*654 OIL AND GAS WELLS - "TURNKEY" OR "FOOTAGE" DRILLING CONTRACTS. - Petitioners entered into a contract for the drilling of a well on land covered by an oil and gas lease, which provided that the well should be drilled to a depth of 2,950 feet for a total consideration of $11,000, payable $4,000 in cash and $7,000 in oil if, as, and when produced, saved and marketed. The contractor did not agree to furnish all labor, material, and equipment and turn over a completed well for a stipulated price. Petitioners furnished fuel and water, some labor and trucking, and made other expenditures in the nature of intangible expenses, amounting to $3,344.05. Held, such contract was not a "turnkey" contract, and petitioners are entitled to deduct intangible drilling and development expense from gross income in determining net taxable income; held, further, such expense is not deductible in computing the limitation on the percentage depletion allowance provided in section 114(b)(3), Revenue Act of 1932.
*804 These are consolidated*655 proceedings for the redetermination of deficiencies in income tax for the calendar year 1933 in the amount of $490.04 in the case of each petitioner. Petitioners assign as error the action of respondent (1) in including in their gross income oil payments made directly to petitioners' assignors, or predecessors in title, from oil and gas leases operated by them; (2) in disallowing as an expense deduction the cost of cement used in an oil well; and (3) in computing the limitation on the depletion allowance by deducting from gross income from the property certain intangible drilling and development expenses. At the hearing respondent was granted leave to file, and subsequently did file, an amended answer making claim for increased deficiency on the ground that he had erroneously allowed a deduction of $13,367.45 alleged to be a capital expenditure, representing the amount paid for an oil well under a "turnkey" contract.
FINDINGS OF FACT.
Petitioners are husband and wife, residing in Tyler, Texas, and the property and income referred to herein were their community property and income under the laws of Texas.
During 1933 petitioners operated two oil and gas leases, one of which*656 was known as the Cook lease and the other as the Long lease. In the instruments through which the titles to these properties were acquired, it was provided that a fraction of the oil from the respective properties should go to the assignors, or their predecessors in title, until they had received oil, or proceeds from the sale of oil, in a specified amount. The fractions of the oil so specified were delivered by petitioners to the pipe lines serving the properties to the credit of the respective holders of the oil payments, who received payment directly from the purchasers of the oil, and not from petitioners. The amount so received in the taxable year by *805 the holders of the oil payment on the Cook lease was $1,762.70. The amount received in such year by the holder of the oil payment on the Long lease was $5,201.97. Respondent, in determining the deficiencies, included these amounts in petitioners' gross income.
Petitioners claimed in their returns an expense deduction $360of, representing the cost of cement installed in a well on the Long lease, which deduction was disallowed by respondent. The purpose of putting cement in an oil well is to hold the casing, and*657 to prevent water and sand from getting into the upper stratum or oil producing horizon. After the cement is once installed, it is impossible to salvage any part of it.
Petitioners customarily followed the practice of charging to expense the intangible drilling and development cost incurred in drilling oil wells.
During the taxable year petitioners caused a well to be drilled on the Long lease, and in their returns deducted for drilling and development expense the total sum of $14,344.05, which included the item of $360 for cement, above referred to. From the total amount so claimed as a deduction for drilling and development expense, respondent subtracted the amount of $616.60 as unpaid balance of oil payment to the drilling contractors, and the amount of $360 for cement, and allowed the balance of $13,367.45 as a deduction from petitioners' taxable gross income in determining the deficiencies in controversy. However, respondent also deducted the same amount from the gross income from the property in computing the limitation on the percentage depletion allowance provided in section 114(b)(3) of the Revenue Act of 1932.
On October 15, 1932, petitioners entered into a contract*658 for the drilling of the well in question on the Long lease, the drilling contractors being therein referred to as the second parties, reading in part material here as follows:
Now THEREFORE, it is agreed between the parties as follows: Second parties for and in consideration of the agreements and obligations on the part of the first party to be done, paid and performed, as hereinafter set out, do hereby agree, bind and obligate themselves to go upon the oil and gas leasehold estate covering the lands above described at a location to be selected by first party and begin the actual drilling of a well thereon not later than the 25th day of October, 1932, and to drill same with all reasonable care and caution to a depth of 2,950 feet * * *
* * *
Second parties shall furnish all labor, a complete drilling rig and all necessary equipment for the drilling of said well, and shall at their own expense carry all necessary insurance for the protection of those parties working in and about said drilling operations and shall at all times hold first party harmless for any injury or accident which may be caused to any person or property by said drilling operations.
* * *
*806 In*659 consideration of the agreements and obligations to be done, paid and performed on the part of the second parties first party does hereby agree, bind and obligate herself to pay to second parties the sum of FOUR THOUSAND ($4,000.00) DOLLARS in cash within three days after the completion of said well and does further agree, bind and obligate herself to deliver to the Security State Bank of Wewoka, Oklahoma, an assignment in favor of second parties for SEVEN THOUSAND ($7,000.00) DOLLARS payable out of 1/4th of all of the oil and/or gas if, as and only when, however, same is produced, saved and marketed from said leasehold estate * * *
OPINION.
HILL: The first issue for decision here is whether respondent erred in including in petitioner's gross income certain oil payments made directly to their assignors or predecessors in title from oil and gas leases operated by them. During the taxable year petitioners operated two oil and gas leases, known as the Cook lease and the Long lease, respectively. The fractions of the oil reserved by petitioner's assignors, or their predecessors in title, were delivered to the pipe line companies and the proceeds paid directly to them by the purchasers*660 of the oil, the amount so paid in the taxable year to the holder of the oil payment on the Cook lease being $1,762.70, and on the Long lease $5,201.97. In determining the deficiencies, respondent included these amounts in petitioners' gross income. Such action was erroneous. The amounts in question should be excluded from petitioners' gross income, and should also be excluded in computing the percentage depletion deduction allowable to petitioners. ; .
The second and third issues will be considered together. During the taxable year petitioners caused a well to be drilled on the Long lease, and in their income tax returns claimed a deduction of $14,344.05 as intangible drilling and development expense. The deficiencies in controversy here were determined by respondent in accordance with a revenue agent's report, approved by him. In such report the deduction mentioned was allowed in the amount of $13,367.45. The amount of $976.60 thereby disallowed consisted of two items, the first being $360 representing cost of cement used in the well drilled on the Long lease, which*661 petitioners charged to drilling and development expense and included in the deduction of $14,344.05, but which respondent capitalized and added to equipment cost; the second item being $616.60 representing unpaid balance of oil payment at December 31, 1933, referred to in the revenue agent's report as "given in payment for footage contract for drilling well."
The latter adjustment is not questioned by the petitioners, but they contend that the $360 expended for cement used in the well is properly a part of drilling and development expense, and that respondent erred in disallowing such item.
*807 In determining the deficiencies, respondent also deducted the sum of $13,367.45 as operating expense in computing the net income from the property, 50 percent of which is a limitation upon the amount allowable for percentage depletion under the provisions of section 114(b)(3) of the Revenue Act of 1932. Petitioners assail this action of the respondent as erroneous, and their contention must be sustained. Whether or not the sum of $13,367.45 is properly deductible from gross income in determining the taxable net income of petitioners, it is not an operating expense, and, therefore, *662 in any event, is not deductible in computing the limitation on the percentage depletion allowance. Respondent's action on this point is reversed. ;; ; .
While respondent originally allowed the sum of $13,367.45 as a deduction from gross income on account of drilling and development expense, by amended answer respondent now alleges that such action was erroneous, in that the amount allowed represented the cost to petitioners "of the drilling of a completed well under a 'turn-key' job contract and was improperly allowed as a deduction." And respondent formally makes claim for the increased deficiency which would result from the correction of the alleged error.
Decision of the question raised by respondent's amended answer depends on whether the contract for the drilling of the well on the Long lease was a "turnkey" contract, or provided for the drilling on a footage basis. The consideration paid under a "turnkey" contract represents an expenditure*663 for the acquisition of a capital asset, and is not a deductible expense. ; ; ; . If the contract under consideration was not a "turnkey" contract, the amount in controversy is deductible as expense pursuant to the option exercised by petitioners under article 236 of respondent's Regulations 77, Revenue Act of 1932, the pertinent provisions of which are set out in the margin. 1
*664 *808 A "turnkey" contract is one which requires the drilling contractor to furnish all casing, fuel, and material and to turn over a completed well for a stipulated price. ;. In , the contracts designated as "turnkey" contracts required a "completed well, with equipment furnished by the contracting driller, in place and ready for production." A footage contract is one which provides for payment "at so much per foot of well drilled."
The contract for the drilling of the well on the Long lease, involved in the instant case, we think clearly was not a "turnkey" contract, but should be classified as a "footage" contract. The contractors did not agree to furnish all labor, material, and equipment and to turn over a completed well for a stipulated price. They agreed only to furnish all labor, a complete drilling rig, and necessary equipment for drilling the well, together with accident insurance, and to drill the well to a depth of $2,950 feet, for which they were to be paid a total consideration of $11,000, consisting of $4,000*665 in cash, and $7,000 in oil if, as, and when produced, saved, and marketed. Thus, the consideration for the drilling of the well was slightly less than $3.73 per foot, and the contract was no less a "footage" contract because it recited a total stipulated lump sum consideration for drilling to a depth of $2,950 feet instead of an agreed price per foot.
Moreover, it appears from the record that petitioners furnished the fuel and water, labor and trucking, and cement and fittings, and made other expenditures in the nature of intangible expenses, amounting to $3,344.05; they obviously also furnished all casing and other equipment required to complete the well and put it into operation.
In our opinion, respondent's original action, in treating the contract as a footage contract and in allowing the disputed deduction in determining the deficiencies, was proper. The claim set forth in the amended answer for increased deficiency is, therefore, denied.
This leaves for examination only the question whether respondent erred in disallowing, as a part of the deduction for intangible drilling and development expense, the sum of $360 representing the cost of cement used in the well drilled*666 on the Long lease. Respondent's regulations, quoted supra, provide for charging to expense, at the taxpayer's option, "expenditures for those drilling and development items which in themselves do not have a salvage value." The evidence before us shows that the cement used in the Long well may properly be regarded as a drilling and development item, and that after installation it did not have, and could not possibly have had, any salvage value. The amount in controversy is, therefor, deductible. Respondent's action is reversed.
Judgment will be entered under Rule 50.
Footnotes
1. (a) Items chargeable to capital or to expense at taxpayer's option.
(1) Option with respect to intangible drilling and development costs in general: All expenditures for wages, fuel, repairs, hauling, supplies, etc., incidennt 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. * * * 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. * * * ↩