*223 Decisions will be entered under Rule 50.
1. During the taxable years involved petitioners were engaged in the oil business in Texas. They acquired certain oil and gas leases and as part of the consideration therefor expressly agreed to drill oil wells upon the leased property. Held, the cost of drilling these wells represented a part of the cost of the leases and must be recovered by way of depletion, and the provisions of article 23 (m)-16, Regulations 101, granting petitioners an option to either capitalize intangible drilling costs or deduct them as ordinary and necessary business expenses, are not applicable.
2. Petitioners also were lessees in other leases in which there were provisions that unless petitioners commenced the drilling of a well within an agreed length of time the leases would terminate. Held, that the costs of the wells drilled upon the properties covered by these leases were incurred as a part of the consideration for a leasehold interest in the properties and oil in place and such costs are not deductible as intangible drilling costs.
3. In one of the taxable years involved petitioner Fleming-Kimbell Corporation made certain charitable contributions*224 for which it took a deduction under section 23 (q) of the Revenue Act of 1938. Held, these charitable contributions were not "deductions attributable to the mineral property upon which the depletion is claimed" within the meaning of article 23 (m)-1 (h), Regulations 101, and in computing the limitation on percentage depletion under section 114 (b) (3) of the Revenue Act of 1938 such charitable contributions need not be deducted from "gross income from the property" in determining the petitioner's "net income from the property."
*14 This is a consolidated proceeding involving income tax deficiencies determined against F. H. E. Oil Co. for its taxable years ended January 31, 1939 and 1940, in the respective amounts of $ 7,103.40 and $ 10,353.06, and against Fleming-Kimbell Corporation for its taxable years ended April 30, 1939 and 1940, in the respective amounts of $ 8,717.18 and $ 5,677.44. Certain assignments of error have been abandoned and others*225 have been withdrawn from consideration by agreement. As to the latter, it was stipulated at the hearing that dues and membership fees paid by petitioners to the Independent Petroleum Association may be deducted from income. These dues and fees amount to $ 375 and $ 500 for the two taxable years in the case of F. H. E. Oil Co. and $ 500 and $ 625 in the case of Fleming-Kimbell Corporation. It was further stipulated that the overhead expenses fixed by respondent in computing depletion allowances should be increased, in both proceedings, by the amounts of such dues and fees; that with respect to F. H. E. Oil Co. such overhead expenses for its taxable years ended January 31, 1939 and 1940, should be reduced by $ 16,121.26 and $ 14,312.18, respectively; that in the case of F. H. E. Oil Co. such adjusted overhead expenses should be allocated in full to oil activities, with 60 percent thereof allocated to operations and the balance to development; that the 60 percent so allocated to operations should be further apportioned among the producing properties upon the basis of receipts from production; and that the 40 percent so allocated to development should be apportioned among the properties*226 upon which development occurred upon the basis of the amount expended on the respective properties. Respondent has also conceded his error in disallowing deductions of $ 68.59 in 1939 and $ 5,587.97 in 1940 claimed by F. H. E. Oil Co. as deductible intangible drilling and development costs with respect to wells drilled upon its Airport lease. Effect will be given to the stipulation and concession in the recomputation under Rule 50.
Remaining for consideration are two questions, but one of which is common to both petitioners, namely, whether petitioners are entitled to deduct from their income for the taxable years in question *15 "intangible drilling and development costs" incurred in the drilling of nine oil wells on leased property. The second question, affecting Fleming-Kimbell Corporation's tax for its year ended April 30, 1939, is whether charitable contributions are to be deducted from gross income from the property in computing the limitation on percentage depletion.
Both parties kept their books and made their returns on the basis of cash receipts and disbursements. F. H. E. Oil Co.'s fiscal year ended on January 31 and Fleming-Kimbell's ended on April 30. Returns*227 were filed with the collector of internal revenue for the second collection district of Texas at Dallas.
The proceedings were submitted upon oral testimony and documentary evidence, from which we make the following findings of fact.
FINDINGS OF FACT.
During all times here pertinent F. H. E. Oil Co., hereinafter called "F. H. E.," and Fleming-Kimbell Corporation, hereinafter called "Fleming-Kimbell" were Texas corporations engaged in producing oil, with principal offices in Fort Worth, Texas. F. H. E. has since been dissolved. Wm. Fleming was president and general manager of both companies. They operated most of their properties jointly. Petitioners have consistently followed the practice of expensing their so-called "intangible drilling and development costs" incurred in the drilling of oil wells and of expensing the cost of dry holes.
From 1936 through 1940 petitioners acquired rights under various leases, assignments, and agreements. They treated such acquisitions as constituting nine named "leases," hereinafter called "tracts," upon each of which a well was drilled.
The nine tracts and the amounts expended by each petitioner in the respective taxable years for so-called "intangible*228 drilling and development costs" in connection with the drilling of the well on each tract follow:
| Fleming-Kimbell | F. H. E. Oil Co. | |||
| Tract | ||||
| 4/30/39 | 4/30/40 | 1/31/39 | 1/31/40 | |
| First National Bank | $ 5,513.91 | $ 961.30 | $ 4,696.55 | |
| Standard of Kansas | $ 5,762.96 | 4,470.71 | ||
| Dodge | 5,451.93 | |||
| A. W. Johnson | 5,282.81 | 5,169.78 | ||
| M. K. Carter | 5,079.12 | 5,073.50 | ||
| Burkitt | 5,289.05 | 5,164.03 | ||
| Betz-Robinson | 5,027.26 | |||
| Monnig | 5,206.71 | 87.10 | 5,297.66 | |
| McKinzie | 5,520.73 | 512.11 | 4,679.45 |
Petitioners deducted the above amounts expended by them in computing their taxable income for the periods in question. Respondent disallowed such deductions.
*16 The parts of each lease, assignment, or agreement in evidence which are pertinent to the principal issue are summarized or quoted in the following paragraphs.
(a) First National Bank tract. -- Rights in this tract were acquired under an oil lease dated June 21, 1939, and running from C. L. Mahaney and First National Bank of Palestine, Texas, to Fleming-Kimbell, Carter-Gragg Oil Co., and Wm. Fleming, trustee. It does not appear that F. H. E. obtained any interest in this tract. The printed granting clause*229 recites:
That the said lessor, for and in consideration of Ten and no/100 ($ 10.00) Dollars cash in hand paid * * * and other covenants and agreements hereinafter contained on the part of the lessee to be paid, kept and performed has granted, demised, leased and let, and by these presents does grant, lease and let unto the said lessee for the purpose and with the exclusive right of exploring, drilling, mining, and operating for, producing, and owning oil, gas, sulphur and all other minerals * * * all that certain tract of land * * * described as follows, to-wit:
Twenty acres, more or less, in the James Madden League [here follows legal description].
Typed in as a part of the first paragraph is the following: "If no well be commenced on said land on or before August 15, 1939, this lease shall terminate as to both parties." Paragraph 3 provides for a primary term of five years, paragraph 4 provides for royalties, and paragraph 5 provides that the lease shall terminate if operations for drilling of a well be not commenced by June 21, 1940, unless lessee pay delay rentals.
(b) Standard of Kansas tract. -- Rights in this tract were acquired under two oil leases, the printed portions*230 of which are identical to the analogous parts of the lease mentioned in (a) above, except as hereinafter noted. One of the leases is dated December 8, 1939, and runs from Elizabeth B. Crane to petitioners and Carter-Gragg Oil Co. and covers 2,032 acres. The following quotation is typed in as part of the granting clause:
If operations for the drilling of a well are not commenced by lessee on some part of the land covered by this lease within sixty (60) days from date hereof, and thereafter drilled with due diligence to a depth sufficient to test the known producing horizons in the woodbine sands, this lease shall terminate as to both parties. * * *
Clause 5 pertaining to delay rentals does not fix a date on or before which a well must be commenced. After the printed portion of this clause is typed the following: "This clause is subordinate to the provision hereof regarding commencing a well within 60 days hereinabove set out."
The second lease is dated September 15, 1939, and runs from the Standard Oil Co. of Kansas to petitioners and Carter-Gragg Oil Co. *17 and covers 199.98 acres. Added to the printed granting clause of this lease is the following:
If operations for the*231 drilling of a well are not commenced by Lessee on the A. W. Johnson tract of 425.81 acres * * * within 25 days from date hereof and thereafter drilled with due diligence * * * this lease shall terminate as to both parties; and if said well is drilled by lessee on the A. W. Johnson tract as aforesaid, then if operations for the drilling of a well be not commenced on the tract covered by this lease within ninety days after the well on said Johnson tract shall have been completed (either as a producer or a dry hole), and if said well on this tract be not thereafter drilled with due diligence to a depth sufficient to test the known producing horizons in the Woodbine sand, this lease shall terminate as to both parties. * * *
The printed paragraph 5 pertaining to delay rentals is deleted in its entirety from this lease.
(c) Dodge tract. -- Petitioners acquired rights in this tract under an oil lease dated January 10, 1940, and running from Percy Jones and wife to petitioners. The granting clause of the lease is as follows:
Witnesseth: That the said lessor, for and in consideration of Ten and No/100 Dollars * * * and of the covenants and agreements hereinafter contained on the part*232 of lessee to be paid, kept and performed, have granted, demised, leased and let and for these presents do grant, lease and let unto the said lessee for the sole and only purpose of mining and operating for oil and gas * * * save and take care of said products, all that certain tract of land [description of tract containing 200 acres].
The lease is for a primary term of one year and provides for the payment of the usual royalty. Typed into the instrument is the following:
If no well be commenced at some location on the land covered by this lease, and not more than two locations from the center of said section 15 within sixty (60) days from date of this lease and the drilling thereof continued with due diligence to a depth sufficient to test the formation from which the wells now on said section are producing, unless oil or gas in paying quantities is found at a lesser depth, this lease shall terminate as to both parties and be of no further force or effect.
(d) A. W. Johnson tract. -- Petitioners' rights in this tract were acquired under an assignment of a lease to which reference is made in the assignment. The lease is not in evidence. The assignment is dated September 11, *233 1939, and the granting clause is as follows:
For the considerations and on the terms and conditions and subject to the provisions and reservations hereinafter set out, Tide Water Associated Oil Company, a corporation, and Seaboard Oil Company of Delaware, a corporation, hereinafter called Assignors, * * * do hereby assign * * * unto Carter-Gragg Oil Company * * *, F. H. E. Oil Company, * * * and Fleming-Kimbell Corporation, hereinafter called Assignees, * * * all of the right, title and interest of Assignors in and to said oil and gas lease, as amended, ratified and confirmed, insofar as it covers [a described tract of 425.81 acres, excepting a tract of 160 acres].
*18 Within the body of the assignment is the following provision:
Unless Assignees, within seventy-five days from the date of this assignment, shall commence operations for the drilling of a well on the land hereby assigned * * * and thereafter shall drill said well at their sole cost and expense with reasonable diligence and in a good workmanlike manner, to a depth sufficient to test the known producing horizons in the Woodbine Sand, this assignment shall become null and void and the leasehold estate hereby assigned*234 shall revert to and re-vest in Assignors. * * *
(e) M. K. Carter tract. -- Petitioners acquired rights in this tract under a lease assignment from the Tide Water and Seaboard oil companies, identical in form to that described in (d) above. The lease is not in evidence. The assignment is dated October 16, 1939, and contains the same provision regarding the reversion of the leasehold estate unless a well is commenced and drilled with reasonable diligence.
(f) Burkitt tract. -- Petitioners acquired rights in this tract under a lease assignment from the Tide Water and Seaboard companies dated November 10, 1937, which is similar to the assignments noted in (d) and (e) above and is identical to them in so far as the granting and revesting clauses are concerned. The lease is not in evidence.
(g) Betz-Robinson tract. -- Rights in this tract were acquired under an assignment dated June 8, 1938, transferring the assignors' interests in three leases referred to in the instrument in so far as such leases cover two 10-acre tracts. The leases are not in evidence. The assignment runs from Champlin & Bass, Inc., a corporation, M. Dave Lufkin, and T. W. Tyler to F. H. E. It does*235 not appear that Fleming-Kimbell obtained an interest in this tract. It is recited that the assignment is made "for and in consideration of the sum of Ten Dollars ($ 10.00) cash to them [assignors] paid and on the terms and conditions, and subject to the reservations hereinafter stated * * *." Included as a part of such assignment is the following:
This assignment is conditioned that the said Assignee, F. H. E. Oil Company, shall, on or before the 15th day of July, 1938, begin operations for the drilling of a well for the discovery of oil or gas, * * * and thereafter with reasonable diligence prosecute the drilling of said well to completion * * *. If said Assignee fails or refuses to commence the drilling of said well within the time provided, or, having begun same, fails or refuses to prosecute the drilling of same with reasonable diligence * * *, then, and in either of said events, all rights, title and interest herein assigned to said Assignee shall lapse and determine, and shall thereupon become reinvested in and owned by Assignors. * * *
(h) Monnig tract. -- Petitioners acquired rights and interest in this tract under an agreement and an assignment subsequently made pursuant*236 to such agreement. The agreement, dated December 31, 1938, is between Tide Water and Seaboard oil companies, first parties, and F. H. E., second party. It recites that first parties are the owners of a certain lease to which reference is made. The lease is not in evidence. First parties agree to assign to F. H. E. their rights under such lease *19 subject to overriding royalties to be reserved, and to furnish to F. H. E. abstracts of title covering the tract in question. It is further provided as follows:
If title to said land is found to be satisfactory, Second Party [F. H. E.] agrees, subject to the terms hereof, on or before thirty (30) days from the date of such written acceptance, to commence a well on the above described land at a location to be selected by Second Party, and thereafter to drill said well with reasonable diligence, * * * It is likewise agreed that, if, after the acceptance of said title, Second Party does not commence a well on said land as herein provided, or, having commenced said well, does not prosecute the drilling thereof to completion, then, on the happening of either of said contingencies, this agreement shall become null and void, and First*237 Parties and Second Party shall be released from all obligations hereunder. * * *
* * * *
If on completion said well is not a producer of oil or gas in paying quantities it shall, at Second Party's sole cost and expense, be promptly plugged and abandoned. * * *
The assignment is dated April 11, 1939, after the well was drilled, and runs from the Tide Water Co. and Seaboard Oil Co. to F. H. E., Fleming-Kimbell, and Carter-Gragg Oil Co. It passes assignors' interests in a leasehold estate of 650 acres, described in the instrument, and reserves to the assignors an overriding royalty. It is recited that the assignment and conveyance is made and accepted in accordance with and subject to the provisions of the agreement of December 31, 1938, and it is further stated that the "Assignees herein do hereby acknowledge and declare that F. H. E. Oil Company, in executing the aforesaid agreement, was acting for and on behalf of all of the Assignees herein named."
(i) McKinzie tract. -- Petitioners claim to have acquired rights and interests in this tract under one oil lease, nine assignments, and one agreement made in connection with one of such assignments. The oil lease is dated June *238 22, 1936, and runs from M. A. Davey and J. O. Monnig to Carter & Gragg Oil Co., a partnership. The record fails to disclose that petitioners became entitled to interests obtained under this instrument. The granting clause of this lease is as follows:
Lessor, in consideration of One Thousand Thirty-three and 55/100 Dollars ($ 1,033.55) in hand paid, of the royalties herein provided, and of the agreements of Lessee herein contained, hereby grants, leases and lets exclusively unto Lessee for the purpose of investigation, exploring, prospecting, drilling and mining for the producing oil, gas and all other minerals * * * Our undivided (7/16) Seven-Sixteenths interest in [a tract of 67 1/2 acres]. * * *
Paragraph 2 states that the lease is for a primary term of 10 years. Paragraph 3 provides for royalty payments. Paragraph 4 provides that if operations for drilling are not commenced on said land on or before June 22, 1937, the lease shall terminate as to both parties unless delay rentals are paid. The lease contains no other provisions with respect to the drilling of wells.
*20 Each of the assignments refer to one or all of three certain leases covering undivided interests in*239 the same 67 1/2-acre tract as is involved in the lease next above described. The three leases to which reference is so made are (1) an oil lease in which Alice McKinzie is lessor and W. H. McMeans is lessee, recorded in volume 269 of the deed records of Anderson County, Texas, page 563 (in some assignments the volume is given as 259, the page 363), hereinafter called McKinzie lease; (2) an oil lease dated "the day of May, 1936," in which Jessie Hutchison. Bessie Gill, Mattie Butler, and their respective husbands, and Lillian McKinzie are lessors and W. H. McMeans is lessee, recorded in volume 269 of the deed records of Anderson County, Texas, page 567, as corrected by instrument dated May 20, 1936, and recorded in volume 279 on page 540 of such deed records, hereinafter called Hutchison lease; (3) an oil lease running from Alice McKinzie as guardian of the estate of Wm. McKinzie and Jeffie McKinzie, minors, to W. H. McMeans, W. R. Petty, and Walter Willis, recorded in volume 280 on page 286 of such deed records, hereinafter called Minors lease. The latter three above mentioned leases in the aggregate embrace an undivided one-half interest in the oil, gas, and minerals in*240 the 67 1/2-acre tract. The Minors lease covers an undivided one-twelfth interest in such property. The record fails to disclose the extent of the interests covered by the McKinzie and Hutchison leases, respectively. The leases are not in evidence.
One assignment is dated November 4, 1938, and runs from W. H. McMeans, J. B. King, W. J. Madigan, J. E. Bradley, and O. M. Wroe to petitioners and Carter-Gragg Oil Co. It recites that the assignors are the owners of an undivided interest in the McKinzie, Hutchison, and Minors leases, aggregating 11.25 acres, and assigns such rights and interests thereunder for and in consideration of the sum of $ 10 and other valuable considerations. Also dated November 4, 1938, is an agreement made by and between the same parties wherein is recited the execution of such assignment and in which the following appears:
But as a part consideration for the transfer and assignment by first parties to second parties [petitioners and Carter-Gragg Oil Co.] of said leases, second parties hereby agree, bind and obligate themselves, their heirs, successors, assigns, and legal representatives, jointly and severally, that they shall and will within thirty days from*241 the delivery of this contract, properly and legally executed by each and all of the first parties, commence in good faith operations for the drilling of an oil well on some part of the 22 1/2 acres to be designated by them, as aforesaid, and shall and will continue in good faith the resonably diligent and active operations of drilling said well for the discovery and production of oil from said 22 1/2-acre tract * * *
A second assignment is dated November 7, 1938, and runs from J. E. Bradley and O. M. Wroe to petitioners and Carter-Gragg Oil Co. It refers to the McKinzie, Hutchison, and Minors leases and *21 states that assignors are the owners of an undivided interest in such leases to the extent of 2 acres of the 67 1/2 acres of land, which are thereby assigned. The instrument recites that the assignees have fully performed the contract and agreement of November 4, 1938, in so far as these assignors are concerned and that they have no further rights or interests in or under such contract and agreement.
A third assignment is dated November 5, 1938, and runs from H. F. Cheatham to petitioners and Carter-Gragg Oil Co. It refers to the McKinzie, Hutchison, and Minors leases and*242 recites that the assignor owns an undivided interest amounting to 6.1875 acres of the 67 1/2-acre tract. Such interest is passed to assignees for and in consideration of the sum of $ 10 and other valuable considerations. Also included in said assignment is the following:
But as a part and further consideration for this transfer and assignment to the assignees above mentioned, said assignees hereby agree, bind and obligate themselves, * * * that they shall and will within 30 days from the date of this transfer and assignment, * * * commence in good faith operations for the drilling of an oil well on some part or portion of said 67 1/2-acre tract at a point and location thereon to be selected by them and shall and will continue in good faith reasonably diligent and active operations of the drilling of said well for the discovery and production of oil therefrom, * * *
A fourth assignment is dated June 7, 1937, and runs from W. R. Petty to petitioners and Carter-Gragg Oil Co. It refers to the McKinzie lease and recites that assignor is the owner of an equal undivided one-tenth interest in such lease and all rights thereunder. Such rights and interests are transferred to assignees *243 for and in consideration of $ 1 and other good and valuable considerations.
A fifth assignment is dated July 6, 1937, and runs from T. L. Horn to petitioners and Carter-Gragg Oil Co. and refers to the McKinzie lease. It recites that assignor is the owner of an equal undivided one-tenth interest in and to such lease and all rights thereunder and transfers them to assignees for and in consideration of $ 1 and other valuable considerations.
A sixth assignment is dated July 6, 1937, and runs from Walter Willis to petitioners and Carter-Gragg Oil Co. It refers to the McKinzie lease and states that assignor is the owner of an equal undivided one-tenth interest in and to such lease and all rights thereunder, which is transferred to assignees for and in consideration of $ 1 and other valuable considerations.
A seventh assignment is dated July 6, 1937, and also runs from Walter Willis to petitioners and Carter-Gragg Oil Co. It refers to the Hutchison lease and states that the assignor owns an equal undivided one-third interest in such lease and all rights thereunder, which is transferred to assignees for and in consideration of $ 1 and other valuable considerations.
*22 An eighth assignment*244 is dated June 7, 1937, and runs from W. R. Petty to petitioners and Carter-Gragg Oil Co. It refers to the Hutchison lease and recites that the assignor is the owner of an undivided one-third interest in such lease and all rights thereunder, which is transferred to assignees for and in consideration of $ 1 and other valuable considerations.
A ninth assignment is dated July 6, 1937, and runs from W. R. Petty and Walter Willis to petitioners and Carter-Gragg Oil Co. It refers to the Minors lease and states that assignors are the owners of an undivided two-thirds interest in such lease, which is transferred to assignees for and in consideration of $ 1 and other good and valuable considerations.
In all instances where petitioners and Carter-Gragg Oil Co. are jointly named as assignees or lessees in the above instruments, it is provided that the interests transferred shall go three-eighths to F. H. E., three-eighths to Fleming-Kimbell, and two-eighths to Carter-Gragg Oil Co.
All of the above tracts, excepting the Dodge tract, were located upon the extreme edge of the Long Lake Field. The Carter tract was located between two producing fields, but in a territory generally regarded as dry. *245 There were two producing wells, each at off-set distance from the McKinzie, Betz-Robinson, and First National tracts. With respect to the other tracts, it was considered doubtful that oil production would be had.
An oil well was begun and completed on each of the nine tracts and all were in fact producers, with the exception of the well drilled on the Monnig tract. The Monnig tract was a part of a larger lease upon which producing wells had theretofore been drilled and which was, hence, held in force by this production. None of the wells were drilled by petitioners with their own rigs. On the contrary, in each instance, the drilling was contracted to other parties.
It was the practice of petitioners to obtain interests by lease or assignment which did not obligate them to drill but did give them time to correlate logs and other data for the purpose of determining whether, in their opinion, there existed a strip producing oil on the tract so covered by the lease or assignment. Actual drilling would be commenced only if petitioners concluded that the prospects for obtaining oil were favorable.
For the taxable year ended April 30, 1939, respondent deducted from Fleming-Kimbell's*246 gross income, for the purpose of computing the limitation upon the percentage depletion allowances to which Fleming-Kimbell was entitled, the sum of $ 5,132.50 which that petitioner had contributed during such year to various charities.
*23 OPINION.
We are first called upon to determine whether petitioners are entitled to deduct from income in each of the taxable years in question "intangible drilling and development costs" incurred in the drilling of nine oil wells on leased property. The amounts expended are not in controversy. Petitioners assert that Regulations 101, section 23 (m)-16, 1 and the identical provision of Regulations 103, granting to them an option to deduct such expenditures or to charge them to capital, apply in this proceeding. If they do, then petitioners must prevail, for they previously exercised the option in favor of deducting intangible drilling and development costs. However, respondent contends that the option does not extend to such costs incurred under the facts here, on the ground that the drilling and completion of the wells in question were a part of the consideration for the acquisition of rights under the several leases and assignments.
*247 Thus, we have a clear-cut issue and one which is new only as it bears upon the particular facts which are here before us. The principle to be applied is settled. It is well stated in , as follows:
The ultimate question for decision, therefore, is whether or not the oil wells drilled in this case were drilled as consideration for the assignment of the undivided interests in the oil properties; for if they were drilled as consideration for the assignment, the drilling and development costs are not deductible under the regulation but must be treated as a capital expenditure. * * *
The answer to this question has recently been held determinative under similar facts in ; ; and . So it is in the present proceeding.
Petitioners first attack the principle itself and the conclusions reached in the above cited cases which support it. They argue that there exists no basis*248 for an exception in instances where drilling is performed as a part of the consideration for capital interests acquired. Hence, they say, cases refusing the option in such instances are *24 incorrectly decided and should not be followed. We are not impressed by this contention.
Petitioners' further contentions are advanced upon the premise that the Hardesty case and the others in its line apply solely to instances where drilling is expressly stated in the lease instrument as constituting a consideration for the property rights which passed thereunder. Proceeding upon this premise, petitioners seek to distinguish the facts here except as to their acquisition of interests in 15.4375 acres of the McKinzie tract from McMeans, King, Madigan, and Cheatham. Save as noted, petitioners allege, in short, that under the terms of each instrument in evidence they were not obligated to drill; that they could not be forced to respond in damages for failure to drill; and that drilling provisions were conditions subsequent, the failure to perform which merely resulted in the divesting of title to property which had vested in them upon the execution of the particular instrument. They *249 urge these circumstances as taking the case without the ambit of the Hardesty case and the rule there applied and, conversely, as placing it within that of Regulations 101, section 23 (m)-16, supra.
Petitioners' contentions beg the question. As we have indicated, the determinative inquiry to be made is whether the drilling of the wells constituted a part of the consideration for the interests which petitioners acquired in the several tracts. This inquiry is not limited to a casual examination of the leases and assignments to ascertain if the parties therein expressly stated that drilling was "consideration" for the grant. Nor can the question be resolved by noting that the drilling provisions have the aspect of conditions rather than covenants or promises. A conclusion based upon this distinction would exalt words over substance. Moreover, the answer is not dependent upon whether the leasehold interests be regarded as vesting upon the execution of the leases or assignments, subject to defeasance for nonperformance of conditions, or upon the completion of wells upon each of the leased tracts.
In ,*250 the court said:
Appellee attempts to distinguish the State Consolidated case from the instant one by the fact that in the former case title to the property was not to pass until after the property owner had received his $ 1,400 from the proceeds of the well, while in the instant case title passed upon the execution of the contract. We do not think that this distinction changes the situation. In both cases the drilling expenditures were the consideration for the passing of title to the land.
We do not understand the Hardesty and other recently reported decisions as requiring varying answers contingent upon variables in terminology used in the leases. Petitioners err in assuming that they stand for any such amorphous distinction. While it may be true that *25 the instruments considered in these cases did contain express provisions to drill, the decisions were based, as we have said, upon the fact that the drilling was a consideration for the interests acquired, not upon the formalities of conveyancing.
With the foregoing explanation of the principle involved and the contentions of the parties, we come to a consideration of the real question. The several leases and *251 assignments through which petitioners claim to have acquired rights and interests in the first seven tracts listed in the findings of fact may be considered together. In each instance the property was leased for the purpose of mining and operating for oil and gas and for a purely nominal consideration. In each instance the instrument contained a clause which provided, in substance, that unless the petitioners commenced an oil well within a certain number of days and diligently prosecuted the drilling to completion the lease and assignment would terminate as to both petitioners and their grantors. These instruments, consequently, fall within the category of the "unless" form of lease which terminates ipso facto upon the failure to exercise the option granted. . The usual "unless" lease contains a provision entitling the lessee to extend the time during which he must drill to avoid termination by the payment of a specified rental. However, no so-called delay rental clauses are here involved. Such a printed clause was deleted in one of the leases covering the Standard of Kansas tract and *252 was expressly subordinated to the typed drilling provision in the other. Although not so stated in the lease, construction requires that the printed delay rental provision be held subordinate to the typed drilling provision in the lease involving the First National Bank tract. . None of the other instruments contain a delay rental clause. In view of the expressed limitation of the grants, the nominal consideration, the provisions for drilling within a period measured in days, and the refusal to accord options to extend the period by the payment of rentals, it appears obvious that the primary purpose of these leases and assignments was to procure the drilling of wells to test the underlying structure for oil. It can not be gainsaid that the essence of the consideration for such leases and assignments was the drilling of the wells in question. ; .
The same conclusion obtains when the question is approached*253 from the petitioners' standpoint. In this view it is necessary to determine what interests petitioners had in each tract, as grantees, after the date of each lease or assignment but before a well was completed on the tract. As we have indicated above, petitioners contend that they *26 had a fee interest, subject to termination upon breach of condition subsequent and, since they were thus drilling upon their own property, that the deduction for intangible drilling costs must be allowed. However, petitioners misconceive the legal effect of their "unless" leases and assignments. These instruments did not confer upon petitioners a title to the several tracts, but merely gave to them a privilege of going upon the land for the purpose of drilling a well. The effect of the "unless" lease with a delay rental clause was stated by the Circuit Court of Appeals for the Fifth Circuit in , wherein the court said:
Such instruments as the one in question have been passed on frequently by the courts of Texas. It is well settled by the decisions of those courts that such an instrument confers on the so-called lessee a privilege*254 for the specified time, with the option to secure the extension of the privilege for an additional period upon complying with the prescribed condition, and that time is of the essence of such a provision as the one above set out. ; ; ; . * * *
The court in that case further said:
* * * The consequence of a failure to do what is required to acquire a right or thing is not a forfeiture of it. * * * The equitable rule as to relieving against forfeitures has no application to the case of a failure of a holder of an option to do, within the fixed time, what is required to acquire the thing which is the subject of the option. Equity does not undertake to dispense with compliance with what is made a condition precedent to the acquisition of a right.
The instruments here conferred merely the same rights upon petitioners as the lease involved in the Gillespie*255 case gave to the lessee, less the option to secure an extension of time. Petitioners had no capital interest in the property until the wells were commenced and completed in accordance with the terms of the drilling provisions. It follows that such provisions could not be conditions subsequent terminating an interest theretofore obtained. The Supreme Court of Texas takes a like view. In , that court said:
A clause similar to the first [this clause provided that if no well was commenced on the land on or before June 1, 1919, the lease should terminate as to both parties] was referred to in a dictum in , as creating a condition subsequent, that effect having been ascribed to it by distinguished counsel on both sides, and by the learned judges writing the majority and minority opinions in the Court of ). This may have arisen from failure to recognize a distinction between the customary "drill or pay" clause and the*256 "unless" clause. The clauses under consideration in the Davis case and here come within the class of "unless" clauses. The correct rule seems to be that, while the usual "drill or pay" clause in an oil lease does introduce a condition *27 subsequent, for the benefit of the lessor alone, yet, as said by Mr. Summers, "where the 'unless' drilling clause is used, a failure of the lessee to drill or pay a stipulated sum of money ipso facto terminates the lease, without the necessity of re-entry, action or their equivalents by the lessor. For this reason the interest created in the lessee by such lease cannot be one terminable by breach of condition subsequent. * * *" * * *
In that case the Supreme Court of Texas further clearly indicates the determinative characteristic of a condition subsequent as applied to oil and gas leases as follows: "As stated in Justice Bonner's opinion, under a limitation the estate granted is automatically terminated on the happening of stipulated events, while under a condition subsequent the lessor has the election to terminate or continue the contract after breach of the condition."
Under the "unless" provision of the leases and assignments in*257 the instant proceeding the failure to perform the condition to drill would ipso facto terminate the contract as to both parties. In such event the lessor or assignor would have no right of election to terminate or to continue the contract. Hence, such condition was not a condition subsequent.
In Chi.-Okla. Oil & Gas Co. an oil and gas lease required the drilling of a test well within a specified time and provided that the failure so to drill would ipso facto terminate the lease. The Supreme Court of Oklahoma stated in its opinion therein that:
As the right of the lessee to the possession of any part of the lands depends upon his entry for the purpose of prospecting for the minerals, the mere grant of such right by the terms of the lease does not operate, in praesenti, to vest an estate in the lands in the lease. .
The quoted pronouncement of the Oklahoma Supreme Court is applicable to the facts here. It follows that the vesting of an estate under the lease there involved and similarly under the leases*258 and assignments here involved occurred only upon the performance of the condition to drill the test well. Such condition was, therefore, not a condition subsequent to the vesting of title but was a condition precedent to such vesting. It is obvious that there can be no divestiture of title by the failure to perform a condition the performance of which is necessary to the vesting of title.
We think it clear that the right to oil and mineral in place, obviously a capital asset, accrued to petitioners under each "unless" instrument only upon the drilling of the well. The exercise of the privilege to drill was the assumption of the obligation to drill, the performance of which was the primary consideration for the leasehold interest in each tract. Petitioners drilled not to prevent the loss of something already acquired or to avoid liability for damages, but to acquire the thing for which the drilling was required as consideration, namely, *28 title to oil in place. Since the intangible drilling and development costs here involved arose in connection with the drilling of the first well on each tract, it is apparent from the foregoing discussion that they form a part of the consideration*259 for and constitute capital expenditures in the acquisition of the First National Bank, Standard of Kansas, Dodge, M. K. Carter, A. W. Johnson, Burkitt, and Betz-Robinson tracts. Accordingly, such costs may not be deducted but can be recovered only through depletion allowances. ;;;; .
We next consider the question in relation to the drilling of the dry hole on the Monnig tract. In each instance the assignment to petitioners was not executed until after they had drilled on the property. Petitioners drilled to enjoy the avails of a contract whereby the first parties agreed to assign their leasehold interest in the tract provided petitioners performed a positive undertaking to drill. Performance was required in order to obtain any interest in the tract which was the subject of the contract. In the final analysis the position of the parties was practically*260 identical to that existing in respect to the "unless" type instruments. Under the latter, leasehold interests automatically became vested in petitioners when the drilling requirement was performed, while here the passing of title was contingent upon the execution of a further instrument, the assignment itself. However, in both cases, petitioners were entitled to no interest in oil in place until a well was drilled. Clearly, the drilling of the well on the Monnig tract also was a consideration for the interests acquired. See , wherein the material facts are undistinguishable from those here giving rise to the Monnig leasehold.
Petitioners contend that the rule of the Hardesty case does not apply where the well turns out to be as here a dry hole. There is no merit to this contention. Regardless of the outcome, the drilling operation was undertaken as a part of the consideration for the assignment of the lease. The option accorded by the regulations to expense the cost of nonproductive wells extends only to situations in which such a well*261 is drilled by the taxpayer on land in which he has a fee interest.
The instruments in evidence to sustain the deduction claimed respecting the McKinzie tract present a different picture. By the agreement dated November 4, 1938, petitioners specifically agreed to commence and continue a well as part of the consideration for the assignment of interests in 11.25 acres. Petitioners were released from the obligation as to two acres three days later. Drilling was likewise expressly made a consideration for the assignment of H. F. Cheatham's interest in 6.1875 acres of the McKinzie tract. Hence, in respect of *29 15.4375 acres in this tract petitioners clearly drilled the well as a consideration for the acquisition of a capital asset and petitioners concede as much. None of the other instruments in evidence, however, contain any reference whatever to drilling. Accordingly, petitioners contend that they need capitalize only so much of the intangible drilling costs of the McKinzie well as 15.4375 bears to 67.5. This contention is based upon the theory that their interests in the McKinzie tract embraced a total of 67 1/2 acres and is made in reliance on *262
The difficulty in following petitioners lies not with their general proposition, but in the state of the record. It is elementary that the burden of showing the respondent's determination to be erroneous falls upon the petitioners. Among other facts, petitioners here were each obliged to establish that they had an interest in each tract upon which they drilled; that the drilling was not consideration for the interests acquired; and, with respect to the McKinzie tract which raises the apportionment issue, the numerator and denominator of the ratio to be applied. To establish these matters in connection with the McKinzie tract petitioners offered in evidence 11 instruments, all of which were received. One was an oil lease covering a seven-sixteenths interest in a 67 1/2-acre tract. However, this interest was granted to Carter & Gragg Oil Co., a partnership. There is nothing in the record which purports to show that petitioners acquired any interest whatever in this portion of the 67 1/2-acre tract from Carter & Gragg, or anyone else. We can not indulge in an assumption that they did. Of the remaining 10 instruments, 3 were assignments of a one-tenth interest in a certain lease*263 by which Alice McKinzie leased her undivided interest in the 67 1/2-acre tract. Two instruments were assignments of a one-third interest in a certain lease by which other parties leased their undivided interest in the 67 1/2-acre tract. We do not know the extent of the original lessors' interests in the tract, however, since the leases themselves were not offered in evidence and no testimony was given on this point. Consequently, we are unable to determine what interests petitioners obtained. Moreover, a one-sixteenth interest in the 67 1/2-acre tract is altogether unaccounted for. It is obvious that proof of the denominator of the apportionment ratio is lacking to such a degree as to make any figure a mere guess. In these circumstances we must sustain respondent.
Furthermore, it is at once apparent that petitioners have failed to prove a right to expense the intangible cost of the McKinzie well upon a totally different ground. As we have stated, several of the assignments contained no drilling provision. Upon this fact alone is based petitioners' contention that drilling could constitute no part of the consideration for the interests thus acquired. But as assignees of a *264 lease petitioners acquired no greater rights than those of their assignor *30 thereunder and were subject to all the obligations, conditions, and considerations imposed by the lease upon the assignor. None of the leases in relation to the McKinzie tract, except the lease to Carter-Gragg Oil Co., were offered in evidence and no evidence was offered as to the provisions thereof. Not having the information which such evidence would afford for consideration in connection with the provisions of the intervening assignments of the leases, we have no factual basis upon which to determine whether it is permissible under the regulations in question to expense the intangible drilling costs of the well drilled on such leased premises. We can not, therefore, hold that respondent erred in denying the applicability of such regulations in respect of the drilling of such well.
This observation applies also to the state of the proof respecting petitioners' acquisition of interests in the A. W. Johnson, M. K. Carter, Burkitt, Betz-Robinson, and Monnig tracts. In each instance the assignments covering these properties themselves contained drilling provisions which, as we have held, required drilling*265 as a part of the consideration for the capital assets which petitioners acquired. This suffices to support our conclusion as to the drilling expenses on these tracts. However, had these assignments been silent regarding drilling or had drilling provisions therein been of a character not bringing them within the rule of the Hardesty case, we would still be obliged to approve the respondent's determination disallowing deductions for the intangible costs of the wells on these tracts, since neither the underlying leases nor their provisions are before us.
F. H. E. was not a lessee under the lease conveying interests in the First National Bank tract. Fleming-Kimbell was not mentioned in the assignment of the leasehold interest in the Betz-Robinson tract. No evidence was offered to supply the missing links. Nevertheless, F. H. E. claimed a deduction for intangible drilling expenses in connection with the First National Bank well and Fleming-Kimbell claimed one for similar expenses in connection with the Betz-Robinson well. It can not be said, and in fact is not contended, that such expenses are deductible on the theory that petitioners, in the named instances, were merely acting*266 as contractors drilling for others and so entitled to a business expense deduction, for petitioners did not actually do the drilling. The drilling was contracted by them, not to them. Such expenses are not deductible by F. H. E. in respect of the well on the First National Bank tract nor by Fleming-Kimbell in respect of the well on the Betz-Robinson tract, because of failure to prove an interest, respectively, in such tracts.
For the reasons discussed above we hold that petitioners are not entitled to expense the intangible drilling and development costs connected with any of the nine wells.
*31 The second question in this proceeding is whether charitable contributions made by Fleming-Kimbell during the taxable year ended April 30, 1939, are to be deducted from gross income from the property in computing the limitation on percentage depletion pursuant to section 114 (b) (3) of the Revenue Act of 1938. Respondent claims that they are, while petitioners contend to the contrary.
The statute provides that the allowance for percentage depletion shall not exceed 50 per cent of the net income of the taxpayer from the property (computed without allowance for depletion). The Commissioner*267 has issued a regulation 2 defining the term "net income of the taxpayer from the property" for the purposes of this limitation. It requires that "gross income from the property" be reduced by the allowable deductions attributable to the mineral property upon which the depletion is claimed. . It does not provide that gross income must be reduced by all the deductions which may be allowed the taxpayer by statute. The answer here turns upon whether the charitable deductions in question are attributable to Fleming-Kimbell's oil properties.
*268 We do not think that they are so attributable. To be deductible as ordinary and necessary expenses under section 23 (a) of the Revenue Act of 1938, charitable contributions must have in a direct sense a reasonable relation to the business of the taxpayer corporation. However, the respondent makes no contention that the charitable contributions involved here were so closely related to Fleming-Kimbell's business as to make them deductible under section 23 (a). On the contrary, the parties seem to assume that the instant charitable contributions are of the character deductible only by virtue of section 23 (g) of the Revenue Act of 1938, which permits the deduction of certain contributions up to a limited amount regardless of their connection with a corporate taxpayer's business. Charitable contributions thus deductible do not appear to constitute deductions attributable to the mineral property upon which depletion is claimed within the meaning of the quoted regulations. On this issue, we sustain the petitioner.
Decisions will be entered under Rule 50.
*32 Black, J., dissenting: The majority opinion, after discussing the legal effect of oil leases which contain*269 the "unless" clauses and the oil wells which have been drilled thereunder, concludes: "It is apparent from the foregoing discussion that they form a part of the consideration for and constitute capital expenditures in the acquisition of the * * * tracts. Accordingly, such costs may not be deducted but can be recovered only through depletion allowances." (Citing cases.)
I agree that such expenditures are capital expenditures but the very purpose of article 23(m)-16 of Treasury regulations printed in the margin is to give the taxpayer the option of either deducting as a business expense the intangible drilling costs incurred in drilling a producing oil well which he owns, or to capitalize such intangible drilling costs to be recovered through depletion.
I think a producing oil well is a capital asset to a taxpayer who brings it in and owns it, whether he does it on land which he owns in fee simple, or on land which he has leased for development with an affirmative obligation to drill one or more wells in his program of development, or on land which he has leased with a mere option to drill within a given time and the lease to be forfeited unless he does drill, or on land where *270 the lease contains no specific provisions at all as to when development shall begin. A producing oil well in all the cases which I have enumerated is a capital asset in the hands of the owner, I think, and just as much so in the one case as in the other. It seems to me that article 23(m)-16 is broad enough to include within its provisions all the cases I have mentioned above and I dissent from the view that it should be denied application to wells drilled under the circumstances which exist in the instant case.
I further dissent from that part of the majority opinion which would deny the right to deduct intangible drilling costs to F. H. E. in respect of the well on the First National Bank tract and to Fleming-Kimbell in respect of the well on the Betz-Robinson tract, on the further ground of failure to prove an interest, respectively, in such tracts. I do not understand that the Commissioner either in his deficiency notice or at the hearing of these proceedings made any contention that petitioners were not the joint owners of the wells which they drilled on the two leases thus mentioned, in the drilling of which they incurred the intangible drilling costs which they here seek to*271 deduct. The Commissioner makes no such contention in his brief. The issue as presented by the parties was whether under the drilling clauses of the leases -- not only the First National Bank lease and the Betz-Robinson lease, but the other leases in evidence -- petitioners were entitled to deduct their intangible drilling costs as business expenses, they having elected so to do in prior years, or whether they must *33 capitalize them. That was the only issue between the parties on this phase of the case, as I understand it, and I think it is a mistake for the majority opinion to hold there was a failure of proof as to ownership of the oil wells in these two particular instances.
Footnotes
1. Art. 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. Such expenditures have for convenience been termed intangible drilling and development costs. * * *
(2) Option with respect to cost of nonproductive wells: In addition to the foregoing option the cost of drilling nonproductive wells at the option of the taxpayer may be deducted from gross income for the year in which the taxpayer completes such a well or be charged to capital account returnable through depletion and depreciation as in the case of productive wells.↩
2. Art. 23 (m)-1. Depletion of mines, oil and gas wells, other natural deposits, and timber; depreciation of improvements. --
* * * *
(h) "Net income of the taxpayer (computed without allowance for depletion) from the property," as used in section 114 (b) (2), (3), and (4) and articles 23 (m)-1 to 23 (m)-28, inclusive, means the "gross income from the property" as defined in paragraph (g↩) less the allowable deductions attributable to the mineral property upon which the depletion is claimed * * * including overhead and operating expenses, development costs properly charged to expense, depreciation, taxes, losses sustained, etc., but excluding any allowance for depletion. Deductions not directly attributable to particular properties or processes shall be fairly allocated. * * *