do without violating the fifth amendment. In support of its argument of the constitutional infirmity of Section 636(b), taxpayer relies principally on Hoeper v. Tax Commission of Wisconsin, 284 U.S. 206, 52 S. Ct. 120, 76 L. Ed. 248 (1931); Heiner v. Donnan, 285 U.S. 312, 52 S. Ct. 358, 76 L. Ed. 772 (1932), and Schlesinger v. Wisconsin, 270 U.S. 230, 46 S. Ct. 260, 70 L. Ed. 557 (1926). In each of these cases, the Supreme Court struck down tax provisions which it concluded were arbitrary and capricious and thus violative of fundamental due process.

In Hoeper v. Tax Commission of Wisconsin, supra, the Court held that a Wisconsin statute which taxed the combined total incomes of a wife and husband to the husband alone was a violation of the due process and equal protection clauses of the fourteenth amendment. The state's family unit taxation was found impermissible because a wife's separate property and income were hers alone in Wisconsin. The Court stated:

'We have no doubt that, because of the fundamental conceptions which underlie our system, any attempt by a state to measure the tax on one person's property or income by reference to the property or income of another is contrary to due process of law as guaranteed by the Fourteenth Amendment. That which is not in fact the taxpayer's income cannot be made such by calling it income.' 284 U.S. at 215.

Taxation of the husband for the wife's income was found unacceptable because it was inconsistent with the property rights which had been granted the wife in Wisconsin. The Court rejected the proposition that the tax statute was an attempt by the Wisconsin legislature to redefine the property rights of the husband and the wife since that body had left unchanged the previous individual property rights vested in the wife. Therefore, the Court did not answer the question whether the state could have taxed the husband for the wife's income where the wife's income was attributable to the husband under applicable property law.

Schlesinger v. Wisconsin, and Heiner v. Donnan, hold that it is arbitrary and capricious for a state or the federal legislature to create an irrebutable presumption that a transfer made within a certain period of time before the donor's death is a gift in contemplation of death. In both cases, the Wisconsin legislature in Schlesinger and Congress in Heiner, had created irrebutable presumptions that transfers made within six years and two years respectively of the donor's death were made in contemplation of death. Under both statutory schemes, the estate was not permitted to show that a transfer had been motivated by other than the donor's ensuing death.

In Heiner, the Court noted that the estate tax statute was enacted to levy duties on transfers which occur because of the death of the donor. Estate taxes are imposed to tax one's right to leave property to his beneficiaries at death. In contrast, a donor may wish to bestow property on another by an inter vivos conveyance without any consideration that his death may be impending. 'The 'generating source' of such a gift is to be found in the facts of life and not in the circumstance of death.' Heiner, supra, 285 U.S. at 322. Assuming that life motives have impelled the donor to initiate the transfer involved, then the fact that death subsequently occurs does not affect the character of the gift as originally made. A life motivated inter vivos gift once made is complete and 'death does not result in a shifting, or in the completion of a shifting, to the donee of any economic benefit of property, which is the subject of a death tax . . .' Heiner, supra, 285 U.S. at 323. The essential purpose of a death transfer tax was thus given decisive and controlling weight in resolving the statutory presumption attached to certain life transfers.

The Court concluded that Congress may enact appropriate legislation to prevent the evasion of death taxes by donors who attempt to transfer their property in contemplation of death. Where gifts are made as a result of the donor's desire to avoid estate taxes and death thereafter ensues, Congress may tax such transfers. Any rule which seeks to tax life transfers must be phrased in language which will permit an appropriate representative of the transferor's estate to demonstrate that the donor was motivated in fact by circumstances other than his subsequent death. Therefore, the legislative schemes in Heiner and Schlesinger were condemned because two classes of gifts had resulted from the tax provisions with the tax consequences of each class depending on the fortuitous and conclusive factor that death occurred within a certain period of time. Such a classification was found to be arbitrary since a logical basis for the distinction was lacking. Where the statutory presumption was determined to be applicable, the donee was forced to pay the tax even though he had previously been the beneficiary of a completed inter vivos gift. Moreover, as the Court stated, the motivation to make a gift varies with the individual circumstances of the donor and the donee. Congress had attempted to remove any chance for the estate to establish the actual facts surrounding the gift and thus the estate was denied a fair opportunity of a hearing on the contested issue of fact.

Although the logic evidenced in the cases discussed above is unassailable and enduring, we think the present statutory provision does not fall within any of the proscriptions delineated in those opinions. Where a taxpayer attacks a tax statute on the grounds that it contravenes the fifth amendment, the thrust and focus of his attack must be specific. The underlying and crucial question to be answered must be whether there is a reasonable basis in fact for the legislative scheme or classification drawn into focus. The parameters of a court's review is limited. We should not second-guess the legislature where there is factual support for the distinctions it has drawn. Judicial intervention should be limited to those situations where the legislative classification under review is so arbitrary and capricious as to amount to a denial of fundamental due process. The Supreme Court set the tone for a reviewing court when a taxing scheme is challenged by enunciating the following principle:

'. . . The due process clause of the 5th Amendment . . . is not a limitation upon the taxing power conferred upon Congress by the Constitution . . . (except) . . . in a case where although there was a seeming exercise of the taxing power, the act complained of aws so arbitrary as to constrain to the conclusion that it was not the exertion of taxation but a confiscation of property; that is, a taking of the same in violation of the 5th Amendment, or, what is equivalent thereto, was so wanting in basis for classification as to produce such a gross and patent inequality as to inevitably lead to the same conclusion.' Brushaber v. Union Pacific RR., 240 U.S. 1, 24-25, 36 S. Ct. 236, 244, 60 L. Ed. 493 (1915).

Viewing the case, in this light, we think tht the enactment under review accords reasonable treatment to taxpayers in similar economic situations.

The Congress by enactment of Section 636(b) has equated a retained production payment with a purchase money mortgage on property. This equation requires that taxpayers be treated identically because the economic reality of both undertakings is substantially similar. The legislative history plainly and unequivocally supports the Congressional classification as a reasonable one. It is well established that while state law determines the legal interests a taxpayer has in property, federal law will determine how those legal interests are to be taxed by the United States, Burnet v. Harmel, 287 U.S. 103, 53 S. Ct. 74, 77 L. Ed. 199 (1932).

Taxpayer has failed to demonstrate to us how this transaction is substantially or significantly different from a purchase money mortgage given to secure the unpaid balance of the purchase price of property even though personal liability for the debt is waived by the mortgagee. Taxpayer is permitted to gain a valuable capital asset by using the property to produce income to retire the production payment, retained by Guinn, the assignor of the working interest. This is the same splitting of interests that occurs when one purchases an apartment building and rents the building to pay off the outstanding mortgage retained by the seller to secure the payment of the balance due on the transaction.

Legal title to the property concerned is not the decisive factor in determining whether the government may tax the income accruing to that property. Anderson v. Helvering, supra. Taxation should be based on the economic realities of the particular commercial transaction involved. By piercing the veil created by the 'magic words' which were used in the instant transaction between Guinn and the taxpayer, Congress has accorded taxpayer the same treatment meted out to others similarly situated. We think the Congressional enactment here involved is consistent with the observation made by the Supreme Court when it said:

'Refinements of title are without controlling force when a statute, unmistakable in meaning, is assailed by a taxpayer as overpassing the bounds of reason, an exercise by the lawmakers of arbitrary power. In such circumstances the question is no longer whether the concept of ownership reflected in the statute is to be squared with the concept embodied, more or less vaguely, in common-law traditions. The question is whether it is one that an enlightened legislator might act upon without affront to justice. Even administrative convenience, the practical necessities of an efficient system of taxation, will have heed and recognition within reasonable limits. Liability does not have to rest upon the enjoyment by the taxpayer of all the privileges and benefits enjoyed by the most favored owner at a given time or place. Government in casting about for proper subjects of taxation is not confined by the traditional classification of interest or estates. It may tax, not only ownership, but any right or privilege that is a constituent of ownership. Liability may rest upon the enjoyment by the taxpayer of privileges and benefits so substantial and important as to make it reasonable and just to deal with him as if he were the owner, and to tax him on that basis.' Burnet v. Wells, 289 U.S. 670, 678, 53 S. Ct. 761, 764, 77 L. Ed. 1439 (1932).

Thus we cannot conclude that the classification here attacked is so lacking in reason as to be arbitrary or capricious. The legislative scheme under review is a reasonable measure by Congress to remove the unequal and unjust treatment of taxpayers which occurs merely from the form of the transaction employed.

Accordingly, Section 636(b) is constitutional at least as applied to the transactions revealed by the record in this case. The judgment of the district court is affirmed.