*1005 1. During the taxable year 1932 petitioner entered into contracts with three individuals whereby they furnished certain sums of money to petitioner for the purchase and development of oil and gas mining leases, on condition that petitioner "pay and account" to them for specified proportions of the mineral production "if, as and when produced, saved and sold." Held, the rights of the respective parties each constituted an economic interest in the oil production, and petitioner's gross income for the taxable year includes only the portion of the proceeds from oil sales for which it was not required to account to the other parties; held, further, the deduction for percentage depletion allowable to petitioner should be computed on the basis of its gross and net income from the properties, the net income limitation to be determined without deduction of the cost of drilling a dry hole.
2. In the taxable year petitioner operated two oil and gas mining leases, under the terms of which the original lessors had retained certain interests in the oil production. Held, petitioner's gross income does not embrace the amounts so paid to the original lessors out of the proceeds from*1006 oil sales.
*657 This proceeding is for the redetermination of a deficiency in income tax for the year 1932 in the amount of $18,383.40. The issues raised by the pleadings are (1) whether respondent erred in determining that petitioner realized a profit from the drilling of an oil well known as the Hale No. 3 well; (2) whether respondent correctly determined that certain funds received by petitioner were derived from the sale of "oil payments" and whether respondent correctly included such funds in petitioner's gross income, or whether the transactions were in reality loans; (3) whether respondent erred in disallowing deductions for interest and similar charges paid in connection with the alleged loans; (4) whether respondent erred in including in petitioner's gross income certain sums received by Farrell and Moncrief and by the trustees of the Kilgore Independent School District from oil produced from properties operated by petitioner; and (5) whether respondent erred in computing the depletion allowable to petitioner by treating as an expense of operating*1007 a certain property the cost of a dry hole drilled thereon.
FINDINGS OF FACT.
Petitioner is a Texas corporation, with its principal office at Wichita Falls, and throughout the taxable year was engaged primarily in the business of producing oil and in drilling oil wells for itself and associated interests.
Issue (1). - During the taxable year petitioner owned a one-half interest in what was known as the Hale lease. The other one-half interest was owned by three individuals. Petitioner drilled a well on this lease, known as the Hale No. 3 well, under a turnkey agreement with the other joint owners of the lease whereby they paid petitioner in the taxable year the sum of $5,750 for their one-half share of the development in drilling and equipping the well. One-half of the cost of drilling and equipping this well was $4,122.23.
Respondent included in petitioner's gross income, as profit derived from the transaction, the amount of $1,627.77, being the difference between $4,122.23, representing one-half of the cost, and $5,750, the amount paid to petitioner by the other joint owners. Petitioner on its books and in its income tax return treated the entire cost as "paid or*1008 accrued" by it, and reduced such amount by the cash received from the associated interests, capitalizing the balance as leasehold investment. Issue (2) and (3). - In 1932 petitioner had an opportunity to acquire certain oil properties in the East Texas Field, then owned by the Gulf Coast Oil Co. A payment of $125,000 was required. Petitioner did not have the money with which to make this purchase. It first secured an option to purchase the properties and then acquired *658 the money therefor and for drilling two wells on other oil and gas leases owned by it and for the payment of certain existing obligations, through the arrangement with R. A. Westbrook and S. A. Thompson hereinafter set forth.
On February 22, 1932, but effective as of 7 a.m. February 1, 1932, petitioner executed an instrument entitled "Oil Payment Contract, Ortiz Oil Company to S. A. Thompson and R. A. Westbrook." On March 7, 1932, petitioner executed an instrument entitled "Amendment No. 1 to Oil Payment Contract to S. A. Thompson and R. A. Westbrook", and on April 4, 1932, May 31, 1932, and May 9, 1933, petitioner executed additional instruments designated as amendments Nos. 2, 3, and 4 to the*1009 original instrument, respectively. All of said instruments were duly recorded in the deed records of Rusk County. Texas, and amendments Nos. 3 and 4 were also recorded in the deed records of Gregg County, Texas. The amending instruments merely increased the amount which petitioner agreed in the original instrument "to pay and account" to Westbrook and Thompson, and to bring additional properties within the terms of the original instrument.
The original instrument, after setting forth descriptions of certain oil and gas mining leases, and reciting ownership of interests therein by petitioner, contained the following pertinent provisions:
NOW THEREFORE, KNOW ALL MEN BY THESE PRESENTS: That Ortiz Oil Company, a corporation * * * for and in consideration of the sum of One Hundred ($100.00) Dollars cash and other valuable consideration to it in hand paid by R. A. Westbrook and S. A. Thompson * * * the receipt of all of which is herein and hereby acknowledged in full, the undersigned Ortiz Oil Company, for itself, its successors, assigns, and legal representatives, hereby contracts and agrees to pay and account to R. A. Westbrook and S. A. Thompson (a one-half part to each separately) *1010 for the market value of the proportions of the production hereinafter defined, from the following described tracts of land * * * until the full sum of * * * $270,666.66 [increased by the amending instruments to $350,000.00] shall have been paid and accounted, if, as and when same is produced, saved and sold from said lands and leases, to the said R. A. Westbrook and S. A. Thompson (a one-half part to each separately).
* * *
The proportions of the production of oil, gas and other minerals produced, saved and sold from the last hereinabove described tracts * * * which are to be paid, delivered or accounted to the said R. A. Westbrook and S. A. Thompson (a one-half part each separately) and which proceeds or deliveries are to be received by the said R. A. Westbrook and S. A. Thompson to be by them credited on the total amount of $270,666.66 [increased by the amending instruments to $350,000.00] are as follows:
* * *
Ortiz Oil Company for itself, its successors, and assigns, covenants and agrees that it will not sell or dispose of the proportions of the production on said tracts of land herein incumbered for less than the posted price for oil, gas, casinghead gas or gasoline*1011 of like quality, gravity and character, and in event *659 the posted prices for East Texas Oil should fall and market conditions become unsatisfactory to the said R. A. Westbrook and S. A. Thompson, as has been heretofore experienced in said field, then the said R. A. Westbrook and S. A. Thompson shall have the optional right of demanding delivery to them of their proportion of said oil and other production in kind upon furnishing storage or connection facilities whereby they can store said oil or dispose of it to better advantage, but in such event Ortiz Oil Company shall be credited with the net amount ultimately received by R. A. Westbrook and S. A. Thompson less costs of storage and connections.
* * *
The herein contained agreement to pay and account to the said R. A. Westbrook and S. A. Thompson for said proportions of the production from said leases and leaseholds shall constitute covenants running with the land, and shall be binding upon Ortiz Oil Company, its successors, assigns or legal representatives at all times until said oil payment of $270,666.66 [increased by the amending instruments to $350,000.00] shall have been paid and liquidated in full.
Ortiz*1012 Oil Company, for itself, its successors, assigns and legal representatives hereby contracts and agrees to at all times pay all bills promptly for labor, materials, or supplies used on said leases, and to protect and hold harmless at all times the said R. A. Westbrook and S. A. Thompson, and the oil and gas mining leases and leaseholds from any all mechanic's liens, materialman's liens, or laboer's [sic] liens. Ortiz Oil Company for itself, its successors, assigns and legal representatives, hereby contracts and agrees that it will not assign, transfer, hypothecate, pledge or enter into any memorandum in writing affecting in any way either all or any part of the interests in said leases herein obligated for this oil payment, and the balance of said interests remaining in it at the time of the execution and delivery of these presents, without thhe consent in writing of the said R. A. Westbrook and S. A. Thompson having been first had and obtained. * * * This provision, however, shall not in any manner interfere with the execution and delivery by Ortiz Oil Company of the customary division orders or transfer orders and contracts for the sale of production from said leases and leaseholds, *1013 but same may be entered into from timeto time in due course without the necessity of procuring the consent in writing of R. A. Westbrook and S. A. Thompson. In event of the violation of the provisions of this paragraph by Ortiz Oil Company, this agreement shall be to all intents and purposes considered in default, and R. A. Westbrook and S. A. Thompson shall then and there have the right to declare the whole amount of $270,666.66 [increased by the amending instruments to $350,000.00] immediately due and payable, and they shall have automatically at that time a lien on said oil and gas leases and leaseholds and all personal property thereon or used and obtained in connection therewith, and all wells and production, and all of the rights, title and interest of Ortiz Oil Company, in and to the same, which said lien may be foreclosed in Court the same as a Vendor's Lien, Mortgage Lien or any other lien.
* * *
And for the same consideration Ortiz Oil Company * * * does hereby bind itself, its successors, assigns and legal representatives, to warrant and forever defend all and singular the said interests herein obligated to the amount of said oil payment unto the said R. A. Westbrook*1014 and S. A. Thompson, their heirs and assigns, against the lawful claim of every person whomsoever lawfully claiming or to claim the same or any part thereof during the life of this oil payment contract and until it has been finally paid and liquidated.
*660 The actual consideration moving from R. A. Westbrook and S. A. Thompson to petitioner for the execution of the instruments above referred to was $154,000, paid in the taxable year, and the total amount which Westbrook and Thompson were to receive under those instruments was $359,333.34.
Under the original instrument Westbrook and Thompson paid to petitioner $150,000, of which $125,000 was used to acquire the Gulf Coast Oil Co. properties, and the balance of $25,000 was used for drilling two wells, one on the Johnson lease and one on the Hale lease, and for the payment of obligations then outstanding against the latter property.
Westbrook and Thompson took no part in the management and operation of the properties, except to check the oil runs and ascertain that they were getting their share of the runs under the contracts. They had an "overriding" interest, all expense of development and operation being paid by petitioner. *1015 The amounts going to Westbrook and Thompson were finally discharged in full in 1936. The quantity of oil required to discharge the obligation to Westbrook and Thompson was 394,120 barrels. The properties from which the oil was produced, the estimated oil reserves of each property, the cost of each of the reserves, and the quantity of oil required from each reserve to discharge the oil payments to Westbrook and Thompson were as follows:
| Property | Estimated reserves | Cost of reserves | Oil to Westbrook and Thompson |
| Barrels | Barrels | ||
| Young | 107,000 | $9,439.05 | 21,856 |
| Hale | 375,000 | 13,004.08 | 30,045 |
| School | 83,500 | 3,269.04 | 8,457 |
| Johnson | 80,000 | 4,108.80 | 16,029 |
| Gulf Coast | 1,250,000 | 136,663.95 | 317,733 |
The cost basis allocable to the oil from the reserves in the Young property required to discharge the oil payments to Westbrook and Thompson is $9,439.05/107,000 X 21,856.
By substituting in the above example corresponding figures for each of the above listed properties the allocable cost basis of the oil required from each of the properties to discharge the Westbrook and Thompson oil payments is ascertained.
Petitioner recorded on its*1016 books the amounts payable to Westbrook and Thompson as oil obligations payable. In its income tax return petitioner included in gross income the total amount of oil produced from the properties and took as a deduction a percentage designated as interest, approximating four-sevenths of the total amount paid to or received by Westbrook and Thompson.
*661 In computing the deficiency, respondent treated all amounts received by petitioner from Westbrook and Thompson as proceeds from the sale of "oil payments", and included the amounts in gross income from the properties, subject to depletion, without deduction of any cost basis. Respondent also disallowed the deduction for interest expense taken by petitioner in its return.
On April 2, 1932, petitioner executed an instrument, thereafter recorded in the deed records of Rusk County, Texas, which referred to a certain oil and gas lease executed by Lee Shiloh C. M. E. Church to one LaSelle, who later conveyed and assigned the lease contract to petitioner, subject to a reserved overriding royalty interest. The instrument so executed by petitioner on April 2, 1932, contained, among others, the following provisions:
Now, THEREFORE, *1017 KNOW ALL MEN BY THESE PRESENTS, That the Ortiz Oil Company, a corporation * * * for and in consideration of the sum of Ten ($10.00) Dollars cash and other valuable considerations to it in hand paid by C. H. Staley, * * * the receipt of which is herein and hereby acknowledged in full, the undersigned Ortiz Oil Company * * * does hereby sell, assign, transfer and convey unto the said C. H. Staley of Tillman County, Oklahoma, an undivided one-half of all oil and/or gas produced, saved and sold from the following described tract of land * * * together with an undivided one-half (1/2) interest in and to the said oil and gas leases and leasehold estates thereupon until the C. H. Staley aforesaid shall have been paid the sum of Seventeen Thousand Five Hundred ($17,500.00) Dollars.
When the said C. H. Staley aforesaid shall have been paid in full the sum of $17,500.00 all interest and rights granted and created by this instrument shall revert to said Ortiz Oil Company, its successors and assigns.
Pipe line companies were authorized to pay Staley directly for his share of the oil, until he had received the specified amount. Petitioner agreed to pay all expenses and to protect the property*1018 from liens and hold Staley harmless from them, and also agreed not to sell oil below the posted price without his written consent. The closing warranty clause of this instrument was substantially the same as that in favor of Westbrook and Thompson quoted hereinabove. In addition to the instrument of April 2, 1932, petitioner executed and delivered to Staley two deeds covering other lands as collateral security.
The actual consideration moving from C. H. Staley to petitioner for the execution of the instruments above referred to was $12,500, paid in the taxable year. The payment of $17,500 to Staley was completed in 1936. The quantity of oil required to discharge the obligation to Staley was 21,039 barrels. The estimated oil reserves of the lease involved in the Staley transaction were 75,000 barrels and the cost to petitioner of such reserves was $5,743.19 or 7.657 cents per barrel. The allocable cost of the 21,039 barrels of oil required to discharge the obligation to Staley was $1,610.96.
*662 The transaction with Staley was recorded on petitioner's books and reported in its tax return in the same way as the transaction with Westbrook and Thompson hereinabove referred*1019 to. It was treated by respondent, in determining the deficiency, in the same way that he treated the Westbrook and Thompson transaction.
Issue (4). - Among the properties operated by petitioner in 1932 was the Giles lease, which petitioner had acquired from the Gulf Coast Oil Co. and which that company in turn had acquired from J. C. Farrell and W. A. Moncrief. The consideration for the transfer of the lease by Farrell and Moncrief was "the sum of $1,500 per acre, payable out of one-third of the lessee's 7/8ths of the first oil produced, saved and sold from said premises." Petitioner acquired its title to the property subject to such provision, and in accordance therewith operated the property during 1932. The amount of $9,301.82 was paid to Farrell and Moncrief in 1932 to apply upon their retained interest, and such amount was included by respondent as part of petitioner's gross income from the Giles lease.
Petitioner also operated during 1932 an oil and gas lease on property owned by the Kilgore Independent School District. This lease contract likewise reserved an interest in any oil produced, and pursuant thereto proceeds for the sale of oil were paid to the school*1020 district in 1932 in the amount of $1,122.05, which amount was included by respondent as a part of petitioner's gross income from the property.
Issue (5). - In 1932 petitioner drilled a "dry hole" on the Hale lease at a cost of $9,231.45, which amount it deducted on its return in computing taxable net income. In determining the deficiency, respondent made no adjustment on account of that deduction, but deducted the amount in computing the limitation on the percentage depletion allowance.
OPINION.
HILL: Issue (1). - Petitioner complains of the action of respondent in determining that it derived a profit from drilling the Hale No. 3 well. Petitioner owned a one-half interest in the Hale lease, the other half being owned by three individuals. Petitioner drilled a well on the property under an agreement whereby the other joint owners were to pay the sum of $5,750 as their share for drilling and equipping a well. One-half of the actual cost to petitioner was $4,122.23, and the difference between this amount and $5,750 received by petitioner from the other joint owners, or $1,627.77, respondent included in gross income as profit derived from the transaction.
It cost*1021 the petitioner $8,244.46 to drill and equip the well and it claims the total amount thereof as its development cost and endeavors *663 to capitalize it as such. This claim is apparently based on the theory that the well and equipment were the property solely of petitioner until its coowners paid for an interest therein after the well was drilled and equipped. Accordingly, petitioner charged the amount of $8,244.46 to development cost and credited thereon the $5,750 paid by its coowners, thus reducing its claimed development cost to a net of $2,494.46. We can not accept this theory. The development was a joint enterprise of petitioner and its coowners of the lease under the agreement that petitioner would drill and equip the well in consideration of the payment to it by the coowners of the flat sum of $5,750 for their one-half of such development. This was a turnkey agreement as to the interest of the coowners in the development. The well with the equipment was a development of which the petitioner owned an undivided one-half interest and its coowners a like interest from the inception of the development. Notwithstanding that it cost $8,244.46 to drill and equip the well, *1022 the burden of only one-half of such cost was upon petitioner. Its development cost in this connection was applicable to only a one-half interest in the equipped well and was $4,122.23 instead of $8,244.46, or instead of the latter amount less the credit of $5,750 as claimed by petitioner. Petitioner at no time owned more than a one-half interest in the well and equipment and acquired no capital investment and incurred no development cost in respect of its coowners' one-half interest therein. The sum of $5,750 paid to petitioner by its coowners was, under the turnkey agreement, development cost of such coowners, applicable to their one-half interest in the equipped well, and no part of that sum should be credited to petitioner's development cost. Under the turnkey agreement with its coowners petitioner realized a profit in the amount of the difference between $5,750 and $4,122.23, or $1,627.77, which should be included in its gross income. Accordingly, upon this issue we sustain the respondent.
Issues (2) and (3). - The transactions between petitioner and Westbrook and Thompson and between petitioner and C. H. Staley were substantially similar, differing only as to properties*1023 and amounts. Both were treated by the respective parties hereto in the same manner. For convenience our discussion will be limited principally to the transaction with Westbrook and Thompson. However, the conclusions reached will apply equally to the transaction with Staley.
The transaction with Westbrook and Thompson petitioner treated on its books as a loan. In its income tax return, petitioner included in gross income the total proceeds from the sale of oil in the taxable year, and claimed as a deduction for interest approximately foursevenths of the amount paid in such year to Westbrook and Thompson, *664 approximately three-sevenths of that amount being regarded as repayment of borrowed principal. In computing the deficiency, respondent disallowed the deduction for so-called "interest expense", and treated the total amount received by petitioner from Westbrook and Thompson as proceeds from the sale of "oil payments", but included the amount thereof in petitioner's gross income from the properties, subject to depletion, and without deduction of any cost basis. Neither treatment of the transaction, we think, is correct.
Substantially, the situation involved here*1024 may be summarized as follows: During the taxable year petitioner owned certain oil and gas leases and had an opportunity to acquire certain other oil and gas leases, but did not have the required capital to make the purchase and to develop and operate the properties. It obtained options and then entered into negotiations with Westbrook and Thompson to acquire the necessary funds to finance the deal. The latter individuals paid $154,000 to make such purchase by petitioner, to drill two wells on leases already owned by petitioner and to pay some of its outstanding obligations. The money was not furnished as a loan, to be repaid by petitioner at all events, with interest, as it was treated by petitioner, but as a cash consideration for the purchase by Westbrook and Thompson of certain specified proportions of the oil production, to the extent of $359,333.34 in value, if, as, and when same should be produced, saved, and sold from certain lands and leases, including, among others, those so purchased and drilled.
Such portions of the production belonged to and constituted property of Westbrook and Thompson, and petitioner was obligated only to pay over and account to them therefor, *1025 when produced. The Lien given to Westbrook and Thompson was not intended to secure the repayment of a loan, but to insure that petitioner would adhere to and perform the conditions of the contract and "pay and account" to them for their share of the oil when produced.
Petitioner was to develop and operate the properties, and pay all expenses. Westbrook and Thompson acquired an "overriding interest", their portions of the oil runs being net to them. Westbrook and Thompson paid the money in exchange for an agreed interest in any oil and gas or other minerals that might be "produced, saved and sold" from petitioner's properties. If none were produced, they lost their money, and petitioner was under no obligation to repay it. The transaction constituted a sale by petitioner of oil in place and it realized taxable gain thereon in the amount of $154,000 less the amount of the cost bases allocable to the oils required to discharge the oil payments as set forth in our findings of fact. Westbrook and Thompson were entitled to receive the specified proportions of the proceeds of sales, or to take their share of the oil and gas production *665 in kind, at their election. The*1026 balance of the proceeds or production belonged to petitioner. Therefore, petitioner was not entitled to deduct as interest or otherwise any part of the proceeds of oil paid to Westbrook and Thompson.
The right to share in the oil produced constituted an interest in the oil in place. Hence, the right of Westbrook and Thompson to their proportion of the oil and gas, or proceeds from sales, upon production, constituted an economic interest in the properties, to the extent of the amount agreed upon. Likewise, the right of petitioner to the balance of production constituted an economic interest in the properties. Proceeds from sales of production, therefore, constituted income to Westbrook and Thompson to the extent of the proportion received by them, and the balance only constituted gross income to petitioner. ; ; ; . Petitioner is entitled to a deduction for depletion computed on the basis only of the income received by it as its portion*1027 of the production in the taxable year. . It is not entitled to allowance for depletion on the proceeds of the sale to Westbrook and Thompson. Cf. , which affirmed ; ; and .
The facts in the Staley transaction are so nearly like those in the Westbrook and Thompson transaction, except as to names and amounts, that the discussion on the latter is applicable to the former and the same conclusions of law must be reached in both. Accordingly, we hold that the Staley transaction constituted a sale by petitioner of oil in place and that petitioner realized taxable gain in the amount of $12,500, less the amount of the cost basis allocable to the oil required to discharge the oil payments as set forth in our findings of fact; that petitioner is not entitled to deduct as interest or otherwise any part of the proceeds of oil paid to Staley; that it is entitled to a deduction for depletion computed on the basis only of the income from the property received*1028 by it as its portion of the production in the taxable year; and that petitioner is not entitled to an allowance for depletion on the proceeds of the sale to Staley of an interest in the oil production.
Issue (4). - During the taxable year petitioner paid to Farrell and Moncrief the sum of $9,301.82 on account of the interest retained by them in the oil production from the Giles lease, and in the same year paid the trustees of the Kilgore Independent School District the sum of $1,122.05 pursuant to the terms of the lease by which the school *666 district retained an interest in any oil produced from its land. In computing the deficiency, these amounts were included by respondent as part of petitioner's gross income from the properties. The precise question presented here was decided in The amounts in controversy constituted income to the respective parties receiving them, since the payments were made under rights which represented retained economic interests in the properties. It follows that respondent erred in including such amounts in petitioner's gross income. Respondent in his brief concedes error on this point.
*1029 Issue (5). - In 1932 petitioner drilled a dry hole on the Hale lease at a cost of $9,231.45, which amount it deducted on its return in computing taxable net income. Respondent allowed the deduction claimed by petitioner in determining its taxable income, but deducted the amount from gross income from the property in computing the limitation on the amount of depletion allowable under section 114(b)(3), of the Revenue Act of 1932.
Development cost is not operating cost, and may not be deducted from gross operating income in determining the net income from the property for the purpose of applying the 50 percent limitation on the allowable deduction for depletion provided by the above cited statute, even though such cost has been deducted by petitioner from gross income in computing its taxable income. Respondent's action on this point is reversed. . See also ; ; *1030 .
On brief, petitioner asserts that respondent in determining the net income from the property, before deducting depletion, took into consideration overhead expense and depreciation on physical equipment, in addition to the cost of drilling a dry hole, and contends that "operating profit" does not include such items as overhead expense and depreciation. This question not having been raised in the original pleadings or amendments thereto but raised on brief only, we decline to consider it in this proceeding. ; ; ; .
The deduction for depletion to which petitioner is entitled will be recomputed on the basis of the gross income and the net income from the various properties of petitioner, determined in accordance with the foregoing opinion.
Judgment will be entered under Rule 50.