*929 Petitioner was the owner in the taxable year of an oil and gas payment of which it had a certain unrecovered basis of cost. Payments to be made petitioner in settlement of the oil payment were to be out of four-eights of the oil produced from the lease until the entire agreed sum was paid. In the taxable year petitioner exchanged this oil payment for an overriding oil and gas royalty reserved from the same lease, which provided for a payment of five thirty-seconds of the oil and gas until the oil payment had been made and then became a one-fourth overriding oil and gas royalty as long as oil and gas should be produced from the lease. Held, the exchange is not nontaxable under section 112(b)(1), Revenue Act of 1934, but is taxable under the general rule provided in section 112(a).
*1154 The Commissioner determined against petitioner a deficiency of $1,829.12 in income tax for the year 1934. In its income tax return for 1934 petitioner reported a net income of $37,203.20, on which it was assessed an income tax of $5,115.44. Respondent made several*930 adjustments in this return and determined petitioner's adjusted net income for the year 1934 to be $50,505.92, resulting in the above named deficiency.
One of the adjustments which respondent made in the auditing of petitioner's return for 1934 was to add to petitioner's income the sum of $28,933.68 as representing gain on an exchange of an oil payment for an overriding royalty in the same lease.
The petition contains several assignments of error assailing the different adjustments made by the Commissioner. All of these assignments of error have been waived except the one which contests the action of the Commissioner in adding to petitioner's income the $28,933.68 item above described. That presents the sole issue which we have to determine in this proceeding.
FINDINGS OF FACT.
The petitioner is a Texas corporation, with its principal office at Kilgore, Texas. Petitioner's income tax return for the period here involved was filed with the collector of internal revenue at Dallas, Texas.
The Holmans oil and gas payment, sometimes hereinafter referred to as the Holmans oil payment, was created by an instrument dated November 3, 1932, between Ray Dawson, the then owner*931 of the *1155 Mitchell lease and Ed. Holmans, the substance of which was that Holmans was to drill a well for Dawson upon the Mitchell lease and:
As a consideration for the drilling and equipping and completing of said well as hereinabove set forth, the first party (Dawson) agrees that upon the completion thereof, he will assign to the second party (Holmans) an oil payment in the principal sum of $28,500.00 to be paid out of four-eighths of the entire production of oil and gas from said property, together with an assignment of that interest, the proceeds of which shall be paid directly to the second party by any pipe line or other purchaser of oil from said leasehold estate, said interest and consideration to be wholly free and clear at all times from any expense of maintenance, or operation of said leasehold estate, and free and clear of any gross production or other taxes; said interest to remain an overriding royalty interest until said oil payment is paid; said four-eighths interest out of which the oil payment is to be made to then revert to first party when payment is complete.
By an instrument dated June 29, 1933, Ed. S. Holmans sold and conveyed to the petitioner, *932 Midfield Oil Co., the oil payment above recited which was to be paid out of four-eighths of the oil produced from the Mitchell lease until the agreed payment of $28,500 was completed.
By instrument dated March 23, 1933, Dawson assigned the Mitchell lease to R. E. Kennedy, and in the assignment provided:
Ray Dawson hereby excepts and retains unto himself five-thirty-seconds (5/32nds) of seven-eighths (7/8ths) of all oil produced from said premises from all wells now located thereon and that may be drilled thereon; and three-thirty-seconds (3/32nds) of seven-eighths (7/8ths) of all oil produced from said premises from the wells now located thereon and all wells that may be drilled thereon after all oil payments now of record have been paid, also eight-thirty-seconds (8/32nds) of the gross proceeds received at the wells from casinghead gas or gas produced and marketed from said premises and/or used in the manufacture of gasoline. Said oil shall be delivered free of cost to the credit of Ray Dawson into the pipe line or pipe lines to which the wells on said premises may be connected, or at his election, from time to time, Ray Dawson shall have the right to receive said oil in kind. *933 Such oil shall be in the nature of an overriding royalty and it shall not be subject to any of the costs or expenses incurred in developing and operating said premises. Said oil for the purposes of this contract shall be valued at the current posted field price of Humble Oil and Refining Company for East Texas crude oil on the respective days on which runs are made to the pipe line, or if Humble Oil & Refining Company does not post a price for East Texas crude oil, it shall be valued at the price currently paid by Humble Oil & Refining Company for East Texas crude oil on the respective days on which runs are made to the pipe line unless otherwise arranged.
By instrument dated March 27, 1934, Dawson, for a recited consideration of $10 "and other good and valuable consideration to me paid and secured to be paid by Jupiter Oil Company as follows" (by the execution of its promissory note of even date for the principal sum of $5,000, said note bearing interest at the rate of 10 percent per *1156 annum after maturity, etc.), assigned said overriding royalty to the Jupiter Oil Co.
On April 11, 1934, Dawson, petitioner Midfield Oil Co., R. E. Kennedy, individually, and the Jupiter*934 Oil Co. executed an agreement which recited, first, the ownership by the Jupiter Oil Co. of the Mitchell lease; second, that Midfield had assigned to Dawson the Holmans oil payment; third, that Jupiter had executed to Dawson the $5,000 note. The instrument then stated that the assignment of said oil payment and the execution and delivery of the note represented the consideration paid to Dawson for the overriding royalty interest; that Midifield had assumed the note; and that Dawson would release the note and Midfield would increase the amount of the oil payment to $25,000. The Jupiter Oil Co. agreed to this and in connection with the same transaction Kennedy agreed to dismiss a suit against Dawson with respect to some unrelated property.
Although the Jupiter Oil Co. appears in this transaction, the revenue agent reported on it as follows:
Since it appears that the Jupiter Oil Company never gave to or paid to Ray Dawson the $5,000.00 note mentioned, it appears that the correct construction of these instruments is that the Midfield Oil Company exchanged the balance due on the oil payment for the overriding royalty.
The deficiency notice proceeds upon this same basis.
On*935 April 11, 1934, the Jupiter Oil Co. assigned the Dawson overriding royalty to the Midfield Oil Co.
At the date the Midfield Oil Co. received the Dawson overriding royalty under the transactions above set out, the fair market value of the royalty was $15,000, and not $42,150.48 as the Commissioner has determined.
The Mitchell lease, out of which the Holmans oil payment was to be made and in which the Dawson overriding royalty was reserved had an area of 2.6 acres, on which one producing oil well was situated during the period here in question.
Prior to the issuance of the deficiency notice, petitioner had filed a claim for the refund of $5,115.44 income taxes paid by it for the year 1934, which claim was rejected by the Commissioner in the deficiency notice. The petition in this proceeding was filed April 18, 1938.
OPINION.
BLACK: Petitioner makes two contentions, as follows:
1. That the exchange of the Holmans oil and gas payment due out of oil and gas to be produced from the Mitchell lease for the Dawson overriding oil and gas royalty out of the Mitchell lease was, under the provisions of section 112(b)(1) of the Revenue Act of 1934, a *1157 nontaxable exchange*936 of like kind of property for like kind of property, with no cash difference.
2. That even if the exchange is taxable, the gain to be recognized is only the difference between $15,000 (fair market value of the Dawson royalty at the time of exchange) and $13,216.80 (the amount conceded to represent the unrecovered cost of the Holmans oil payment).
The evidence supports the figures which have been stated by petitioner and we have so found in our findings of fact.
We shall first take up and decide petitioner's first contention, which, if correct, is determinative of the case. Section 112(b)(1) of the Revenue Act of 1934 reads as follows:
(b) EXCHANGES SOLELY IN KIND. -
(1) PROPERTY HELD FOR PRODUCTIVE USE OR INVESTMENT. - No gain or loss shall be recognized if property held for productive use in trade or business or for investment (not including stock in trade or other property held primarily for sale, nor stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest) is exchanged solely for property of a like kind to be held either for productive use in trade or business or for investment.
*937 The exceptions to the recognition of gain on a sale or exchange provided in section 112, including the one which we have just quoted, will be strictly construed as an exception to the general rule that gain is to be recognized and taxed when it is realized. Cf. .
We agree with petitioner that the Holmans oil payment prior to its exchange for the Dawson overriding royalty was held by petitioner for productive use or investment in its trade or business, and we likewise agree that the Dawson royalty was so held by petitioner after it was received in exchange for the Holmans oil payment, but we do not agree that the two properties were of "like kind" within the meaning of the section of the statute just above quoted.
There are two differences in the rights created by the Holmans oil payment and the Dawson overriding royalty, both of which we regard as differences of substance and not of mere form. The first difference is that the Holmans oil payment was limited in amount - that is, the right of the holder terminated after a specified amount of proceeds derived from oil and gas produced on the lease had been received by the holder*938 of the oil payment, while the rights of the holder of the Dawson overriding royalty continued for so long as oil or gas might be produced from the leased property.
The second difference was in the fractions of the oil and gas which were to be applied currently to the oil and gas payment and to the overriding royalty. In the instant case, the fraction of the oil and gas produced on the lease which was to be applied currently *1158 to the Holmans oil payment until it was extinguished was four-eighths of the entire production of oil and gas from the property. That which was to be paid under the Dawson overriding royalty was five thirty-seconds of seven-eighths of the oil and gas until the Holmans oil payment had been paid, and then it became a one-fourth overriding oil and gas royalty, one-fourth of seven-eighths.
While we agree with petitioner that there are some points of similarity between the Holmans oil payment and the Dawson overriding royalty, the differences which we have pointed out are so substantial that we do not think the exchange in question falls within the provisions of section 112(b)(1). On this point the Commissioner is sustained.
As we have already*939 stated, we agree with petitioner on its second point. It is conceded that petitioner has an unrecovered cost basis in the Holmans oil payment of $13,216.80. We have found the value of the Dawson overriding royalty at the time of the exchange to be $15,000. Petitioner's gain from the exchange should be recomputed by the use of these figures.
Decision will be entered under Rule 50.