*85 Decision will be entered under Rule 50.
In 1939 petitioner executed an oil and gas lease covering 1,160 acres for a primary term of 5 years, receiving $ 100,000 bonus or advanced royalty on which petitioner was allowed a depletion deduction in 1939 of $ 27,500. In 1944 24/29 of the acreage was released without production. In 1944 the respondent restored such amount to income on the ground that the lease had been terminated without production. Held:
1. The original lease was not terminated but was extended in a modified form for a primary term of 2 years.
2. Twenty-four twenty-ninths of the sum of $ 27,500 claimed and allowed in 1939 as a deduction for depletion is to be restored to petitioner's income for the taxable year 1944.
*321 This proceeding involves deficiencies in income and excess profits taxes as follows:
| Year | Tax | Deficiency |
| 1943 | Income tax | $ 11,464.64 |
| 1944 | Income tax | 15,219.35 |
| 1945 | Excess profits tax | 3,299.45 |
*322 The only contested issue involves the propriety*86 of respondent's action in restoring to income in the taxable year 1944 a percentage depletion of $ 27,500 claimed and allowed on an oil and gas lease bonus received by petitioner in 1939.
Several other issues have been adjusted by stipulations between the parties in the course of the hearing of the proceeding, to which effect will be given in the recomputation under Rule 50.
FINDINGS OF FACT.
Petitioner is a Texas corporation with its principal office at 2800 Clinton Drive, Houston, Texas. Its income and excess profits tax returns for the taxable periods involved were filed with the collector of internal revenue for the first district of Texas, at Austin, Texas.
Petitioner owns approximately 47,000 acres of land in Brazoria and Galveston Counties, Texas.
On July 21, 1939, petitioner executed an oil and gas lease to Mrs. Mellie Esperson covering 1,160 acres, consisting of 29 40-acre tracts checkerboarded throughout an area comprising approximately 6,500 acres. The lease was for a primary term of 5 years and as long thereafter as oil or gas was produced in paying quantities. If operations for drilling were not commenced on the land on or before 1 year from this date the lease was*87 to terminate unless on or before such anniversary date lessee paid or tendered the sum of $ 5,800 (called rental) which was to cover the privilege of deferring commencement of drilling operations. Upon like payment annually the commencement of drilling operations may be deferred for successive periods of 12 months each during the primary term. If, prior to discovery of oil or gas on said land, lessee should drill a dry hole or holes, or if after discovery of oil or gas the production thereof should cease for any cause, the lease shall not terminate if lessee commences additional drilling or reworking operations within 30 days thereafter or commences or resumes the payment of rentals on or before the rental-paying date next ensuing after the expiration of such 30-day period. Mrs. Esperson paid petitioner a cash bonus of $ 100,000 on the total acreage as a unit, and agreed to pay an annual rental if a well was not commenced on or before the anniversary dates. Mrs. Esperson paid the rentals in lieu of drilling.
The lease, inter alia, specifies as follows:
* * * The down cash payment is consideration for this lease according to its terms and shall not be allocated as mere rental*88 for a period. Lessee may at any time execute and deliver to Lessor or to the depository above named or place of record a release or releases covering any portion or portions of the above described premises and thereby surrender this lease as to such portion or portions and be relieved of all obligations as to the acreage surrendered, and thereafter the rentals payable hereunder shall be reduced in the proportion that the acreage *323 covered hereby is reduced by said release or releases. In this connection the above described premises shall be treated as comprising 1,160 acres, whether there be more or less.
By March 1944 all but 5 of the 40-acre tracts embraced within the Esperson lease had been condemned for oil and gas production.
After March 30, 1943, a unit comprising a 320-acre tract was required to secure a legal priority for the purchase of pipe to drill a distillate well. Because of the location of her twenty-nine 40-acre tracts, Mrs. Esperson could not secure such a priority.
Petitioner owned certain unleased acres in the area covered by the Esperson lease. Its president, Robert W. Henderson, attempted to work out a trade whereby pooling units of 320 acres would*89 be formed, which would include the five 40-acre possibly productive tracts of the Esperson lease.
Mr. Henderson approached representatives of the Phillips Petroleum Co. and the Gulf Oil Corporation, and it was agreed that a 320-acre unit would be formed to which Mrs. Esperson would contribute one of her 40-acre tracts, petitioner 120 acres, Gulf 83 acres and Phillips 77 acres. It was also agreed that a second unit would be formed to which Mrs. Esperson would contribute 80 acres and petitioner 240 acres. A tentative arrangement was also made which would include the remaining 80 acres of the Esperson lease. Petitioner was to receive $ 1,000 per acre in oil for the acreage it contributed to the units. Mrs. Esperson was to receive $ 125,000 in oil if one of the units produced and $ 200,000 in oil if all three units produced, and in addition a 1/48 overriding royalty for the acreage she contributed.
Phillips made a firm commitment to drill a deep well on the first unit and a contingent commitment to drill a well on the second unit. The obligation to drill on the second unit was contingent in that Phillips could either drill or pay a certain sum of money to Mrs. Esperson and petitioner*90 as rent.
Petitioner's president, Robert W. Henderson, went to Warren J. Dale, an attorney representing petitioner and Mrs. Esperson, advised him of the arrangements agreed upon, and requested the preparation of the documents to carry them into effect. Thereupon Dale prepared or caused to be prepared:
(1) Lease from petitioner to Phillips covering 120 acres;
(2) Lease between petitioner and Phillips covering 240 acres;
(3) Three leases for a primary term of 2 years from petitioner to Mrs. Esperson, one covering 40 acres and two covering 80 acres each;
(4) A release from Mrs. Esperson to petitioner, releasing all her right, title and interest in the 1939 lease covering 1,160 acres;
(5) A pooling agreement between petitioner, Phillips, Gulf and Mrs. Esperson covering 320 acres;
*324 (6) Another pooling agreement between petitioner, Mrs. Esperson and Phillips; and
(7) An assignment of the three above-mentioned Esperson leases to Phillips.
The specific provisions of all of the aforementioned documents are incorporated as facts herein by reference as if set forth in full.
All the foregoing documents were dated the same day and although some were acknowledged at a later date, all*91 were delivered on the same day as one transaction. The execution and delivery of each document was contingent upon the execution and contemporaneous delivery of each of the other documents.
Mrs. Esperson paid petitioner no consideration for the three separate leases covering the 200 acres which were a part of the acreage included in the original 1939 lease to her from petitioner.
At the time the pooling agreements were formed, there was an oil well nearby and the acreage was considered proven. On July 15, 1944, Phillips commenced drilling on the land constituting the first-mentioned pool, which resulted in a producing well. Since that time Phillips has drilled two black oil wells. There has been no production from the land in the second pool. One gas distillate well and two black oil wells have been drilled by Phillips on the land in the third pool. Mrs. Esperson has participated in production from the two producing pool units.
No well has ever been drilled and no production of either oil or gas was ever obtained from any of the 1,160 acres covered by the 1939 lease from petitioner to Mrs. Esperson.
OPINION.
The sole issue is whether petitioner is required to restore to income*92 in the taxable year 1944 any part of a depletion deduction of $ 27,500 claimed and allowed in 1939 on a bonus of $ 100,000 received in that year under an oil and gas lease. The respondent contends that the lease having been terminated in 1944 without production, restoration is required under Treasury Regulations 111, sec. 29.23 (m)-10. 1 The validity of such regulation was sustained in Douglas et al. v. Commissioner, 322 U.S. 275">322 U.S. 275.
*93 *325 The original lease from petitioner to Mrs. Esperson dated July 21, 1939, covered 1,160 acres consisting of twenty-nine 40-acre tracts. Its primary term was 5 years and it was to continue as long as gas or oil was produced. Lessee had the option of drilling or paying a fixed annual rental. Lessee paid an initial bonus of $ 100,000 and the annual rentals for the 5-year period. After March 30, 1943, the Petroleum Administrator for War would only grant priority to secure pipe for drilling for gas or oil on a unit of 320 acres. Mrs. Esperson's acreage was so situated she could not secure a priority to drill. (See Petroleum Production Operations Order 11 and Supp. Order No. 1, March 30, 1943; 8 Fed. Reg. 395-8-9).
Included in the acreage covered by the original lease of July 21, 1939, were five 40-acre tracts which were considered proven ground. Petitioner's president undertook to work out an arrangement whereby these 200 acres could be included in pooling agreements of 320 acres so that a priority could be secured to enable drilling operations. He succeeded in getting commitments to the formation of three pool agreements. Mrs. Esperson's 200*94 acres became a part of one or the other of the three pools. Also contributing acreage were petitioner, Phillips Petroleum Co. and Gulf Oil Corporation. Producing wells were drilled on 2 of such pooled units. To carry out the pooling arrangements Mrs. Esperson was to release all her right, title and interest under the original 1939 lease; three new leases were to be executed and delivered to her covering 200 acres included in the original lease; these leases were to be assigned to Phillips, and three pooling agreements were to be executed and delivered. All the documents were to be and in fact were delivered concurrently.
Petitioner contends that each of the documents was an integral step in a single transaction, and so construed the three leases to Mrs. Esperson covering the 200 acres as but a continuation of the original lease in a modified form; hence there was no termination of the original lease as required by the aforementioned regulation.
The respondent contends that the release executed by Mrs. Esperson unconditionally relinquished and surrendered all her right, title and interest in the land covered by the original lease, and since the original lease was terminated without*95 production the restoration to income of the previously allowed depletion of the sum of $ 27,500 is justified. In the alternative, the respondent contends that since 24 of the twenty-nine 40-acre tracts were unconditionally surrendered in the taxable year, 24/29 of the $ 27,500, or $ 22,578.62, should be restored to income.
We think it is clear that Mrs. Esperson did not intend to and did not unconditionally surrender all her valuable rights under the original lease. The execution of the release was contingent upon the execution of the new leases covering the 200 acres included in the *326 original lease. The purpose of these separate instruments was to preserve her interest in such form as would enable her to enter into the pooling agreements, which was the only way then open to her to have drilling operations on the lands covered by the original lease. She paid no new consideration for the new leases.
We conclude that the surrender of the original lease and the giving of new leases covering a part of the acreage embraced in the old lease in its stead, pursuant to the agreement to do so, constituted integrated steps in one transaction and are in legal effect a mere continuation*96 of the former lease in modified form.
The original 1939 lease was neither terminated nor abandoned in its entirety and the respondent erred in restoring to petitioner's income the total amount of depletion deductions of $ 27,500 previously allowed on the payment of the $ 100,000 bonus.
As to the respondent's alternative contention that there should be a pro rata return to income of such portion of the allowed depletion as the released acreage bears to the total acreage embraced in the original lease, we find substantial merit. It is undisputed that 24 of the twenty-nine 40-acre tracts were unconditionally released and surrendered to petitioner on April 24, 1944. These twenty-four 40-acre tracts were condemned for oil and gas production and it may be assumed that there was no oil or gas underlying such tracts to be depleted. No well was ever drilled and no production was ever obtained therefrom.
Petitioner argues that the cash bonus payment of $ 100,000 is not allocable on an acreage basis. It is true the provision of the lease quoted in our findings of fact provides that the lessee may release any portion of the acreage and thereby reduce pro tanto the "rentals," and states*97 "* * * The down cash payment is consideration for this lease according to its terms and shall not be allocated as mere rental for a period. * * *" What this means as between the parties is not clear except that the lessee can not recover from the lessor any part of the bonus payment. In any event, however, its effect can not be extended to control the pending question which is whether as between the respondent and the lessor this cash payment is allocable on an acreage basis for present purposes.
In cases presenting substantially similar facts, we have held that where there has been a termination, expiration or abandonment of a part of the acreage under an oil and gas lease there should be an allocation of the total bonus paid to the acreage abandoned and a restoration to income of that portion of the depletion taken with respect to the abandoned acreage. Grace M. Barnett, 39 B. T. A. 864; Mary F. Waggoner, 47 B. T. A. 699. On the issue of apportionment in a memorandum opinion of this Court we were reversed by the United States*327 Court of Appeals for the Fifth Circuit, Driscoll v. Commissioner, 147 Fed. (2d) 493.*98 We think that the facts in the instant case are indistinguishable from the controlling facts in the Driscoll case, supra. Nevertheless, with due deference to the opinion of the Circuit Court in that case, we will adhere to our decision in that case.
We, therefore, conclude that 24/29 of the sum of $ 27,500 of the depletion deduction previously taken and allowed in 1939 is to be restored to petitioner's income for the taxable year 1944.
Decision will be entered under Rule 50.
Footnotes
1. Regulations 111.
Sec. 29.23 (m)-10. Depletion. -- Adjustments or Accounts Based on Bonus or Advanced Royalty. * * *
* * * *
(c) If for any reason any grant of mineral rights expires or terminates or is abandoned before the mineral which has been paid for in advance has been extracted and removed, the grantor shall adjust his capital account by restoring thereto the depletion deductions made in prior years on account of royalties on mineral paid for but not removed, and a corresponding amount must be returned as income for the year in which such expiration, termination, or abandonment occurs.↩