*987 The petitioner was the owner of an oil and gas lease, and acquired by warranty deed, as to the greater portion of the land, the remaining interests of the lessor, i.e., the fee, less approximately a one-third interest in oil and gas royalties, sold by the lessor to others after execution of the lease. Petitioner then, for a lump sum consideration, assigned the lease as to the greater portion of the land (including lands upon which it had not purchased lessor's rights); executed an original lease on another smaller portion; assigned an oil payment which it had received in payment of a previous assignment of another portion of the lease; and entered into a "Royalty Owner's Agreement", granting to the purchaser certain concessions as to drilling offset wells and designating the purchaser of oil and gas. Held, petitioner is not entitled to percentage depletion upon the consideration received.
*522 In this proceeding there is involved income tax and excess profits tax for the year 1935 in the respective amounts of $9,860.32*988 and $3,585.57.
FINDINGS OF FACT.
The greater portion of the facts have been stipulated and are found by us as stipulated. We abstract the stipulated facts so far as pertinent to consideration of the issue presented, and find additional facts from the evidence, all as follows:
1. The petitioner, a corporation organized and existing under the laws of the State of Texas, has its principal office in Amarillo, Texas, and filed its income tax return for the year 1935 with the collector of internal revenue for the second district of Texas.
2. In 1921 T. D. Lewis and wife, Vida M. Lewis, executed an oil and gas lease to J. B. Martin, covering 2,269.76 acres of land in Hutchinson County, Texas, and 640 acres in Carson County, Texas. The lease reserved to the lessors a royalty of one-eighth of oil and gas produced.
3. In 1926 the Badger Oil Co. acquired by assignment the rights of J. B. Martin in 1,321 acres of the original lease, of which 250 acres were in Carson County, Texas, and the remainder in Hutchinson County, Texas.
4. In 1928 the petitioner assigned to the McIlroy Oil Co. 120 acres of the leasehold in Carson County, Texas. The consideration for such assignment*989 was the agreement by the McIlroy Oil Co. to pay to petitioner $1,,000 out of oil and/or gas, if and when produced and saved from the land.
5. In 1930 the petitioner acquired by assignment from Paul and Weatherly the lease on 126 additional acres in Hutchinson County, Texas, out of the original lease from T. D. Lewis and wife to J. B. Martin.
6. At various times prior to April 17, 1934, T. D. Lewis and wife conveyed to persons not involved herein approximately an undivided one-third interest in the oil, gas, and minerals and the right to receive royalties (but not the right to receive rentals or bonuses from future leases), as to the lands leased to Martin and subject to the lease to him.
7. On April 17, 1934, Vida M. Lewis and the heirs of T. D. Lewis, for a consideration of $40,000 executed to the petitioner a warranty deed to all of the lands in Hutchinson County, Texas, which had been *523 covered by the lease to J. B. Martin. The deed did not cover the lands in Carson County, which were subject to the lease to Martin. In addition to the usual terms of conveyance, the deed contained the following language: "It is our intention to convey all of our interest of*990 every kind and nature whatsoever in and to the above lands, including all of our interest in and to the minerals, rents, and royalties therein."
8. On February 1, 1935, the petitioner and the International Petroleum Co., hereinafter sometimes referred to as International, executed a contract providing for the sale by petitioner to International of (1) the leasehold acquired by the petitioner in 1926, except the 120 acres conveyed to McIlroy Oil Co.; (2) the unpaid portion of the $1,,000 oil payment payable to the petitioner from the McIlroy Oil Co., and (3) the lease on 126 acres in Hutchinson County acquired by the petitioner in 1930 from Paul and Weatherly. The contract provided for the execution and delivery by the petitioner of: (a) An assignment of the oil and gas lease to Martin so far as assigned to the petitioner and covering lands in Hutchinson and Carson Counties, Texas, except the 120 acres which had in 1928 been assigned to the McIlroy Oil Co.; (b) the unpaid portion of the $18,000 oil payment; (c) a bill of sale from the petitioner to International covering personal property in Hutchinson and Carson Counties, Texas, having connection with the leases assigned from petitioner*991 to International; (d) a "Royalty Owner's Agreement" by the terms of which, in effect, the petitioner agrees that, so far as it may lawfully do so, as owner of portion of the royalty interest reserved in the lease, it does not require International to offset existing wells or future wells having daily potential less than 30 barrels, and agrees further that to the extent of petitioner's interest the International shall have the right to designate the purchaser of such royalty, oil, and gas, provided the purchaser pays the current price; (e) an original oil and gas lease from the petitioner to the International, covering the N 1/2 of SW 1/4 of section 6, and W 1/2 of the SW 1/4 of section 7, in block 23, B.S. and F. lands in Hutchinson County, Texas, and providing for reservation of royalty of one-eighth of oil and gas.
9 A deed of trust was executed by International conveying the interests conveyed to B. C. D. Bynum as trustee for petitioner, as security for payment of $165,000 of the purchase price, evidenced by 33 notes of $5,000 each.
10. All of the instruments above referred to were executed to carry out the contract between petitioner and International.
11. At the date*992 of transfer the unpaid portion of the oil payment had a fair market value of $2,000 and the 130-acre lease in Carson County, assigned to International, had a fair market value of $650.
*524 12. Petitioner received as consideration for the contract an initial payment of $200,000 in cash and in August 1935 received the $165,000 evidenced by the 33 notes of $5,000 each, above referred to, making a full consideration of $365,000, and the contract and conveyances thereby provided for. Of the purchase price, $60,000 was stated in the contract to be for, and was for, personal property, leasehold equipment, and fixtures.
13. The petitioner has received as its pro rata share from oil and gas produced from the leasehold assigned to International, since February 1, 1935, the following sums:
| 1935 | $2,922.37 |
| 1936 | 31,856.04 |
| 1937 | 27,682.39 |
| 1938 | 20,388.65 |
| 1939 (through Oct. sales) | 15,009.19 |
| Total | 97,858.64 |
14. At the time of the contract between International and the petitioner, there was discussion with reference to what the International would do with the leasehold. The directors of the petitioner knew that International intended as soon as it became*993 the owner to begin a large development on the property. This intention was carried out, and at the date of hearing there were 42 wells completed upon the property and one well drilling. The petitioner would not have sold for the amount received if it had not anticipated a large return from its retained royalty interest.
OPINION.
DISNEY: The respondent allowed depletion upon amounts received from International by petitioner as royalty payments upon the two-thirds royalty interest owned by petitioner, but denied depletion upon $305,000 received as consideration for conveyances to International. The question presented here arises upon the disallowance of percentage depletion upon the $305,000. The gist of the principal problem is whether depletion is allowable on the theory that the petitioner, having owned both a leasehold and about two-thirds of the lessor's interest, was in effect in conveying to International, the lessor of a lease, retaining an economic interest, under such cases as , or should be denied on the theory that it occupies the position of an assignor of a lease, within the principle enunciated in *994 , and cases to the same effect.
The petitioner executed and delivered (a) an assignment in the usual form of an oil and gas lease as to about 1,327 acres of land, (b) an assignment of an oil payment, (c) an original oil and gas *525 lease; and a "Royalty Owner's Agreement" releasing, as such royalty owner, International from certain obligations as leaseholder.
The oil payment, of a value of $650, was payable from the net proceeds of one-fourth of the oil or gas as, if, and when produced and sold by the McIlroy Oil Co., to whom petitioner assigned the lease. McIlroy was not liable personally for the payments. After any default in payment, petitioner's signature was necessary upon division orders on the sales of oil or gas. In assigning to McIlroy, the petitioner retained an economic interest in the oil and gas, but sold such interest for cash, and was not entitled to depletion upon $650, that part of the $305,000 consideration attributable to the oil payment. *995 ; ; (139).
Included in the lease assigned to International was a tract of 130 acres in Carson County. This was not included in the warranty deed by which the petitioner acquired the remainder of the estate of the lessors. Lewis and wife. Therefore the petitioner owned no interest in the 130 acres, except as lessee. Depletion was properly denied, to the extent of $2,000, the value of the lease. ;. .
This brings us to consideration of the principal issue: As to those lands in which petitioner had acquired not only a lease, but the lessor's interest, except approximately one-third of the rights to royalties under oil and gas leases, is petitioner entitled to depletion upon amounts received, in large part for an assignment of the lease held by it, and as to a smaller amount of land, for delivery of a lease executed by petitioner*996 itself, and for the "Royalty Owner's Agreement" as to offsetting wells, etc.? In effect, the petitioner argues that it occupies the same economic position as the original lessor, having acquired his interests (except one-third of royalty rights conveyed to others) and has an economic interest in the production to be realized from the lease conveyed and is entitled to depletion. Petitioner bases its contention in part upon the idea of merger of lease in the larger estate acquired from the lessor, but urges that, irrespective of merger and ignoring the technical forms of conveyancing, such an interest in future production remained in the petitioner as to require allowance of depletion upon amounts received for the conveyance.
We think it plain that petitioner's position must depend upon whether its leasehold interest was merged into and extinguished by the acquisition of the remaining interests of the lessor; for it is not to be doubted, in the light of the decisions above enumerated, that an assignor of a lease, merely assigning the rights thereunder to his assignee, does not, in receiving a cash consideration for the assignment, *526 derive "gross income from the property" *997 within the terms of section 114(b)(3) of the Revenue Act of 1934. The petitioner, a lessee, having received a cash consideration from International, its assignee, must demonstrate that its position is not that of mere assignor. In fact, it executed, in large part, an ordinary assignment. Repeated pronouncements of course forbid undue regard for mere forms of conveyancing and require consideration of the true economic status of the taxpayer. Yet merger, upon which in essence petitioner must rely to escape the position of ordinary assignor, is a question largely of intent, and the fact of execution of an assignment, rather than an original lease, as to most of the lands, clearly casts some light upon intent, particularly in connection with the other facts here presented. As to a small portion of the lands, the petitioner executed an original lease. Why was an assignment executed as to the greater portion? Obviously, the distinction between assignment and lease was recognized, and an assignment intentionally used. This action, by the owner of both the lease and most of the lessor's interests, seems clear indication of intent not to merge the two interests. "* * * the merger will*998 not be held to take place if it be apparent that it was not the intention of the owner, of if, in the absence of any intention, said merger was against his manifest interest." . (Civ. App. Texas). From examination of all of the evidence herein, we are of the opinion that the petitioner did not intend merger, but intended what was actually done, as to the principal lease - to assign the lease. The language was that of an ordinary assignment, and was so captioned. Therein reference is first made to the lease executed by the land owner in 1921 and then repeated reference is made to the "said lease and all rights thereunder" and to the fact of transfer of right, title, and interest "in and to said lease and rights thereunder." No rights are reserved to the petitioner by the instrument, as would be done under an oil and gas lease (and is in fact specifically done in the original oil and gas lease also executed, and hereinafter discussed). The instrument conveys rights - it does not retain or create them for the petitioner as owner*999 of the fee or royalties or in any manner refer to its rights or ownership other than as lessee. On the contrary, the instrument recites a convenant that the rents and royalties due and payable under the lease have been paid, thus assuming the position of the grantor to be that of lessee. Moreover, the intent to distinguish between positions as lessee and royalty owner is made plain by the fact of the execution by the petitioner of a separate instrument, called "Royalty Owner's Agreement", wherein in substance it agreed, "so far as it may lawfully do so as owner of a portion of the royalty *527 interest reserved in the lease", that International need not drill offset wells and might designate the purchaser of the "royalty oil and gas." The contract between petitioner and International covering the whole transaction provided, first, that petitioner sell and assign an oil and gas lease executed not by petitioner, but in 1921 by T. D. Lewis and wife; and in sharp contrast thereto, provided for execution of "an original oil and gas lease from Badger Oil Company as lessor, to International Petroleum Corporation" upon another smaller amount of land. We conclude that merger was not*1000 intended, but that the petitioner in dealing with International intended to do so as lessee-assignor.
Moreover, as a matter of law there was, in our opinion, no merger. That doctrine involves the extinguishment or "drowning" of a lesser in a larger estate. The petitioner never acquired all of the estate remaining after execution of the oil and gas lease. One-third of the right to receive royalties under the lease and under any future lease was in other hands. A lease can not, we think, be merged in any estate less than that of the full estate of the lessor. In , we held that there was no merger of a leasehold into a two-thirds interest in the fee estate, acquired by the lessee after execution of the lease. We said:
* * * Although the lessee purchased portions of the fee at different times, the leasehold, nevertheless, continued to have a legal existence in its entirety and so could have been sold or otherwise transferred as a whole at any time prior to legal merger of the lesser and greater estate through acquisition of the entire fee by such lessee.
In the present matter also approximately one-third of the royalty*1001 interest was extant in others and the lease was in fact sold or otherwise transferred as a whole - "prior to legal merger of the lesser and greater estate through acquisition of the entire fee by such lessee." Quoting Bouvier, we also observed:
"To have the union operate a merger, the estates must unite in one and the same person, having a commensurate and coextensive interest in each, with no intervening interest in another. A legal estate in fee in one who has only a partial equitable interest, or vice versa, would not merge. ; ."
We consider it clear that the outstanding one-third interest in the royalties was an intervening estate, and that the whole lease can not merge in less than the whole interest of the lessor. The outstanding royalty interests had a right to continuance of the lease and to payment of royalties thereunder. A conception of the lease merged as to two-thirds of the royalty interests, but still existent as to one-third, is an anomaly. Less than the entire lessor's interest can not encompass and "drown" a lease under which every part of the lessor's interest has rights.
*1002 *528 This is no matter of mere legal formality, but one of logic and legal rights of parties. Petitioner, having assigned in due form, its lease, seeks to demonstrate the transaction to be other than mere assignment, with its attendant results as to depletion, and must show reason why the lease has ceased to be such. That reason, we consider not to have been shown, but, on the contrary, we consider that reason and logic point to continuance of the lease. In effect petitioner relies upon the general idea that an economic interest gives right to depletion, but imports the economic interest from its royalty interests (where it is not denied, but given effect by depletion allowed by the respondent) into the leasehold interest. In the royalty interests the petitioner had an investment of $40,000. It is plain that, by depletion allowed on royalties, petitioner is recovering this investment, because in truth the income from royalties is under the statute "gross income from the property", i.e., the property conveyed by warranty deed, including royalty rights. But it is equally plain that the $305,000, or that portion thereof obtained for assigning the leasehold, is not income*1003 from the same property, but is the sale prices of the leasehold, in which the petitioner had a base entirely different from the $40,000 invested in the property conveyed by warranty deed. That investment in the leasehold is not properly recoverable from depletion proper upon a different capital investment. Depletion is allowed "to the recipients of the gross income from the oil and gas by reason of their capital investment in the oil and gas in place." ; . Such investment by the petitioner was the $40,000, not the investment in the lease itself. Moreover, it is to be noted that the $305,000 was not payable in any part out of any oil produced, as in such cases as ; . Though $165,000 of the full consideration of $365,000 paid (including $60,000 for personal property) was not paid at the date of transfer, but was paid later in 1935, the amount was represented by promissory notes, secured by a deed of trust on the lease assigned, the original lease, and the $18,000 oil payment, *1004 the deed of trust providing that upon default the properties should be sold at public outcry in satisfaction of the notes. Obviously, this is not reservation of economic interest. It can not be said, as is said in , limiting , that "the reserved payments are to be derived solely from the production of oil and gas." We conclude and hold that the petitioner is not entitled to depletion as to the amounts received for assignment of the lease to International.
In the state of the record the same must be said as to the original lease executed by the petitioner to International. This comprises a comparatively small portion of the total acreage involved, i.e., 160 acres as compared with about 1,327 acres in the lease assigned. The *529 value of the original lease at execution is not shown. The $305,000 consideration is not divided between original lease and assigned lease. Therefore, even though we should assume that the existence of the Martin lease (if it still existed as to the 160 acres) is without effect on the question as to depletion on any consideration paid for*1005 the new lease, and that under , the petitioner as original lessor might be entitled to depletion upon bonus received, since there is no evidence in the record herein as to what, if anything, was received as consideration or bonus for the 160-acre lease, respondent's determination in that respect is approved. No error being found in respondent's action in disallowing depletion,
Decision will be entered for the respondent.