                                                                                                353




Hon. John Ben Shepperd
secretary    of state
Austin,   Texas

Attention:      Hon. Louis Scott    Wilkerson
                Assistnnt Secretary

                                                 Opi.nion    No.   V-1037.

                                                 Re:    The inclusion       of intangible
                                                        drilling   costs    in an oil corn-
                                                        pany’s   assets     to determine
                                                        its surplus     fol, the purpose
Deal-   Mr.   Shepperd:                                 of franchise      taxation.

                 You    request     the   opinion      of this   office   upon    the follow-
Ing question:

                 “Must the full amount           ot intangtble        drilling    costs
        be included        in a colporation’s        assets     for purpose        of de-
        termining       its surpla       (which    is paat of the measure              of
        i~ts franchise       tar under Article         7084,    VACS)?        As used
        in this question,        ‘intangible     drilling     costs’ are, as de-
        fined in U. 5. Treasuy              Regulations       103, Sec. 29.23         (III)-
         16, “All expenditures          for wages,       fuel, repairs,        hauling,
        supplies,      etc. incident      to and necessary          for the drilling
        of wells and the preparation              of wells for the production
        of oil or gas, . . . ’ ”

                The two statutory        provisions     with which we are here
pl,imarily    concerned      ar’e Articles     7084 and 7089, V.C.S.,,       the first
dealing    with the basis      upon which the franchise        tax is required       to
be paid and the second          the report    required    to be submitted      by the
corpoxatlon     flom    which the amount         of the tax is cal.culated,.     These
two statutes     provide    in part as follows:

                Article    7084.    “( 1) Except       as herein     provided,      ev-
        ery domestic       and foreign      cwpora,tion        heretofore      or here-
        after   char tcred    or authorized         to do business        in Texas,
        oz doing business        1x1 Texas,     shall,    on or be:fwe       May first
        of each year,      pay in advance        to the Sec.~etary         of State n
        franchise     tax for the year following,            based    upon that pro-
        portion    of the outstanding        capit.al   stock,    surplus     and un-
Hon.    John   13en Shepperd,          ,FQ,.~;<:L (V-10~7)




        divided    profits,   plus the amount     of outstanding      bonds,
        fiotrs and debentures          .    as Ihe. grosi    r~xeipts    from
        its business      done in Texas     bears   to the total gross      re-
        ceipts   of the iox [‘oration    from its enf,i~,e business,       which
        tax shall be computed         on the basis    of . . I ”

                 Article      7089.       “Except      as herein          provided        all cor-
        poxations       required        to pay an annual             franchise        tax shall,
        between       Jan~uaxy first         and March          fifteenth       of each year,
        make a sworn report                in duplicate          to the Secr,etary             of
        State,    on forms        fwnished         by that officer,            showing        the
        condition       of such cox,poration             on the last day of the pre-
        ceding     fiscal    year.       The Secretary             of State may for good
        cause     shown by any corporation                    extend       such time to any
        date up to May first.               Said report          shall give the cash
        value of all gross            assets      of the corporation,               the amount
        of its authorized           capital     stock,      the capital         stock actual-
        ly subscribed         and the amount             paid in, the surplu                 and
        undivided       profits      or deficit,      if any, the amount                of mort-
        gage. bonded and current                  indebtedness,             the amount          and
        date of payment            of the last annual,              semi-annual,           quar-
        terly.    or monthly         dividend,       the assessed             value,     for State
        ad valorem         purposes        of all, property            of the corporation,
        real,    personal,        or mixed,        owned by the corporation                      in
        this State and the county                in which assessed                for such pur-
        poses,     the amount          of all taxes        paid, or due and payable
        to the State of Texas,              or to any county,              city or town,
        school     district,      road district,          or other        taxing      subdivi-
        sion of Texas,          for the preceding              tax year,        the total gross
        receipts       of such corporation              from al.1 sources              and tb.e
         gross    receipts       from its business              done in Texas             for the
        fiscal    year preceding,             with a detailed            balance       sheet and
        income       and profit and loss statement                      in such form as
        the Secretary          of State may prescribe.                       . .”

                Thus it is app~~rcnt from an examination                       of the forego-
ing Article     7084 that COUI Items           constlt,ute     the basis      upon which the
tax IS computed.,        They are:       (I) outstanding         capit.al    st.ock;    (2) sur-
plus;    (3) undi,vided     profits;    and (4) outst.anding          bonds,     notes,    and
debentures,      other    than those mal~uring           in less    than a year from date
of issuance.       The total of these factors             is modified,        however,      by the
proportion     the gloss      receipts      from business         done    in Texas       bears
to the gross     receipts      of the corporation          from its entire         business
done III Texas      and outside       of Texas.        The resulting        total, after      the
application     of this proportion,          constitutes      the basis      upon which the
tax owing by the corporation              is determined.

                   The question  resolves   Itself              into whether          or not “‘intan-
gible   driillng     costs”  may be considered                  as outstanding          capital stock,
                                                                                                 355
Hon.    John   Ben   Shepperd,       Page    3 (V-1037)




surplus,   and undivided          profits, or outstanding           bonds, notes, and
debentures    other than         those maturing    in less         than a year from the
date of issuance.

                  We think it quite true that the Lxgislature                    had in per-
spective     the entire    capital     structure       of the corporation         in fixing a
basis    for the calculation        of the franchise          tax, but broke       it down in-
to four component         parts,     as we have heretofore               pointed   out, the
first  of which is the outstanding             capital     stock.      Certainly     by no proc-
ess of reasoning        could intangible         drilling      costs    be considered       as an
element     of or addition       to this item,       or either       of the three     remain-
ing items,      that is, surplus,        undivided      profits,     or outstanding       bonds,
notes,    and debentures,         unless    it fall under the classification              of “sur-
plus:. *’

                 Outstanding        capital     stock,    as used in this statute,          is
capital    stock   which has been issued,               and this regardless        of wheth-
er it is in the hands of the stockholders                    or the corporation.         A.B.
Frank     Co. v. Latham,          145 Tex. 30, 193 S.W.Zd             671 (1946).      S-s
and undivided       profits    are variable          and hence of greater         01~ less val-
ue, dependent       upon the success            or failure     of the operation      of the
business.       These    variable       items     are added to the outstanding             cap-
ital stock as disclosed            by the report        required     to be submitted         to the
Secretary      of State under the provisions                of Ar,ticle   7089, and thus,
together     with the outstanding            bonds,     notes and debentwes,          is re-
flected    the entire     capital     structure       of the corporation       upon which
the tax is computed.

                 Is “intangible  drilling  cost ” “surplus”   as that term   is
used    in this statute?      We think not, unless   the taxpayer   elects to
treat    it as such.

               In the case   of United North and South Development              Co.
v. Heath.   78 S.W.2d    650 (Tex.   Clv. AUD.
                                             _.   1935~. error    dlsm.1,   the court
round it necessary     to consider    fully the meaning      of the term     “sux -
plus” as used in Article       7084.   It is not necessary      to consider    all
of the various    meanings     of the term discussed       in this opinion,    as they
are all somewhat      analogous.     The court    said:

                   “The Legislature           did not undertake         t.o define   what
         is meant      by the term         ‘surplus’.      In a generally       accepted
         commercial         sense,     it usually     applies    to funds remain-
         ing on hand after         fixed charges         or liabilities      have been
         deducted.       As applied         to corporations,       it has been held
         to be the value of all the ccwporation’s                   assets    after   its
         liabilities,     including      its capital     stock,   have heen deduct-
         ed.”
Hon.   John    Ben   Shepperd,      Page    4 (V-iO37)




                 You state      that this definitioc       has been consistently       fol-
lowed and is now being followed                 by the Secretary      of State in connec-
tion with the administration              of the franchise      tax law,    Long accept-
ance of this definition          by the Secretary        of State,  in the absence      of
a statutory      definition,     should not now be changed           without   some com-
pelling    reason.       Moreover,       the Legislatur’e     has met many times         since
the court z,endered          the opinion      in the case    of United North and South
Development        Co. v. Heath,        supra,    and It may6e      presumed     that&
deflnltlon     of the term-       surplus”      given in that case did not meet the
approval      of the L.egislature.         it would have been changed,

                 Your opinmn request            states  that the term    “intangible
drilling   costs”   is used as defined          in United States    Treasury     Regu-
lations   103, Section    29.23 (m)-16.           This term as there defined         is
as follows:

                 “All expendi,tures      for wages,  fuel, repairs,              haul-
        ing, supplies,     etc.,  incident   to and necessary     for           the
        drilling   of wells and the preparation        of wells for             the
        production     of oil or gas. _) . .*

                  In the case    of Commissioner      of Inl:ernal   Revenue     v. Am-
brose,      127 F.2d 47, the Circuit      Court  of Appeals      of this circuit    in
n’iiiticome     tax case    in which intangible   drilling    costs   had been de-
ducted as operating          expense  by the taxpayer      approved     this deduction
in the following       language:


                “Article    23(m)-16        of Treasury   Regulations      86
        relates    to intangible     dr,illing   and development      costs,
        and gives the taxpayer           an optlon either    to deduct    such
        costs   from gross       income      as an expense,    or to charge
        them to his capital        account.      . . .

                 “The lease      operator   who undertakes     his own drill-
        ing is granted     t.he option because     the intangible    costs
        are not capital      in nature,   as they have no salvage       value;
        they can be allocated;         and the expenditures     to defray    the
        intangible   costs     are made by the t.axpayer.”

                  The Federal        statute     and regulations        thereunder        give the
taxpayer      the option to deduct          “lntangibl,e     drilling    costs”    as an op-
erating    expense      or to charge        such costs      to capital     account,      thus rec-
ognizing     that it is acceptable          accounting      practice      to treat     such costs
as operating       expense     or as invested         capital.      Of cwxse,       if a taxpay-
er should elect        to capitalize       “intangible     dl,illing    costs ” in the form
of a reserve       for that pur’pose         and allocate      it from other, available
funds,    amortizing      it over a peI.iod of years              not to exceed       the life of
profltable      development,       there      is nothing    in the law that would pre-
clude this.       The Secretary         of State should accept           It as was done in
‘.   ,




         Hon.   John    Ben    Shepperd,      page    5 (V-1037)



         the case    of United Nort,h dnd South Development      Co. Y. -.---
                                                                        Heath,, supra,
         where    rhe taxpayer  by tts own sworn statement     toCheSecxetary      of
         State fixed the value on what was called      “app~ ec iatrd sur~plus ,”

                          If a taxpayer       has been txtating         Intangible     drilling      costs
         as current      operating      expenses    and making         his repat       to the Secre-
         tar.y of State as required           by Articl~e    7089 upon ihis basis            and has
         paid the taxes       owing upon the basis          of said report,        this, in our opin-
         ion, is in compliance           with the statute.       The Secretary          of State would
         tlerefore      be without     authority    to require       the taxpayer        to revise      and
         pay additional       taxes    based upon the theory           that intangible        drilling
         costs     should have been capitalized            and treated       as taxable       capital.
         If, however,      the t~axpayer has heretofore             submitted       his franchise         tax
         report     by treating     intangible    drilling    costs     as a capital       investment
         to be amortized         over an appropriate          period     of times this likewise
         is acceptable.

                        It is our understanding     that the Secretary      of State has
         so construed     this statute   over a long period    of years   during    which
         time the Legislature       has met several     times,  and we must assume
         that this construction      has been with legislative     approval    or some
         action  would have been taken to chaage          it. As was said by the Su-
         preme    Court   in the case   of Isbell v. Gulf Union Oil Co., 147 Tex. 6,
         209 S.W.2d     762 (1948):

                         “If the Legislature     did not approve    the constrac-
                  tion which had been given the statute,       it could have eas-
                  ily amended    the law.    This was not done.”

                                                       SUMMARY

                            Intangible      drilling    costs    may be treated       as cur-
                  rent annual         operating      expense     under the franchise       tax
                  statute,      or set up as a reserve             by allocation    from other
                  available       capital    resources       and amortized       over an ap-
                  propriate        period    of yeal’s.     Arts..   7084 and 7089, V,C..S.;
                  A.B.     Frank     Co. v. Latham,          145 Tex. 30, 193 S.W.Zd          671
                  (1946)      United North and South Development                   Co. v, Heath,
                  78 &.2       -935,                                      error  di.sm.):  Com-
                  missioner         of Internal      Revenue      v. Ambrose,      127 F.m;
                  Xsbetl v. Gulf Umon 011 C o.,                 4 I Tex. 6, 209 S.W .Ld 762
                  (1948).

                                                                         YOUX~S ve:::*,y t2 uly,
         APPROVED:
                                                                          PRICE       DANIEL
         W 1 V. Geppert                                                  Attorney      Gene:ral
         Taxation  Division

         Charles       D. h4athews
         Executive       Assistant                                                  Assistant

         LPL/mwb
