Comptroller of the Treasury v. Shell Oil Co.

WILNER, Judge. This appeal arises from a disagreement between the Comptroller of the Treasury and Shell Oil Company over the amount of Maryland corporate income taxes owed by Shell for the years 1976, 1977, and 1978. At issue is whether royalties paid by Shell under certain leases for oil and gas producing properties constituted “gross rent,” as defined in one of the Comptroller’s regulations — COMAR 03.04.01.03E(4)(a). In its tax returns for the years in question, Shell treated the royalty payments as gross rent; the Comptroller disputed that treatment, recalculated Shell’s taxes on the premise that the royalties were not in the nature of gross rent, and levied an assessment for the additional taxes he ²⁵⁴ claimed were due.

Shell appealed to the Maryland Tax Court which, without making any specific findings of its own as to the nature of these royalties, sustained the assessments on the basis that the Comptroller had a statutory discretion to disallow the royalties as gross rent. The Circuit Court for Baltimore City, upon Shell’s further appeal, held that the royalties did constitute gross rent as defined in the regulation and thus reversed the Tax Court. The Comptroller is now aggrieved and brings this appeal to us. Shell, a Delaware corporation, is an integrated oil company.

Its principal business is the exploration for and development, production, purchase, transportation, and marketing of crude oil and natural gas, as well as the purchase, manufacture, and marketing of oil and chemical products. Most of that activity takes place outside of Maryland. Within this State, Shell’s principal business consists of marketing oil and chemical products. The parties agree that the portion of Shell’s total business income that may be allocated to Maryland for purposes of the State corporate income tax is to be determined by the three-factor formula provided for in Md.Code Ann. art. 81, § 316(c), as that statute read during the years in question. 1 In summary, the percentage of Shell’s total business income allocable to Maryland is determined by averaging three fractions: (1) Shell’s property in Maryland/Shell’s total property; (2) Shell’s payroll in Maryland/Shell’s total payroll; and (3) Shell’s sales in Maryland/Shell’s total sales.

See Xerox Corp. v. Comptroller, 290 Md. 126, 130 , 428 A.2d 1208 (1981). We are concerned here with the first of these factors, in particular, the valuation of property acquired by Shell for the purpose of exploring for and extracting oil and gas. ²⁵⁵ Potential oil and gas producing properties are normally acquired either by outright purchase or by lease. 2 We are interested in the properties acquired by lease. Three representative samples of Shell’s leasing agreements are in evidence. Together with other evidence, they show that the leasing arrangements entered into by Shell generally provide for three types of consideration to be paid by Shell to its lessors: a lease bonus, a “delay” rental, and a royalty.

The lease bonus, which is not mentioned in the lease itself, is a lump sum payment made to the lessor upon execution of the lease or at some agreed upon time thereafter. The amount of the bonus varies according to the parties’ assessment of the land’s potential for oil or gas production, but, according to the evidence, it is determined in tandem with the amount of royalty to be paid. “Delay” rent is a payment made to extend a lease of non-producing land, to avert a premature termination of the lease. Shell’s typical oil and gas lease requires it to commence drilling within a prescribed period — usually within one year after execution of the lease — and provides that, if drilling has not begun within that period, the lease will terminate unless Shell pays the “delay” rent to the lessor. These payments, then, are not obligatory unless Shell desires to delay drilling operations beyond the time called for in the lease.

The third mode of consideration — royalties—involves payments made at designated intervals based on the amount of oil or gas extracted from the land. As noted, the amount of royalty is usually negotiated in conjunction with the amount of lease bonus, but it generally hovers between Vs and Ve of production. Most oil royalties are payable either in cash or ²⁵⁶ in kind (i.e., a portion of the oil extracted), at the lessee’s option; 3 gas royalties are normally paid in cash. How should Shell’s interest in these leased properties be valued for purposes of § 316(c)? 4 Shell looks to COMAR 03.04.01.03E(4) — the Comptroller’s own regulation, promulgated pursuant to the general authority conferred by Md. Code Ann. art. 81, § 304(a).

That regulation provides, essentially, for “leased or rented property” to be valued by capitalizing the annual rent by a factor of eight. It states, in relevant part: “(a) In determining the capitalized value of rented or leased property includible in the property factor and as described above, the term ‘leased or rented property’ shall include property held by the taxpayer where the legal relation between the parties is that of ‘Landlord and Tenant’, whether that property be held under a gross lease, net lease, percentage lease, or a lease of similar purport. The term ‘Gross Rent’ shall include payments made by a tenant for the privilege of occupying or using the property, including such items as fixed rent, percentage rent, real estate taxes, insurance and maintenance expense borne by the tenant. The term does not include utilities such as gas, electricity, oil, water or items normally consumed by the tenant.

(b) The term ‘Capitalized Value’, for the purpose of these regulations, shall mean a value determined by multiplying the ‘Gross Rent’, as defined in these regulations by eight____” Shell contends that the properties in question are “leased” and that the royalty payments are a form of “percentage rent.” In its returns for the three years at issue, it valued the leased properties by adding to the lease ²⁵⁷ bonus payments either eight times the “delay” rental payments made during the respective tax years, in the case of non-producing properties, or eight times the royalty payments made during those respective years, in the case of producing properties. The Comptroller apparently accepted the inclusion of the lease bonus payments with respect to producing property but (1) disallowed such payments as to non-producing property as well as all “delay” rent, on the ground that non-producing property should not be included in calculating the property factor, and (2) disallowed the capitalization of the royalty payments. Because all of the property in question was located outside of Maryland, the effect of these disallowances was to reduce only the denominator of the co-equal property fraction. That served to increase the amount of Shell’s aggregate business income allocable to Maryland and thus to increase, by a total of $129,312, Shell’s corporate income tax for the three years.

The theory espoused by the Comptroller in rejecting a capitalization of royalty payments was, and is, that such payments do not constitute rent. His argument is somewhat confusing. At times, he seems to regard the transaction between Shell and its lessors as not being the conveyance of a leasehold interest in the land, but rather a sale of the minerals being extracted. Under this approach, the property to be valued is not the interest in the land, but the minerals themselves.

As stated in his brief before us, “[T]he Comptroller analogized the royalty payment to an amount paid for the purchase of oil and gas, and allowed the inclusion of the royalty in Shell’s property factor at its cost, in much the same fashion that any other purchased property, including inventory, such as oil and gas purchased on the open market, cranes, drills and office equipment, would be includable at cost.” At oral argument, he seemed to acknowledge that the property to be valued was the leasehold interest in the land, but contended that the measure of its value was the worth of the minerals extracted. ²⁵⁸ The Tax Court, though agreeing that abandoned property should not be included in calculating the property factor, rejected the broader contention of the Comptroller that all non-producing property should be excluded. The Comptroller, we were advised, has acquiesced in that decision, and so that aspect of the case is not now before us. On the main issue — the capitalization of royalty payments — the Tax Court sided with the Comptroller. It did so, however, not because it necessarily agreed with the Comptroller’s rationale, but rather because it believed that the Comptroller had a statutory right to value the property as he did.

The Tax Court relied for that view on the provision in § 316(c) that “[t]he Comptroller of the Treasury shall have the right, in those cases where circumstances warrant, to alter any of the above rules as to ... the manner of valuation of rented property included in the property factor____” It noted that “[t]here is no Maryland statute or Regulation that specifically provides for the capitalization of royalties paid pursuant to a gas or oil lease” and concluded that “absent statutory authority or legal precedent stating that rents and royalties require similar treatment by the Comptroller when valuing leased property, this is a matter squarely within the Comptroller’s discretion as authorized by Section 316(c).” On appeal, as we have noted, the Circuit Court for Baltimore City reversed, concluding “as a matter of law” that the Tax Court erred “in determining the proper basis for determining the value of leased property of the Shell Oil Company.” The Circuit Court analogized the transaction to a “percentage lease agreement” and thus held the royalties to be within the purview of COMAR 03.04.01.03E(4). The Comptroller is now the aggrieved party. He argues that the Circuit Court erred (1) by exceeding the proper bounds of judicial review of a Tax Court decision, and (2) on the merits by misconstruing the nature of a royalty. We find no error in the Circuit Court’s judgment and shall therefore affirm. ²⁵⁹ (1) Scope of Review Md.Code Ann. art. 81, § 229(o) provides that a Tax Court order shall be affirmed by a reviewing court “if it is not erroneous as a matter of law and if it is supported by substantial evidence appearing in the record.” Under this standard, the court must first consider the legal rule, test, or standard applied by the Tax Court to ensure that the Tax Court order was not “premised solely upon an erroneous conclusion of law.” Ramsay, Scarlett & Co. v. Comptroller, 302 Md. 825, 834 , 490 A.2d 1296 (1985).

See also Supervisor of Assessments v. Carroll, 298 Md. 311 , 469 A.2d 858 (1984). In this analysis, the reviewing court uses the “substitution of judgment” standard, Supervisor v. St. Leonard Shores Joint Ven., 61 Md.App. 204, 212 , 486 A.2d 206 (1985), and thus, “is under no statutory constraints in reversing a Tax Court order which is premised solely upon an erroneous conclusion of law.” Ramsay, Scarlett & Co., supra, 302 Md. at 834 , 490 A.2d 1296 . If satisfied that there has been no error of law, the court then looks to the Tax Court’s findings of fact. As to that, the scope of review is very narrow.

As stated in Ramsay, Scarlett & Co., supra, 302 Md. at 834-35 , 490 A.2d 1296 , paraphrasing language in Comptroller v. Haskin, 298 Md. 681, 693-94 , 472 A.2d 70 (1984): “[A] reviewing court may not substitute its judgment for the expertise of the agency; ... [it] must review the agency’s decision in the light most favorable to it; ... the agency’s decision is prima facie correct and presumed valid; and ... it is the agency’s province to resolve conflicting evidence and where inconsistent inferences can be drawn from the same evidence it is for the agency to draw the inferences.” When the case reached the Circuit Court, there was no real dispute between the parties as to the underlying facts. Indeed, as we have noted, the Tax Court made no findings of fact, but simply deferred to what it believed was the Comptroller’s statutory discretion. The only issues in dis ²⁶⁰ pute were legal ones: were these transactions