*654 1. Held, that petitioners, taking the statutory depletion allowance under section 114(b)(3) of the Revenue Acts of 1936 and 1938, under the percentage method, were not required to return as income in the taxable year part of depletion deductions taken on bonuses received on certain oil and gas leases under the provisions of article 23:m)-10:c) of Regulations 101, because of diminution of their interests in the leases upon a gift of one-half of their interests to a trust at a time when no production had yet occurred under the leases, petitioners retaining an economic interest in the leases, the leases being in full force, there being no termination thereof within the meaning of the regulation, and the underlying distinction between "cost" depletion and "percentage" depletion being such that no income resulted to petitioners as a result of the gift of part interests in the leases.
2. Held, that petitioners were required to return as income the allocable part of a deduction taken on a bonus on a lease, under the percentage method, because part of the lease was terminated before there was production, Sneed v. Commissioner, 119 Fed.:2d) 767, followed, but there was*655 no such obligation until the lease was terminated under its terms.
*700 Respondent determined a deficiency of $2,083.16 in the income tax liability of each petitioner for the year 1938. The only question is whether or not respondent erred in restoring to income in 1938 one-half of certain depletion allowances on bonuses on certain leases, petitioners having assigned one-half of their interests in the leases at a time when the leases had not yet become productive. The returns were filed with the collector for the second district of Texas. The facts are stipulated.
FINDINGS OF FACT.
Petitioners are husband and wife, residing at Wichita Falls, Texas. They filed separate returns, each reporting one-half of the community gross income.
Petitioners acquired a one-half interest in about 8,000 acres of land, the Lazy 9 Ranch, several years prior to 1938. The other half interest was owned by J. L. Waggoner. During 1937 and 1938, prior to April 1, 1938, petitioners and J. L. Waggoner executed several oil and gas leases*656 covering tracts of the above property. Upon the execution of each lease, cash bonuses were paid.
Under the leases, the lessors, J. L. Waggoner and T. J. Waggoner, reserved to themselves, in addition to royalty, one-eighth of seveneighths of the first oil and gas produced, saved, and sold, free of expenses, until $40,000 should be paid. The royalty to be paid by the lessees was one-eighth of all oil produced. All of the oil and gas leases in question were identical in terms. They ran for three years. On April 1, 1938, all of the leases in question were in effect. None had been terminated under their own terms, none had been abandoned, and none had expired.
As of april 1, 1938, under a trust instrument which was filed in Wichita County, Texas, the petitioners conveyed to a trustee in trust for the benefit of their children one-half of their interest in the Lazy 9 Ranch and one-half of their interest in the oil leases. The conveyance provided that the grant covered royalties arising from the outstanding oil leases as follows:
Some parts of said above described land are at this time subject to the terms of oil, gas and mineral leases now of record and this grant is made*657 subject to the terms and conditions of all such valid leases, but covers and includes one-fourth of the rents, royalties and revenues arising from each and all of such leases subsequent to seven o'clock A.M., April 1, 1938. Likewise this grant is to take effect as of seven o'clock A.M., April 1, 1938.
Petitioners retained the share of the cash bonuses which they had received at the time of the execution of each lease, no part thereof being assigned to the trustee.
On April 1, 1938, out of a total of 22 leases executed in 1937, 6 leases were producing and 16 had not yet been brought into production, and, *701 out of a total of 7 leases executed during the first three months of 1938, none had been brought into production.
Out of the cash bonuses paid in 1937 the petitioners received a total amount of $81,806.75 Petitioners reported the bonuses in gross income for 1937 and deducted, and were allowed, on their 1937 returns, the statutory 27 1/2 percent allowance for depletion on the cash bonuses, as advance royalties, in the total amount of $22,496.86.
The cash bonuses received by petitioners on the leases executed during the first three months of 1938 totaled $68,430. *658 Petitioners, on their 1938 returns, deducted for depletion on the bonuses 27 1/2 percent, or $18,818.53.
In determining the deficiency in income tax liability of the petitioners for 1938, the respondent took the position that their assignment to the trustee of one-half of their interest in the oil leases and royalties constituted a in leases executed in 1937 and 1938 which were not producing on April 1, 1938, within the purview and for the purposes of article 23(m)-10(c) of Regulations 101, although the particular leases were in full effect and had not been terminated. 1 Of the total depletion deduction taken in 1937, $10,873.67 was depletion on cash bonuses on leases which were not productive on April 1, 1938. And of the depletion deduction claimed and taken on the return for 1938, $18,818.53, the entire amount was on bonuses on leases which had not become productive on the above date. Petitioners had assigned one-half of their interest in these leases and under his determination, as set forth above, respondent restored to petitioners' income for 1938 one-half of the amount of the depletion deductions taken in 1937 on account of the bonuses received on the leases from which*659 no oil had been produced up to April 1, 1938, or $5,436.84. Also, respondent restored to income one-half of the depletion deduction taken in the return for 1938 on the cash bonuses which petitioners received on the leases executed during the first three months of 1938, in the amount of $9,409.26. With respect to the year 1938 respondent held that petitioners were entitled to depletion deductions *702 on the bonuses on all of the leases executed in 1938, prior to April 1, in the first instance, but that there should be 1938 one-half of such deductions, because of the assignment of one-half of petitioners' interest in the leases, no prodection having occurred. The total included in petitioners' gross income as a result of these determinations is $14,846.10. 2
*660 OPINION.
HARRON: The question under the main issue is whether or not petitioners' gift of one-half of their interest in royalties and revenues which might arise from oil and gas leases after the date of the gift constituted a partial oil or gas prior to the gift, within the purview of subsection :c) of article 23:m)-10 of Regulations 101, which is set forth in the margin, 3 so as to require petitioners to return as income in the year of the gift the proportionate amount :one-half) of the statutory percentage depletion allowances taken on the cash bonuses which were received upon the execution of the particular leases, notwithstanding the fact that the leases were in full effect under their terms at the date of the gift, and no gift was made of any part of the cash bonuses which, rather, were retained in full by the petitioners.
*661 The particular question has not been raised before this Board before.
*703 The respondent's theory will be better understood if background is sketched briefly. Following the decision in Herring v. Commissioner,239 U.S. 322">239 U.S. 322, respondent's general counsel issued G.C.M. 14448, Cumulative Bulletin XIV-1 :1935), p. 98, under which he ruled that is * * * allowable in every case of a bonus payment received in advance of production 69, which provides substantially as does article 23:m)-10:c), a taxpayer must restore to income the amount of a bonus depletion deduction taken on the percentage of income basis as of the year of the termination of a lease where there has been no production from the leased premises, just exactly as he must do where a bonus depletion deduction has been taken on the cost basis. That ruling has received the approval of this Board and one of the Circuit Courts of Appeal (C.C.A., 5th Cir.). Grace M. Barnett,39 B.T.A. 864">39 B.T.A. 864; J. T. Sneed, Jr.,40 B.T.A. 1136">40 B.T.A. 1136; affd., *662 119 Fed.(2d) 767; rehearing denied, 121 Fed.:2d) 725; certiorari denied, Thompson v. Commissioner,314 U.S. 686">314 U.S. 686; Dolores Crabb,41 B.T.A. 686">41 B.T.A. 686; affd., 119 Fed.:2d 772 :remanded on another point, 121 Fed.:2d) 1015). It appears that a rule is now established that, even where the statutory deduction for depletion on a bonus is taken on the percentage of gross income basis, under section 114:b):3) :Revenue Acts of 1936 and 1938), when the lease is terminated, abandoned, or expired before mineral has been extracted, the taxpayer must the amount of such deduction as of the year of the termination of the lease. If, on the other hand, there has been actual production from the lease, however small, prior to the termination of the lease, there is no duty to deduction previously taken on the percentage of income basis, because there has been actual depletion, though small in amount, percentage depletion having no relationship to cost. Colores Crabb, supra.
In this case the reason that respondent made the restoration to income of one-half of the bonus depletion deductions is because petitioners' legal interests in the leases, *663 in the future royalties on production under the leases, were diminished by one-half by virtue of a gift to a trust in the taxable year. None of the leases had been terminated, abandoned, or expired. But respondent seeks here to extend his regulation, under a new interpretation, to apply to the case where an interest in an oil lease is reduced by a gift. Respondent argues that, since the statutory depletion allowance on a bonus on a lease is a deduction anticipated depletion or exhaustion of the oil and gas reserves, petitioners divested themselves of one-half of their interest in the land and the oil and gas reserves at a time when no production had ever been had under the leases, it became certain that the petitioners never *704 could have any depletion on the one-half of the oil and gas for which they had previously received a depletion deduction, and that, therefore, the leases had with respect to the one-half interests which were given away.
Respondent's theory is not sound when tested by the meaning of the percentage of income method of computing depletion.
Petitioners continued to have an economic interest in oil under the leases in question after the gifts, *664 and, of course, stood in a position where their interests, or the bonuses on the leases in question, still were subject to depletion and exhaustion, the leases being in full force and effect. The deductions for depletion on the bonuses were taken under the arbitrary percentage method. Percentage depletion is not based on cost, or on the value or size of the interest, but is based on gross income from property. It is an arbitrary allowance fixed at 27 1/2 percent of gross income from property during the taxable year. Louisiana Iron & Supply Co.,44 B.T.A. 1244">44 B.T.A. 1244. on a different basis from "percentage" depletion. Under the first method of computing the depletion allowance, depletion deductions are limited by the cost or value of the depletable property, and when the cost of the property has been recovered through depletion allowances, no further deductions for depletion are allowable. Under the "percentage" method, "It is possible, and not unusual, for a taxpayer to recover tax free, through percentage depletion, an amount greater than the cost of the property. See also, article 23:m)-1 of Regulations 94, pp. 71, 72. From the above, petitioners having elected the*665 the statutory depletion allowances, it is immaterial, for purposes of article 23:m)-10:c), that the interest of petitioners in the leases was diminished under a gift in the taxable year at a time when no production under the leases had yet occurred. Respondent, obviously, confuses the situation here with depletion under the Under by the cost to the taxpayer of his property, or interest, a diminution in the size of the property or interest retained by a taxpayer would seem to be material, although we do not decide that point here. :Respondent falls into the same error in citing John D. Lamont v. Commissioner, 120 Fed.:2d) 996, where depletion was computed on the basis of the value of the ore reserve on March 1, 1913.)
It is not necessary to set forth the text of G.C.M. 14448, to which reference is made. It is stated there that in the year of the execution of the lease rests upon an anticipation of production, has been no production, then there has in fact been no depletion." It can not be said here taht it became certain on April 1, 1938, the date of the gift, that there would be no production under the leases in question, Cf., opinion denying rehearing in*666 Sneed v. Commissioner,*705 121 Fed.:2d) 725. As a matter of fact, there was production on several of the leases in question after that date. As long as petitioners had an economic interest in the leases and there still remained the leasehold right to carry on production, petitioners had a depletable interest. The bonuses received on the leases were still subject to depletion. As the court stated in the opinion denying a rehearing in the Sneed case, bonuses and whether they represent any depletion. as opposed to the situation in the Sneed case, the question also turns upon a possible productivity under the leases in which petitioners retained economic interests.
Also, as is pointed our in G.C.M. 14448, supra:
* * * For the computation of depletion on the percentage of income basis, the base is the gross income from the property. Since * * * a bonus received in advance of production is of oil and gas wills, * * * and as such is a part of the base for the computation allowed in anticipation of production, such a bonus is subject to depletion without the establishment of any other base.
It follows that when statutory depletion*667 is taken on the percentage of income basis, and when the bonus on a lease, the base, is retained by the lessor, the donor of a part interest in the lease, and when there is no occurrence at the time of the gift of an interest in the lease which determines that there will be no production under the lease, then the position of the donor of part of an interest in the lease is no different after he makes a gift of a part interest from what it was before, for purposes of depletion on the bonus and for the purposes of article 23(m)-10(c). "Percentage" depletion is an arbitrary method. In each taxable year during the term of the lease, the base which is being depleted is a new and different thing, namely, the gross income from the property received in that year. Such income is apportioned under section 114:b):3), by application of the flat percentage, to income and to capital returned through depletion. The depletion allowance of 27 1/2 percent of the income is taken in the year of receipt of income. A capital sum, as is the case in depletion, is not being recovered over a period of years through depletion. In each year the gross income that is realized from the property in that year*668 is the base for the allowance of depletion. Gross income from the property in each year is a different thing. There is a new base in each year that gross income is realized from the property, and there is a base upon which depletion is allowable for as long as there is income from the lease. That, of course, is not so when the "cost" method of depletion is followed. And that is the reason why different rules must be applied with respect to of income with respect to a depletion allowance on a bonus on a lease when *706 received the bonus retains an economic interest in the lease, the question which respondent has raised here does not arise, as a matter of law. It is only when the lease terminates, in fact, without production, ending the existence of the economic interest, that the question presented here can arise.
Respondent's theory here results from failure to distinguish the different underlying elements in the two methods of computing the statutory depletion allowances. If no distinction is to be made between "cost" depletion and "percentage" depletion on lease bonuses in the situation presented by the gift of an interest in an existing lease, as respondent seems*669 to think, then respondent's treatment here is inconsistent in his failing to apply article 23:m)-10:c) to the bonuses on the leases which had become productive prior to the time of the gift of a part of petitioners' interests therein. Under respondent's theory, how can it be said that the bonuses on the leases under production were not affected, for purposes of depletion and of income for tax, by the diminution of petitioners' interest in those leases because of the gift, in just the same way as in the case of the bonuses on the leases which were not under production? In our opinion the lease bonuses as a whole, on both classes of leases, were not brought within the requirements of article 23:m)-10:c), and the reason for so holding is the same for the bonuses on both classes of leases.
Upon the foregoing discussion it is held with respect to each of respondent's contentions that:
:1) Petitioners were not required in 1938, to return as income onehalf of the percentage depletion deductions on the bonuses received on the leases in question in 1937 and 1938, for reasons already stated.
:2) Petitioners, electing the entitled to take depletion deductions on the bonuses paid to*670 them in 1938 on the particular class of leases involed, even though during 1938 gifts of one-half of their interests therein were made, because the bonuses were income to petitioners, no one else, and the bonuses were the base in their hands on which to compute depletion, and the depletion allowance could be deducted only by petitioners. Herring v. Commissioner, supra. The rule that tax is assessed on the basis of annual returns showing the net result of all the taxpayer's transactions during a fixed accounting period, Burnet v. Sanford & Brooks Co.,282 U.S. 359">282 U.S. 359, has no applicability under the facts of this case.
:3) Under authority of the Sneed case, there is properly restored to the income of petitioners in 1938 the amount of $137.50 which was deducted in 1937 as percentage depletion on the bonus allocable to the part of the Jones lease which was terminated before production in 1938 under the terms of the lease. Respondent amount to petitioners' income in *707 theory under the main issue, which method was wrong although the result was right. This separate issue in the case demonstrates that no inequity results to respondent*671 under the holding made here under the main issue. No escapes tax under application of article 23:m)-10:c), strictly according to its terms, to depletion deductions taken on the method of depletion by waiting for the occurrence of actual termination of the lease. There is no sound reason for depriving a taxpayer of the full benefit of the "percentage" depletion allowance on a bonus for the reason that his legal interest in the lease is diminished by a gift made at a time when no production has yet taken place, but is still fully possible under the terms of the lease. There may be other considerations having a different effect where a lessor sells an interest in a lease before production has taken place, but that question is not raised here.
Respondent's determination under the main issue is reversed. The provisions of article 23(m)-10(c) are not applicable to the situation presented in the main issue.
Reviewed by the Board.
Decision will be entered under Rule 50.
Footnotes
1. The explanation given in the statement attached to the notice of deficiency is as follows:
of your community interest in all lands making up the Waggoner Brothers Lazy Nine Ranch. Such lands had been leased and statutory depletion of 27 1/2% of the lease bonuses received prior to April 1, 1938, has been allowed as a deduction from gross income for the years in which the lease bonuses were received, resulting in withholding from taxation in the year of receipt of the bonus a portion of such bonus income equal to the depletion allowed thereon. Through the gifts in trust you divested yourself of one-half of your interest in and title to such lands and of your economic interest in the property under which economic interest the allowance of statutory depletion on the lease bonuses received was authorized.
divestiture of title and interest, you sustained no depletion and it is held that you realized income in the year of such divestiture equal to the portion of the bonus income deferred through the allowance of statutory depletion. ↩
2. The parties have stipulated that $14,846.10 is the correct amount instead of $15,327.71 actually
Among the leases executed in 1937 one was executed to E. F. Jones. In December of 1938 40 acres of the Jones lease were terminated under the terms of the lease for nonpayment of rental, without any production having been obtained therefrom. The part of the cash bonus on this lease which was received in 1937 by petitioners and which is allocable to the 40 acres was $500. In their returns for 1937 petitioners took, and were allowed, depletion deduction of 27 1/2 percent thereof, or $137.50. The entire amount of $137.50 constitutes income to petitioners in 1938, as a restoration to income of a depletion deduction previously allowed on an oil lease which terminated before the extraction of oil which was paid for in advance under the provisions of article 23(m)-10(c) of Regulations 101. Respondent properly included the above amount in petitioners' gross income for 1938.↩
3. (c) If for any reason any such mineral lease expires or terminates or is abandoned before the mineral which has been paid for in advance has been extracted and removed, the lessor shall adjust his capital account by restoring thereto the depletion deductions made in prior years on account of royalties on mineral paid for but not removed, and a corresponding amount must be returned as income for the year in which the lease expires, terminates, or is abandoned. ↩