*1527 1. Petitioners were the owners of an oil payment payable out of seven-sixteenths of the oil produced by designated wells. A seven-sixteenths interest in the oil produced was assigned to them until the payments were completed. Held, petitioners were the owners of an economic interest in the oil properties involved and amounts received by them during the taxable year under these payments must be included in income, the cost basis of such payments to be recouped only through depletion. T. W. Lee,42 B.T.A. 1217">42 B.T.A. 1217, followed.
2. Petitioners, under the terms of two agreements, one for the assignment of an interest in an oil and gas lease, and the other for the execution of a similar lease, were required to drill two wells on each of the leases. Held, the costs of drilling and developing such wells may not be deducted as an ordinary and necessary business expense under article 23(m)-16 of Regulations 94 but must be capitalized, since by the provisions of the described agreements the drilling of the wells constituted the consideration for the assignment and execution of the leases here involved.
*246 These proceedings, consolidated for trial, are brought for the redetermination of the following deficiencies in income tax:
| Calendar year 1935 | Calendar year 1936 | |
| F. F. Hardesty | $69.23 | $828.71 |
| Mrs. F. F. Hardesty | 69.23 | 844.71 |
| Estate of R. A. Elliott | 219.80 | |
| Mrs. E. Caddie Elliott | 219.80 |
There are two questions presented, the first of which is involved only in the two Hardesty cases: (1) Are petitioners entitled to apply the entire amount of receipts from a certain oil payment owned by them to liquidate the cost before reporting any of such receipts as taxable income? and (2) Is the Hardesty-Elliott Oil Co., in which the petitioners own partnership interests, entitled to deduct as an ordinary and necessary business expense the cost of drilling two wells each on the Richter "A" and "B" leases under article 23(m)-16 of Regulations 94 in determining the income distributable and taxable to petitioners?
An additional issue relating to the respondent's determination that the drilling agreement here involved constituted a taxable exchange has been settled*1529 by concession of error by the respondent.
The facts have been stipulated and as so stipulated are adopted as our findings. The material portion of them is set out hereinafter.
FINDINGS OF FACT.
Petitioners F. F. Hardesty and Eula P. Hardesty are husband and wife, residing at 2215 Forest Park Boulevard, Dallas, Texas. They were married prior to 1935 and all of their income received during the taxable years constituted community income.
R. A. Elliott (now deceased) and petitioner E. Caddie Elliott were husband and wife during the taxable year and had their principal office at 1218 Fair Building, Fort Worth, Texas. All of their income received during the taxable year constituted community income.
Issue No. 1.
Petitioner F. F. Hardesty acquired on September 17 and on October 2, 1934, interests in certain oil payments known as the Haddaway oil payments, by means of agreements executed on those dates which provided as follows: Petitioner F. F. Hardesty and two others agreed to drill immediately two oil wells on described parcels of land, certain equipment and material, labor, and fuel costs to be supplied by petitioner and his cocontractors. The consideration for*1530 drilling these wells was two oil payments each in the amount of $22,500 payable each *247 out of seven-sixteenths of the total oil produced by each well. By further provision of the agreement seven-sixteenths of all the oil and gas produced by each well was assigned to the petitioner and his two cocontractors to be held by them until the agreed payments had been fully made when such interest was to revert to the owner of the lease. In the event that the oil and gas produced was not sufficient to pay petitioner F. F. Hardesty and his cocontractors the payments agreed to be made, they were authorized to salvage the material placed in the wells and to apply the amounts realized first to salvaging expenses and then to the balance due on the $22,500 payments. Any balance then remaining due was to be paid out of seven-eighths of the oil produced from another well which petitioner was in such instance authorized to drill.
Petitioner F. F. Hardesty's share of the oil payments to be received under these agreements was $11,250, of which $1,459.46 and $2,230 were received by him in the calendar years 1935 and 1936, respectively. His portion of drilling costs incurred pursuant to*1531 the agreements was $5,051.64. The Commissioner has determined that petitioner may apply to the liquidation of the cost of the drilling only that percentage of the payments received in each year which drilling cost bears to the total payment to be received. In this way he has determined that 5,051.64/11,250 of the payments or $655.35 for 1935 and $1,000.35 for 1936 may be applied to cost and the balances of $804.11 and $1,229.65 must be taxed equally to petitioner and his wife as income for those respective years.
Issue No. 2.
The Hardesty-Elliott Oil Co. was during the taxable years a copartnership in which petitioners had the following interests: R. A. Elliott (now deceased), 10 percent; F. F. Hardesty, 25 percent. The remaining 65 percent was owned by one William Fleming, trustee.
On April 9, 1936, the F.H.E. Oil Co., a corporation, acting jointly for itself and the Hardesty-Elliott Oil Co., entered into an agreement designated an "Assignment of Oil and Gas Lease" by which O. L. Killian, the owner of a certain described oil and gas lease known as the Richter "A" lease, sold, assigned, and transferred to the F.H.E. Oil Co., as assignee, a three-fourths interest in the*1532 lease, which reserved to the lessor, in the usual form, one-eighth of the minerals taken from the leased premises. The assignor retained the remaining one-fourth interest in the lease. The assignee was given full power to develop, operate, and manage the lease and to sell the oil taken therefrom, the assignor to bear one-fourth of operating costs and to receive one-fourth of the net proceeds realized from the oil, payable monthly and secured by a lien on the total oil produced.
*248 It was provided in addition that "as part of the consideration for this assignment and the rights thereby granted" the assignee was to immediately commence the drilling of a well on the leased premises, furnishing equipment and doing all things necessary to complete the well. If the first well should produce as much as one hundred barrels of oil per day the assignee agreed to drill a second well in similar fashion.
The Hardesty-Elliott Oil Co. and the F.H.E. Oil Co., acting jointly, commenced the drilling of an oil well on the Richter "A" lease on April 10, 1936, which was completed on May 9, 1936. Thereafter a second well was begun on the lease on June 10, 1936, and completed on July 6, 1936. *1533 Both wells were commercial producers. In connection with the drilling of the two said wells the partnership expended as its share of the necessary fuel, labor, hauling, and other items of intangible drilling and development costs a total of $10,727.34. Of this amount so expended the partnership deducted on its books and in its income tax return as an ordinary and necessary business expense the sum of $7,795.10 and capitalized the remainder, or $2,932.24.
On March 23, 1936, the F.H.E. Oil Co., a corporation, acting jointly for itself and the Hardesty-Elliott Oil Co., entered into an agreement designated a "development contract and escrow agreement" with one Henry H. Furth and others in which it was stated that on that date Henry H. Furth et al. had executed to the F.H.E. Oil Co. an oil lease known as the Richter "B" lease on certain described land and had delivered the lease to the St. Louis Union Trust Co. as escrow agent. The F.H.E. Oil Co. agreed therein to begin the drilling of a well on the land covered by the lease within 30 days and to drill the well to a named depth within 6 months unless gas or oil was found at a lesser depth. Drilling operations were not to be discontinued*1534 for more than 14 consecutive days during this period, $20 per day liquidated damages for a breach of this provision being agreed to by the parties. A substitute well was to be started within 20 days if the well should be lost by fire, accident, or act of God during the drilling period. It was further agreed that within 30 days after completion of the first well the F.H.E. Oil Co. would drill a second well in similar fashion.
On proof of the drilling of the first well to the required depth or the discovery of oil or gas in paying quantities at a lesser depth it was agreed that the lease held in escrow should be delivered to the F.H.E. Oil Co.
It was agreed in addition that the F.H.E. Oil Co., as security for its performance under the contract, should pay to the escrow agent $10,000, which should be returned on proof of the completion of the two wells.
*249 By provision of the agreement a copy of the lease was attached to it. The agreement was filed on May 6, 1936, and recorded on the following day in the deed records of Ward County, Texas.
The lease executed and delivered to the escrow agent on the day of the agreement reserved to the lessor the usual one-eighth*1535 royalty of all gas and oil produced and, in addition, reserved to the lessor the right to receive $20,000 out of one-eighth of the remaining seven-eighths of the oil or gas produced by both wells.
The Hardesty-Elliott Oil Co. and F.H.E. Oil Co. on May 13, 1936, entered upon the land covered by the Richter "B" lease and drilled two wells, completing the first on June 5, 1936, and the second on August 7, 1936. Both were commercial producers. Immediately after the completion of the first well and before the second was begun the escrow agent delivered to the F.H.E. Oil Co. and Hardesty-Elliott Oil Co. the Richter "B" lease, which was filed for record in the deed records of Ward County, Texas, on June 23, 1936.
In connection with the drilling of the two wells the Hardesty-Elliott Oil Co. incurred and paid in 1936 $7,768.75, or $3,884.38 per well, as its share of the expenditures for wages, fuel, repairs, hauling, supplies, etc., and other items of intangible drilling or development costs. No portion of such expenditures was deducted by the partnership on its books or Federal income tax return for 1936.
The Hardesty-Elliott Oil Co. had prior to the taxable year consistently followed*1536 throughout its existence the practice of charging to expense all expenditures for wages, fuel, repairs, hauling, and supplies, etc., of the type classified as intangible drilling and development costs by article 23(m)-16 of Regulations 94, incurred by it in drilling oil and gas wells upon its properties and it consistently made its tax returns upon that basis.
OPINION.
ARUNDELL: The issues in this proceeding have been enumerated at the outset and will be considered in the order there set forth.
Issue No. 1.
We are called on here to say whether the petitioners, F. F. Hardesty and his wife, may apply the whole of the proceeds received by them during the taxable year 1935 under the Haddaway oil payment to the cost of that payment as claimed by them, or may thus apply only the portion representative of cost and report the residue as taxable income as claimed by the respondent. The petitioners concede on brief that the issue here is substantially the same as that presented in T. W. Lee,42 B.T.A. 1217">42 B.T.A. 1217. In that case, contrary to the contentions of both parties in the instant case, we held that the basis of oil payments *250 which represented an economic*1537 interest in the oil properties to which they applied, as evidenced either plainly by an assignment to the payee of the oil interest out of which the payments were to be made or more remotely by other factors, must be recovered through depletion. Accordingly, we held that proceeds received under such oil payments must be included in taxable income, with appropriate deductions for depletion.
The disposition of the present case is governed by that holding. In the situation before us there was an assignment of the interest from which the payments were to be made and accordingly no close question arises as in T. W. Lee, supra. It is clear that petitioners had an economic interest in the oil properties in question and they must therefore recoup their cost of the oil payment through depletion.
Accordingly, petitioners must include in income the entire amount of the proceeds received during the taxable year under the oil payments and are not entitled to the allowance for the return of cost made by the respondent. They are, however, entitled to appropriate deductions for depletion.
Issue No. 2.
The question for decision under this issue is whether any of the*1538 intangible development and drilling costs incurred by the Hardesty-Elliott Oil Co., a partnership, in drilling the four wells, as described above, on the Richter "A" and "B" leases may be deducted as a business expense from the income of the partnership in computing the income distributable and taxable to petitioners.
Petitioners raise a preliminary question, contending that the issue as it relates to the Richter "A" lease is not properly before us, since it was not raised in the original pleadings or amendments thereto, but is an affirmative issue raised by the respondent for the first time on supplemental brief. The situation as to this is somewhat unusual. The petitioners by amended petition squarely raised the issue in allegations that "respondent erred in failing and refusing to allow as a deduction * * * the said intangible drilling and development costs totaling $10,727.34 and $7,768.75 respectively." These allegations were denied by the respondent's answer to the amendment. Consequently, the petitioners err in their statement that the issue was not raised by the pleadings. In the petitioners' first brief filed in these proceedings they say that "the issue presented by*1539 the amended petitions with respect to drilling costs on the Richter 'A' lease is hereby waived." Therein they recognize that they raised the issue which they now say was never raised by the pleadings. As the petitioners have waived the issue, perhaps it would be sufficient to say that the issue should be decided for the respondent on the waiver. But the respondent asks for decision on the merits, and the petitioners have *251 filed a reply brief arguing the question at length, apparently not desiring to have it decided on their waiver. In this posture of affairs we think the question properly before us for decision on the merits and we prefer to so dispose of it.
As the cases now stand as to this issue, the respondent has not allowed deductions for the cost of drilling wells on the Richter "A" and "B" leases for the reason that they constitute, in his view, the capital cost of the interests in the leases which were acquired thereby and must, therefore, be capitalized. The principal argument of the petitioners in reply is that the drilling and development of the leases in question did not constitute "consideration" for the interests acquired by the Hardesty-Elliott Oil*1540 Co. in the leases and that as ordinary intangible development and drilling expenses they are deductible on the authority of article 23(m)-16 of Regulations 94.
We have previously passed on the general question which is thus framed. It arises here, as in several former instances, where the taxpayer in the execution or assignment of an oil lease or a deed to oil property agrees to drill a certain number of wells on the leased or acquired premises. We have held in this situation that, where it is clear that the drilling constitutes consideration for an interest in the land or lease, the drilling and development costs so incurred must be capitalized. See State Consolidated Oil Co.,19 B.T.A. 86">19 B.T.A. 86; affd., 66 Fed.(2d) 648; certiorari denied, 290 U.S. 704">290 U.S. 704; Nunn-Stubblefield Oil Co.,31 B.T.A. 180">31 B.T.A. 180. The Circuit Court of Appeals in affirming the former case noted the argument of the taxpayer that authority to deduct such drilling costs as business expense was found in article 223 of Regulations 62, which corresponds to article 23(m)-16 of Regulations 94, relied on by petitioners here. The court in answering that argument held that*1541 this provision of the regulations applied only to expenses incurred on land which the taxpayer owned or had theretofore leased and was "not intended to apply to one who drills a well upon land in performance of a contract to purchase an interest therein."
The issue presented thus resolves itself into the question of whether, in the circumstances of each of the two leases and agreements before us, the development and drilling which the Hardesty-Elliott Oil Co. was obligated to perform may properly be regarded as the consideration for the interests acquired in the leases. This requires a separate consideration of each lease and its pertinent agreement.
The terms of the instrument of assignment by which the Hardesty-Elliott Oil Co. acquired a three-quarters interest in the Richter "A" lease expressly provide that the assignee shall drill two wells on the leased premises, under certain conditions, "as part of the consideration for this assignment and the rights hereby granted." It must, therefore, be assumed that the parties to the agreement regarded the *252 outlays to be made by the Hardesty-Elliott Oil Co. in drilling as the quid pro quo for the assigned interest in*1542 the lease. This is a factor of prime significance in making the determination which we are called on to make and, unless contradicted by the circumstances surrounding the agreement, may be accepted as conclusive. See United States v. Sentinel Oil Co., 109 Fed.(2d) 854, where it was agreed by the parties that the drilling was the consideration for the lease involved. Such contradiction is not to be found in the fact that the assignment was completed before the drilling was begun. While this factor has been thought to be of significance by the Commissioner as set forth in G.C.M. 10686, C.B. XI-2, p. 257, his views have now been altered as shown by G.C.M. 22224 (July 23, 1940). The petitioners concede on brief that no argument in their favor may be founded on the time of the assignment of the lease. From an interpretation of the whole instrument it seems plain that the drilling operations were directly attributable to the requirements of the assignment and constituted a part of the consideration therefor. In this situation, and in view of the fact that no other circumstance attendant on the execution of the assignment which might alter*1543 this conclusion have come to our notice, it must be held on the authority of Nunn-Stubblefield Oil Co., supra,State Consolidated Oil Co., supra, and United States v. Sentinel Oil Co., supra, that the costs of drilling and developing the Richter "A" lease must be capitalized. Compare Edwards Drilling Co.,35 B.T.A. 341">35 B.T.A. 341; affd., 95 Fed.(2d) 719; Cook Drilling Co.,38 B.T.A. 291">38 B.T.A. 291; and F.H.E. Oil Co.,41 B.T.A. 130">41 B.T.A. 130, 134, cases in which the deduction of drilling costs as business expense is allowed since it is held that the interest acquired did not constitute an interest in the land.
Petitioners urge, however, that Nunn-Stubblefield Oil Co., supra, is distinguishable from the instant case in that there the transaction involved an exchange of the drilling operations for the lease, the transferor of the lease retaining merely an overriding royalty interest and in no way participating in the operation of the lease. In the present case, on the other hand, it is contended that the arrangement contemplated constituted a joint venture in which the drilling*1544 operations were contributed by petitioners as their share in the venture. Therefore, it is said, the petitioners became the owners of a three-quarters interest in the venture by virtue of the agreement, and the drilling which took place thereafter was thus done on a lease owned at least in part by the petitioners. In this guise, it is contended, the situation falls within the situation contemplated by article 23(m)-16 and petitioners are thus entitled to deduct the three-fourths of the expense in proportion to their ownership.
We do not regard this interpretation of the assignment agreement as the true one. The object of the assignor in entering into the contract, as is made plain by the provisions placing in the assignee's *253 hands the whole management of the lease and the disposition of the oil and gas, was to secure the development of the lease by another, retaining to himself a share in the profits, if any, resulting from the oil and gas produced. The whole cost of the development was to be borne by the assignee, without risk of the loss of any money to the assignor. It is true the assignor agreed to pay a portion of the operating expenses after the wells were*1545 drilled and had begun to produce, but this by provision of the agreement was to be subtracted from the gross proceeds of the oil to which the assignor was entitled. The situation differs therefore only slightly from the royalty arrangement agreed on in Nunn-Stubblefield Oil Co., supra, and for our purposes here that difference is without significance. The principal fact remains that the assignee received an interest in the lease in consideration of his agreement to drill on the leased premises; this requires capitalization of the drilling expense without regard to the fact that thereafter the proceeds of the oil were to be divided and the expenses borne by both parties to the agreement.
The question raised by the provisions of the Richter "B" lease and the accompanying "Development Contract and Escrow Agreement" presents a somewhat closer issue. The provisions of the agreement are plain enough as to the drilling of the first well on the Richter "B" lease. It is expressly stated to be "in consideration of the covenants and agreements set out in said oil and gas lease." This conclusion, moreover, is bolstered by the escrow provisions which expressly render the*1546 delivery of the lease dependent on petitioners' meeting this requirement. As to the second well, however, the result is less plain. It was to be drilled after the delivery of the lease and the failure to drill it was to result only in the forfeiture of the $10,000 bond as liquidated damages. These factors, however, we deem insufficient to make any distinction between the first and second wells. United States v. Sentinel Oil Co., supra.In that case it was held that the time of the transfer to the taxpayer-driller of the interest which was to be transferred in connection with the drilling was not determinative of whether the drilling constituted consideration for the transfer. The significance of the liquidated damages provision in its application to the second well is paled by the fact that it applies equally to the performance of all other provisions of the agreement, including the drilling of the first well.
A significant feature of the agreement relative to the Richter "B" lease which in our opinion compels the conclusion that the drilling of both wells constituted consideration for the lease is the form in which the agreement was executed, separate*1547 and apart from the lease itself and in lieu of the payment of any consideration in cash at the time of executing the lease. This factor also answers petitioners' argument *254 that in the more usual oil and gas lease the prime or only consideration is the royalties agreed to be paid. In this case we have more than a simple oil lease; there is a separate agreement under which petitioners assume obligations for the discharge of which they are to receive full and free title to the lease. The costs thus incurred by them are plainly consideration for the lease and must be capitalized.
Decision will be entered under Rule 50.