1946 U.S. Tax Ct. LEXIS 243">*243 Decision will be entered under Rule 50.
1. Cash payments and certain costs of drilling and equipping a test well on an oil and gas lease were consideration for the acquisition of an ownership interest in such lease and are recoverable only through depletion and depreciation allowances.
2. Certain expenditures made in drilling and equipping oil and gas wells in consideration for the right to receive payments from the proceeds of oil and gas if, as, and when produced until such payments should equal the amount of such expenditures plus a bonus and interest were not loans secured by such oil payments, but were a capital investment in an economic interest in oil and gas in place, and they are recoverable only through depletion allowances.
3. Under various agreements, petitioner paid the owners of an oil and gas lease an amount in cash, cleaned out an existing oil well on the lease, drilled and equipped two additional wells, and advanced to the owners $ 250 in cash. Controversies arose as to the resulting rights of the parties in the leasehold. In settlement thereof a new agreement was made annulling the prior agreements and stipulating that petitioner was the owner of an undivided1946 U.S. Tax Ct. LEXIS 243">*244 one-third of the leasehold and in addition had the right to receive $ 50,000 with interest out of oil from the entire leasehold, if, as, and when produced. Held, that petitioner acquired such ownership in the lease and an in-oil payment interest in the remaining undivided two-thirds of the lease at the date of the agreement last made; that each such interest is a separate capital assset; and that the cost of each such interest is a capital investment recoverable only through depletion allowances.
4. Held, as to each lease here involved, petitioner's undivided fractional interest therein and an in-oil payment in the remaining fractional interest are separate properties in computing percentage depletion.
6 T.C. 628">*629 This proceeding is for the redetermination of a deficiency in petitioner's income tax for the calendar year 1941. The return for that period was filed with the collector of internal revenue at Oklahoma City, Oklahoma. Respondent determined a deficiency of $ 6,450.21, which petitioner contests only to the extent of1946 U.S. Tax Ct. LEXIS 243">*245 $ 3,406.86. At the trial an amendment to petition was filed, and respondent filed an amended answer asking that the deficiency determined be increased by the amount of $ 4,739.12, bringing the total of the deficiency determined and claimed to $ 11,189.33 and the amount in controversy to $ 7,782.47.
The determinative questions presented are: (1) Whether for purposes of computing allowance for depletion the interests of petitioner in each of two oil and gas leases comprise two properties or only one property; (2) whether intangible drilling and development costs of certain oil and gas wells are deductible as expenses or must be capitalized as the cost of a capital asset, recoverable only through depletion allowances; and (3) whether the right to receive payments from the proceeds of oil and gas if, as, and when produced, limited to the recovery of a specified sum of money, was security for the repayment of a loan or was a capital asset the cost of which is recoverable only through depletion allowances.
FINDINGS OF FACT.
Petitioner, an Oklahoma corporation with its principal office in Tulsa, Oklahoma, was engaged during the year 1941 in business as an oil and gas well drilling contractor. 1946 U.S. Tax Ct. LEXIS 243">*246 In connection with that business it entered into contracts for the drilling of wells in the testing and development of oil and gas leases referred to as the Stumps and Warner leases. Under these contracts petitioner received, or was to receive, certain interests in such leases and the oil production therefrom.
Stumps Lease.
On June 27, 1941, petitioner (called contractor) entered into an agreement with Branine and Goering (called owners) to drill, equip, and complete a test well and thereafter to drill such other well or wells, if any, as might be agreed upon, on a certain oil and gas lease then owned by the latter and known as the Stumps lease, covering land located in Ellsworth County, Kansas.
6 T.C. 628">*630 Pertinent provisions of the contract are:
1. Subject to examination and approval of title in the manner hereinafter provided, Contractor agrees within fifteen (15) days after acceptance thereof to commence operations for the drilling of a test well for oil and gas (on certain described land) and to thereafter drill the same to a depth sufficient in the judgment of Contractor to test the Arbuckle Sand horizon usually found in said locality at an approximate depth of thirty-three1946 U.S. Tax Ct. LEXIS 243">*247 hundred (3300) feet, said drilling cost to be advanced and paid by Contractor, and if said well, in the sole judgment of Contractor, does not justify running pipe and testing after reaching the depth above mentioned, then and in such event Contractor may plug and abandon said well and this agreement shall be thereafter terminated and at an end.
2. It is further understood, however, that if Contractor shall deem it advisable to run pipe and test said well, then and in such event the cost of running pipe, cement, acidizing, shooting, equipping or otherwise testing and putting said well on production shall be advanced and paid by Contractor. If the well is not completed as a commercial producer, Contractor shall have the right to plug and abandon the same, pulling pipe and salvaging all recoverable material, retaining title thereto, Owners not to be chargeable with any part of said advanced costs or expense. If, however, said well is completed as a producer of oil or gas in paying quantities, then the cost of testing, completing and equipping said well shall be sustained as hereinafter provided.
3. After the completion of the first well upon the leasehold premises above described, 1946 U.S. Tax Ct. LEXIS 243">*248 such additional wells may be drilled upon said leasehold premises as may be mutually agreed upon by the parties hereto. The entire cost of drilling and the entire cost and expense of completing, testing and equipping of such additional wells shall be likewise sustained and paid in the manner hereinafter provided. * * *
4. Upon approval and acceptance of title Owners agree to make, execute and deliver to Contractor assignment of an undivided one-half (1/2) interest in and to the aforementioned oil and gas mining leases, which shall be an absolute conveyance. Concurrent with the execution and delivery of the aforementioned assignment, owners shall also make, execute and deliver to Contractor an additional assignment of the remaining one-half (1/2) interest in and to the aforementioned oil and gas mining leases, together with the production of oil, gas and casinghead gas which may hereafter be produced from any wells located upon said acreage, said assignment to be in the nature of a mortgage to secure Contractor against the cost and expense advanced by Contractor hereunder for the account of owners. Contractor shall reassign said undivided one-half (1/2) interest in and to said leases1946 U.S. Tax Ct. LEXIS 243">*249 and the production therefrom to Owners when and in the event Contractor shall have been fully reimbursed in the manner hereinafter provided for its expense incurred in performing the operations provided herein. Owners further covenant and agree to in no manner encumber said mortgaged undivided one-half (1/2) interest in any of said leases or wells which may be located thereon, or the production therefrom, during the life of this agreement.
5. For all wells drilled by Contractor hereunder (except the first well), it shall be entitled to charge Owners one-half (1/2) of the footage charge for drilling, and for day work, * * * together with one-half (1/2) of the actual cost otherwise incurred by Contractor for labor, material, equipment, acidizing and various types of testing which may be deemed advisable, and other miscellaneous charges * * *. Upon the completion of each well Contractor shall prepare a statement reflecting such expense, including all items properly included therein, to which 6 T.C. 628">*631 total the sum of six (6) per cent shall be added, the same constituting a part of Contractor's profit for the performance of said drilling and the furnishing of said services, material1946 U.S. Tax Ct. LEXIS 243">*250 and equipment.
6. It is further understood and agreed that Contractor shall have the operation of all leases and wells which may be drilled upon the above described leasehold premises hereunder, Contractor to charge Owners one-half (1/2) of the amount necessarily laid out and expended for such operations, statements and supporting papers reflecting the same for the preceding calendar month to be furnished Owners by Contractor monthly, the amounts so paid currently to become a part of the obligation payable to Contractor hereunder in the manner herein provided. * * *
7. Owners agree to make, execute and deliver to Contractor proper division or transfer orders, effective with first production, designed to allow Contractor to collect and receive the proceeds of all of the production of oil, gas and casinghead gas accruing to the interest of Owners from all of said leases and the wells hereafter completed thereon. The monies so received shall be applied monthly on the amount becoming due to Contractor hereunder, Contractor being permitted to charge said account interest at the rate of six (6) per cent per annum, computed monthly on current balances. It is further agreed and understood1946 U.S. Tax Ct. LEXIS 243">*251 that if Owners shall desire to sell and dispose of their retained interest in and to any undeveloped lease they shall have the privilege of doing so, and Contractor shall release its mortgage thereon, provided, however, that Contractor shall receive the proceeds of any such sale to apply on the amount due it accruing hereunder. Contractor shall likewise receive the proceeds from the sale of any material or equipment which may be salvaged from said leases and wells during the life of this agreement, one-half (1/2) of the same to be credited on the amount due Contractor.
8. It is agreed to be the real purpose and intent of this contract that as the consideration to Contractor it is to receive and acquire title to an undivided one-half (1/2) interest in said leases above described, as heretofore mentioned, and retain the same, and is to receive, in the nature of a mortgage, an assignment covering the remaining one-half (1/2) interest, the proceeds from the sale of production from said interest to be received by Contractor, if, as and when produced, and which (with other sources of revenue secured to Contractor hereunder) shall operate to carry the retained interest of Owners without1946 U.S. Tax Ct. LEXIS 243">*252 personal liability for any deficiency which may so occur.
* * * *
14. Notwithstanding anything hereinabove contained, Owners reserve the right at any time, upon ten (10) days notice in writing to Contractor, to tender any pay off in cash the full amount due Contractor on the date of payment, computed in conformity with this agreement, Contractor thereupon to re-assign all right, title and interest hereunder acquired in and to an undivided one-half (1/2) interest in the above described leases.
15. When and in the event Contractor shall have been fully reimbursed for all sums due it under this agreement, and there shall be no further drilling operations which may be mutually considered desirable, then and in that event this contract shall terminate and Contractor shall make, execute and deliver to Owners a reassignment of their undivided one-half (1/2) lease interest above mentioned. It is further understood and agreed that if one-half (1/2) of the proceeds from production and the sale of leases and salvage shall be insufficient to fully reimburse and discharge the obligation to Contractor hereunder, Owners shall have no personal liability for such deficiency.
16. It is further agreed1946 U.S. Tax Ct. LEXIS 243">*253 that at such time as Contractor shall have been fully reimbursed in the manner hereinabove provided for one-half (1/2) of the cost 6 T.C. 628">*632 of developing and operating said leases to the extent that the parties may mutually agree upon, and Owners' undivided one-half (1/2) interest therein shall have been reassigned to them, settlement shall be made monthly by Owners to Contractor in cash for their proportionate part of the cost of future operation of said properties.
Pursuant to the foregoing agreement and subject to the terms thereof, Branine and Goering, on July 23, 1941, by duly executed instruments in writing, made an absolute conveyance to petitioner of an undivided one-half interest in the Stumps lease, together with all personal property thereon or used or obtained in connection therewith. Simultaneously with the execution of the foregoing designated conveyance Branine and Goering, by duly executed instruments in writing, assigned to petitioner the remaining undivided one-half interest in and to the Stumps lease, together with all personal property thereon. These latter instruments of assignment were in form absolute conveyances, but were executed pursuant to the terms of1946 U.S. Tax Ct. LEXIS 243">*254 paragraph 4 of the foregoing agreement, which provided that such remaining undivided one-half interest should "be in the nature of a mortgage to secure Contractor against the cost and expense advanced by Contractor hereunder for the account of Owners," and that "Contractor shall reassign said undivided one-half (1/2) interest in and to said leases and the production therefrom to Owners when and in the event Contractor shall have been fully reimbursed in the manner hereinafter provided for its expense incurred in performing the operations provided herein."
In 1941 petitioner drilled and equipped well No. 1. This was the test well which it was required to drill under the terms of the foregoing agreement.
The cost to petitioner of absolute ownership of an undivided one-half interest in the Stumps lease was the total of the following itemized amounts:
| Cost of drilling well No. 1 | $ 7,644.01 |
| One-half of cost of cleaning and testing well No. 1 | 1,529.08 |
| One-half of cost of equipping well No. 1 | 4,706.45 |
| Cash payment | 500.00 |
| Total | 14,379.54 |
In 1941 petitioner also drilled and equipped on the Stumps lease three wells in addition to well No. 1, all being commercial producers1946 U.S. Tax Ct. LEXIS 243">*255 except the last, well No. 4, which was a dry hole.
The total of all costs, expenses, and cash advancements which petitioner was authorized under the foregoing agreement to recover from the proceeds of produced oil attributable to the remaining undivided one-half interest in the Stumps lease was the measure of the cost of its right to receive for such purposes the proceeds of oil as produced from such remaining undivided one-half interest.
6 T.C. 628">*633 Under the terms of the agreement and the instruments of assignment above referred to, petitioner received all the oil runs from the Stumps lease during the year 1941.
Warner Lease.
On December 9, 1941, petitioner entered into a final agreement with Branine and Holl respecting an oil and gas lease known as the Warner lease, covering property located in Rice County, Kansas. This contract was substituted for and expressly revoked agreements between the same parties dated May 5, and September 5, 1941, and an undated agreement. The provisions of the contract of May 5 with respect to the drilling of a test well and advancement of the expenses thereof are substantially the same as those of the Stumps contract. The agreement of December 1946 U.S. Tax Ct. LEXIS 243">*256 9, 1941, defined the rights and obligations of the parties thereto in respect of the Warner lease which arose out of such revoked agreements and the operations and performances thereunder. It stipulated (1) that petitioner was the absolute owner of an undivided one-third interest in the leasehold, subject to an outstanding oil payment of $ 10,000 reserved to one S. L. Parks, and (2) that Branine and Holl were absolute owners of an undivided two-thirds interest in the leasehold, subject to the $ 10,000 oil payment of Parks and subject to the terms and conditions set forth in the contract.
Pursuant to the agreement Branine and Holl, on December 9, 1941, jointly executed an assignment to petitioner of an undivided one-third interest in the Warner lease, subject to the $ 10,000 oil payment to Parks. On the same day they jointly executed an assignment to petitioner of an undivided two-thirds interest in the leasehold subject to the Parks oil payment and the terms of the contract of December 9 to secure to petitioner its in-oil payment in such two-thirds interest.
In 1941, prior to the agreement of December 9, 1941, petitioner paid Branine and Holl $ 14,000 in cash and drilled and equipped1946 U.S. Tax Ct. LEXIS 243">*257 well No. 2 and well No. 3, both commercial producers, on the Warner lease under the agreements which were revoked by the agreement of December 9, 1941. There was already one producing well on this lease when petitioner drilled well No. 2. Also in 1941 prior to December 9, petitioner advanced $ 250 in cash to Branine and Holl. This advancement was not for the development and operation of the lease, but was charged against the leasehold interest of Branine and Holl and was to be recovered solely out of the proceeds of oil from such lease.
In further defining the rights and obligations of the parties thereto in respect of such lease, the agreement of December 9, 1941, provided that petitioner was to receive all of the oil or gas produced and saved from the leasehold until receipt therefrom totaled $ 50,000, with interest at 6 percent per annum from December 5, 1941. Proceeds from all 6 T.C. 628">*634 oil sold from the leasehold up to the time of execution of this contract which had been or would be received by petitioner were to be applied as a credit upon the $ 50,000. All future development and operation of the leasehold was to be by mutual consent of the parties, cost to be paid by 1946 U.S. Tax Ct. LEXIS 243">*258 petitioner, with no personal obligation whatsoever on Branine and Holl. Such costs, however, were to be added to the $ 50,000 and the whole to be repaid, with 6 percent interest, solely from oil produced. Petitioner was to pay out of the proceeds of such oil produced, first, all future cost of operation and maintenance of the leasehold, and the balance thereof was to be applied to the repayment of other moneys expended by petitioner as above indicated. When and if the $ 50,000 and authorized additions were repaid to petitioner out of oil, petitioner was to reassign an undivided one-third interest to Branine and an undivided one-third interest to Holl. Branine and Holl, on ten days notice, were to have the right to pay off in cash the full amount then owing petitioner as computed under the agreement, and petitioner was then to make the reassignments to each as indicated above.
The expenditures which petitioner had made in respect of the Warner leasehold property in 1941 when the agreement of December 9, 1941, was executed and on the basis of which the respective rights of petitioner and its assignors in such leasehold were defined and determined, were the following itemized amounts: 1946 U.S. Tax Ct. LEXIS 243">*259
| Cash payment | $ 14,000.00 |
| Cost of cleaning well No. 1 | 213.07 |
| Cost of drilling well No. 2 | 10,835.43 |
| Cost of drilling well No. 3 | 15,638.07 |
| Cost of equipping wells Nos. 2 and 3 | 19,658.65 |
| Cost of operations | 406.25 |
| Advancement of cash | 250.00 |
| Total | 61,001.47 |
Under the terms of the agreement of December 9, 1941, petitioner had the right to recover $ 33,333.33 of the above total amount expended solely out of the proceeds of the oil attributable to its assignors' undivided two-thirds interest in the leasehold if, as, and when such oil was produced. The cost to petitioner of its one-third ownership in such lease was the difference between $ 61,001.47 and $ 33,333.33, or $ 27,668.14.
The cost to petitioner of the right to receive the proceeds of oil attributable to the two-thirds undivided interest of its assignors if, as, and when such oil was produced, was two-thirds of $ 50,000, or $ 33,333.33, plus such, if any, additional cost and expenditures which were likewise so recoverable under the terms of the agreement of December 9, 1941.
6 T.C. 628">*635 OPINION.
There is no controversy as to the amounts of the expenditures or as to the amount of the gross income in the taxable 1946 U.S. Tax Ct. LEXIS 243">*260 year attributable to the respective leaseholds herein involved.
The divergent contentions of the parties grow out of the characterization ascribed to such expenditures. As to the Stumps lease, petitioner contends that the cost of drilling well No. 1 was $ 7,644.01, and that this amount, plus the cash payment of $ 500, constitutes the consideration for the acquisition of its undivided one-half ownership in that lease. It attributes one-half of all other expenditures to its ownership in the lease under various characterizations other than capital investment. In the taxable year petitioner deducted as expense intangible drilling and development cost attributable to its one-half ownership of the lease. We are unable to determine from the record what, if any, other expenditures attributable to its one-half ownership petitioner deducted. The remaining one-half of all such other expenditures is designated by petitioner as oil payment costs, against which it claims the right to offset the proceeds of oil received under such oil payment arrangement until it has recovered the full amount of its oil payment cost. Petitioner, in effect, contends that its expenditures recoverable through 1946 U.S. Tax Ct. LEXIS 243">*261 oil payments constitute a loan and not the purchase price of a capital asset recoverable only through depletion allowances.
As to the Stumps lease, respondent contends that petitioner's undivided one-half ownership of the lease and its oil payment interest in the remaining undivided one-half of the lease constitute one property and that, therefore, the cost to petitioner of its leasehold interest is the cost of its ownership of an undivided one-half interest plus the cost of its oil payment interest in the other undivided one-half of the leasehold. Respondent further contends that such cost is a capital investment, recoverable only through depletion allowances.
As to the Warner lease, petitioner accounts for expenditures totaling $ 60,751.47. This total is made up of the itemized expenditures in connection with such lease set out in our findings of fact, less the item "advancement of cash, $ 250." In its amendment to petition, petitioner attaches this item to the Stumps lease. The evidence shows that this advancement was made to Branine and Holl, the assignors of the Warner lease. In its amendment to petition, petitioner allocates to leasehold cost only $ 2,660.15. Such amount1946 U.S. Tax Ct. LEXIS 243">*262 is part of the cash payment of $ 14,000. The remainder of such $ 14,000 is allocated to equipment cost and oil payment cost in the respective amounts of $ 2,006.52 and $ 9,333.33. One-third of the cost of drilling wells Nos. 2 and 3 and one-third of the cost of cleaning out well No. 1 were allocated to development expense and two-thirds to oil payment cost. One-third 6 T.C. 628">*636 of the cost of equipping wells Nos. 2 and 3 was allocated to equipment cost and two-thirds to oil payment cost. One-third of the cost of operations was allocated to lease operating expense and two-thirds to oil payment cost.
To summarize, petitioner allocated to leasehold cost $ 2,660.15, to development expense $ 8,895.52, to equipment cost $ 8,559.40, to lease operating expense $ 135.42, and to oil payment cost $ 40,500.98.
Of the Warner lease expenditure, it appears that the petitioner deducted the intangible drilling cost, or the amounts designated development expense. It is apparent also, that other designated expenditures were deducted by it in its income tax return, but we are unable to determine from the record the particular items and amounts of such deductions.
Petitioner claims the right to offset1946 U.S. Tax Ct. LEXIS 243">*263 oil payments against the expenditures recoverable only through such payments until it has recovered the full amount of such expenditures which it designates oil payment cost. In other words, petitioner contends, as it did in respect of the Stumps lease, that its expenditures recoverable through oil payments constitute a loan and not the purchase price of a capital asset recoverable only through depletion allowances.
Respondent contends, in respect of the Warner lease, that petitioner's undivided one-third ownership thereof and its oil payment interest in the remaining undivided two-thirds of such leasehold constitute one property and that, therefore, the cost to petitioner of this leasehold interest is the cost of its ownership of such undivided one-third interest plus the cost of its oil payment interest in the remaining undivided two-thirds of such leasehold. Respondent further contends that such cost is a capital investment, recoverable only through depletion allowances.
The basis of adjustments resulting in the deficiency, set forth in the explanatory letter accompanying the notice of deficiency, was the revenue agent's report. This report was admitted in evidence for the limited1946 U.S. Tax Ct. LEXIS 243">*264 purpose only of showing the revenue agent's method of computing depletion allowances. In such report depletion was computed both on the percentage basis and the cost basis, and on the theory that both interests in each leasehold were only one property instead of two properties. In his computation of cost depletion the revenue agent assumed a certain amount of oil reserve attributable to each of the two interests in each lease and then combined the two reserves as the reserve of one property. Also, in his computation of both percentage and cost basis depletion, the revenue agent treated as the cost of leasehold (one property) the total of the costs of both interests in each leasehold.
Since the revenue agent's report was admitted in evidence only for the limited purpose above indicated, and since such report is not 6 T.C. 628">*637 competent to establish the verity of its contents, it is not evidence of the amounts of oil reserves therein attributed to each of the leasehold interests involved. Moreover, there is no evidence in the record establishing such amounts.
Since the factor expressing the rate of depletion of oil reserves is a necessary element in the computation of cost depletion1946 U.S. Tax Ct. LEXIS 243">*265 allowance in respect of oil and gas in place, and since such factor can not be determined in the absence of the establishment of the amount of oil reserves, the revenue agent's method of cost depletion, computation, and the result thereof, are of no avail.
There being no basis in the facts of this case for cost depletion computation, allowable depletion must be computed on the percentage basis, and for the purposes of such computation we still have for decision the question of whether the two interests in each leasehold constitute one property or two properties.
We think that under the facts here the two interests in each lease must be held to be two properties, and we so hold. They are inherently separate and different in character. One is an outright ownership in fee of an undivided part of the leasehold estate. The other is less than a fee title interest in the remaining undivided part of the leasehold. There is no merger of the titles to the two interests. See G. C. M. 24094, 1944 C. B. 250. Cf. Wm. H. Cree, 47 B. T. A. 868. The undivided portions to which petitioner's two interests in each lease attached are fully1946 U.S. Tax Ct. LEXIS 243">*266 as distinct as if they were in separate leaseholds. Cf. Helvering v. Jewel Mining Co., 126 Fed. (2d) 1011; J. T. Sneed, Jr., 40 B. T. A. 1136; affd., 119 Fed. (2d) 767; certiorari denied, 314 U.S. 686">314 U.S. 686. Not only was it realistic and practical for petitioner to treat the two interests as separate properties, as was done in Black Mountain Corporation, 5 T.C. 1117, but it was under a legal obligation to so treat them in recording expenditures and income. We regard that treatment as correct under the statute and regulations governing depletion computation. Sec. 114 (b) (3), I. R. C.; sec. 19.23 (m)-1 (i), Regulations 103.
Hugh Hodges Drilling Co., 43 B. T. A. 1045, relied upon by respondent, is distinguishable as to both issue decided and facts controlling. We held there, with respect to the Day-Roff lease and the Hembree No. 1 lease, that a working interest in a lease until specified amounts are received therefrom in oil, with a lesser working interest thereafter, is a present depletable economic 1946 U.S. Tax Ct. LEXIS 243">*267 interest. The issue there was depletability, and we do not regard that decision as controlling here.
Recovery of petitioner's capital expenditures in the fee interest here is not limited solely to depletion allowances, but in part may be had through deduction of intangible drilling and development costs and depreciation allowances incurred subsequent to the vesting of such fee title. In the oil payment interests here all intangible drilling and 6 T.C. 628">*638 development costs and all equipment costs attributable thereto are capital expenditures applied to the acquisition of expansions or enlargements of such oil payment interests, and they are not deductible as expense, but are recoverable only through depletion allowances. As to the in-oil payment interest, petitioner has no depreciable property ownership or interest. Hence, in respect of the in-oil payment interest, no deductions are allowable for depreciation.
It follows that, while the oil and/or gas produced from the entire leasehold estate is attributable proportionately to each of the two interests until the in-oil payment obligation shall be fully satisfied, the limitation of percentage depletion allowance to an amount not 1946 U.S. Tax Ct. LEXIS 243">*268 in excess of 50 percent of net income may occasion a less amount of percentage depletion allowance proportionately in respect of the fee ownership interest than in the case of the oil payment interest. It may conceivably result in no depletion allowance for the fee interest and 27 1/2 percent depletion allowance for the oil payment interest. It is obvious that deductions for intangible drilling and development costs and for depreciation applicable in respect of the income attributable to the fee ownership of the lease are not available against the income attributable to the oil payment interest. However, a holding that the two interests in question are one property for depletion purposes would necessitate the computation of allowable depletion in violation of such announced principle.
Petitioner acquired an undivided one-half ownership in the Stumps leasehold in consideration of a cash payment of $ 500 plus the cost of drilling well No. 1 thereon and one-half the cost of cleaning out, testing, and equipping such well. The amount of the expenditures constituting such consideration, totaling $ 14,379.54, was a capital investment, recoverable only through depletion and depreciation1946 U.S. Tax Ct. LEXIS 243">*269 allowances. F. H. E. Oil Co. v. Commissioner, 149 Fed. (2d) 228; Commissioner v. Rowan Drilling Co., 130 Fed. (2d) 62; Hardesty v. Commissioner, 127 Fed. (2d) 843.
Subsequent intangible drilling and development costs in the taxable year attributable to petitioner's undivided one-half of such lease are deductible as expense under the provisions of Regulations 103, sec. 19.23 (m)-16 (a) (1). 1Hunt v. Commissioner, 135 Fed. (2d) 697; G. C. M. 22332, 1941-1 C. B. 228. Petitioner's deduction of such items as expense was an election so to do. Regulations 103, sec. 19.23 (m)-16 (d).
1946 U.S. Tax Ct. LEXIS 243">*270 6 T.C. 628">*639 Petitioner acquired an in-oil payment interest in the remaining undivided one-half of the Stumps lease. Such acquisition was an economic interest in the oil in place and hence a capital asset. Palmer v. Bender, 287 U.S. 551">287 U.S. 551; Thomas v. Perkins, 301 U.S. 655">301 U.S. 655. Its cost to petitioner is a capital investment, recoverable only through depletion allowances. Hugh Hodges Drilling Co., 43 B. T. A. 1045. See G. C. M. 24,849, 5 I.R.B. 4, 1946. The measure of such cost is the total amount of all costs, expenses, and advancements which petitioner was authorized by agreement with its assignors to recover from the proceeds of oil, attributable to such undivided one-half interest in the lease.
We hold that petitioner acquired an undivided one-third ownership of the Warner lease on the date, and by virtue, of its agreement of December 9, 1941, with Branine and Holl, and an assignment of even date therewith from Branine and Holl to petitioner. We hold that petitioner acquired an in-oil payment interest in the remaining undivided two-thirds interest in the Warner1946 U.S. Tax Ct. LEXIS 243">*271 lease on the date, and by virtue of, such agreement, and an assignment of even date therewith from Branine and Holl to petitioner. The cost to petitioner of its one-third ownership in such lease was $ 27,668.14, and the cost to it of the in-oil payment in the remaining two-thirds interest in such lease was $ 33,333.33. Each of the interests thus acquired was a separate capital asset and the cost of each such interest is recoverable only through depletion allowances. F. H. E. Oil Co. v. Commissioner, and other cases cited, supra.
The total payments, expenditures, and advancements made by petitioner in respect of the Warner leasehold on and prior to December 9, 1941, in the amount of $ 61,001.47, must be capitalized and allocated in the amounts above stated to the two capital investments above described.
Decision will be entered under Rule 50.
Footnotes
1. Sec. 19.23 (m)-16. Charges to capital and to expense in the case of oil and gas wells. -- (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., 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. * * *↩