*109 Decision will be entered under Rule 50.
1. Petitioner was granted the drilling and development rights in certain submerged oil property by the State of California. Under the terms of such grant petitioner was required to drill certain offset wells. Upon completion thereof, petitioner was to continue uninterrupted drilling operations until a total of 83 wells were thus drilled. Held: The drilling of wells during 1939 to 1943, inclusive, subsequent to the required number of offset wells was a part of the consideration for acquisition of the drilling rights from the State of California and as such the intangible drilling costs incident thereto are not deductible in accordance with the option contained in Regulations 111, section 29.23 (m)-16.
2. Pursuant to the State Lands Act of 1938 all oil wells bottomed in the submerged oil deposits were required to be drilled from filled lands or slant-drilled from littoral drill sites. The necessary drill sites and easements appertaining thereto were acquired from certain upland owners by petitioner for which it agreed to pay an amount equal to 24 1/2 per cent of its net profits. Held: Petitioner was the sole recipient of an economic*110 interest in the submerged oil deposits; no third parties thereafter acquired any such interest; the amounts paid by petitioner equal to 24 1/2 per cent of its net profits were not so paid as rent or royalty on an economic interest in the oil and gas in place; and, therefore, petitioner is entitled to include such amounts in its gross income subject to the statutory allowance for depletion.
*962 This proceeding involves corporate income tax, declared value excess-profits tax, and excess profits tax, as follows:
| Deficiency | Overpayment | ||
| Year | determined | claimed | |
| 1939 | $ 32,114.88 | ||
| 1940 | 31,271.85 | ||
| 1941 | 5,470.28 | ||
| Income tax | 1942 | 34,075.82 | |
| 1943 | 46,767.42 | $ 2,883.04 | |
| 1944 | 31,822.17 | 17,828.29 | |
| 1945 | 47,892.34 | 1,758.12 | |
| 1939 | $ 20,455.80 | ||
| 1940 | 5,973.03 | ||
| Declared value excess-profits tax | 1942 | 6,996.71 | |
| 1944 | 2,982.50 | ||
| 1945 | 8,764.91 | ||
| 1940 | $ 24,545.60 | ||
| 1941 | 54,525.59 | $ 23,942.25 | |
| Excess profits tax | 1942 | 81,158.14 | 31,379.00 |
| 1944 | 34,102.12 | 27,385.23 | |
| 1945 | 22,219.31 | 51,088.51 |
There are two questions presented in this case. One, involving the taxable years 1939 to 1942, inclusive, is concerned with the propriety of petitioner's deducting so called intangible drilling costs incurred during those years in producing oil from submerged coastal lands on a portion of an operating grant from the State of California.
The second issue raises the question of whether petitioner may properly*112 take a depletion deduction in the taxable years 1939 to 1945, inclusive, on an amount equal to 24 1/2 per cent of its net income, which amount it paid to certain upland owners on and through whose properties petitioner had located "whipstock" wells for purposes of producing oil from the adjacent submerged lands.
*963 The State of California has proposed additional franchise taxes against petitioner for the years 1939 to 1946, inclusive, based on adjustments of income similar to those set out in the deficiency letter herein. The State has requested, and obtained, from petitioner agreements waiving the statute of limitations for assessing such additional franchise taxes for the years 1939 to 1946, inclusive. Petitioner has filed protests against these additional franchise taxes.
The parties have stipulated that if petitioner prevails as to both of the foregoing issues, and if it is not entitled to deduct any franchise taxes not allowed in the deficiency letter, petitioner will be entitled to additional depletion deductions, as follows:
| 1941 | $ 19,443.62 |
| 1942 | 96,189.89 |
| 1943 | 91,452.47 |
| 1944 | 218,032.38 |
| 1945 | 244,764.71 |
If petitioner prevails as to the second issue above, *113 but not as to the first, it has been stipulated that then petitioner will be entitled to additional depletion deductions, as follows:
| 1941 | $ 35,874.23 |
| 1942 | 96,189.89 |
| 1943 | 82,446.98 |
| 1944 | 218,032.38 |
| 1945 | 244,764.71 |
The parties have entered into agreements from time to time pursuant to section 276 (b), Internal Revenue Code, extending the period for the assessment of additional taxes for each of the years 1941 to 1945, inclusive. These agreements were executed within 3 years, respectively, from the time the returns to which they apply were filed by the taxpayer.
Respondent has filed an amendment to his amended answer in which he makes claim for any increased deficiency in petitioner's income tax that may result from our holdings herein.
FINDINGS OF FACT.
Most of the facts have been stipulated. Oral stipulations made and the written stipulation filed with exhibits attached are adopted and made a part hereof.
Petitioner is a corporation organized under the laws of California on June 20, 1933. It was completely inactive until 1938. Its principal office and place of business is 811 West Seventh Street, Los Angeles, California. The petitioner filed its corporate income tax, *114 declared value excess-profits tax, and excess profits tax returns for the calendar years 1938 to 1945, inclusive, with the collector of internal revenue *964 for the sixth district of California at Los Angeles, California. From its inception, petitioner has kept its books and filed its tax returns on the accrual basis.
Prior to 1938 the State of California permitted State lessees and oil operators to develop and operate submerged coastal oil deposits from piers, islands and barges. This practice resulted in waste petroleum products interfering with fishing and bathing along the beaches of southern California. In 1938 the State Legislature passed the State Lands Act of 1938 under which the State Lands Commission was appointed with power to lease the submerged lands in such manner as to prevent the oil operations from despoiling the beaches. From August 8 to 13, 1938, this Commission published a Notice of Intention to Receive Offers to enter into an agreement for extraction of oil and gas from an area of submerged lands situated off Huntington Beach, California. The area involved was approximately 835 acres and was the area which eventually was covered by State Easement No. *115 392.
Petitioner made a bid and submitted same on August 30, 1938. With its letter transmitting the bid it filed a form of Agreement for State Easement, later identified as No. 392, and attached to this agreement was so called "Exhibit A (for entire tract)" which constituted the drilling requirements. There was also attached thereto "Exhibit B" which set out the royalty which petitioner agreed to pay, as well as an endorsement by upland owners indicating that such owners had given petitioner authority to drill wells on their land and to run its wells through their property out under the ocean. Also attached to the transmittal letter were the following:
(a) Permit agreement executed with upland owners.
(b) Cashier's check for $ 15,000.00 payable to the Treasurer of the State of California.
(c) Certified copies of resolutions authorizing petitioner's officers to execute the agreement for the foregoing permit and the agreement for Easement No. 392.
(d) Certificate of Ownership showing that all petitioner's stockholders were residents of the State of California.
In addition, petitioner furnished the $ 25,000 bond required by the Agreement for State Easement No. 392.
Petitioner's bid*116 was accepted and it entered into the Agreement for State Easement No. 392 with the State Lands Commission on September 26, 1938. The granting clause reads, in part, as follows:
Section 1. That the State, in consideration of the royalty to be paid, the covenants to be performed, and the conditions to be observed by the Grantee, as herein set forth, does hereby grant to the Grantee an exclusive easement appurtenant to the lands of the Grantee hereinafter described, through, in and under lands of the State of California (hereinafter referred to as the State lands), hereinafter more particularly described, together with the exclusive right to drain, take, receive, extract, remove, and produce from the State lands oil, gas, and other hydrocarbon substances through certain oil wells to be drilled, operated *965 and maintained by the Grantee in the manner hereinafter provided, the tops of which such wells shall be located upon that portion of those certain littoral lands and uplands lying within a prolongation or projection northerly of the sidelines of the hereinafter described parcel of state lands * * *.
The Agreement then continues, in part, as follows:
Section 2. The Grantee *117 in consideration of the foregoing hereby agrees:
(a) To furnish a bond in favor of the State of California, and approved by the State in the penal sum of $ 25,000.00 to guarantee the faithful performance by the Grantee of the terms, covenants and conditions of this agreement and of the provisions of the Act.
(b) To commence operations for the drilling of wells into the State lands, and to thereafter continue with such drilling in accordance with the drilling program, attached hereto, marked Exhibit "A", and by reference made a part hereof.
(c) To pay to the State of California a royalty in accordance with the formula, marked Exhibit "B", attached hereto, and by reference made a part hereof, on the oil produced and saved from each well producing from the State lands or on demand the State's percentage of oil produced in accordance with said Exhibit "B", * * *.
* * * *
(d) To pay to the State annually in advance as rental the sum of one (1) dollar per acre for each acre of State lands herein described, which rental shall be credited against the royalties, if any, as they accrue for the year for which such rental is paid.
Beginning in 1923, Standard Oil Company of California drilled*118 wells on the uplands, which petitioner was required to use in connection with the operation of its State lease, and has produced oil from such uplands ever since. The drilling program contained in the Exhibit "A," referred to above, called for petitioner to drill 12 wells near the shore to offset a like number of existing wells of the Standard Oil Company. By virtue of subsequent amendments to this original agreement executed on March 22, 1939 and August 12, 1943, and under certain conditions set forth therein, petitioner was temporarily relieved of its immediate obligation to drill the twelfth well. Petitioner has agreed to the capitalization of the intangible drilling costs of the 11 wells so drilled by it as being its principal acquisition cost of obtaining the lease.
The drilling program further provides, in part, that:
After Grantee [petitioner] has completed the drilling of all offset wells herein provided to be drilled, it shall continue drilling (subject to the right of quitclaiming as provided in this agreement) with at least two drilling outfits (commencing its first well at the easterly side of the State lands) until Grantee has drilled into the State lands a total of*119 eighteen (18) wells, including offset wells. Thereafter, Grantee shall continuously operate at least one drilling outfit until Grantee has drilled into the State lands a total number of wells equal to the nearest whole number obtained by dividing the total acreage of the State lands herein described by ten (10).
*966 The Grantee shall, however, be entitled to drill as many additional wells as Grantee desires.
* * * *
Petitioners right to quitclaim, mentioned in the preceding paragraph, was set out in section 9 of the Agreement for Easement No. 392, as follows:
The Grantee, at any time after drilling offset wells required to be drilled under this agreement, may quitclaim this agreement as to all of the State lands embraced herein or as to any part or parts thereof, and in the event of a partial quitclaim, Grantee's obligations hereunder as to the number of wells (other than offset wells) to be drilled shall be reduced proportionately; provided however, that Grantee shall be obligated to make payment of all rents, royalties and other obligations due and payable to the State accrued to the date of such quitclaim; and further, provided, however, that in the event Grantee quitclaims*120 a portion of the State lands such portion quitclaimed shall be in a compact form and not less than ten (10) acres; and further, provided, that the Grantee at the request of the State shall grant to any lessee or subsequent grantee of such quitclaimed area, upon such terms and conditions as the State may prescribe, a right to the free use with Grantee of rights of way, easements, or other interests in the State lands acquired by this agreement, as may be necessary or convenient in connection with the operations in such quitclaimed area under a lease or subsequent easement.
In drilling the wells pursuant to the above agreement, petitioner incurred the following intangible drilling and development costs and charged its claimed share thereof to expense:
| SOUTHWEST EXPLORATION COMPANY | |||
| Intangible Drilling and Development Costs on State Easement No. 392 | |||
| Lawson, | Petitioner | ||
| Year | Total 100% | et al. 10 5/8% | 89 3/8% |
| 1938 offset wells | $ 149,181.50 | $ 15,850.54 | $ 133,330.96 |
| 1939 offset wells | 100,293.97 | 10,656.23 | 89,637.74 |
| Other wells | 320,929.87 | 34,098.80 | 286,831.07 |
| Totals | $ 421,223.84 | $ 44,755.03 | $ 376,468.81 |
| 1940 | $ 205,834.10 | $ 21,869,87 | $ 183,964.23 |
| 1941 | $ 253,625.69 | $ 26,947.73 | $ 226,677.96 |
| 1942 | $ 176,944.24 | $ 18,800.33 | $ 158,143.91 |
| SOUTHWEST EXPLORATION COMPANY | ||
| Intangible Drilling and Development | ||
| Costs on State Easement No. 392 | ||
| Capitalized by respondent | ||
| Year | As depreciable | As depletable |
| 1938 offset wells | $ 56,930.71 | $ 76,400.25 |
| 1939 offset wells | 27,404.75 | 86,278.10 |
| Other wells | 69,679.02 | 193,106.94 |
| Totals | $ 97,083.77 | $ 279,385.04 |
| 1940 | $ 47,204.48 | $ 136,759.75 |
| 1941 | $ 56,721.09 | $ 169,956.87 |
| 1942 | $ 37,963.85 | $ 120,180.06 |
Petitioner, in its returns for the first year in which intangible oil well drilling and development costs were incurred, exercised the option granted in the regulations to deduct such items from gross income as expenses. Respondent disallowed the deduction of such intangible expenses and capitalized them as items returnable through depletion or depreciation, as shown above. The first 11 wells drilled by petitioner during 1938 and 1939 pursuant to State Easement No. 392 offset existing wells of Standard Oil Company of California. As previously *967 noted, petitioner is not now contesting the disallowance of the intangible drilling and development costs incurred in connection therewith. Thereafter, petitioner continued the drilling of wells*122 in accordance with the terms of State Easement No. 392. As to wells drilled after December 31, 1942, the respondent has allowed petitioner to deduct 89 3/8 per cent of all intangible drilling and development costs in accordance with applicable regulations.
Pursuant to certain conditions specified in Exhibit "A" attached to the above-mentioned Agreement for Easement No. 392, petitioner did not drill or deepen, nor was it required to drill or deepen, any wells prior to January 1, 1943. Petitioner developed a region known as the Jones Zone and drilled a number of wells in that zone. All of the wells drilled by petitioner had their tops on the uplands and their bottoms under the ocean more than 200 feet from the mean high tide line. All of petitioner's production in the years involved came from the property covered by Agreement for State Easement No. 392.
Certain provisions were made in the foregoing agreement relative to petitioner's failure to carry out any of the terms and conditions set forth therein. These provisions read, in part, as follows:
Section 2 (n). * * * should the Grantee at any time during the term hereof be adjudged a bankrupt, either upon Grantee's voluntary petition*123 in bankruptcy, or upon the involuntary petition of Grantee's creditors, or any of them, or should an attachment be levied and permitted to remain for an unreasonable length of time upon or against the interest, rights or privileges of Grantee in or to any oil, gas or other hydrocarbon substances produced from any well or wells drilled by Grantee upon said lands, then all of the interests, rights, and privileges of Grantee in and to all oil, gas or other hydrocarbon substances produced and saved from the State lands by reason of Grantee's operations thereon, shall immediately cease, terminate and end, and in such event the State shall have, and Grantee, by the acceptance thereof, hereby gives the State the right, option and privilege to cancel and terminate this agreement and all of the terms and provisions granted hereby, and all of the rights and privileges of Grantee in and to or upon the State lands, and in and to any oil, gas or other hydrocarbon substances produced and saved from the State lands by reason of Grantee's operations thereon, and all of Grantee's rights and privileges granted by this Agreement shall immediately cease and terminate and end upon the State so exercising*124 its option in writing.
* * * *
Section 13. If the Grantee shall fail to comply with the provisions of the Act so far as applicable or make default in the performance or observance of any of the terms, covenants and stipulations hereof, or of the rules and regulations of the State now promulgated, and all reasonable rules and regulations which may hereafter be promulgated, and such default shall continue for the period of thirty (30) days after written notice thereof to the Grantee, and no steps shall have been taken within that time, in good faith, to remedy said default, then the State may enter upon the premises of the Grantee and take possession of the same and all facilities, tools, equipment and supplies for the purpose of operating said wells of the Grantee until such time as all money defaults of the *968 Grantee to the State have been fully satisfied, or if such default cannot be satisfied by the payment of money, then the State shall have the right and power to cancel this agreement or to close said well or wells which are not being conducted or operated in the manner prescribed by the provisions of this agreement, the rules and regulations of the State now promulgated, *125 and reasonable rules and regulations of the State which may be hereafter promulgated; but this provision shall not be construed to prevent the exercise by the State of any legal or equitable remedy which the State might otherwise effect. The waiver of or failure of the State to act upon any particular cause of forfeiture shall not prevent the cancellation and forfeiture of this agreement for any other cause of forfeiture or for the same cause occuring [sic] another time.
On August 25, 1938, petitioner entered into an agreement with Huntington Beach Company, Pacific Electric Railway Company, Pacific Electric Land Company, Bolsa Land Company, Bolsa Chica Gun Club and Standard Oil Company of California, as permittors for the permit referred to above, possession of which was a prerequisite to the acceptance of its bid for Easement No. 392. Under this agreement petitioner was permitted to go on the uplands belonging to the permittors, open the tops of its oil wells, drill into the land and under the land of the permittors, out under the ocean, and to place its derricks, machinery, etc., on the surface of the land. The agreement prohibited petitioner from bottoming any of its wells*126 under the uplands, but required that all such wells be bottomed and completed so that all the perforated pipe at producing intervals should be located within the confines of the State land. As a matter of practice, Standard Oil Company required that all the bottoms be at least 200 feet off shore from the mean high tide line.
Also on August 25, 1938, petitioner entered into an agreement with the Huntington Beach Company, Pacific Electric Railway Company, Pacific Electric Land Company, and Standard Oil Company of California by the terms of which it was agreed that the surface location and subsurface course through the uplands, to be drilled by petitioner from the uplands into the State Easement, had to have Standard Oil Company's written approval. That contract was complied with in all respects. All of petitioner's wells have been drilled to conform with its agreement with the State and with the upland owners. There were no "filled lands" as that term is used in article 6 of the State Lands Act of 1938.
On September 27, 1938, petitioner entered into an agreement with Pacific Electric Railway Company, Pacific Electric Land Company, and Huntington Beach Company. Under this agreement*127 petitioner agreed to pay to the upland owners, as rental for the rights and *969 privileges given by them to petitioner under its agreements of August 25, 1938, as follows:
8. Southwest shall pay to Second Parties as rental an amount equal to the following percentages of the "net profits":
17.75% to Huntington Beach Company,
1.576% to Pacific Electric Railway Company,
5.174% to Pacific Electric Land Company.
Said rental payments shall be made on or before the 25th day of the month immediately following the time when "net profits" arise in the operations herein referred to. * * *.The agreement of September 27, 1938, also contained the following provisions:
13. It is understood and agreed that nothing herein shall add to, modify, or limit the privileges given to Southwest by Second Parties and others in those certain agreements dated August 25, 1938, or the rights given to Southwest under said State Easement, nor shall any default hereunder by Southwest cause a forfeiture of the rights or privileges given Southwest by Second Parties under said agreements of August 25, 1938.
* * * *
19. This agreement shall not be construed to give Second Parties any right, title, or interest*128 in said State Lands or in or under said State Easement, and said Southwest may, at any time, at its election, without any consent or participation by Second Parties, modify said State Easement or surrender, and terminate the same in accordance with the provisions thereof. In the event that Southwest shall assign its interest in State Easement, such assignment shall be made subject to the assumption by the assignee thereunder of all of the obligations of Southwest under this agreement.
* * * *
22. This agreement and the two said agreements of August 25, 1938, and any and all rights of Southwest in or to the property covered thereby, shall terminate upon the expiration of said Easement No. 392 or any renewals, extensions, or modifications thereof. Upon such termination, Southwest shall proceed diligently to remove any and all facilities which it may have placed upon said uplands and shall forthwith restore said uplands as nearly as possible to the condition in which said premises existed prior to the commencement of operations thereon by Southwest. Southwest shall immediately upon such termination pay to Second Parties whatever sums of money which may then be due them.
* * * *
23. *129 It is the express intention of the parties hereto not to create a partnership relationship.
OPINION.
This case presents two questions. The first is whether petitioner may properly deduct the so called intangible drilling costs of certain oil wells drilled by it during the years 1939 to 1942, inclusive.
*970 Petitioner claims the right to the deduction here in dispute by virtue of the option granted in Regulations 111, section 29.23 (m)-16. 1
*130 Respondent contends that the regulations cited and relied upon by petitioner are inapplicable to the present factual situation. He argues that the drilling of the wells in question constituted part of the consideration for the Agreement for State Easement No. 392.
The regulations in question apply to the so called intangible costs incurred in connection with drilling wells on property, the title to which is held in fee or under a lease by the taxpayer-driller. They do not apply to such costs when the drilling is done on the land of another or as consideration for acquisition of an interest in the lands of others. Hardesty v. Commissioner, 127 F. 2d 843, affirming 43 B. T. A. 245. Thus, if the wells in question were drilled as part of the consideration for the Easement Agreement, then the so called intangible costs incident thereto are not deductible pursuant to the option contained in the aforementioned regulations. Rather, they represent capital expenditures recoverable only through depletion allowances. F. H. E. Oil Co., 3 T. C. 13, affd. 147 F. 2d 1002; F. F. Hardesty, 43 B. T. A. 245,*131 affd. 127 F. 2d 843; United States v. Sentinel Oil Co., 109 F. 2d 854; State Consolidated Oil Co. v. Commissioner, 66 F. 2d 648, certiorari denied 290 U.S. 704. On the other hand, if such drilling was not a part of the consideration for the Easement Lease, then the expenses incurred in connection therewith are properly deductible as maintained by petitioner. The ultimate question is whether the drilling of the wells in question was part of the consideration by which petitioner acquired its interest in the leased premises. The answer to this question is dispositive of this issue.
*971 Petitioner agrees with the foregoing statement of law. However, it contends that it was obligated to drill only the first eleven offset wells as consideration for the lease; that any wells drilled thereafter were so called optional wells drilled on its own lease; that the drilling of the optional wells was not a condition precedent but was in the nature of a condition subsequent; that it had and exercised the option to charge the drilling costs to expenses; and that, therefore, *132 it should be permitted the deductions in dispute.
We are entirely unimpressed by petitioner's argument. Rather, we feel that the provisions of the Easement Agreement support respondent's position and point up the fact that complete execution of the drilling program attached to and made a part of the Agreement for Easement No. 392 was the primary consideration for the Agreement.
The prescribed drilling program clearly contemplated the full development of the entire 835 acres involved. It required petitioner to maintain continuous drilling operations until a total of 83 wells had been drilled. This requirement was subject only to petitioner's right to quitclaim the Agreement as to all the "State lands" embraced therein "* * * or as to any part or parts thereof * * *." In the event of a partial quitclaim pursuant to this arrangement, petitioner's obligations with respect to the number of wells to be drilled other than offset wells, was proportionately reduced. Thus, petitioner's obligation could be alleviated only to the extent to which it was assumed by petitioner's grantee in any such quitclaim transaction.
In the event of petitioner's failure to continue and to complete the prescribed*133 drilling program or to quitclaim the agreement to a party who could assume petitioner's obligations, provision was made in the Agreement whereby the State could reenter the premises upon 30 days' notice, cancel the Agreement, or exercise any legal or equitable remedy to which it might otherwise be entitled. Further, the Agreement also terminated should petitioner be adjudged a bankrupt or should an attachment be levied. Consequently, it appears that petitioner's right, title, or interest in and to the oil and gas in place vested only as and when the prescribed drilling program was completed. While petitioner itself was in no sense bound to continue the drilling and development program set forth as a part of the Agreement, only by doing so could it acquire and retain any right, title, or interest under the Agreement. Clearly the acquisition of such rights was contingent upon petitioner's continued drilling and its completion of the prescribed number of producing wells.
As said above, the primary purpose of the Agreement for State Easement No. 392 was to procure the drilling of oil wells on, and the development of, the entire 835 acres covered by the lease. This was *972 the*134 essence of the transaction and constituted the consideration therefor. Accordingly, it matters not whether we regard petitioner's interest as vesting upon execution of the Agreement subject to being divested for nonperformance of conditions subsequent or upon completion of the number of producing wells prescribed in the drilling program. F. H. E. Oil Co., supra.Under either view, the drilling of the wells was the consideration for petitioner's interest in the gas and oil in place. In United States v. Sentinel Oil Co., supra, the Court said, inter alia:
Appellee attempts to distinguish the State Consolidated Oil case from the instant one, by the fact that in the former case title to the property was not to pass until after the property owner had received his $ 1,400 from the proceeds of the well, while in the instant case title passed upon the execution of the contract. We do not think that this distinction changes the situation. In both cases the drilling expenditures were the consideration for the passing of title to the land.
The foregoing is apposite here.
We hold, therefore, that petitioner is not entitled*135 to the deductions claimed. Respondent's action in disallowing such deductions is sustained.
The second question involves petitioner's right to a depletion deduction on the 24 1/2 per cent of its net profits which it paid to certain upland owners. It was on and through the property of these owners that petitioner had located various "whipstock" wells for the production of gas and oil from the submerged lands located adjacent thereto.
As pointed out above, petitioner acquired the sole right to exploit the oil property in question by virtue of its 1938 agreement with the State of California. The terms of this agreement provided that any development of, or drilling into, the submerged lands covered thereby must be conducted from littoral or upland sites. This provision required as a condition precedent to the agreement that the requisite easements be procured from the owners of the adjacent uplands and that certification as to such action then be made in the form of an endorsement by the upland owners attached to the agreement as finally executed. In consideration of the necessary easement and certification petitioner agreed to pay to the upland owners involved an amount equal to*136 24 1/2 per cent of its net profits.
Petitioner seeks to include the foregoing amount within its gross income subject to a deduction for depletion in accordance with sections 23 (m)2 and 114 (b) (3), 3 Internal Revenue Code.
*137 *973 In order to determine whether petitioner is entitled to include the above amount within its gross income and then be allowed the depletion claimed, we would briefly recall the purpose and intent of the statutory allowance. Because of their inherent nature, oil and gas reserves, together with other mineral deposits, have been recognized and designated as wasting assets. Anderson v. Helvering, 310 U.S. 404. By this designation it is meant that a portion of the capital asset is consumed in the production of income through exploitation thereof. Helvering v. Bankline Oil Co., 303 U.S. 362. Hence, Congress has granted the deduction in question as an equitable means of allowing a tax free return of the capital so consumed in the process of production. Anderson v. Helvering, supra.It follows that the depletion deduction is allowable only to those who have a capital investment or economic interest in the oil or other mineral in place from which income is received by reason thereof. Kirby Petroleum Co. v. Commissioner, 326 U.S. 599; Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25;*138 Helvering v. Bankline Oil Co., supra;United States v. Spalding, 97 F. 2d 701. In determining whether a taxpayer has such an investment or interest no significance attaches to the particular legal form of the transaction creating the rights. Burton-Sutton Oil Co. v. Commissioner, supra;Palmer v. Bender, 287 U.S. 551; Lynch v. Alworth-Stephens Co., 267 U.S. 364. It is enough that the taxpayer has acquired through any form of legal relationship the right to share in the oil produced. Palmer v. Bender, supra.And a right to share in the profits from the sale of the oil following extraction is analogous to a right to share in the mineral itself. Helvering v. Twin Bell Oil Syndicate, 293 U.S. 312; Anderson v. Helvering, supra;Kirby Petroleum Co. v. Commissioner, supra;Burton-Sutton Oil Co. v. Commissioner, supra.However, the term "economic interest" does*139 not embrace a "* * * mere economic advantage derived from production through a contractual relation to the owner by one who has no capital investment in the mineral deposit * * *." Helvering v. Bankline Oil Co., supra.On the contrary, it appears clearly that an allowance for depletion is warranted only where, by *974 agreement between the parties, the taxpayer has obtained a capital interest in the oil and gas in place, to the severance and sale of which one must look for the return of capital consumed in that process. The right to share in the net receipts disassociated from an economic interest therein does not entitle the holder thereof to an allowance for depletion. Kirby Petroleum Co. v. Commissioner, supra;Burton-Sutton Oil Co. v. Commissioner, supra;Anderson v. Helvering, supra;Helvering v. O'Donnell, 303 U.S. 370.
In the instant case, it cannot be gainsaid that petitioner possessed an economic interest in the oil involved. The dispute arises as to whether petitioner was the sole owner of such an interest*140 during the taxable years. Petitioner contends that it acquired and has retained the entire economic interest conveyed under the Agreement for State Easement No. 392. Respondent, on the other hand, rejects petitioner's contention and argues on brief that the upland owners, by their endorsement of the Agreement for State Easement No. 392, became parties thereto; that such owners thereby acquired an economic interest in the oil and gas in place directly from the State; that the income received therefrom by the upland owners is includible in their gross income, rather than that of petitioner, subject to the depletion deduction here in dispute.
We have no desire or purpose to enter into the dispute as to the claims to rights in the submerged coastal areas (see United States v. California, 332 U.S. 19 [1947]) and what we say herein is not intended in any way to pass upon the competing interests asserted in that litigation or growing out of the cited decision. 4
*141 Prior to 1938 the State allowed such oil property as is here involved to be developed and operated from piers, islands or barges. In that year the State Legislature passed the so called State Lands Act of 1938 pursuant to the provisions of which such methods of drilling and development were proscribed. This Act called for each well thereafter drilled in the submerged lands to be drilled from filled lands or slant-drilled from an upland or littoral drill site. All equipment, derricks, machinery, appliances, surface structures and operations were required to be located upon such site. Section 87 (a), Chap. 5, Calif. Stats., Ex. Sess., 1938. This statute was passed as a regulatory measure applying to the development and exploitation of the coastal oil deposits. Obviously, the Act was not meant to convey any economic interests therein to anyone. Nor do we believe that it so did. Consequently, *975 insofar as the 835 acres here involved are concerned, any present economic interests therein were acquired by virtue of, and simultaneously with, the Agreement for State Easement No. 392 or through some transaction subsequent thereto.
The State and petitioner were the only parties*142 to the body of this agreement. The granting clause therein granted to petitioner the sole and "* * * exclusive right to drain, take, receive, extract, remove, and produce from the * * * lands oil, gas, and other hydrocarbon substances * * *." This right is not made subject to any preexisting rights and there is no provision therein for income derived from oil production to be shared with third parties. Within its four corners, then, it would appear that such economic interests as were passed therein, were acquired by petitioner alone. Nor do we feel that further interests were obtained by other parties outside thereof because of the endorsement attached thereto but not included therein by any reference. There also appears to have been no such acquisition by third parties through any action on the part of the petitioner. There are in evidence three instruments whereby petitioner acquired the requisite upland easements. In return for such easements the owners thereof were granted the right to 24 1/2 per cent of the net profits derived from petitioner's operations. But we do not feel that such parties thereby acquired a capital interest in the oil in place. One such agreement*143 specifically provides that it shall not be so construed as to be a transfer of "* * * any right, title or interest in [the] * * * State lands or in or under [the] * * * State Easement, * * *"; and that it was the express intention of the parties thereto not to create a partnership relationship. Further, these parties were never owners nor lessees of the leased property. They did not, and could not, during the taxable years, have produced oil therefrom. Nor did they at any time during the period have any capital investment in the oil or gas in place. Cf. United States v. Spalding, supra.It would seem that the above-mentioned agreements could be terminated or modified at any time petitioner's agreement with the State of California was so terminated or modified. Under these circumstances it would appear that the upland drill sites and the agreements granting them to petitioner could be abandoned and terminated by petitioner at any time the State of California might see fit to change its policy toward drilling in the submerged coastal lands.
In summation, then, it is our view that petitioner was the sole recipient under the Agreement for State *144 Easement No. 392 of an economic interest in the oil property involved; that at no time thereafter was any economic interest therein acquired by third parties; that the *976 amounts equal to 24 1/2 per cent of petitioner's net profits were not paid as royalties or rents based upon an economic interest therein; and that, therefore, these amounts are includible in petitioner's gross income subject to the statutory allowance for depletion. Accordingly, we so hold. Respondent's claim for increased deficiencies, affirmatively set out in his amended answer, will be considered in the recomputation under Rule 50.
Decision will be entered under Rule 50.
Footnotes
1. REGULATIONS 111. INCOME TAX.
Sec. 29.23 (m)-16. Charges to capital and to expense in case of oil and gas wells. -- (a) Taxable years beginning prior to January 1, 1943. -- The provisions of this subsection apply only to taxable years beginning prior to January 1, 1943.
(1) Items chargeable to capital or to expense at taxpayer's option:
(i) Option with respect to intangible drilling and development costs in general: 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, may, at the option of the taxpayer, be deducted from gross income as an expense or charged to capital account. Such expenditures have for convenience been termed intangible drilling and development costs. Examples of items to which this option applies are, all amounts paid for labor, fuel, repairs, hauling, and supplies, or any of them, which are used (A) in the drilling, shooting, and cleaning of wells; (B) in such clearing of ground, draining, road making, surveying, and geological work as are necessary in preparation for the drilling of wells; and (C) in the construction of such derricks, tanks, pipe lines, and other physical structures as are necessary for the drilling of wells and the preparation of wells for the production of oil or gas. In general, this option applies only to expenditures for those drilling and development↩ items which in themselves do not have a salvage value. For the purpose of this option labor, fuel, repairs, hauling, supplies, etc., are not considered as having a salvage value. even though used in connection with the installation of physical property which has a salvage value. Drilling and development costs shall not be excepted from the option merely because they are incurred under a contract providing for the drilling of a well to an agreed depth, or depths, at an agreed price per foot or other unit of measurement. [Emphasis added.]
2. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* * * *
(m) Depletion. -- In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each case; such reasonable allowance in all cases to be made under rules and regulations to be prescribed by the Commissioner, with the approval of the Secretary. * * *↩
3. SEC. 114. BASIS FOR DEPRECIATION AND DEPLETION.
* * * *
(b) Basis for Depletion. --
* * * *
(3) Percentage depletion for oil and gas wells. -- In the case of oil and gas wells the allowance for depletion under section 23 (m)↩ shall be 27 1/2 per centum of the gross income from the property during the taxable year, excluding from such gross income an amount equal to any rents or royalties paid or incurred by the taxpayer in respect of the property. * * *
4. Since the decision in United States v. California, supra↩, extraction of oil from the California submerged coastal lands, pursuant to leases previously granted by the State, has been authorized by stipulations executed by the State and the United States. See Hearings before Senate Committee on Interior and Insular Affairs on S. 155, 81st Cong., 1st Sess., pp. 279-282; Hearings on S. J. Res. 195, 81st Cong., 2d Sess., pp. 22-26; S. J. Res. 20, 82d Cong., 1st Sess., pp. 13-17.