*806 1. Income from a lease between the petitioner and the State of California is taxable under the principle of Burnet v. Jergins Trust,288 U.S. 508">288 U.S. 508.
2. Under the facts of this case petitioner has no depletable interest arising out of casinghead gas contracts. Signal Gasoline Corporation v. Commissioner, 66 Fed.(2d) 886, distinguished.
*910 The respondent has determined deficiencies in income tax of $8,903.92, $2,551.85, and $5,811.67 for the taxable years 1927, 1928, and 1930, respectively, and the petitioner has brought these proceedings for the redetermination thereof, at the same time claiming overpayment for the latter year of $33,710.32.
Numerous issues were raised by the pleadings but those pertaining to depreciation, bad debts, profit upon the sales of miscellaneous *911 equipment, commission paid upon the sale of real estate, and certain depletion (other than below) have been settled by stipulation of the parties, as hereinafter shown, leaving for our consideration only two issues, (1) whether*807 the petitioner is totally exempt from income tax upon that portion of its income derived from a certain lease between the petitioner and the State of California, and (2) whether the petitioner is entitled to depletion growing out of its operations under so-called casinghead gas contracts.
FINDINGS OF FACT.
The petitioner, a corporation, organized and incorporated under the laws of the State of California, was engaged during each of the taxable years in controversy, and for many years prior thereto, in the business of producing oil from properties in which it owned an interest or in which it had acquired an interest as lessee, and also in the business of producing casinghead gasoline under the terms of various so-called "casinghead gas" contracts. For this latter purpose it maintained and operated, during each of said years, casinghead gasoline plants situated in the Signal Hill Oil Field, of Los Angeles, California. Its books of account were kept and its returns were filed on the accrual basis.
Under what is referred to by the parties as "Lease #89", dated October 22, 1929, the State of California leased certain oil and gas lands situated in the county of Santa Barbara, *808 California, to J. H. Barneson, vice president and director of the petitioner, who acted as agents for the petitioner, pursuant to the provisions of chapter 303, Statutes of California 1921, approved May 25, 1921, entitled "An Act to Reserve All Minerals in State Lands, etc." Barneson and his wife assigned all their right, title, and interest in said lease to the petitioner on November 14, 1929, and on December 19, 1929, the assignment was duly approved by the State of California.
The petitioner, upon acquiring the aforesaid lease, immediately commenced drilling operations, and since that date it has continuously operated in accordance with the provisions thereof. In rendering its income tax return for the calendar year 1930, the petitioner, under protest, included in its taxable net income the income attributable to its operations under that lease in the amount of $177,129.75. Due to changes in allowable depreciation and depletion the income attributable to the petitioner's operations under the lease would be reduced from $177,129.75, as reflected in its return, to $139,014.28. The petitioner realized net income from its operations under said lease, during the calendar year 1930, *809 of $139,014.28.
Natural gas, commonly known as "wet gas", as it flows from the earth, is not a salable commodity. It is only through processing - by *912 separation of the gasoline therefrom - rendering it dry, that it may be sold for commercial uses. Conversely, it is only through the separation of dry gas from wet gas that the gasoline is salable. It is this process that produces casinghead gasoline. The content of gasoline in wet gas varies from one-half gallon to six gallons a thousand cubic feet of gas produced, depending upon its richness.
In and prior to the taxable years the petitioner entered into numerous contracts with oil producers for the treatment of "wet gas" by the extraction of gasoline therefrom. Those contracts provided, generally, that the petitioner should install and maintain the necessary pipe lines and connections from casingheads or traps at the mouth of the well to its plant, through which the producer agreed to deliver to the petitioner's plant the natural gas produced at such well, and that the petitioner should extract the gasoline therefrom, the petitioner to pay the producer 33 1/3 percent of the total gross proceeds derived from the*810 sale of gasoline extracted from wet gas or, at the producer's option, therein provided, to deliver 33 1/3 percent of the salable gasoline, so extracted, to the producer. A slightly different type of such contract provided for the outright "purchase" from the producer of all natural gas produced at a given well, the petitioner paying 33 1/3 percent of the gross proceeds received by it from the sale of gasoline extracted from said gas. Some of the dry gas remaining after removal of the gasoline was blown to the air and wasted because there was no market for it, while some was sold to public utilities, in which case the petitioner accounted to the producer for a proportion of the proceeds provided for under the contract and some was returned to the wells to be used for pressure purposes.
The petitioner first raised the question of depletion under the casinghead gas contracts by amended petition.
OPINION.
MORRIS: The petitioner seeks total exemption of the income derived during the taxable year 1930 from "Lease #89", between itself and the State of California, under the doctrine of implied immunity, relying primarily upon *811 Burnet v. Coronado Oil & Gas Co.,285 U.S. 393">285 U.S. 393. The respondent, on the other hand, relies upon Burnet v. Jergins Trust,288 U.S. 508">288 U.S. 508.
Burnet v. Coronado Oil & Gas Co., supra, arose out of a lease entered into between the State of Oklahoma and Coronado Oil & Gas Co. "By the Enabling Act Congress required as a condition precedent to the admission of Oklahoma into the Union that her Constitution should make provision for common schools; and for their benefit it granted certain lands to the state with the proviso that *913 those valuable for minerals, gas, and oil should not be sold prior to January 1, 1915, but might be leased. Act of June 16, 1906, 34 Stat. 267, 270, 272, 273. The State Constitution (article 11, § 1) established a common school system and pledged her faith to preserve the lands so conveyed by the United States as a sacred trust, and to keep the same for the uses and purposes for which they were granted. The Legislature prescribed regulations for leasing and directing payment of the proceeds into the school fund." Surnet v. Coronado Oil & Gas Co., supra. Some of those lands were leased*812 to Coronado Oil & Gas Co., by which the state was to, and did, receive a certain percentage of the gross production of oil and gas produced thereunder. The Court there held that the lease was an "instrumentality of the state for the purpose of carrying out her duty in respect of public schools."
In Burnet v. Jergins Trust, supra, the city of Long Beach, California, had acquired and held certain acreage for water supply purposes until, in 1922, oil was discovered in the vicinity thereof, when A. T. Jergins Trust was organized under the laws of California to obtain an oil and gas lease upon such lands. It was stipulated in such lease that the city should receive 40 percent and A. T. Jergins Trust, 60 percent of the proceeds of oil and gas recovered. The taxpayer in that proceeding relied upon Gillespie v. State of Oklahoma,257 U.S. 501">257 U.S. 501 and Burnet v. Coronado Oil & Gas Co., supra.But the Court said, holding the income taxable, "In both of those cases the sovereign was acting as the trustee of an express trust with regard to the lands leased. In both the burden upon the public use was more definite and direct than in*813 the present case. As said in the Coronado case, the doctrine of Gillespie v.Oklahoma is to be applied strictly and only in circumstances closely analogous to those which it disclosed."
We find nothing, in principle, to distinguish the instant case from Burnet v. Jergins Trust, supra.The proposed tax is upon the net income of an independent private corporate entity from any and all sources, not upon the property of the municipality, upon its share of the oil recovered, the lease itself, nor the gross income therefrom. This income is just as remote from any governmental function as it was there. Certainly there is no close analogy between the circumstances of this case and those found in Burnet v. Coronado Oil & Gas Co., supra.Upon this issue we sustain the respondent's determination.
The petitioner alleges and contends that it is entitled to depletion under its casinghead gas contracts and in support of such contention it relies upon Signal Gasoline Corporation v. Commissioner, 66 Fed.(2d) 886, reversing the *814 Board at 25 B.T.A. 861">25 B.T.A. 861.
*914 Sections 234 and 204 of the Revenue Act of 1926, applicable to allowable deductions and the basis for determining depletion, etc., are as follows:
SEC. 234. (a) In computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:
* * *
(8) In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each case; such reasonable allowance in all cases to be made under rules and regulations to be prescribed by the Commissioner with the approval of the Secretary. In the case of leases the deductions allowed by this paragraph shall be equitably apportioned between the lessor and lessee;
* * *
SEC. 204. (c) The basis upon which depletion, exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property shall be the same as is provided in subdivision (a) or (b) for the purpose of determining the gain or loss upon the sale or other disposition of such property, except that -
* * *
(2) In the case of oil and gas wells the*815 allowance for depletion shall be 27 1/2 per centum of the gross income from the property during the taxable year. Such allowance shall not exceed 50 per centum of the net income of the taxpayer (computed without allowance for depletion) from the property, except that in no case shall the depletion allowance be less than it would be if computed without reference to this paragraph.
The applicable provisions of the Revenue Act of 1928 are substantially the same as those of the Revenue Act of 1926 quoted above.
In Signal Gasoline Corporation, supra, the petitioner acquired a number of already existing casinghead gas contracts for which it assumed certain obligations, aggregating in excess of $50,000, and it paid cash of $107,488.41, and 450,000 shares of its common capital stock, par value $1 a share. There, as here, the petitioner, under its contracts - in many respects similar in terms to the contracts of this petitioner, but differing in many other vital respects - acquired wet gas from producers in the State of California. The contracts here are similar in their aims and objects but they differ widely in their scope of performance. The aims and objects, in both instances, *816 were to produce wet gas and by a process of manufacture to render that wet gas a salable, useful commodity. They were similar in that the petitioner, in each instance, was to acquire, but purchase, leases, or otherwise, all of the natural gas produced at a specified well for the purpose of extracting the gasoline therefrom and disposing of it, together with the dry gas - that is, such dry gas as was not consumed in the manufacture or blown to air, for the benefit of the parties concerned in proportion to their contractual interests. In both cases the petitioner was required to lay the necessary pipe lines from the well to the absorption plant and, of course, such rights of ingress and egress as were necessary to the upkeep of such pipe lines were *915 provided for. One noteworthy distinction, however, appears in the fact that in the instant case the producer, not the petitioner, was required to furnish necessary cashingheads and gas traps to which the producer agreed to deliver the wet gas and from which the petitioner agreed to convey, through its pipe line, to its plant for treatment. In that case there appears to have been a much greater obligation on the part of the*817 petitioner. Its duties respecting the production of gas did not cease with the delivery of wet gas to the casinghead or gas traps but it was required "whenever it became feasible and advisable, to install a vacuum upon the wells" and furthermore, "that it would install the necessary equipment and maintain such vacuum as was desired" by the producer "for regulating the presure to be exerted in the operation." The petitioner there "assisted in driling wells by furnishing separators, casing, derricks, boilers, other drilling equipment on the outcome of the well", for which it "received no payment, if the well was dry." Not only were the producers there bending their efforts toward the production and delivery of gas to the petitioner, but "producers and the petitioner were both engaged in continuous steps to win oil and casing-head gas from their position in the earth." In that case "After a well had ceased flowing in commercial quantities from the natural pressure, it was necessary, in the case of most of the wells, for petitioner to take direct means by the introduction of high pressure dry gas into the well to induce a larger flow of oil and gas." In the instant case the petitioner*818 was only required to return to the producer such quantity of gas as was necessary for injection proposes - it was required to take no "direct means" to bring about the production of gas - what means it took were indirect and merely incidental to its contractual obligation.
So much for the distinctions between the instant case and the case relied upon by the petitioner to support its claim. Let us examine a contract of this petitioner and see if we are able to find, as the court did there, that the interest of the petitioner was in the nature of a profit a prendre. Unless there was, of course, the petitioner would have no depletable interest. It is clear to our minds that it was intended by these contracts to establish an independent relationship between the parties, the producer, producing wet gas, on the one hand, and the manufacturer, converting that wet gas into salable commodities on the other. The preamble of this typical contract recites that the prducer "is the owner of the natural gas produced" under that contract; that the petitioner has erected a plant for the extraction of gasoline; that in order to obtain "an adequate supply of gas for said plant" the petitioner*819 "desires to receive from Producer all of the natural gas which may be produced" under such *916 contract; that the "Producer is desirous of having the gas produced" under that contract "treated for the extraction of gasoline therefrom", and "as an inducement to Bankline to operate a plant capable of treating the natural gas produced" the producer "is willing and desires to deliver to Bankline all of the natural gas produced."
The body of the contract repeatedly speaks in language of separate and independent obligations of the parties leaving not the slightest suggestion of an intention to create a right of profit a prendre. Speaking of this right, the court in Signal Gasoline Corporation, supra, said: "Considered by themselves, the contracts may not specifically convey any title to gas in the ground, but the contracts confer upon petitioner the right to enter upon the land and connect its pipes directly with the oil wells, install meters, and petitioner is required to maintain vacuums on the oil wells. These provisions, together with the method of operation sanctioned by the parties whereby petitioner, by means of gas lifts, rodless pumps, and the use of compressors*820 to create vacuums, extracted the gas that would otherwise not be produced from the premises, conferred upon it an incorporeal right to be exercised in the land in relation to the gas which was in the nature of a grant of a profit a prendre." The only provision for the use of vacuum, found in only two of these contracts (there being seven), one of which, entered into between the petitioner and the General Petroleum Corporation on June 9, 1922, says:
The first party [General Petroleum Corporation] hereby agrees to deliver to the second party [petitioner] at the traps or casing-heads of the wells in said Signal Hill District during the life of this agreement as hereinafter set forth, all gas which is now or which may be hereafter produced by the first party from any or all wells located in said Signal Hill District, and the said second party shall have the right to apply such vacuum if any as the said second hereafter indicate, and the vacuum to be applied to such wells may be changed from time to time as conditions in such wells warrant, but such change can only be made upon the sanction and consent in writing of said first party.
This provisions, however, falls far short*821 of establishing an absolute duty upon the petitioner or an absolute right in it to apply a vacuum without the approval of General Petroleum Corporation. At any rate there is really no proof of record that this contract, which was to continue so long as General Petroleum Corporation had available gas in the Signal Hill District, was actually in force during the years in question. Nor does the other contract in which it is provided for, dated March 23, 1926, alter our conclusion.
The court there was convinced that the contracts under consideration and the "methods employed in reducing the wet gas to possession" created "an interest in the gas in place or a right to share in the gas produced." It concluded that the petitioner has the "requisite *917 economic interest which under the statute entitled it to reasonable allowances for depletion." We are not so convinced.
There is not sufficient evidence for us to find here, as the court did there, that when the wells were drilled down to sand, only a small portion of the gas rose sufficiently to be caught in the casinghead, nor may we conclude from the evidence before us, as the court did, that "This would amount to such an*822 insignificant quantity we would not have justified the erection of a plant to reduce it." There is some evidence of record from which we may conclude that difficulties were encountered from time to time in forcing the gas to the surface, but we can not conclude that this difficulty was of such magnitude as the court there was able to find. Nor may we conclude, assuming the petitioner to have been cognizant of such factors at the outset, that it would not have installed such an extensive plant had not its contract with the producer granted it an interest in the mineral in place or assured it of a portion of the gross proceeds therefrom. It is safe to say, we believe, that this petitioner had no enforceable rights whatsoever under its contracts prior to the time the wet gas was actually placed in its pipe line, i.e., after it had passed beyond the casingheads and gas traps supplied by the producer and into the pipe line, except the right, perhaps, to demand that the producer deliver whatever was produced through its pipe lines for treatment during the period of contractual relationship.
Upon the record, the petitioner has wholly failed to establish a depletable interest under the*823 statute.
Even if all other facts, to which we have referred, pointed to a favorable conclusion for the petitioner, we are of the opinion that the proof upon the subject of rates falls short of the mark for reasons which we need not discuss. See Lomita Gasoline Co.,33 B.T.A. 385">33 B.T.A. 385.
Recomputation of the deficiencies, if any, should be in accordance herewith and the stipulation of the parties.
Reviewed by the Board.
Judgment will be entered under Rule 50.
SMITH and MURDOCK concur in the result.
TRAMMELL, VAN FOSSAN, and ARNOLD dissent.
BLACK, concurring in the result: I agree without reservation as to the first point. I concur in the result which has been reached in the majority opinion on the second point, but I do so on the ground stated in the concluding paragraph of the opinion to the effect that petitioner has failed to show that the value of wet gas at the mouth of the well purchased under casinghead gasoline *918 contracts was in excess of the royalties paid therefor and therefore was not shown any proper basis for depletion deductions. Signal Gasoline Corporation,30 B.T.A. 568">30 B.T.A. 568; affd., 77 Fed.(2d) 778;*824 Lomita Gasoline Co.,33 B.T.A. 385">33 B.T.A. 385.
I do not concur in that part of the discussion in the majority opinion which holds that the casinghead gas contracts in the instant case are sufficiently different from those present in Signal Gasoline Corporation v. Commissioner, 66 Fed.(2d) 886, as to make the two cases distinguishable and to justify the holding in the majority opinion that petitioner in the instant case has no depletable interest arising out of the cashinghead gas contracts. Petitioner's failure of proof to show what amount of depletion deductions, if any, it is entitled to take, appears to be similar to that in the case above cited. As the court said in Signal Gasoline Corporation v. Commissioner, 77 Fed.(2d) 778, "Since the taxpayer is seeking a deduction for depletion from its otherwise taxable income, the burden of proof in upon it not only to prove that it is entitled to the deduction but also to prove the correct amount thereof."
ARUNDELL and LEECH concur in the above.