*1231 1. Where during the taxable year petitioner received as consideration for drilling an oil well for others, an oil payment contract which it capitalized on its books, but as to which it had received no assignment from the lessee of the fractional oil interest out of which the payment was to be made, petitioner is not the owner of any economic interest in the oil in place, is not entitled to depletion on any payment received under such contract, and should return as a part of its gross income all payments received during the taxable year and should deduct as ordinary and necessary business expenses the expenditures which it incurred in drilling the oil well. Edwards Drilling Co.,35 B.T.A. 341">35 B.T.A. 341, followed.
2. Where during the taxable year petitioner was the owner of certain oil payment contracts which it had received for drilling oil wells for others and had capitalized on its books and it had received a written assignment from the owners of the oil lease of the fractional interest out of which the oil payments were to be made, until such payments were completed, petitioner is the owner of an economic interest in the oil in place and is entitled to recover the cost*1232 of such oil payments by way of depletion and not by way of deducting the full cost of such oil payments before any income therefrom is returnable for taxation. Willis R. Dearing,36 B.T.A. 843">36 B.T.A. 843; affd., 102 Fed.(2d) 91.
3. For purpose of limitation on percentage depletion to 50 percent of net income from oil property, such net income must be reduced by development expenditures deducted in computing taxable net income. Helvering v. Wilshire Oil Co.,308 U.S. 90">308 U.S. 90.
*131 The Commissioner has determined a deficiency of $3,526.33 in petitioner's income tax for the fiscal year ended January 31, 1935. The deficiency results from several adjustments which the Commissioner has made in petitioner's income tax return for the fiscal year ended January 31, 1935. Some of these adjustments petitioner does not contest and some it does challenge.
The issues raised by petitioner's assignments of error may be stated as follows:
1. Is petitioner entitled to recover tax free its entire*1233 basis of cost of certain oil payment contracts and assignments of which it was the owner before returning anything received from such contracts as income? If the answer to this question is in the negative, then how should petitioner's income, if any, from amounts received during the taxable year from such contracts, be determined?
2. Are intangible drilling and development costs deductible from the gross income from the property in arriving at the 50 percent of net income limitation on percentage depletion provided by section 114(b)(3) of the Revenue Act of 1934? The facts as to this issue are not in dispute and it presents only a question of law.
FINDINGS OF FACT.
The petitioner, F. H. E. Oil Co., is a private corporation, chartered under the laws of Texas. Its principal office and place of business is at Fort Worth, Texas. Petitioner's income tax return for the taxable year involved was filed with the collector of internal revenue for the second collection district of Texas, at Dallas, Texas.
On November 28, 1933, petitioner entered into a contract with Roscoe F. Oakes and E. E. Combs to drill an additional well on what is known *132 as the Fox lease, which*1234 covered a 53-acre tract of land in Rusk County, Texas. As consideration for drilling and completing this well petitioner was to receive the sum of $22,500, payable out of one-half of seven-eighths of the first oil, gas, and casinghead gas produced saved, and marketed therefrom. The contract contained an assignment and conveyance to the petitioner, its successors and assigns, of one-half of seven-eighths of the first oil produced, saved, and marketed from the well until the proceeds of such interest equaled $22,500. It was specifically provided in the contract that the lessees, Oakes and Combs, were not to be personally liable for the consideration petitioner was to receive.
On April 19, 1934, petitioner entered into a supplemental contract with Oakes and Combs to drill and complete two additional wells on the Fox lease for a consideration of $43,000, payable out of one-half of seven-eighths of the first oil and gas produced from said wells. This contract, like the first one, contained an assignment and conveyance to petitioner of one-half of seven-eighths of the oil and gas in place until the proceeds of such interest equaled $43,000. Also, it was provied in the contract that*1235 the lessees were not to be personally liable for the $43,000, and said amount was payable only out of the oil which the wells were to produce.
Under date of January 3, 1934, petitioner entered into a contract to drill and complete a well on what is known as the Anderson lease, which covered 13 4/7 acres of land situated in Gregg County, Texas. The consideration which petitioner was to receive for the drilling of this well was $15,500, to be paid out of seven-eighths of the oil and gas produced from the well until the said sum was fully paid. This contract, unlike the contracts covering the Fox lease, did not contain any conveyance or assignment of the seven-eighths of oil and gas in place out of which the $15,500 was to be paid. The contract did, however, contain a provision that there was no personal obligation on the part of the owners of the lease to pay the consideration which petitioner was to receive for drilling the well.
The total cost of drilling the wells on the Fox lease was $28,426.11 and the cost of drilling the one well on the Anderson lease was $8,670.98. Within the taxable year petitioner collected with respect to the Anderson oil payment the sum of $10,184.04, *1236 and with respect to the Fox lease oil payment the sum of $11,879.83.
On its books and in its Federal income tax return for its fiscal year ended January 31, 1935, petitioner applied all amounts collected under the two said oil payment contracts against its basis for computing gain or loss thereon, which was cost. As the amounts collected on the Anderson lease oil payment contract exceeded the cost of that contract by $1,513.06, this amount was reported as a taxable gain from collections under that contract.
*133 No gain was reported by petitioner with respect to collections under the Fox lease oil payment contract, for the reason that petitioner had not at the close of the taxable year 1935 recovered its investment in the said oil payment contract, and petitioner contends that no income should be returned from it until its entire cost basis is recovered.
In the notice of deficiency dated March 3, 1938, from which this appeal is taken, the respondent increased petitioner's reported gross and net taxable income for its fiscal year ended January 31, 1935, by "profit on oil payments" in the amount of $2,846.48 on account of petitioner's collections under its Anderson lease*1237 oil payment contract, and in the amount of $6,876.92, on account of petitioner's collections under its Fox lease oil payment contract.
In his computation of the additional sums included in petitioner's 1935 income on account of payments received on these oil payments, the respondent held and determined that a certain part of the payments received represented a return of capital and a certain part thereof represented profit realized within the taxable year.
The respondent's method of computation was as follows:
| Amount of Payment ot be received | Cost of Payment | Percent of costProfit | |
| Anderson Lease Oil Payment | $15,161.17 | $8,670.98 | 7.192 |
| Fox Lease Oil Payment | 67,500.00 | 28,426.11 | 42.1127 |
OPINION.
BLACK: Issue 1. - We think this issue must be decided for petitioner in so far as the $10,184.04, received by petitioner during the taxable year from the Anderson lease oil payment is concerned. In consideration of petitioner's drilling an oil well for the owners of the Anderson lease under a turnkey contract, petitioner was to receive $15,500 out of a certain percentage of the oil to be produced from the lease. No assignment or other conveyance*1238 was made to petitioner of the fractional oil interests out of which petitioner was to receive its $15,500. This oil payment contract appears to be in all respects the same as were the Sonbar Corporation and Bussa Co. oil payments in . We held in that case as to those two oil payments, as follows:
With respect to petitioner's income from oil payments under its drilling contracts with the Sonbar Corporation and the Bussa Co., respectively, such contention can not be sustained. The statutory allowance for depletion is predicated upon the receipt of gross income from the operation of oil and gas wells by one who has a capital investment in the oil and gas in place and may not be allowed *134 to one who has no such capital investment but only an income derived from production, through a contractual relation or personal covenant with the owner of the mineral deposit. ; ; *1239 .
If in the instant case we had the question before us as to whether petitioner was entitled to a deduction for depletion on the $10,184.04 payment received on the Anderson lease oil payment, we would have to answer in the negative on authority of the Cook Drilling Co. case, supra.
As to this Anderson oil payment, petitioner did not acquire a capital asset and had no capital investment therein. What petitioner did do was to expend $8,670.98 in drilling the well for others on the Anderson lease in the course of its business as oil well driller, and it is entitled to have these expenses deducted as ordinary and necessary business expenses and should return as a part of its gross income all receipts during the taxable year from the Anderson oil payment. Cf. ; affd., . As shown in our findings of fact, petitioner received during the taxable year $10,184.04 from the Anderson oil payment. By including this $10,184.04 in petitioner's gross income and allowing as a deduction from gross income $8,670.98 expended in drilling*1240 the well, as ordinary and necessary business expenses, the same result is reached as petitioner reached in its income tax return in the treatment of this particular item. However, we wish to make it clear that the result is not to be reached by treating the Anderson oil payment as a capital asset, but is reached by including in gross income the receipts in the taxable year from the oil payment and the allowance of proper deductions for ordinary and necessary business expenses.
The situation is different as to the $11,879.83 which petitioner received on the Fox lease oil payments. As to these oil payments petitioner received a clear assignment of one-half of seven-eights of the first oil, gas, and casinghead gas produced, saved, and marketed from the well to be so drilled by petitioner. Petitioner thereby became the owner of an economic interest in the oil to be produced and was entitled to recover its cost not by way of deduction of the expenses of drilling, but by way of depletion, and if depletion exceeds cost, nevertheless taxpayer is entitled to the depletion deductions. Cf. *1241 . These oil payments from the Fox lease were in all essential respects the same as we had before us in ; affd., .
The court (C.C.A., 5th Cir.), in affirming our decision in the Dearing case, laid down the rule which it seems to us governs in these cases, where the owner of an oil payment has either reserved an interest in oil to be produced from a lease which he owns or has acquired *135 an interest in oil in place by a valid assignment from the owner of a lease. The court said:
The partnership thereby acquired a property which was salable and we have no doubt that should it sell that property it could deduct the cost of it in ascertaining gain, as the taxpayer wishes to do. But the production of oil under the contract is not a sale of the partnership's interest in the oil in place, but is an enjoyment of that interest. Its interest in the oil reserve is not thereby sold, but only depleted. Neither of them can deduct cost in dealing with the income so received, but each may reduce his income 27 1/2% on account of the depletion of his capital*1242 investment. [Citing cases.]
We should state here that not only is a taxpayer in such a case entitled, as the court says, to percentage depletion of 27 1/2 percent, but if depletion based on cost will yield a larger deduction to the taxpayer than percentage depletion, then petitioner is entitled to that instead of percentage depletion.
It seems perfectly clear that in the instant case depletion based on cost will give petitioner a larger deduction than percentage depletion. Percentage depletion on $65,500 to be received under the Fox oil payments would only yield $17,912.50, whereas petitioner's cost of these payments was $28,426.11.
Petitioner is of course entitled to have its entire cost returned to it by way of depletion, and if production should cease before petitioner finally recovers its entire cost, then, in the year when it becomes certain that it will not recover its entire cost by way of depletion, petitioner will be entitled to take a loss of the remainder of its investment. Cf. .
Apparently depletion based on cost in the taxable year will yield petitioner substantially the same deduction as respondent has*1243 given petitioner under the heading "Cost of payment applicable to year." He has determined $5,002.81 to be the "Cost of payment applicable to year" of the Fox oil lease payments and has excluded that amount from petitioner's gross income. But whether depletion based on cost yields petitioner a deduction of $5,002.81 or some other figure, whatever figure is correct should be used in allowing petitioner depletion on the $11,879.83 oil payments received from the Fox leases during the taxable year.
Issue 2. - The respondent must be sustained as to this issue under authority of the Supreme Court's recent decisions in , and . There was no issue as to the facts on this issue, therefore, we made no finding of fact upon it. This issue does not concern the income from the oil payments which we have just been discussing, but concerns depletion deductions from income which petitioner received during the taxable year from other oil properties.
Decision will be entered under Rule 50.