*1300 1. The Quintana Petroleum Co. acquired an oil lease by assignment, agreeing to pay to the assignor one-fourth of the net proceeds from the operation of the leased properties. In its income tax return for 1937 it deducted from gross income depletion in the amount of $12,896.30 representing 27 1/2 percent of the gross income. It also deducted from gross income $7,142.28 representing one-fourth of the net proceeds paid by the company to the assignor, which deduction was disallowed by the respondent. Held, that the $7,142.28 is a capital expenditure and not a legal deduction from gross income.
2. From the production of oil on which the Quintana Petroleum Co. claimed percentage depletion the Commissioner excluded oil sales from certain leases in the amount of $915.42 representing portions of bonuses or advance royalties allocable to oil sold in 1937. Held, that the petitioner is not entitiled to an allowance for depletion in respect of the $915.42.
*625 These proceedings, consolidated for hearing, *1301 are for the redetermination of a deficiency in income tax of the Quintana Petroleum Co., Docket No. 100314, in the amount of $14,712.37. The other petitioners are before the Board as transferees of the assets of the Quintana Petroleum Co., which was liquidated and dissolved in December 1938. They all admit their liability as transferees for any deficiencies which may be determined against the Quintana Petroleum Co. (not exceeding $14,712.37) except Katherine T. Cullen, transferee, Docket No. 100319, who received assets of not more than $8,125.91 upon the liquidation or distribution. She is, therefore, not liable as a transferee to an amount in excess of $8,125.91.
The questions in issue are (1) whether the Quintana Petroleum Co., hereinafter called the petitioner, is entitled to deduct from gross income for 1937, $7,142.28 representing one-fourth of the net proceeds from the operation of the Duval County Ranch Co. lease paid to the assignor of the lease, and (2) whether the petitioner is entitled to include in the basis for the allowance of depletion, in respect of other leases, portions of the bonuses or advance royalties paid prior to 1937 but allocable to products sold in*1302 1937.
FINDINGS OF FACT.
The petitioner, prior to its dissolution in December 1938, was a Texas corporation with its principal office in Houston. Its income tax return for 1937 was filed with the collector of internal revenue for the First District of Texas at Austin.
In 1922 the Duval County Ranch Co., as lessor, exected to the Gulf Production Co., as lessee, an oil, gas, and mineral lease covering certain described property in Duval and Webb Counties, Texas.
On January 17, 1933, the Gulf Production Co. assigned the lease to Trinity Drillers, Inc. (the assignor reserving all sulphur rights) so far as it covered certain described tracts of land, subject to the condition that Trinity Drillers, Inc. (hereinafter called Trinity), drill two oil wells on the leased property upon demand by the Gulf Production Co. and that it assume and comply with all the terms of the original lease. The assignment was also made subject to the *626 terms and conditions of a separate agreement between the parties, executed the same day, which provided that:
* * * If as a result of Trinity's operations on said land, oil and gas should be produced therefrom in paying quantities, then, *1303 after paying all of the costs and expenses incurred in drilling, equipping, and operating said well, Trinity shall account to Gulf monthly for one-fourth (1/4th) of the net proceeds of such operations.
The agreement then specified the costs and expenses deductible by Trinity in computing the amount of the payments to be made to the Gulf Production Co.
On February 6, 1933, Trinity assigned a one-half interest in the lease to petitioner "free and clear of any charge or deduction on account of the one-fourth (1/4th) of the net proceeds of operations so reserved or retained by, or provided to be paid to, Gulf Production Company, by Trinity Drillers, Inc."
At the same time Trinity and petitioner entered into an agreement whereby Trinity agreed, upon demand either by the Gulf Production Co. or petitioner, to drill two wells on the property, and petitioner agreed to pay Trinity $6,500, one-half upon completion of the first well and one-half upon completion of the second well.
The other one-half interest in the lease, charged with the whole of the obligation to the Gulf Production Co., passed through various parties and was finally acquired by petitioner as follows:
(a) A one-fourth*1304 interest in the lease was assigned to petitioner by J. R. Wheless, Jr., on October 12, 1933, the assignment providing that the interest should be "subject to its proportionate part of any charge or deductions on account of one-fourth (1/4th) of the net proceeds of operations reserved and retained by or provided to be paid to Gulf Production Company, as set out in contract and assignment between Gulf Production Company and Trinity Drillers, Inc., dated January 17, 1933." For such assignment petitioner agreed to pay Wheless $15,000, but the obligation was settled for a total payment of $11,967.53.
(b) The remaining one-fourth interest was assigned to petitioner by the S.R. & C. Oil Corporation on November 7, 1933, the instrument providing, as in the assignment from Wheless, that the interest transferred should be subject to the charge or deduction on account of the one-fourth of the net proceeds of operations reserved or retained by, or provided to be paid to, the Gulf Production Co. By the terms of the assignment the S.R. & C. Oil Corporation retained a $10,000 oil payment, payable out of one-eighth of the first seven-eighths of oil produced. Petitioner also paid $10,000 in cash*1305 to the S.R. & C. Oil Corporation at the time the assignment was made.
*627 As a result of the transfers and assignments above referred to petitioner acquired the entire interest assigned by the Gulf Production Co. to Trinity and petitioner was under the obligation to account to the Gulf Production Co. monthly for one-fourth of the net proceeds of operations on the leased property. During the taxable year petitioner paid $7,142.28 to the Gulf Oil Corporation (successor to Gulf Production Co.), hereinafter called Gulf, on account of this obligation.
The total production of oil from the Duval County Ranch Co. lease in 1937 was $46,895.65. In its income tax return for 1937 the petitioner claimed and was allowed a depletion allowance of $12,896.30 representing 27 1/2 percent of the total production. In addition it claimed the deduction of $7,142.28 paid to Gulf as profit-sharing payments. This amount was disallowed by the respondent in the determination of the deficiency.
In connection with the acquisition in prior years of certain oil and gas leases from which production was had during the taxable year petitioner paid cash bonuses. In his computation of the allowable*1306 depletion the respondent has deducted from the gross income of each of these leases that proportion of the bonus allocable to the products sold from the lease during the taxable year. The total of the amounts so deducted is $915.42, which sum is stipulated to be correct if respondent's treatment is proper.
OPINION.
SMITH: The first question for decision is whether petitioner is entitled to deduct from the gross income of 1937, $7,142.28 representing the total of profit-sharing payments paid to the Gulf Oil Corporation in connection with the operation of an oil and gas lease. The petitioner contends that the amount is deductible from gross income either (a) as rentals or royalties, or (b) as other ordinary and necessary business expenses. The respondent contends that the amount represents a part of the cost to it of the Duval County Ranch lease; that under the statute the petitioner is entitled to deduct for depletion 27 1/2 percent of the production from the lease; that that amount was intended by Congress to return to the taxpayer its capital investment; and that the $7,142.28 here in question did not constitute an expense deductible from gross income.
*1307 We think it clear that Gulf did not during the year 1937 have an investment in the Duval County Ranch Co. lease which is subject to depletion. See ; ; ; ; *628 . As stated in :
* * * A share in the net profits derived from development and operation, * * * does not entitle the holder of such interest to a depletion allowance even though continued production is essential to the realization of such profits. * * *
It is quite clear that if the payment of the $7,142.28 here in question constituted a part of the consideration for the Duval County Ranch Co. lease it did not constitute an expense payment. This is the position taken by the respondent, and we think that it is correct. In *1308 , it was held that the payment of legal fees incurred in the defense of a claim against oil properties represented capital expenditures or additional cost of the property and was not to be allowed as an expense deduction. In ; appealed and reversed on other issues, , the Board held that the payments of 4 percent of the proceeds from the sale of oil to attorneys for services in defending title to and securing land patents on the oil-producing property were capital expenditures, recoverable by way of depletion. In our opinion the respondent properly disallowed the deduction of the $7,142.28 in question.
The second question for decision is whether the petitioner is entitled to compute the depletion allowance upon other leases than Duval County Ranch Co. lease upon the full amount of the production from those leases, or upon such amount reduced by the portion of the bonus payments paid in prior years which are allocable to the production of the taxable year. Such allocable portion is in the amount of $915.42.
Section*1309 114(b)(3) of the Revenue Act of 1936 provides that the basis for depletion shall be as follows:
(3) PERCENTAGE DEPLETION FOR OIL AND GAS WELLS. - In the case of oil and gas wells the allowance for depletion under section 23(m) shall be 27 1/2 per centum of the gross income from the property during the taxable year, excluding from such gross income an amount equal to any rents or royalties paid or incurred by the taxpayer in respect of the property. * * *
Regulations 94, article 23(m)-1(g ) provides in part:
In all cases there shall be excluded in determining the "gross income from the property" an amount equal to any rents or royalties which were paid or incurred by the taxpayer in respect of the property and are not otherwise excluded from the "gross income from the property." If royalties in the form of bonus payments or advanced royalties (see article 23(m)-10) have been paid in respect of the property in the taxable year or in prior years, the amount excluded from "gross income from the property" for the taxable year on account of such payments shall be an amount equal to that part of such payments which is allocable to the products sold during the taxable year.
*1310 *629 It is well settled that advance bonus payments or advance royalties are depletable interests to the recipient. ; ; ; Such items are not depletable interests both to the lessor and lessee. In , the Board said: "Two separate and distinct taxpayers are not entitled to receive depletion deductions as to the same oil interest."
In , the lessee-taxpayer was obligated to pay the lessor royalties of one-fourth of gross production. In that case, as in the instant proceedings, the lessee claimed that it was entitled to a depletion allowance based upon the gross production. The Commissioner determined that its depletion deduction should be limited to 27 1/2 percent of the gross production less the one-fourth royalties paid to the lessor, and his determination was sustained by the courts.
We think it clear that the petitioner is not entitled*1311 to a depletion allowance in respect of bonus payment as to which the lessor is entitled to a depletion allowance. The action of the respondent with respect to this issue is approved.
Reviewed by the Board.
Decisions will be entered under Rule 50.Footnotes
1. Proceedings of the following petitioners are consolidated herewith: H. R. Cullen, Transferee, Docket No. 100315; H. R. Cullen, Trustee, Transferee, Docket No. 100316; H. R. Cullen, Successor Trustee, Transferee, Docket No. 100317; H. R. Cullen, Guardian, Transferee, Docket No. 100318; Katherine T. Cullen, Transferee, Docket No. 100319; Estate of Harry Holmes, deceased, Lucy B. Holmes, Executrix, Docket No. 100320; Harry Holmes, Jr., John B. Holmes and Thomas J. Holmes, Successor Trustees, Docket No. 100321. ↩
1. Dissent. See p. 1318. ↩