*259 Decision will be entered for the respondent.
Excess Profits -- Sec. 722 (b) (4) -- CABPNI. -- The petitioner has failed to prove CABPNI sufficient to give a larger excess profits credit than that allowed by the Commissioner under section 713 (e).
*794 Claims for excess profits tax relief under section 722, Internal Revenue Code of 1939, for the years 1944 and 1945 have been denied by the Commissioner. The petitioner claims relief based on: (1) A change in capacity resulting from an increase in the number of oil *795 well drilling rigs; (2) a change resulting from acquiring oil payments and working interest in leases*260 as compensation for drilling wells and (3) the interruption of normal base period operations by a fire which destroyed one of its drillings rigs in 1936. The following facts as found by the commissioner of the Court who heard the evidence have been adopted as the findings of fact.
FINDINGS OF FACT.
Some of the facts were stipulated and are incorporated herein by this reference.
The petitioner is an Oklahoma corporation engaged in the oil well drilling business. It was organized on May 14, 1935. Its returns for the years involved, the calendar years 1944 and 1945, were filed with the collector of internal revenue for the district of Oklahoma.
At the time of its organization, the petitioner took over an oil well drilling business then being operated as a sole proprietorship by its organizer, G. C. Parker. The petitioner's authorized capital stock consisted of 1,000 common shares of a par value of $ 100 each, of which 467 shares were issued to Parker in exchange for certain oil well drilling equipment. These assets had a basis to Parker of $ 188,326.71, and the petitioner assumed liabilities of Parker amounting to $ 141,426.71.
One share of the petitioner's stock was issued to Parker's*261 wife, Gladys C. Parker, and one share to C. W. Baker. On January 15, 1936, 381 additional shares were issued to Gladys C. Parker, 40 shares to Maude Koons, and 35 shares each to E. McDaniel and C. J. Stafford. These additional shares were all issued at par value. On July 1, 1936, 40 additional shares were issued to C. R. McVay at $ 200 per share. Of the $ 8,000 so received by the petitioner, $ 4,000 was credited to capital stock and $ 4,000 to paid-in surplus.
There were redemptions of the petitioner's stock in 1944 and 1945 which were reflected in its books as follows:
| Year | Number of | Amount | Amount | |
| shares | charged | charged | Stockholders | |
| to capital | to surplus | |||
| 1944 | 40 | $ 4,000 | $ 28,000.00 | Maude Koons |
| 17 | 1,700 | 11,900.00 | E. McDaniel | |
| 1945 | 18 | 1,800 | 12,600.00 | E. McDaniel |
| 40 | 4,000 | 1 33,000.00 | C. R. McVay | |
| 35 | 3,500 | 32,330.05 | C. J. Stafford |
Parker began working in the oil fields at an early age, first as a laborer and later as a drilling contractor. His drilling operations prior to the petitioner's organization were in the States of Kansas, *796 Oklahoma, and Texas. The petitioner continued*262 to operate in those States and later extended its territory to others.
The petitioner used both cable tool and rotary-type drills. With the cable, or percussion, drill, a weighted, plunger-type bit, or "churn," is forced into the ground and the loose cuttings are removed by a bailer. With the rotary-type drill the cutting is done by a circular bit attached to a steel pipe which is rotated from the surface. To remove the cuttings a mud mixture is forced down through the pipe and flows back around the outside of the pipe bringing the cuttings to the surface.
By the early 1930's, most of the oil well drilling was done with rotary drills. They were much faster than the cable tool drills and were better suited to deep well drilling. A well bored with the rotary drill required casing only to a depth of about 350 feet, or to the oil-bearing sands, while with the cable tool drilling casing was required for the entire depth of the hole. Cable tools continued in use, however, for shallow well drilling and for completing deep wells which had been bored to oil-producing sands with the rotary drill. The cable tool drill was favored for finishing wells because it exerted less pressure on*263 the oil-producing sands.
There are several types of oil well drilling contracts in use. In some, the driller contracts to bore a well to a certain depth at a fixed price; in others, the driller is paid so much a foot or so much per day. The cost in either case depends upon the geological formations and other conditions in the particular locality. In some instances the driller's compensation consists of an interest in oil property. In a new field there is usually a "field price" set by the developers and the major drilling contractors, which is generally followed during the early development. Sometimes there is competitive bidding among the drillers, particularly where there is no great demand for new wells or when drilling business is slack because of a depression in the oil industry. Crude oil prices and production determine the amount of oil produced and, generally, the prosperity of the driller is tied in with the activities of the major oil producers.
Conditions were favorable for the drilling contractors in the midcontinent area where the petitioner operated during 1936 and 1937, and the first half of 1938. A sharp decline in crude oil prices occurred in October 1938, *264 amounting to from 10 to 20 cents per barrel in the petitioner's trade area. In some fields, before the drop in crude oil prices, there were temporary shortages of drilling rigs with little or no competition among the reputable drillers. This was true particularly in newly opened areas. As a new field would open up, the drillers would move in their rigs from other locations and would begin competing for contracts. The first drillers in a new field had an advantage both in contract price and in the quantity of work *797 obtained. However, moving drilling equipment any great distance was costly and time consuming. Drillers were cautious about moving equipment to unproven areas. Some of the major producers did their own exploratory drilling. In times of severe competition, some of the smaller or less reputable drillers were forced out of business.
The demand for drilling decreased in the Kansas and Oklahoma areas in 1938 and 1939, but new fields were opened up in Illinois in those years. The following table shows the total number of oil and gas wells drilled in the States in which the petitioner operated during the years 1936 to 1939, inclusive:
| Total wells | ||||
| State | ||||
| 1936 | 1937 | 1938 | 1939 | |
| Arkansas | 90 | 140 | 224 | 229 |
| Colorado | 19 | 19 | 11 | 19 |
| Illinois | 4 | 408 | 2,032 | 3,806 |
| Indiana | 165 | 146 | 163 | 294 |
| Kansas | 1,722 | 2,657 | 1,642 | 1,450 |
| Kentucky | 273 | 575 | 796 | 657 |
| Louisiana | 994 | 987 | 1,072 | 1,176 |
| Michigan | 756 | 925 | 999 | 1,455 |
| New Mexico | 564 | 674 | 534 | 654 |
| Oklahoma | 2,857 | 2,926 | 2,087 | 2,081 |
| Texas | 12,527 | 14,997 | 12,184 | 9,436 |
| Total | 19,971 | 24,454 | 21,744 | 21,257 |
*265 The total number of oil and gas wells drilled in the United States during the base period was: 28,962 in 1936, 35,213 in 1937, 29,127 in 1938, and 28,012 in 1939.
The petitioner is one of the larger oil well drilling concerns and has always been highly regarded by the major oil producers for its efficiency and dependability. Its customers, during the base period, included Continental Oil Company, Gulf Oil Company, the Texas Company, the Carter Oil Company, Amerada Petroleum Corporation, and others. The petitioner had the reputation of maintaining outstanding crews for its rigs, having up-to-date equipment and being financially responsible. Some of the producers were willing to pay the petitioner slightly above the prevailing rate in order to secure its services. The petitioner never cut its drilling prices below the prevailing area rate. Whenever competitive bidding and rate cutting forced the rate to a point below a safe profit margin, the petitioner left the area.
When the petitioner began business in 1935, it had 4 mechanical rotary rigs, an A-C electric rotary rig, a steam rotary rig, and some cable tool equipment. The electric and steam rotary rigs were of but little use*266 or value. Thereafter, the petitioner increased both its mechanical rotary rigs and its cable tool equipment. It had 7 rotary rigs at the end of 1935, 11 at the end of 1936, 18 at the end of 1937, 22 at the end of 1938, and 23 at the end of 1939. The petitioner seldom *798 purchased a complete new rig but from time to time purchased various parts which it used in assembling complete rigs. It sometimes switched equipment on its rigs to meet changing needs.
The petitioner's fixed assets at the time of its organization and at the close of each of the years 1935 to 1939, inclusive, were as follows:
| Fixed assets | May 14, 1935 | Dec. 31, 1935 | Dec. 31, 1936 | Dec. 31, 1937 |
| Rotary tools | $ 190,580.80 | $ 357,982.06 | $ 793,987.84 | $ 1,313,818.01 |
| Cable tools | 6,121.85 | 9,888.64 | 39,050.00 | 64,604.48 |
| Lease | ||||
| investment | 800.00 | |||
| Sundry assets | 2,978.37 | 6,346.75 | 15,364.40 | 28,484.90 |
| Total | $ 199,681.02 | $ 374,217.45 | $ 848,402.24 | $ 1,407,707.39 |
| Less reserves | 53,808.18 | 91,135.50 | 208,292.97 | 443,572.39 |
| Net book value | $ 145,872.84 | $ 283,081.95 | $ 640,109.27 | $ 964,135.00 |
| Fixed assets | Dec. 31, 1938 | Dec. 31, 1939 |
| Rotary tools | $ 1,713,791.46 | $ 2,066,533.79 |
| Cable tools | 85,958.97 | 95,590.20 |
| Lease | ||
| investment | 282,464.57 | 509,606.18 |
| Sundry assets | 44,689.21 | 44,015.06 |
| Total | $ 2,126,904.21 | $ 2,715,745.23 |
| Less reserves | 720,144.95 | 1,067,136.55 |
| Net book value | $ 1,406,759.26 | $ 1,648,608.68 |
*267 The following table shows the location, by States, of the petitioner's rotary rigs at the end of each of the years 1935 to 1939, inclusive:
| State | 1935 | 1936 | 1937 | 1938 | 1939 |
| Kansas | 4 | 7 | 10 | 5 | 4 |
| Illinois | 2 | 4 | 6 | ||
| Kentucky | 3 | ||||
| Indiana | 2 | ||||
| Oklahoma | 3 | 3 | 2 | 4 | 2 |
| Colorado | 1 | 1 | 1 | ||
| Texas | 3 | 3 | |||
| New Mexico | 3 | ||||
| Michigan | 1 | ||||
| Louisiana | 1 | 5 | |||
| Arkansas | 1 | ||||
| Total | 7 | 11 | 18 | 22 | 23 |
The petitioner occasionally rented rigs from other drillers when it did not have a rig available for a particular job. It drilled 3 wells with rented rigs in 1936 and 4 in 1937. The following table shows the total number of wells completed by the petitioner during the base period years and the total number of feet drilled on completed wells, under each type of contract and with each type of drilling rig:
| 1936 | 1937 | 1938 | 1939 | |||||
| Description | ||||||||
| Wells | Feet | Wells | Feet | Wells | Feet | Wells | Feet | |
| Drilling contracts: | ||||||||
| Mechanical rotary | ||||||||
| tools | 68 | 246,910 | 138 | 499,160 | 162 | 531,161 | 155 | 521,810 |
| Cable tools | 12 | 37,798 | 18 | 56,956 | 4 | 13,395 | 7 | 22,506 |
| Steam rig -- rotary | 1 | 4,609 | 1 | 7,281 | 1 | 7,233 | ||
| Rental rig -- rotary | 3 | 6,571 | 4 | 11,078 | ||||
| A-C electric rotary | 4 | 13,199 | ||||||
| Oil payments: | ||||||||
| Rotary tools | 3 | 9,507 | 1 | 3,374 | ||||
| Leases: | ||||||||
| Rotary tools | 2 | 7,618 | 4 | 13,666 | ||||
| Cable tools | 4 | 13,307 | 5 | 15,478 | ||||
| Ford-Barnsdall | ||||||||
| contract: | ||||||||
| Rotary tools | 5 | 22,297 | 3 | 13,152 | ||||
| Total | 84 | 295,888 | 168 | 597,181 | 179 | 598,385 | 174 | 586,612 |
*268 *799 The number of wells completed by the petitioner under footage contracts, by States, during the base period years, was as follows:
| 1936 | 1937 | 1938 | 1939 | |
| Colorado | 2 | 1 | 2 | |
| Illinois | 4 | 31 | 64 | |
| Indiana | 1 | 2 | ||
| Kansas | 69 | 145 | 82 | 54 |
| Kentucky | 28 | 9 | ||
| Louisiana | 1 | 7 | ||
| Michigan | 3 | 1 | ||
| New Mexico | 1 | 4 | 15 | |
| Oklahoma | 14 | 11 | 4 | 6 |
| Texas | 1 | 5 | 24 | 14 |
| Total | 84 | 168 | 179 | 174 |
The average number of working days per rig for the petitioner's rigs was 198 days in 1936, 246 days in 1937, 220 days in 1938, and 184 days in 1939.
The petitioner's income and expenses for the years 1936 to 1939, inclusive, as adjusted by revenue agents, were as follows:
| 1936 | 1937 | 1938 | 1939 | |
| Total drilling | ||||
| income | $ 1,295,724.17 | $ 2,583,386.50 | $ 2,509,817.99 | $ 2,354,697.59 |
| Total drilling | ||||
| expense | 914,960.41 | 1,937,463.64 | 1,884,667.10 | 2,138,492.98 |
| Gross profit | ||||
| from drilling | 380,763.76 | 645,922.86 | 625,150.89 | 216,204.61 |
| Other expense | 90,610.59 | 162,037.02 | 157,612.69 | 166,773.92 |
| Net profit -- | ||||
| drilling | 290,153.17 | 483,885.84 | 467,538.20 | 49,430.69 |
| Other income: | ||||
| Oil payments | 26,014.50 | 20,783.52 | ||
| Lease income | 6,733.51 | (29,861.75) | ||
| Net income per | ||||
| R.A.R. | 290,153.17 | 483,885.84 | 500,286.21 | 40,352.46 |
*269 Included in the "other expense" shown above, were charge-offs for dry holes of $ 14,556.55 in 1938 and $ 11,024.10 in 1939.
The petitioner's excess profits net income, as adjusted by revenue agents, amounted to $ 1,341,230.77 in 1944 and $ 1,223,330.22 in 1945. Its excess profits credit, as computed by the Commissioner under section 713(e), Internal Revenue Code of 1939, amounted to $ 382,546.72 for 1944 and $ 381,600.09 for 1945. The petitioner's excess profits tax liability, as determined by the Commissioner, amounted to $ 281,088.84 for 1944 and $ 711,129.26 for 1945. The amounts of excess profits tax here in controversy are $ 281,088.84 for 1944 and $ 389,129.54 for 1945.
The petitioner's average base period net income was $ 322,848.02 for 1940 and 1941, and $ 402,775.55 for the years 1942 to 1945, inclusive, as adjusted under section 713(e).
In 1937 the petitioner, for the first time, began drilling oil wells under contracts which entitled it to an interest in the oil lease as its compensation. The interests so acquired prior to December 31, 1939, and the date the wells were completed, were as follows: *800
| Petitioner's oil properties | Date |
| completed | |
| Chalk Estate | |
| Well #1 | Jan. --, 1939 |
| Erwin | |
| Well #1 | Apr. 21, 1938 |
| Well #2 | July 27, 1938 |
| Well #3 | Jan. 10, 1939 |
| King Ranch | |
| Well #1 | Feb. --, 1939 |
| Well #2 | Mar. --, 1939 |
| Well #3 | Mar. 9, 1940 |
| McComb | |
| Well #1 | May 12, 1938 |
| Well #2 | July 2, 1938 |
| McDonald | |
| Well #1 | July 19, 1939 |
| Well #2 | Apr. 25, 1939 |
| Well #3 | Dec. 4, 1939 |
| Well #4 | Aug. 28, 1940 |
| State "A" | |
| Well #1 | Oct. 11, 1938 |
| Ford-Barnsdall | |
| Well #1 | June 15, 1938 |
| Well #2 | July 29, 1938 |
| Well #3 | Sept. 9, 1938 |
| Well #4 | Nov. 12, 1938 |
| Well #5 | Dec. 11, 1938 |
| Well #6 | Jan. 21, 1939 |
| Well #7 | Feb. 21, 1939 |
| Well #8 | Apr. 5, 1939 |
| Boomhower-Rogg | |
| Well #1 | June 18, 1937 |
| Well #2 | July 22, 1937 |
| Well #3 | Aug. 27, 1937 |
| Rumsey | |
| Well #1 | Mar 23, 1938 |
*270 On October 21, 1939, the petitioner entered into a contract with the Carter Oil Company to drill 2 wells in Okfuskee County, Oklahoma, on property known as the "E. Welty 'A' Lease." In the consideration for drilling and operating the wells, the Carter Oil Company assigned to the petitioner the said lease "down to and including the Cromwell Sand Formation" which was at a depth of approximately 3,400 feet, subject to the retention by the Carter Oil Company of an overriding royalty of one-eighth (1/8) of the oil and gas produced from the seven-eighth (7/8) working interest. The petitioner began drilling well No. 1 on the E. Welty "A" Lease on November 30, 1939, and completed it January 6, 1940. This well produced 3,197.14 barrels of oil in January 1940. The net production allowed by the "Corporation Commission of Oklahoma" was 3,100 barrels in that month. The cost of the well, as capitalized for income tax purposes prior to December 31, 1939, was $ 19,073.92, of which $ 13,810.18 represented drilling costs and $ 5,263.74 represented equipment costs.
A second well known as "E. Welty 'A' No. 2" was begun by the petitioner April 6, 1940, and was completed April 22, 1940, as a dry hole. *271 The cost of the drilling as capitalized for Federal income tax purposes was $ 12,615.37.
The petitioner pledged its oil lease interests with the banks to secure loans for financing its business operations.
A fire occurred at the site of a well which the petitioner was drilling in Logan County, Oklahoma, February 7, 1936, which resulted in damage to the petitioner's drilling equipment of approximately $ 100,000. The loss of the equipment was fully covered by insurance, but there was no insurance coverage for the petitioner's loss of profits on the contract. As a result of the fire, the petitioner sustained an operating loss on the contract of $ 3,634.59.
*801 OPINION.
The actual average base period net income of the taxpayer was $ 328,669.42. However, the Commissioner, in the computation of the excess profits credit of the petitioner for the taxable years, did not use that figure but used instead $ 402,755.55, an adjusted figure arrived at under section 713 (e). He allowed an excess profits credit of $ 382,546.72 for 1944 and one of $ 381,600.09 for 1945. The petitioner, in order to obtain any relief in this case, must establish a fair and just amount to represent normal*272 earnings to be used as a constructive average base period net income which will result in a credit larger than that allowed by the Commissioner. The petitioner is contending in this case for constructive average base period net income in the amount of $ 564,920.98, which it arrives at by reconstructing its income for each of the base period years as follows: $ 755,241.41 for 1936, $ 849,610.47 for 1937, $ 556,936.04 for 1938, and $ 97,896.01 for 1939.
Section 722 (b) (4) provides that the excess profits tax shall be considered excessive and discriminatory in a case like this if its average base period net income is an inadequate standard of normal earnings because the taxpayer, during the base period, changed the character of its business and the average base period net income does not reflect a normal operation for the entire base period of the business. The term "change in the character of the business" includes a difference in the capacity for production or operation. The principal contention of the petitioner is that it had a change in capacity resulting from the acquisition of additional drilling rigs during the base period. The Commissioner concedes that there was an increase*273 in the drilling equipment owned by the petitioner during the base period years which increased its capacity for production or operation but argues that the petitioner has not shown that it is entitled to any relief by reason of that change.
Section 722 (b) (4) contains a provision that "[if] the business of the taxpayer did not reach, by the end of the base period, the earning level which it would have reached if the taxpayer had commenced business or made the change in the character of the business two years before it did so, it shall be deemed to have commenced the business or made the change at such earlier time." The petitioner does not expressly rely upon this provision or show that it has any application to the case. The petitioner argues, however, that it could have employed 23 rotary rigs and all of its additional cable tool equipment throughout the base period if it had had that equipment on hand at all times.
The Commissioner claims that the petitioner was not using to their full capacity in any taxable year, except perhaps in 1937, the drilling rigs which it actually possessed in each of those years, its earnings fell *802 off in 1939 when it owned the most rigs, *274 the footage drilled in 1937, 1938, and 1939 was about the same, the petitioner was getting practically all of the business which it could get regardless of how many drills it had, except perhaps in 1937, and the low earnings of 1939 were attributable in some part to the fact that the petitioner had too many rigs. The Commissioner disagrees with most of the petitioner's proposed reconstruction of base period earnings and argues that the ownership of additional rigs would not have increased the earnings of the taxpayer to an extent which would even approach that necessary to bring relief because of numerous other factors.
Careful study of the entire record on this point fails to show any reasonable basis for the petitioner's computation on this, its principal point. It provides no reason to compute increased earnings for 1939. The taxpayer had in that year all of the rigs that it is talking about. 1938 was the taxpayer's best base period year from the standpoint of net earnings, despite the decline in crude oil prices in October of that year. It started that year with 18 rotary rigs and ended with 22. There is insufficient indication that the earnings for that year would have been*275 greater had the petitioner acquired the additional rigs a fraction of a year sooner. It is possible that the earnings of the petitioner for 1936 and 1937 might have been somewhat larger if it had had some additional rigs during those years. It used 3 rented rigs in 1936 and 4 in 1937. It might have earned a little more on those jobs if it had been able to use its own rigs, and it might possibly have gotten some additional business if it had owned additional rigs. However, it is not clear from the evidence that this is so, and certainly it is not apparent that sufficient earnings for relief would have been derived in this way.
The petitioner began in 1937 to drill oil wells under contracts in which its compensation would be an interest in the oil lease or oil payments, but would receive nothing for drilling a dry hole. Previously its contracts had been for a cash consideration for the work done. It contends that this change in its method of receiving its payment was a change in the operation of its business or a difference in the products or services furnished within the meaning of section 722 (b) (4). It is not necessary to decide whether or not this was a change within those*276 provisions. Its actual experience during the base period years from this change and the record as a whole fail to indicate any improvement in its earnings sufficient to justify a finding that there would have been any substantial constructive average base period net income from this source.
Section 722 (b) (1) provides that the excess profits tax shall be considered to be excessive and discriminatory in a case like this if the average base period net income is an inadequate standard of normal earnings *803 because in one of the base period years normal production output or operation was interrupted or diminished because of the occurrence during the base period of events unusual and peculiar in the experience of such taxpayer. The petitioner claims relief under this provision based upon a severe fire which occurred in 1936. The fire destroyed about $ 100,000 worth of equipment belonging to the petitioner and required the petitioner to bring in other equipment to finish the well. The equipment loss was fully covered by insurance. The petitioner says that instead of its average profit of about $ 11,000 on a well it had a loss on this well of about $ 3,600 and its income for *277 1936 should be increased by approximately $ 14,700 on this account. It is unnecessary to decide this point because even the amount claimed would not be sufficient, in combination with all other additional earnings which the record might justify, to give the taxpayer any relief.
Reviewed by the Special Division.
Decision will be entered for the respondent.
Footnotes
1. Additional $ 4,000 charged to paid-in surplus.↩