*2 Decision will be entered under Rule 50.
1. Interest. -- Petitioner, a corporation engaged in the business of investing in oil properties, issued income debentures in exchange for its own stock. Held, interest payments on such debentures are deductible under section 23 (b), I. R. C.
2. Depletion. -- Petitioner increased the 1947 cost basis of its royalty interests by the excess of cost depletion deductions over percentage depletion deductions for the years 1933 to 1939 when percentage depletion had been claimed for those years. Held, increase to cost basis in the years before us improper and depletion determined from the increased basis disallowed.
*1071 This case *3 involves deficiencies in income tax for the years 1944, 1945, and 1947 in the following amounts:
| Year | Deficiency |
| 1944 | $ 15,828.73 |
| 1945 | 5,139.91 |
| 1947 | 22,355.48 |
Originally three issues were presented, but one issue was stipulated out by the parties. To facilitate the consideration of the two remaining issues, (1) whether payments made to income debenture holders were payments of interest or dividends, and (2) whether the depletion deductions claimed by petitioner were the amounts permitted or required by the statute, a separate findings of fact and a separate opinion will be presented for each issue.
FINDINGS OF FACT.
Petitioner, a corporation engaged in the business of investing in oil properties, was organized February 24, 1933, under the laws of Texas, with an authorized capital stock of 125,000 shares of no par value common stock, all of equal rank and dignity. It filed its income tax returns for the years in controversy with the collector of internal revenue for the second district of Texas, at Dallas. Petitioner's books were kept and its returns were filed on an accrual basis.
*1072 Issue 1.
On January 1, 1943, petitioner had outstanding 113,836 shares of*4 no par value common stock at a stated value of $ 2 per share. There was likewise set up on petitioner's books on that date paid-in surplus in the amount of $ 542,982.81. On that date petitioner had outstanding sinking fund bonds in the amount of $ 146,800, with a maturity date of less than one year, and additional sinking fund bonds in the amount of $ 1,485,000, with an original maturity date of one year or more. Between January 1, 1943, and April 15, 1943, petitioner sold 5,000 shares of no par value common stock for which it received the aggregate amount of $ 30,000, so that on the latter date petitioner had outstanding 118,836 shares of common stock carried on its books at a stated value of $ 237,672 and a paid-in surplus of $ 562,982.81.
On April 9, 1943, the Executive Committee made a resolution to recommend to the directors and stockholders of the petitioner corporation "the authorization of $ 625,000.00 par value of Income Debentures." Subsequently on April 15, 1943, the directors adopted a resolution which would effectuate the recommendation, and on the following day at a stockholders' meeting the action of the directors was approved. Between April 15, 1943, and July 1, *5 1943, petitioner sold 6,164 shares of its common stock for the aggregate sum of 36,984, part of which was set up as capital stock at a stated value of $ 2 per share, and the other part, $ 24,656, in the paid-in surplus account. As a result of these sales, petitioner, on July 1, 1943, had all of its authorized capital stock outstanding and had set up on its books a capital stock account in the aggregate of $ 250,000, or a stated value of $ 2 per share, and a paid-in surplus account in the amount of $ 587,638.81.
As of July 1, 1943, the stock of petitioner was owned by 820 different individuals, approximately fifty of whom resided outside the State of Texas. Approximately three per cent of these shareholders owned 40 per cent of the outstanding stock. Participation in the authorized debenture exchange was as follows: 76 of the shareholders holding 1,561 shares sold their stock between July 1 and December 31, 1943; 75 of the shareholders owning approximately 11,208 shares exchanged all of their stock for debentures; 67 shareholders owning 7,571 shares exchanged approximately all of their stock for debentures; 300 shareholders owning approximately 97,692 shares exchanged approximately*6 75 per cent of their stock for debentures; and 300 shareholders owning approximately 7,000 shares exchanged none of their stock for debentures.
The important provisions of the issued income debentures are as follows:
*1073 INCOME DEBENTURE
KNOW ALL MEN BY THESE PRESENTS: That SABINE ROYALTY CORPORATION, hereinafter called the Company, for value received, promises to pay to the registered holder hereof on July 1, 1968, the sum of
ONE HUNDRED DOLLARS
with interest on said amount from date issued (see reverse side), until paid, at the rate of eight per cent per annum, payable semi-annually on the first day of January and July of each year hereafter, out of income exceeding expenses (including taxes and other proper charges), bond interest and bond sinking fund deposits. All interest payable hereon shall be cumulative, and will be payable by Company check. Payment of principal and unpaid interest on this income debenture will be payable at the Mercantile National Bank at Dallas, Dallas, Texas, in lawful money of the United States of America.
This income debenture, and all other debentures of this series, are in all respects secondary and subordinate to present or future sinking*7 fund bonds, notes payable or accounts payable of Sabine Royalty Corporation, and all holders hereof accept, and hold the same subject to the superior rights and claims of the said present or future sinking fund bonds, notes and accounts payable. No interest or principal shall be payable on any income debenture until all matured interest and principal payments due on the sinking fund bonds, and other credit obligations, have been paid or provided for.
* * * *
All matured claims of the income debenture holders against earnings or assets shall be and are hereby made superior to those of stockholders, and the Company agrees that as long as any of its income debentures are outstanding, it will not pay any dividends on its stock until all accrued and unpaid interest on its income debentures has been paid or provided for. In the event of dissolution or liquidation of the Company, the holders of all income debentures shall be entitled to be paid in full, both principal and interest, before any assets of the Company are distributed to any stockholder.
In case of any default under this income debenture of any of the provisions herein contained, the Company shall be given ninety days written*8 notice before any legal action may be taken by the owner or holder thereof, or before the income debenture may be placed in the hands of an attorney for collection. After said ninety days' notice, if this income debenture be collected by legal proceedings, the Company agrees to pay to the holder a reasonable attorney's fee, hereby fixed at five per cent of the amount then due hereon. At the option of the holder, failure of the maker to pay any installment of interest due and payable under the terms hereof, within ninety days after written demand therefor has been made in the manner designated in the first sentence of this paragraph, shall mature the principal sum of this debenture, and the same shall forthwith be and become due and payable.
After the exchanges were consummated, petitioner's charter was amended and its capital stock was reduced to 31,250 shares of no par common stock at a stated value of $ 5 per share. The income debentures were credited on the books with $ 625,000, and the offsetting debits were $ 187,500 to capital stock and $ 437,500 to paid-in surplus. At the same time, paid-in surplus was debited with $ 93,750 and the capital *1074 stock was credited *9 with $ 93,750, thereby raising the stated value of the capital stock to $ 5 per share.
In each of the years in question petitioner had sufficient income exceeding expenses, bond interest and bond sinking fund deposits to pay the amount provided for in the income debentures. Petitioner, during the years 1943 to 1947, inclusive, paid interest to the debenture holders in the following amounts:
| 1943 | $ 25,000 |
| 1944 | 50,000 |
| 1945 | 50,000 |
| 1946 | 50,000 |
| 1947 | 50,000 |
These amounts were taken as deductions by petitioner in each of the named years; however, deficiencies were determined for the years 1944, 1945, and 1947.
Issue 2.
Petitioner is engaged in the business of investing in oil properties, primarily oil royalties. In the early part of its business, the investments were restricted to proven oil royalties. Petitioner would only invest in royalties which were estimated to have a sufficient reserve, over the life of the property, to return to it ten times its cost. Later, this was reduced to six times, and, at the lowest, four times petitioner's cost.
In its tax returns filed for the years 1933 to 1939, inclusive, petitioner claimed depletion on the percentage of income method. *10 Audits of petitioner's tax returns for the years 1933 through 1939 by respondent indicated deficiencies or overassessments for several of the years. The adjustments made by the respondent included minor adjustments to the amount of the depletion claimed. However, respondent allowed the percentage of income method for computing depletion for these years.
Upon audit of petitioner's income tax returns for the years 1940 and 1941, wherein it claimed percentage depletion deductions, respondent made adjustments in the amount of depletion claimed, and proposed deficiencies in Federal taxes for the year 1940 in the amount of $ 6,279.02, and for 1941 in the amount of $ 15,002.08. Petitioner filed a protest to these proposed deficiencies and requested an oral conference. During the course of the conference it was suggested that petitioner submit cost depletion schedules to determine whether cost depletion would result in greater deductions for depletion than percentage depletion for the years 1940 and 1941.
Petitioner, sometime during 1944, submitted cost depletion schedules for the first time for the years 1933 through 1941. After an examination of petitioner's books and records, respondent*11 revised the schedules submitted by petitioner. His revision was primarily concerned with *1075 petitioner's estimates of recoverable oil in the ground. Respondent reduced the estimate of the recoverable oil in the ground for leases where petitioner's actual oil production record indicated that petitioner's estimate was excessive. Petitioner's records were complete and continuous for each of the properties from the date of purchase or acquisition. Respondent, in revising the 1933-1941 cost depletion schedules in 1944, used the data that would have been available if the schedules had been actually prepared in each of the earlier years. In his revision for the years 1933-1941 he deducted from the cost basis of petitioner's property the percentage or cost depletion, whichever was greater, for the year in question.
The 1933 to 1941 depletion schedules as revised by respondent were accepted by petitioner. Utilizing the depletion deductions and the resulting cost basis in these revised schedules, petitioner submitted amended returns for the years 1940 and 1941, and received refunds in the amount of $ 22,692.03 for the year 1940 and $ 4,519.78 for the year 1941.
In petitioner's*12 original income tax return for the year 1942 it claimed percentage depletion. However, upon recognition that a cost depletion deduction would exceed percentage depletion, it filed an amended 1942 return and received a refund of $ 760.54. In the amended return petitioner claimed cost depletion, using the cost basis as agreed to in the 1944 revised cost depletion schedules. In petitioner's tax returns for the years 1943 through 1946 it claimed cost depletion. In petitioner's income tax return for 1947 it claimed the amount of $ 264,947.82 as allowable depletion. Petitioner arrived at the amount claimed by first computing the difference between (a) percentage depletion deduction claimed and allowed on its returns for the years 1933 through 1939, and (b) greater cost depletion deduction as computed in the revised depletion schedules for the same years. This difference was then added to the depletable sum remaining from 1946 so as to increase the 1947 cost basis. Petitioner's deduction for cost depletion in 1947 was computed on this increased cost basis.
Respondent determined that a depletion deduction of $ 217,397.69 was allowable. He determined the 1947 cost basis by reducing*13 the 1946 cost basis by the depletion sustained in 1946. He computed cost depletion on the 1947 basis thus determined.
In its petition the petitioner adopted a second method of computing its cost basis for the cost depletion deductions. Therein it added the difference between the cost depletion deduction and percentage depletion deduction for the years 1933 through 1939 to the 1943 cost basis of its properties. It then recomputed the cost depletion deduction for each of the years 1943 through 1947. As a result of these recomputations on the increased cost basis petitioner now claims additional depletion deductions for each of the years 1943 through 1947.
*1076 The cost basis for the year 1943 of each of petitioner's properties is the 1942 cost basis less the depletion sustained in 1942, as reported and allowed on the 1942 amended return. The cost basis for petitioner's properties for the 4 years subsequent to 1943 is the 1943 cost basis less the allowable depletion, as determined by the respondent for the years before us.
OPINION.
Issue 1.
Petitioner claims that payments to income debenture holders were, in fact, interest payments and deductible under section 23 (b), *14 Internal Revenue Code. Respondent has determined that these amounts were paid as dividends, and has therefore disallowed the interest deductions.
A number of criteria must be taken into consideration before determining whether a certain security is in fact a form of capital stock or evidence of indebtedness. John Kelley Co., 1 T. C. 457, 462, affd. 326 U.S. 521">326 U.S. 521; New England Lime Co., 13 T. C. 799. No single factor is necessarily controlling for the Court usually considers each of the following factors alone, and also as a concomitant of the others; the name given to the security, maturity date, source of payment, certainty of payment, status of the security holder as compared to other creditors, interest of the holder in management, intent of the parties, and business purpose.
The securities in question were always called and always recorded as "Income Debentures," requiring the payment of interest. Interest was payable annually at the rate of 8 per cent and was cumulative. Petitioner assumed a definite obligation to pay the matured claims of the debenture holders, and payment was not discretionary*15 even though "secondary and subordinate" to other bonds and accounts. The debentures mature on July 1, 1968, and are unqualifiedly due at that time. Cf. Charles L. Huisking & Co., 4 T. C. 595, 600.
The intent of the parties to remove an element of proprietorship was evidenced by the initial reduction of capital stock after the exchange. Cf. Lansing Community Hotel Corporation, 14 T. C. 183, affd. 187 F. 2d 487. This intent is further substantiated by the fact that the participating shareholders relinquished their voting power, a proprietary interest, in exchange for a promise of petitioner corporation to pay a sum certain on July 1, 1968. Together both of these considerations support the theory of indebtedness. Cf. John Kelley Co., supra;Talbot Mills v. Commissioner, 326 U.S. 521">326 U.S. 521, affd. 3 T. C. 95; I. T. 3095, 1937-2 C. B. 217.
The fact that ultimate payment to the debenture holders was "secondary and subordinate" to other creditors is evidence of a stockholder relationship. *16 However, this is not fatal to the holders' status as *1077 creditors. Elliott-Lewis Co. v. Commissioner, 154 F.2d 292">154 F. 2d 292; John Kelley Co., supra;Clyde Bacon, Inc., 4 T.C. 1107">4 T. C. 1107. In further support of the creditor relationship is the fact that the maturity claim of the debenture holders is absolved from risks and hazards of the business, except those risks incident to ordinary creditors. Interest payable "out of income exceeding expenses" does not in itself support the creditor relationship, but when coupled with the words "cumulative" and "unpaid interest * * * will be payable," the creditor relationship is fortified. Cf. Pierce Estates, Inc., 16 T. C. 1020; Lansing Community Hotel Corporation, supra;New England Lime Co., supra.
In support of the theory of proprietorship, respondent points out "that the debentures were not issued for borrowed money" and did not "represent any new contributions to the capital." We did not recognize this argument as determinative in the Lansing Community Hotel*17 Corporation case, and repeat it here. Respondent also alleges that the change from the stock to debentures was effectuated solely as a tax avoidance scheme. The evidence indicates that the change was made to satisfy the demands of some shareholders for an interest other than stock, and to effect small administrative economies. Here, as in the New England Lime Co. case, "The parties recognized that the shift would help the petitioner taxwise, but that is not sufficient reason for denying the deductions claimed." Cf. Toledo Blade Co., 11 T.C. 1079">11 T. C. 1079.
The amounts paid and claimed by petitioner are held to be interest on the income debentures and are deductible under section 23 (b), I. R. C. Since the respondent raises no question about the amounts claimed as deductions for the years in question, his disallowance of same is reversed.
Issue 2.
The issue before us is: What is the allowable depletion deduction for petitioner's royalty interests for the years before us? The allowable depletion deduction is dependent upon the basis of petitioner's oil properties during the years 1943 to 1947. The basis as determined by petitioner is correct if, *18 as it contends, percentage depletion is the allowable depletion for the years 1933 through 1939. On the other hand, respondent is to be sustained if, as he contends, cost depletion is the allowable depletion for the same years.
As shown in our findings, the petitioner took percentage depletion deductions on its royalty interests for the years 1933 through 1941. In 1941, during conferences with respondent concerning 1940 and 1941 deficiencies, it was suggested that the cost depletion might result in greater deductions for petitioner than percentage depletion. Subsequently, petitioner voluntarily submitted cost depletion schedules for the years 1933 through 1941; the years prior to 1940 were then *1078 barred by the statute of limitations. Respondent revised petitioner's schedules, and on the basis of the revised schedules for the years 1933 through 1941 petitioner received a substantial refund for the years 1940, 1941, and also 1942. Petitioner now claims that the percentage depletion deduction taken in the years 1933 through 1939 should have been used to reduce the cost basis in its properties, and urges us to hold percentage depletion as the allowable depletion for those*19 years. Petitioner's present position is incongruous with its prior position. It was sufficiently satisfied with the depletion deductions in the 1944 cost depletion schedules to utilize these deductions and cost bases in the amended returns for 1940 to 1942, and other returns for 1943 through 1946.
In 1947 petitioner added to the 1947 cost basis the difference between percentage depletion and greater cost depletion for the years 1933 through 1939. Petitioner cites no authority for this increase to the cost basis; nor can we find any authority for such an increase. This addition provided an increased cost basis, and it made possible an increased cost depletion deduction which was not, in fact, the depletion actually sustained in 1947. The revised cost depletion schedules, which were agreed to by petitioner and respondent, were prepared on the principle that cost depletion, being greater than percentage depletion, was the depletion sustained for the years 1933 through 1941. The effect of adding the difference between the percentage depletion deduction and cost depletion deduction would be to allow petitioner to benefit, in 1947, from a depletion which was sustained in the years*20 1933 through 1939. In the light of the well established rule that depletion must be taken in the year sustained, petitioner has erroneously computed its 1947 depletion deduction. Section 23 (n), I. R. C.; United States v. Ludey, 274 U.S. 295">274 U.S. 295. Cf. Virginian Hotel Corporation of Lynchburg v. Helvering, 319 U.S. 523">319 U.S. 523, reversing 132 F.2d 909">132 F. 2d 909.
In its petition, petitioner abandoned the method originally used in reporting the deduction for the 1947 cost depletion. Now petitioner suggests that the difference between the percentage depletion deduction and the greater cost depletion deduction for the years 1933 through 1939 be added to the 1943 cost basis of its royalty interests. In doing this, petitioner, for 1943 and each subsequent year, increases its cost basis and thus concomitantly increases the corresponding deduction for cost depletion. Cf. Regulations 111, section 29.23 (m)-2. By using this increased basis petitioner again erroneously computed the cost depletion deductions; for, as we said above, depletion must be taken in the years sustained. Again, the amount petitioner seeks *21 to add to its cost basis in 1943 represents depletion sustained in the years 1933 through 1939.
*1079 Petitioner's rationale for increasing the basis of its royalty interests is that the deductions for percentage depletion reported for the years 1933 through 1939 represented the allowable depletion. Petitioner now rationalizes that the respondent improperly revised the cost depletion schedules in 1944 because at the time of adjustment some of the adjusted years were barred by the statute of limitations.
Petitioner's contention is not well founded. In 1944 petitioner agreed to its own cost depletion schedules as revised by respondent. Even though these depletion schedules encompassed the years 1933 through 1939, petitioner used the schedules to its own advantage in its amended returns for 1940, 1941, and 1942. It did not then complain that the years 1933 through 1939 were barred by the statute of limitations; we think that its failure to do so, and its acceptance of tax benefits on the basis of the revised depletion schedules, precludes any change of position now. We shall not go behind these schedules; nor shall we now increase the cost basis of petitioner's properties. *22 Therefore, the allowable depletion deductions for petitioner shall be as determined by the respondent for the years 1943 through 1947.
Decision will be entered under Rule 50.