*9 Decision will be entered under Rule 50.
1. Deductions -- Percentage Depletion -- Economic Interest -- Heavier Hydrocarbons in Gas in Place. -- The petitioners are entitled to percentage depletion deductions because they owned, under written assignments, economic interests in heavier hydrocarbons contained in gas in place.
2. Income -- Completed Contract Basis -- Accrual -- Year of -- Lack of Evidence. -- The petitioner, on a completed contract basis, is required to accrue in the year of completion of a contract a portion of a fee connected therewith because of failure of proof that collection of that fee was subject to any reasonable uncertainty at the end of that year.
3. Income -- Cash Basis -- Receipt -- Year of. -- Nonnegotiable notes which were subject to many complicated agreements and conditions are not the equivalent of cash and not income to the petitioner, on a cash basis, in the year the notes were given.
*1043 The Commissioner determined deficiencies in income tax as follows:
| Petitioner | Docket No. | 1944 | 1945 |
| Edward J. Hudson | 16380 | $ 37,672.21 | |
| John B. Baird | 16382 | 1,760.25 | |
| Mildred Bennett Baird | 16383 | 1,763.90 | |
| Mary B. Downes | 16384 | 2,023.66 | |
| J. R. Downes | 16385 | 2,008.67 | |
| Maracaibo Oil Exploration Corporation | 17314 | 4,887.45 | $ 6,259.66 |
He also determined a deficiency in excess profits tax of $ 58,019.81 for the fiscal year ended July 31, 1944, against Hudson Engineering Corporation, Docket No. 16381.
The issues for decision are (1) whether the petitioners, other than Hudson Engineering Corporation, were entitled to percentage depletion deductions in 1944 and 1945 based on income derived from the production and sale of heavier hydrocarbons removed from the natural gas contained in the North Houston Field; (2) whether Hudson Engineering Corporation, on a completed contract basis, should have accrued as income during its fiscal year ended July*11 31, 1944, $ 50,000 of a $ 120,000 fee due to it; and (3) whether the face value of promissory notes received in 1944 by Hudson, who was on a cash basis, was includible in his gross income for that year as a long term capital gain. If it is held that those notes represented income in that year, an alternative issue is whether Hudson is entitled to return that gain on the installment basis.
FINDINGS OF FACT.
The petitioners, Edward J. Hudson, John B. Baird, his wife, Mildred B. Baird, J. R. Downes, his wife, Mary B. Downes, individuals, and Hudson Engineering Corporation, a corporation, filed their returns for the taxable years with the collector of internal revenue for the first district of Texas. Maracaibo Oil Exploration Corporation, a corporation, filed its returns for those years with the collector of internal revenue for the second district of Texas. All of the property and income of petitioners Baird and Downes during the year 1944 was community property.
*1044 The North Houston Field, located about 15 miles from Houston, Texas, contained reserves of natural gas in place in the reservoir, about 95 per cent by volume of which consisted of lighter elements known as methane*12 and ethane, and the other 5 per cent consisted of heavier elements including propanes, butanes, pentanes, and others. All of the heavier elements may be referred to hereinafter as heavier hydrocarbons. The heavier elements after separation were worth approximately twice as much as the lighter elements in 1941. Those various elements existed in a natural state in the reservoir and were not the result of a manufacturing operation. The natural gas in place in the reservoir is in the form of vapor. The heavier hydrocarbons condense into a liquid known as condensate or distillate if there is a reduction in the pressure or temperature of the gas.
Ten different individuals and companies owned over 200 leases in the North Houston Field in 1941. There was some production at that time, but the method used was uneconomical and the lease owners were not satisfied with the situation. Hudson proposed that a recycling method be used in the field and as a result of his proposal a number of agreements were entered into on August 1, 1941.
The lease owners, in order to induce Hudson to enter into a processing contract, assigned to Hudson on August 1, 1941, one-half of their interests in the heavier*13 hydrocarbon constituents of the gas in place above a certain depth. A typical assignment was in part as follows:
Whereas, Kirby Petroleum Company is the owner of valid and subsisting oil, gas and mineral leases, covering certain lands situated in and near the North Houston Field * * *
Now, Therefore * * * Kirby Petroleum Company * * * does hereby bargain, sell, transfer, assign and convey to E. J. Hudson * * * an undivided one-half (1/2) interest in and to all of the Propanes, Butanes, Pentanes and other heavier hydrocarbon constituents contained in the gas in place, above the depth of 7500 feet below sea level, under the lands covered by said leases * * * * * * and to the extent only that such hydrocarbon constituents may be subject to be produced from wells which the Railroad Commission of Texas or other regulatory authority asserting jurisdiction may classify as gas wells from time to time as production may be undertaken. This conveyance does not cover or convey any well or the casing, equipment or other personal property in said well or on the said leases.
There is specifically excepted and reserved herefrom such part and portion of said Propanes, Butanes, Pentanes and other*14 heavier hydrocarbon constituents not used or utilized by the assignees hereunder * * * in producing natural gasoline and condensates under the terms of a certain Processing Contract of even date herewith * * *.
This assignment and conveyance is expressly made subject to all the terms and conditions of the Processing Contract above referred to * * *
To Have and To Hold unto the said E. J. Hudson, his heirs and assigns, the said undivided one-half (1/2) interest in the hydrocarbon constituents above referred to, together with the right to enter upon the premises, to mine and process the said hydrocarbon constituents in place in the gas, to the extent herein conveyed, so long as said leases may exist, * * * and with the further limitation that *1045 this grant shall be determinable and ipso facto terminate with the termination in any manner of the Processing Contract entered into as of this date * * * and this grant shall terminate as to any producing horizon upon cessation of use or utilization thereof under said Processing Contract after use or utilization is once begun. All rights and interests conveyed hereunder shall revert to Kirby Petroleum Company, its successors and assigns, *15 forever, upon the termination hereof.
Hudson later assigned portions of the interest which he thus acquired as follows:
| Assignees | Effective | Fractional |
| date | portion | |
| John R. Downes | Aug. 1, 1941 | 0.0750 |
| John B. Baird | Aug. 1, 1941 | .0750 |
| J. M. Flaitz | Aug. 1, 1941 | .0750 |
| Lehman Corporation | Mar. 26, 1942 | .3750 |
| Maracaibo Oil Exploration Corporation | Mar. 26, 1942 | .1250 |
Those assignments by Hudson carried all the benefits and obligations he possessed under the assignments by the lease owners to him.
The lease owners entered into a unitization and recycling agreement on August 1, 1941, (referred to hereafter as the unitization agreement) whereby they agreed to pool their interests so that the leases might be consolidated for the purpose of production, in accordance with the terms of a processing contract entered into between the lease owners and Hudson on the same day.
The processing contract also entered into on August 1, 1941, described the lease owners as sellers and Hudson as buyer. It provided that Hudson was to construct a plant at his own expense to extract the heavier hydrocarbons from the natural gas to be delivered to him by the sellers and to return to the field*16 under pressure the residue gas. That method is called recycling. That agreement recited that one-half of the heavier hydrocarbons had been assigned to Hudson, but that assignment was to be canceled in case the processing contract failed to become effective or was terminated because of certain contingencies. The contract became effective and was not terminated.
Hudson was required to pay taxes on his interests in the leases.
It was contemplated and provided in the processing contract that Hudson would transfer an interest in it to a corporation to be formed to own and operate the plant and thereby would be relieved of all personal liability under the contract. Distillate Production Corporation (hereafter referred to as Distillate) was formed for that purpose and an assignment of a part of the processing contract was made to it on March 26, 1942. The contract recited that an undivided one-half interest in the heavier hydrocarbon constituents contained in the gas in place had been assigned to Hudson. It provided that Distillate was to receive a processing fee to be charged against Hudson's portion of the products. Distillate was to market the product saved in the processing *1046 *17 and was to pay one-half of the proceeds, less the agreed processing fee to Hudson and his assigns, and was to pay all of the remaining one-half to the lease owners. Distillate agreed to construct a plant and provide the necessary equipment to perform the processing contract.
The agreements were carried out and production was substantially increased. The operation continued through the taxable years.
The Commissioner, in determining the deficiencies, disallowed depletion deductions claimed by Hudson, the Bairds, and the Downes, with the following explanation:
It is held that the interest owned by you in the North Houston Field is not an economic interest in a natural resource and that the income reported by you from such source is income derived from a manufacturing and processing operation and not from the severance and sale of a natural resource. No depletion is allowable in respect of such income. The depletion claimed, therefore, has been disallowed.
His explanation with regard to Maracaibo was as follows:
It is held that you and your associates acquired an interest in the cycling plant and not an interest in oil in place in connection with the North Houston Unit. The amount*18 of depletion, $ 12,037.37, claimed in your return, in the taxable year, is accordingly disallowed.
Distillate entered into a contract with Hudson Engineering Corporation (hereinafter called Engineering) to construct a processing plant at an estimated cost of $ 849,270 plus a fee of $ 120,000 which Distillate agreed to pay to Engineering under the following conditions:
The total amount of $ 120,000 covering process engineering design, overhead and profit shall become a fixed obligation of your company upon completion of the plant and commencement of its operation, and shall be due after payment by Distillate Production Corporation of:
1. All obligations to equipment vendors incurred before commencement of plant operation together with all interest thereon, or any obligations incurred in the refunding thereof, and;
2. Notes to the Lehman Corporation and Maracaibo Oil Exploration Corporation amounting to $ 450,000 together with all interest thereon, or any obligations incurred in the refunding thereof.
Hudson, Baird, and Downes owned the stock of Engineering and were also stockholders of Distillate. Other stockholders of Distillate were Maracaibo, the Lehman Corporation (hereinafter*19 called Lehman), and J. M. Flaitz. Lehman and Maracaibo agreed to lend Distillate a total of $ 450,000 to be used in the construction of the plant.
The plant was completed in October 1943. Its actual cost, including the Engineering fee, was $ 1,529,072. Distillate owed at that time $ 450,000 to Lehman and Maracaibo, the fee of $ 120,000 to Engineering, and $ 944,587.88 to equipment vendors. It borrowed $ 950,000 from the Chase National Bank of New York City to pay the equipment vendors, mortgaging all of its properties as security for that loan. *1047 Hudson, Baird, Downes, and Flaitz (hereinafter referred to as Hudson et. al.), Lehman, and Maracaibo also pledged all of their mineral interests in the North Houston Field with the bank as additional collateral for the loan and agreed to purchase participating interests in the loan from Chase out of proceeds from the pledged interests. Lehman and Maracaibo agreed that their loan of $ 450,000 would be subordinate to the Chase loan. Hudson et al. agreed to purchase participating interests in the $ 450,000 indebtedness due to Lehman and Maracaibo. The participating interests in the Chase loan were to be subordinate to the $ *20 120,000 fee owed to Engineering. However, Distillate addressed a letter dated November 15, 1943, to Engineering stating that the fee or $ 120,000 was to be subordinate to the debt due to Chase and the participants therein. Engineering subscribed to that letter.
Distillate sustained net losses in each year up through 1944 and its balance sheet at the end of that fiscal year showed a deficit of about $ 69,000 after deducting liabilities (including the $ 120,000 fee due Engineering and $ 450,000 due Lehman and Maracaibo, the $ 552,820.95 due Chase, and $ 125,000 due the participants in the Chase loan) from total assets of $ 1,342,376.84 (consisting principally of a plant costing about $ 1,500,000, less depreciation of about $ 346,000).
Engineering kept its books and reported its income on a completed contract basis. It did not include the $ 120,000 fee in its reported income for the fiscal year ended July 31, 1944. The Commissioner, in determining the deficiency, valued the fee at $ 50,000 and included that amount in Engineering's income for the fiscal year ended July 31, 1944.
Distillate has never made any payment on the $ 120,000 fee. It showed an operating loss in excess of $ *21 100,000 up to the close of 1947. It made payments on the Chase loan and on the Lehman-Maracaibo loan by using money offsetting its reserve for depreciation on its plant. The indications are that the operation of the plant will probably cease in 1948 or 1949 and it was extremely uncertain at the time of the trial whether Distillate would ever be able to pay anything upon account of the fee of $ 120,000. Meanwhile, however, Engineering had sold an interest in that fee to the other parties mentioned herein for $ 26,000.
Hudson in July and September 1944 made four assignments each of one twenty-fifth of the interest in the heavier hydrocarbons in place which he had acquired under the assignment from the lease owners. Each assignment was subject to the obligations, reservations, and exceptions contained in the original assignments to Hudson, the unitization agreement, the processing contract, the agreement between Hudson and Distillate, and the various financing agreements mentioned above.
*1048 Hudson received as part consideration for the assignments non-negotiable notes of the assignees in the total amount of $ 96,000. Each assignee gave three notes for $ 8,000 each, one payable*22 in one year, another in two, and the third in three years. The notes bore interest at 3 per cent.
The assignees also agreed to pay Hudson certain additional amounts when the net profits of the assignees exceeded $ 32,000. He received no cash or other property in 1944 as consideration for the assignments. Hudson reserved liens on the interests assigned to secure payment under the notes and the agreements of the assignees. He and each assignee entered into a collateral agreement relating to the payment of the notes on the same day that they were executed. The agreement provided that when any of the notes became due the assignees had the option of paying them in cash or of assigning to Hudson a portion of participating interests in the Chase and Lehman and Maracaibo loans which they would have purchased, meanwhile, from proceeds from the mineral interests, provided that Hudson had the option of extending the date of payment of the notes from year to year in lieu of accepting the participating interests in the loans.
The first payments which Hudson received on the notes were about $ 4,500 interest and $ 1,700 principal in 1948.
Hudson kept his books and prepared his returns for 1944*23 on a cash basis. He did not include the notes in his taxable income for that year. The Commissioner in determining the deficiency included those notes in the income of Hudson at 50 per cent of their face value of $ 96,000 as a long term capital gain, with the following explanation:
It is held that the notes aggregating $ 96,000.00 in face amount received by you upon sales of fractional interests in your North Houston contracts had a fair market value of $ 96,000.00 when received by you and that this amount is longterm capital gain realized by you in the year 1944, one-half of which, or $ 48,000.00, has been included in your taxable income for 1944.
The notes in the principal amount of $ 96,000 had no fair market value in 1944.
The stipulations of fact filed by the parties are incorporated herein by this reference.
OPINION.
The theory was expressed in some of the notices of deficiency that the income derived by the petitioners was "from a manufacturing and processing operation and not from the severance and sale of a natural resource." The evidence shows that the income was from the severance and sale of a natural resource without the intervention of any manufacturing operations.
*24 The respondent argues that all of the agreements entered into on August 1, 1941, must be considered together, and they show that Hudson *1049 did not acquire any economic interest in the minerals in place in the ground, but received only the right to the heavier hydrocarbons for the purpose of removing them from the other gas and to receive one-half of the gross proceeds from their sale in consideration for constructing and operating the recycling plant. He concedes that the assignments refer to the gas in place, but contends that the words "in place" are not used elsewhere and, since Hudson was described in the processing contract as buyer, he was not an economic owner of the gas in place. He argues that the owners of the leases did not part with any economic interests, for they continued to pay the royalty owners in accordance with the original leases, they retained control over the drilling of wells, and the assignments were to terminate with the termination of the processing contract. He also argues that the economic interest in the minerals which would be subject to depletion could not be divided so that Hudson would have a depletable interest in the heavier hydrocarbons, *25 but none in the lighter ones. These and other arguments advanced by him have been carefully considered, but the conclusion has been reached that Hudson and his assigns did have economic interests in the heavier hydrocarbons in place, which interests are subject to depletion under the applicable provisions of the code and Regulations 111, section 29.23 (m)-1.
The assignments clearly and definitely give to Hudson a one-half interest in the heavier hydrocarbons in place. Cf. ; affd., . He and his assigns retained that interest throughout the period here in controversy. Those assignments were fully recognized by all of the parties to the agreements of August 1, 1941, and in subsequent agreements. There is nothing inconsistent with the assignments in the other agreements. The interests were given to Hudson in order to induce him to enter into the processing contract and it was to those interests that he had to look for his profit from the whole transaction. It is immaterial that they were subject to some condition or conditions subsequent under which they might be terminated. *26 The respondent has not cited any cases involving assignments such as those shown herein. The parties have stipulated the amount of the depletion allowable if those taxpayers had depletable interests.
The second issue is whether the Commissioner erred in adding $ 50,000 to the income of Engineering for its fiscal year ended July 31, 1944. Engineering reported its income for that year upon a completed contract basis. It had a contract to build the plant for Distillate. Its fee under that contract was $ 120,000. The contract was completed in October 1943, which was within the fiscal year ended July 31, 1944. Those circumstances would normally require the accrual for that year of the entire fee of $ 120,000. ; affirmed on this issue, . *1050 The petitioner, to avoid accrual of the fee, would have to prove that as early as the end of that year some contingency or reasonable uncertainty about the ultimate payment was known to exist which would justify the petitioner's failure to accrue and report this item. ,*27 et seq.; affd., .
The respondent has included only $ 50,000 of the total in income for that year, thus indicating that he thought there was sufficient uncertainty as to payment to excuse the petitioner from accruing the balance. It was incumbent upon the petitioner to show that there was similar uncertainty as to the $ 50,000. That it has failed to do. There is evidence to show that in the taxable year the payment of this fee was subordinate to a number of other obligations of the debtor, but the evidence does not show that the prospects of payment at that time were so uncertain that no part of the fee should have been accrued. There is considerable evidence to show that at a much later date there was great uncertainty, but the uncertainty must have been apparent not later than the end of the taxable year in question. The petitioner in his reply brief, discussing this very question, states that at the beginning of the operations in the latter part of 1943 it was "too early to foretell what the income of either Distillate or Hudson Engineering would be." The evidence is not inconsistent with that statement. Obviously, evidence merely*28 showing that the income of the debtor could not be foretold is not sufficient to excuse a creditor using a completed contract method of reporting income from reporting a fee in a situation like this one. There is no evidence to show whether or not, or the extent to which, the future losses of Distillate were foreseen or forseeable. The petitioner must lose on this point because the evidence does not support its contention.
The third issue is whether Hudson had income of $ 96,000 from receipt of notes in that amount for the assignment of fractional portions of his interest in the heavier hydrocarbons in place which interests had no basis to him. Section 111 (b) provides that "The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received." Hudson received no money; therefore, the question is: Had the notes any fair market value and, if so, what was it?
These notes were nonnegotiable and were subject to many complicated agreements and conditions. They were not unqualifiedly payable in money. Their ultimate payment depended upon the life of the North Houston Field and*29 the success with which the operations in that field could be carried on. This is a situation similar to the one dealt with in , in which we *1051 held that certain nonnegotiable notes were not the equivalent of cash and that the income of the petitioner on a cash basis would be reflected more accurately by reporting the payments on the notes as income in the year of receipt rather than including the face amount of the notes in income in the year in which the notes were given. It is held that the Commissioner erred in taxing Hudson with income of $ 96,000 based upon the receipt of these notes in 1944.
Decision will be entered under Rule 50.
Footnotes
*. Proceedings of the following petitioners are consolidated herewith: Hudson Engineering Corporation; John B. Baird; Mildred Bennett Baird; Mary B. Downes; J. R. Downes; and Maracaibo Oil Exploration Corporation.↩