*257 Decision will be entered under Rule 50.
As consideration for certain of its stock, petitioner agreed to pay over a period of 20 years certain percentages of the oil and gas produced under its seven-eighths working interest in oil and gas leases, after deducting certain expenses. The percentages were the only recourse of the parties who transferred the stock. Held, on the facts, that the parties transferring the stock received economic interests in the oil and gas in place and that the amounts paid to them in the taxable years are not includible in petitioner's income.
*549 The Commissioner determined a deficiency of $ 3,002.86 in income tax*258 for the year 1940. The questions involved are whether the amount of $ 25,646.18 from certain oil and gas runs, paid by petitioner to two former shareholders, is includible in petitioner's taxable income for 1940, and, if so, whether the amount of $ 25,646.18 is deductible as interest under section 23 (b), of the Internal Revenue Code. Other issues not presented for determination, will, by agreement between counsel, be reflected in entry of decision under Rule 50.
FINDINGS OF FACT.
The petitioner, an Oklahoma corporation, has had its principal office since about April 1937 in San Antonio, Texas. It is engaged in the business of acquiring developed and undeveloped oil and gas leases, developing and operating oil and gas leases, selling oil and gas leases or interests therein, producing oil and gas and other minerals, and carrying on all other activities incident thereto. Its income and excess profits tax returns for 1937 and all subsequent years were filed in the first district of Texas at Austin, Texas.
Since its organization in 1922 the petitioner has kept its books of account and made its income and excess profits tax returns on an accrual basis.
The capital stock of petitioner*259 issued in 1922 and outstanding in 1936 was held by persons as follows:
| Shares | |
| Thomas Gilcrease | 650 |
| F. G. Walling | 150 |
| Pierce Larkin | 100 |
| G. B. Bancroft and wife (equally) | 100 |
| Total | 1,000 |
Walling and Larkin acquired the above shares of the par value of $ 100 each at or about the date of the organization of petitioner in 1922. without any cost to either of them.
On September 1, 1936, Walling entered into an installment contract in writing with Robert Lee Humber, under the terms of which Walling sold the 150 shares of petitioner owned by him to Humber for the sum of $ 208,000, payable $ 10,000 at the execution of the contract, $ 35,000 on or before December 30, 1936, and the remainder of $ 163,000 between January 1 and June 30, 1937. The certificates for the 150 shares were to be held in escrow by petitioner to secure the payment of the purchase price.
On or about December 5, 1936, petitioner advised Humber that it desired to purchase the 150 shares which he had purchased from Walling. Whereupon Humber on December 5, 1936, assigned to petitioner *550 all of his rights to such shares in consideration of the repayment to him by the petitioner of the sum of $ 10,000*260 which he had previously paid to Walling and the assumption by petitioner of the outstanding liability of Humber to Walling under the contract dated September 1, 1936. As an assignee of Humber, petitioner on December 30, 1936, executed its demand note for the sum of $ 35,000 payable to Walling and on the same date paid the note, leaving a balance of $ 163,000 outstanding and payable during 1937 to Walling under the contract of September 1, 1936.
On January 19, 1937, Walling was indebted to petitioner in the amount of $ 61,831.51, which amount was, pursuant to agreement, applied in reduction of the balance due and payable during 1937 from the petitioner to Walling, leaving an unpaid balance of $ 101,168.49. On January 19, 1937, Walling, as first party, and petitioner, as second party, entered into an agreement which, in so far as pertinent herein, is as follows:
Whereas, there is now due party of the first part herein for said stock from the second party, the sum of One Hundred One Thousand One Hundred Sixty Eight and 49/100 ($ 101,168.49) Dollars, and the parties hereto have agreed that the payment of said sum shall be changed and modified so that the second party may extend the *261 payment of said indebtedness over a period of years, as hereinafter provided, and as security therefor second party has agreed to assign to first party a portion of the net runs of all of the oil and gas produced and saved from the oil and gas leasehold estates more particularly set forth and described in Exhibit "A" hereto attached and made a part of this agreement.
Now, Therefore, It is hereby mutually agreed by and between the parties hereto, that the second party shall pay to the first party said sum of One Hundred One Thousand One Hundred Sixty Eight and 49/100 ($ 101,168.49) Dollars, together with interest thereon at the rate of 10% per annum from this date, said payments to be made in the following manner, to-wit:
A. The second party shall pay to the first party, on the 20th day of each and every month hereafter for a period of twenty (20) years from this date, 11% of the Gilcrease Oil Company's present interest in the oil and gas runs from the leasehold estates described in Exhibit "A", after deducting all legitimate operating and development expense accruing subsequent to this date, including a charge of Ten ($ 10.00) Dollars per well per lease, as office overhead.
B. All *262 payments shall first be applied to interest and the excess then be credited on said principal indebtedness.
C. The first party shall resort only to said 11% of the Gilcrease Oil Company's present interest in the oil and gas runs from said leasehold estates for the payment of said indebtedness, and in case said 11% shall fail, within twenty (20) years, to pay said indebtedness, the remaining unpaid portion thereof shall automatically become cancelled and the second party be released of all further liability. Any excess received by first party over and above the principal sum of the indebtedness herein named, shall be and become the property of the first party as additional consideration for the extension of the time for the payment of said indebtedness as herein provided.D. The second party shall execute and deliver to the first party an assignment of said 11% of the present interest of the Gilcrease Oil Company in the oil and gas runs from said leasehold estates and which assignment shall be of full force *551 and effect for a period of twenty (20) years, at the expiration of which time said assignment shall become null and void, and all rights therein shall revert to second*263 party.
E. It is further understood and agreed that in the event of the sale or disposition of any of the leaseholds described in said Exhibit "A", any such transfer shall be made subject to the 11% interest of the first party above described.
In conformity with the above agreement petitioner executed and delivered to Walling a separate assignment of oil and gas runs covering each oil and gas lease affected by the above agreement. The assignments were identical in all respects, except for the introductory recital clauses thereof describing and locating each oil and gas lease. The assignments, omitting the introductory recitals, were as follows:
Now, Therefore, in consideration of One Dollar (and other good and valuable considerations) the receipt of which is hereby acknowledged, the undersigned, the present owner of said interest in the said lease and leasehold estate, and all rights thereunder, or incident thereto, does hereby bargain, sell, transfer, assign and convey eleven (11%) percent of all its said right, title and interest as above set forth, within and to the net proceeds of the oil and gas produced from said * * * interest now owned by it, to F. G. Walling, his heirs and*264 assigns, up to and including the 18th day of January, 1957, after which date this assignment shall become null and void and of no further force nor effect, and said interest so assigned herein shall immediately thereafter revert to said Gilcrease Oil Company, its successors and assigns, assignor herein.
Complete operative control of said lease is hereby reserved to assignor or its assignees during the life of said lease and assignor or its assignees are authorized to sell and receive the proceeds of all oil and/or gas produced from said leased premises during the life thereof.
In Witness Whereof, the undersigned assignor has executed this instrument this 19th day of January, 1937.
On or about December 1, 1938, Walling assigned an undivided one-half interest in and to the oil runs to which he was entitled under the agreement between himself and petitioner of January 19, 1937, to his wife, Katherine A. Walling.
On February 2, 1937, petitioner, as second party, entered into an agreement with Larkin, as first party, whereby it acquired 100 shares of petitioner's stock owned by Larkin. The agreement, in so far as pertinent, provided as follows:
Whereas, the first party has agreed to accept*265 said sum of One Hundred Fifty Thousand ($ 150,000) Dollars for said stock and to extend the payment thereof over a period of years, as hereinafter provided, and as security therefor second party has agreed to assign to the first party a portion of the net runs of all of the oil and gas produced and saved from the oil and gas leasehold estates, more particularly set forth and described in Exhibit "A" hereto attached and made a part of this agreement.
Now, Therefore, It is hereby mutually agreed by and between the parties hereto that the second party shall pay to the first party the sum of One Hundred Fifty Thousand ($ 150,000) Dollars, together with interest thereon at the rate of 10% per annum from this date, said payments to be made in the following manner, to-wit:
*552 A. The second party shall pay to the first party on the 20th day of each and every month hereafter, for a period of twenty (20) years from this date, 12 1/2% of the Gilcrease Oil Company's present interest in the oil and gas runs from the leasehold estates described in Exhibit "A", after deducting all legitimate operating and development expense accruing subsequent to this date, including a charge of $ 10.00 *266 per well per month per lease, as overhead.
B. All payments shall be applied to interest and the excess then be credited on said principal indebtedness.
C. The first party shall resort only to 12 1/2% of the Gilcrease Oil Company's present interests in the oil and gas runs from said leasehold estates for the payment of said indebtedness, and in case said 12 1/2% shall fail, within 20 years, to pay said indebtedness, the remaining unpaid portion thereof shall automatically become cancelled and the second party be released from all further liability. Any excess received by first party over and above the principal sum of the indebtedness herein named, together with interest as herein provided, shall be and become the property of the first party as additional consideration for the extension of the time for the payment of said indebtedness, as herein provided.D. The second party shall execute and deliver to first party assignments of 12 1/2% of the present interests of the Gilcrease Oil Company in the oil and gas runs from the leasehold estates, which assignments shall be of full force and effect for a period of twenty (20) years, at the expiration of which time said assignments shall *267 become null and void, and all rights therein shall revert to second party.
E. It is further understood and agreed that in the event of the sale or disposal of any of the leaseholds described in said Exhibit "A," any such transfer shall be made subject to the 12 1/2% interest of the first party above described.
In conformity with the above agreement the petitioner extended and delivered to Larkin separate assignments, identical in form in all respects, except for the introductory recital clauses therein, describing and locating each oil and gas lease, of "12 1/2% of all of its right, title and interest * * *, within and to the net proceeds of the oil and gas produced" from the leasehold estates described in Exhibit A of the agreement "up to and including the 1st day of February, 1957." The assignments were in the same form as the assignments given to Walling, except for the difference in the name of the assignee, interest transferred, and closing date.
The oil and gas mineral estates from which the Walling and Larkin interests were conveyed are the seven-eighths mineral working interest, or fractional parts thereof, covering lands in Oklahoma and Texas.
The stock certificates evidencing*268 the capital stock of petitioner acquired by it from Walling and Larkin were marked "Cancelled" by petitioner.
As of December 31, 1936, the par value of the issued and outstanding capital stock of petitioner was reduced to $ 85,100 and as of December 31, 1937, it was $ 75,100. The $ 100 par value share (above the $ 85,000 par value and $ 75,000 par value, respectively) represented a qualifying share issued to C. H. Steel prior to December 31, 1936. *553 The foregoing reductions in stock were by reason of the acquisition of the Walling and Larkin shares.
One of the leases affected by the Walling agreement of January 19, 1937, and the Larkin agreement of February 2, 1937, was commonly described in petitioner's books of account as the Sullivan lease. The wells on this leasehold, which were producing at around 3,100 or 3,200 feet, sometime prior to December 15, 1939, went dry. Petitioner contacted drilling contractors who agreed to drill a well to a horizon of about 7,500 feet at a cost of about $ 22,500. Both Walling and Larkin were consulted relative to the incurring of the additional developing expense. Walling did not want to incur a pro rata share of such expense and on*269 December 15, 1939, he and his wife assigned to petitioner an undivided 11 percent of 40 percent of the oil and gas runs up to and including January 18, 1957, from the Sullivan tract. Larkin, however, agreed to the proposed drilling and retained his interest. The well was drilled, but proved to be dry.
Operations of the leases involved in the Walling and Larkin agreements were conducted by petitioner at all times without consultation with Walling and Larkin. They were consulted only in the case of unusual circumstances which required extraordinary expenditures for the further development of leases such as were required on the Sullivan lease. Monthly statements were made by petitioner, showing gross income from the sale of oil and gas runs from each lease involved in the Walling and Larkin agreements, operating expenses, development expenses, overhead, and net income or loss and the percentage and amount thereof credited (or debited as the case was) to Walling and Larkin.
According to petitioner's records there was paid from 1937 to 1944, inclusive, under the Walling agreement a total of $ 88,049.17, of which $ 72,451.33 was applied on interest and $ 15,597.84 on principal, leaving*270 a balance due on principal to Walling and his wife at the end of 1944 of $ 85,570.65 and interest of $ 1,037.64. There was paid from 1937 to 1944, inclusive, under the Larkin agreement a total of $ 97,474.91, all of which was applied on interest, leaving a balance due on principal to Larkin at the end of 1944 of $ 150,000, and $ 19,986.63 on interest.
During the calendar year 1940, payments based on the agreement and assignments involved herein made by petitioner were as follows:
| Applied on | |||
| Payments | |||
| Principal | Interest | ||
| F. G. Walling | $ 7,842.35 | $ 2,282.16 | $ 5,560.19 |
| Katherine A. Walling | 6,280.57 | 1,714.02 | 4,566.55 |
| Pierce Larkin | 15,519.44 | 15,519.44 | |
| Total | 29,642.36 |
*554 In its Federal income and excess profits tax return for the calendar year 1940, petitioner claimed an interest deduction of $ 25,646.18 as follows:
| F. G. Walling | $ 5,560.19 |
| Katherine A. Walling | 4,566.55 |
| Pierce Larkin | 15,519.44 |
| Total | 25,646.18 |
The deduction was disallowed by the Commissioner.
OPINION.
The facts are not materially disputed -- except that petitioner contends that Walling and Larkin from time to time reimbursed petitioner for their proportionate*271 part of development expenses. The evidence is only that they were debited with such proportionate part, and we have so found. With such finding, and eliminating unessentials, the situation is in substance that petitioner acquired some of its stock in consideration of certain 20-year interests in oil leases -- more fully described below. That amounts of money were designated as "payment" for the stock is immaterial, since under the agreements the seller could resort only to the oil and gas interest for "payment," accepting same for the 20-year period for the stock, whether that period produced more or less than the amount stated in dollars. The consideration for stock was clearly the oil and gas interest, not an agreement to pay stated amounts. Nor is it important that the agreements described the oil and gas runs as assigned "as security," for on the whole agreement they were not security, but consideration. There was no personal liability to be secured.
Though the respondent calls the question one of deductibility of ordinary and necessary business expense (or, in the alternative, of deductibility of interest), plainly it is: Whose was the income from the oil and gas leases, *272 in the percentages here involved? The test has in effect been made the same as whether the economic interest in the oil and gas is such as to require allowance of depletion, that is, whether there is a capital investment in the oil and gas in place. Anderson v. Helvering, 310 U.S. 404">310 U.S. 404.
Under the facts here before us, it is our opinion that the vendors, Walling and Larkin, obtained such economic interest. The language of Palmer v. Bender, 287 U.S. 551">287 U.S. 551, allowing depletion to one who acquires "by investment, any interest in the oil in place, and secures, by any form of legal relationship, income derived from the extraction of the oil, to which he must look for a return of his capital," describes the vendors here. Since they must perforce look to the oil and gas *555 only, for the return of their capital, it was income derived from extraction of oil, and we think it can not be soundly denied that they had an interest in the oil in place. Distinction has been made between payment from "net profits" and "net proceeds" from oil or gas property; e. g., Helvering v. Elbe Oil Land Development Co., 303 U.S. 372">303 U.S. 372;*273 Helvering v. O'Donnell, 303 U.S. 370">303 U.S. 370; Helvering v. Bankline Oil Co., 303 U.S. 362">303 U.S. 362; Euleon Jock Gracey, 5 T. C. 296, citing Quintana Petroleum Co., 44 B. T. A. 624, wherein the matter was considered as one of profit sharing, though the word "net proceeds" appears in the instrument involved. A mere covenant to pay "net profits" does not convey an economic interest. Here, however, there was no mere agreement to share profits. The interests in oil and gas here involved are variously described in the agreements and the assignments executed pursuant thereto. In the contracts (as to both Walling and Larkin) it is agreed that petitioner assign as security "a portion of the net runs of all of the oil and gas produced and saved from the oil and gas leasehold estates"; also, that petitioner shall for 20 years pay 11 percent (12 1/2 percent in case of Larkin) of petitioner's interest "in the oil and gas runs from the leasehold estates * * * after deducting all legitimate operating and development expense * * *," including a charge of $ 10 per well as overhead. *274 The contracts further refer to resort only to the stated percentage of petitioner's interest "in the oil and gas runs" and provide that there shall be executed an assignment of the stated percentage of the petitioner's interest "in the oil and gas runs," and that any transfer of the leaseholds shall be subject to such 11 percent (or 12 1/2 percent) interest. Each assignment, entitled "Assignment of Oil and Gas Runs," recites the assignment of the stated percentage of petitioner's interest "within and to the net proceeds of the oil and gas produced," and reserves operative control of the leases to petitioner. It is thus seen that primarily there was conveyed an interest in oil and gas produced with provision for deduction of expenses -- at the least, a conveyance of net proceeds of the oil and gas produced, and not mere profits. Such conveyance has been held to carry a depletable economic interest. Hugh Hodges Drilling Co., 43 B. T. A. 1045. That case considered various leases, interests in which were conveyed for consideration in services rendered, and included instances where shares in the net proceeds from oil and gas runs were conveyed. Also, *275 in some instances, the conveyances were described, as here, as by way of security. Thus, in one of the situations covered, the petitioner contracted to drill a well for oil or gas, and to receive for such service $ 84,000 out of the oil or gas out of three-fourths of the seven-eighths working interest, until $ 84,000 had been run to his credit; plus three-eighths vested interest *556 in the lease; but if oil or gas was produced from the well in insufficient quantities to amount to $ 84,000 (out of the interest specified), the petitioner would be entitled only to the amount produced therefrom, and if none was produced, he would receive nothing. In short, as here, he was to receive (if oil was produced) whatever was produced from the designated interest less than $ 84,000 in value, and above that value an interest in the lease. Operating expenses were to be borne proportionately if oil or gas was produced. Here, the situation is in one respect even more clearly seen to entail only an interest in the oil or gas, for in the instant case Walling and Larkin were to receive the stated percentage, even though over the 20-year period it might amount to more than the amount stated *276 in dollars. Another situation examined in Hugh Hodges Drilling Co. involved drilling a well for $ 80,000, to be paid only out of three-eighths of the seven-eighths working interest and the production of oil or gas due therefrom, with joint operation and deduction of actual operating expense. The arrangement was stated to be "as security," and recited that payment was to be only out of the conveyed "net working interest," after payment of expenses. A third situation in the same case involved a well drilled for which the driller was to be paid "the first $ 200,000.00 income derived from the sale of oil and/or gas produced from the 12/16ths of the 7/8ths working interest," to insure which payment that amount of "income and proceeds" was assigned -- all this after deduction of actual operating expenses. The driller was to control and operate until paid. All these arrangements and others not detailed here were held to convey economic interests subject to depletion.
In Spalding v. United States, 97 Fed. (2d) 697; certiorari denied, 305 U.S. 644">305 U.S. 644, net proceeds from oil and gas were consideration for drilling and other services. *277 The court distinguished net profits and net proceeds, and held that a depletable economic interest was acquired for the drilling and services. It is to be noted that, as in the instant case, the contract was for a term of years. See also Caldwell Oil Corporation, 47 B. T. A. 707; affd., 141 Fed. (2d) 559. We conclude and hold that the vendors, Walling and Larkin, acquired economic interests subject to depletion and that the proceeds of such interests paid them in 1940 did not constitute income to the petitioner. Helvering v. Armstrong, 69 Fed. (2d) 377; Reynolds v. McMurray, 60 Fed. (2d) 843. Hence, the $ 25,646.18 is excludible from petitioner's income.
This renders it unnecessary to consider the alternative contention that deductible interest was paid by the petitioner.
Decision will be entered under Rule 50.