*969 The petitioner owned a sublease on certain oil-bearing lands near Bakersfield, California. Under an agreement entered into on March 8, 1934, a corporation was to advance money to it for the drilling of oil wells, which was to be recovered in double the amount of the advances from one-half of five-sixths of the proceeds of the sales of oil. Held, that the advances were not "income from the property" within the meaning of section 114(b) of the Revenue Act of 1934, and that upon the evidence the petitioner is not entitled to any depletion allowance for 1935.
*659 This is a proceeding for the redetermination of deficiencies of $2,661.25 and $967.73, respectively, in income and profits tax for 1935. The petitioner not only claims that it is not liable for the deficiencies determined, but that it is entitled to a refund of the taxes which have been paid for 1935.
The petition, as amended to conform to the proof, alleges error on the part of the respondent as follows:
(a) In arriving at net income respondent erroneously failed to allow a deduction*970 for depletion, when petitioner is entitled to a depletion deduction of not less than $24,619.87.
(b) In arriving at net income respondent erroneously allowed a depreciation deduction on oil well drilling equipment of only $1,008.85, when a reasonable allowance for depreciation on petitioner's drilling equipment is not less than $6,377.18.
(c) In arriving at net income respondent erroneously allowed a depreciation deduction of only $4,745.97 on petitioner's interest in the San Joaquin Lease Equipment, when a reasonable deduction on such equipment is not less than $19,766.58.
*660 (d) In arriving at net income respondent erroneously disallowed a loss of $8,437.86 sustained by petitioner during the year upon the abandonment of San Joaquin Well No. 2.
(e) In arriving at net income respondent erroneously disallowed as a deduction for attorneys' fees the sum of $581.76.
The respondent admits error with respect to the disallowance of the deduction of attorneys' fees in the amount of $581.76.
FINDINGS OF FACT.
1. Petitioner is a corporation engaged in the business of producing oil, with its principal office at Los Angeles, California. Its income tax return for*971 1935 was filed with the collector at Los Angeles.
2. Petitioner kept its books and rendered its tax returns upon the accrual basis.
3. Petitioner's income tax return for the calendar year 1935 was filed on April 15, 1936, and disclosed a tax liability of $1,465.50, which was paid by the petitioner in 1936. The petitioner herein was filed December 9, 1938.
4. In 1934 petitioner and the Sovereign Oil Corporation (hereinafter referred to as Sovereign), as joint venturers, subleased from the Shell Oil Co. (hereinafter referred to as Shell) the "San Joaquin lease" in the Mountain View oil field near Bakersfield, Kern County, California. The lease was taken in the name of Sovereign, and Sovereign took charge of developing and operating the property and selling the products. Petitioner and Sovereign each contributed one-half of the money needed and shared equally the expenses and income from the lease. Sovereign collected the income, paid the bills, kept the books, and rendered detailed monthly statements to petitioner. Petitioner's books were posted from those statements. Petitioner and Sovereign paid no bonus to Shell for the lease, but under the lease Shell received royalties*972 and an option to purchase oil. Shell purchased all of the oil produced.
5. After the "San Joaquin lease" was acquired petitioner and Sovereign had to obtain money to develop the property. Accordingly, an agreement was entered into on March 8, 1934, with the Royalty Service Corporation, Ltd. (hereinafter referred to as Royalty), which provided that Royalty should from time to time advance certain sums of money to Sovereign and the petitioner and that Sovereign and the petitioner would repay said money to Royalty in double the amount, but only out of a certain portion of the oil, if, as, and when produced from the well or wells which were to be drilled with the funds so provided.
*661 The agreement above referred to provides in part as follows:
WHEREAS, Royalty desires to purchase a portion of the oil, gas and other hydrocarbon substances to be produced * * *;
* * *
1. AGREEMENT TO BUY
AND SELL - FIRST WELL:
Royalty agrees to buy, and Sovereign agrees to sell, transfer and deliver unto Royalty, an undivided one-half (1/2) of five-sixths (5/6) of all of the oil, gas and other hydrocarbon substances that may be produced and saved from the Chanac and/or Santa*973 Marguerta sands and/or any shallower sands, from the first well to be drilled by Sovereign on the property * * *
Royalty was to advance the money in periodic installments as the well was driven. Royalty also took an option (later exercised) to advance additional funds for the drilling of additional wells upon the terms above described. After Royalty should receive back from sales of oil 200 percent of the amounts advanced, the petitioner was given the option to pay Royalty $10 in cancellation of the agreement.
6. Royalty had no voice in the management and operation of the San Joaquin lease. Sovereign and the petitioner had charge of all drilling operations, pumping, selling, and collecting.
7. Payments were made to Royalty according to the aforesaid contract as the oil was produced, by delivering oil into the pipe line of Shell for account of Royalty. Monthly statements were furnished to Royalty.
8. In 1935 petitioner received the sum of $63,500 from Royalty under said contract. This amount was reported by the petitioner and treated by the respondent as taxable income of 1935. The petitioner also received the sum of $50,859.19 from regular sales of oil from the*974 San Joaquin lease. Its share of royalties paid on the San Joaquin production in 1935 amounted to $24,832.38.
9. Respondent has held that the payment of $63,500 received by the petitioner from Royalty in 1935 was not "income from the property." By deducting the aforesaid royalties, and expenses of $37,376.33 borne by the petitioner, from the amount of $50,859.19 received from regular oil sales, respondent has determined that petitioner had no net income from the San Joaquin property in 1935. He therefore has allowed no depletion deduction in his determination of net income for 1935.
10. Petitioner drilled four wells upon the San Joaquin lease. The first well was drilled to the shallow sand and was completed on June 10, 1934; the second and third wells were drilled to the deepest producing sand and were completed in February 1935. At the end of 1934 petitioner was not able to estimate the amount of *662 the oil reserves in its San Joaquin lease because it was a new field and there had not been sufficient drilling to determine the extent of the oil in the various sands. By the end of 1935 the limits of the sands had been determined; the lease had been completely drilled; *975 and the oil reserves could be estimated. The total oil reserves in the San Joaquin lease at the time petitioner commenced to operate it in 1934 were 750,000 barrels. The oil produced in 1934 was 94,959 barrels and that produced in 1935 was 331,654 barrels.
11. Petitioner installed certain leasing equipment on the San Joaquin lease, consisting of derricks, tanks, pumps, fittings, lines, rods, casing, etc., which equipment cost, in 1934, $32,772.47. The additions made to such equipment in 1935 cost $19,864.54, making a total cost at the end of 1935 of $52,637.01. (This cost includes equipment at well No. 2 of $8,437.86, abandoned in 1935.) The salvage value of such lease equipment after exhaustion of the oil was 10 percent of its original cost.
12. In its 1934 return petitioner took a deduction of $747 for depreciation on equipment at well No. 1 (the only well completed in 1934). This amount was determined on the arbitrary basis of an estimated ten-year life and that amount was allowed by the respondent in his deduction. No depreciation was taken on any other lease equipment in 1934 because no other wells had been completed.
13. In 1935 petitioner, in its books and*976 in its tax return, took a deduction for depreciation in the amount of $17,743.29, computing on the unit of production basis. Respondent held that there were not sufficient data available from which to compute depreciation on the unit of production basis, and allowed a deduction of $4,745.97, computed on the straight line basis.
14. Commencing with 1935, the unit of production basis is a reasonable basis for the allowance of depreciation on petitioner's San Joaquin lease equipment because nearly all of its drilling and its largest production occurred in that year and the production declined thereafter. The depreciation deduction on lease equipment to which the petitioner is entitled for 1935 is $19,762.43.
15. In 1935 petitioner owned drilling equipment consisting of boilers, pipe, engines, tools, and other movable equipment used in the drilling of oil wells, which had been purchased prior to 1931. The depreciated cost of such equipment on December 31, 1930, was $15,087.79. A reasonable rate of depreciation on the unrecovered cost of such drilling equipment is 25 percent per year. The drilling equipment on hand at December 31, 1930, was fully depreciated prior to 1935.
*977 *663 16. New drilling equipment was purchased by the petitioner during 1934 at a cost of $3,887.05, and during 1935 at a cost of $2,289.43. The respondent allowed depreciation of $1,008.85 on this equipment for 1935. The petitioner is entitled to a depreciation allowance of $1,257.94 for 1935 in respect of the drilling equipment purchased in 1934 and 1935.
17. Well No. 2 was completed February 1, 1935, in the Santa Marguerta sand, the deepest producing sand in the Mountain View oil field, where the San Joaquin lease was located. The well produced a total of 82,355 barrels, the last monthly production of 4,240 barrels being reported in November 1935. When this well was first brought in it produced "wet" oil and finally went to water and had to be abandoned before the end of 1935. Upon abandonment, the petitioner removed all of the lease equipment from the well except the casing and fittings. A small account of the casing might have been pulled, but it had no salvage value and was left in the well along with the rest of the casing and fittings which the California law and regulations required to be left in an abandoned well. The petitioner has not at any time since*978 1935 gone back to this well and reopened it and it has not produced any oil or gas since November 1935, and petitioner has not received any income from it since that time.
18. The cost of the equipment left and abandoned in well No. 2 was $8,437.86. No depreciation had been taken or allowed upon this amount. Petitioner charged the entire amount out of its lease equipment account on December 31, 1935, and took it as a loss in that year. Respondent has disallowed the deduction. The petitioner has not been compensated for said loss by insurance or otherwise and is entitled to a deduction from income of the sum of $8,437.86 as a loss in 1935.
OPINION.
SMITH: 1. Depletion deduction. - In its income tax return for 1935 petitioner reported a net income of $10,531.83. This was after the deduction from gross income of a depletion deduction of $13,213.10. The respondent disallowed the deduction of the claimed depletion allowance in the determination of the deficiency and determined a net income of $29,886.41. In his deficiency notice he stated:
(g) You deducted in your return depletion in an amount of $13,213.10, whereas no depletion is allowable as shown by the following*979 computation:
| Regular oil sales | $50,859.19 |
| Less payments in oil (item i herein) | 24,832.38 |
| Corrected oil sales | $26,026.81 |
| Expenses | 37,376.33 |
| Net income | None |
*664 Article 23(m) - 4, Regulations 86.
* * *
(i) Royalties paid in oil, pursuant to lease agreement with Shell Oil Company, constitute allowable deductions from your gross income in the amount of $24,832.38.
Section 23 of the Revenue Act of 1934 provides in part:
In computing net income there shall be allowed as deductions:
* * *
(m) DEPLETION. - In the case of * * * oil and gas wells, * * * 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. * * *
Section 114(b) of the same revenue act provides in part:
(b) BASIS FOR DEPLETION. -
* * *
(3) PERCENTAGE DEPLETION FOR OIL AND GAS WELLS. - In the case of oil and gas wells the allowance for depletion under section 23(m) shall be 27 1/2 per centum of the gross income from the property during the taxable year, *980 excluding from such gross income an amount equal to any rents or royalties paid or incurred by the taxpayer in respect of the property. 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 under section 23(m) be less than it would be if computed without reference to this paragraph.
It is the respondent's position that the $63,500 received by the petitioner from Royalty during 1935 was not "income from the property" within the meaning of section 114(b) of the Revenue Act of 1934; that the petitioner sold an economic interest in its lease with Shell to Royalty, and that under the decision of the Supreme Court in , the petitioner is not entitled to depletion in respect of the $63,500 received from the sale of such economic interest.
The facts in this case are analogous to those in ; affd. (C.C.A., 5th Cir.), *981 . In 1932 the Ortiz Oil Co. entered into contracts with three individuals whereby they furnished certain sums of money to the Ortiz Oil Co. for the purchase and development of oil and gas mining leases, on condition that it "pay and account" to them for specified proportions of the mineral production "if, as and when produced, saved and sold." We held that the rights of the respective parties each constituted an economic interest in the oil production, and that the Ortiz Oil Co.'s gross income for the taxable year included only the portion of the proceeds from oil sales for which it was not required to account to the other parties; that the $154,000 which the company received from Westbrook and Thompson in payment of $350,000 oil payment *665 thereafter to be made to Westbrook and Thompson was income of the Ortiz Oil Co. for the year 1932 as sale of a part of its properties, and that if the Ortiz Oil Co. were to reduce this $154,000 it would not be by way of depletion but by way of an allocated part of the cost of the original leasehold. We said:
* * * Proceeds from sales of production, therefore, constituted income to Westbrook and Thompson to*982 the extent of the proportion received by them, and the balance only consituted gross income to petitioner. ; ; ; . Petitioner is entitled to a deduction for depletion computed on the basis only of the income received by it as its portion of the production in the taxable year. . It is not entitled to allowance for depletion on the proceeds of the sale to Westbrook and Thompson. Cf. , which affirmed ; ; and .
The petitioner attempts to distinguish the Ortiz Oil Co. case from the instant proceeding and says:
* * * The case [Ortiz Oil Co.] involved two contracts which the Board stated were indistinguishable as to facts and were governed by the same conclusions of law. Only parts of the contracts*983 are quoted in the Board's opinion. In the Staley contract (quoted on page 661), it appears that Staley was given "an undivided one half of all oil and/or gas produced, saved and sold from the following described tract of land * * * together with an undivided one half interest in and to the said oil and gas leases and leasehold estates thereupon." The quoted portions of the Westbrook and Thompson contract do not disclose that the lease was assigned to them, but since the Board stated that there was no material difference between the two contracts, it may be assumed that the unquoted part of the contract provided that the lease in this instance was also assigned to Westbrook and Thompson. But the quoted portions of the contract do provide (page 659) that the agreement to pay and account to Westbrook and Thompson "for said proportions of the production from said leases and leaseholds shall constitute covenants running with the land." Furthermore, Ortiz Oil Company bound itself to warrant and defend forever the interests "herein obligated to the amount of said oil payment" unto the said Westbrook and Thompson. Such provisions establish the intent to convey an interest*984 in the land. Such covenants and warranties do not appear in petitioner's contract.
The Board is of the opinion that the distinction sought to be made between the Ortiz Oil Co. case and the proceeding at bar is without substance. Cf. .
There is no question in this proceeding but that the $63,500 received by the petitioner in 1935 from Royalty is taxable income of the petitioner. It was not, however, from a sale of oil. The petitioner is not entitled to depletion in respect of the economic interest in the lease sold by it. We think that the respondent did not err in excluding from "income from the property" the $63,500 here in question. With the exclusion of such amount of $63,500 the petitioner *666 had no net income for 1935 "from the property" and hence was not entitled to any depletion deduction for that year.
2. Depreciation allowance in respect of well drilling equipment. - At December 31, 1930, petitioner had on hand well drilling equipment which had an undepreciated cost of $15,087.79. This equipment was not used during the years 1931, 1932, and 1933, but was in storage. The petitioner contends*985 that this well drilling equipment suffered no depreciation during those years. The testimony is to the effect, however, that there was an obsolescence of this equipment of from 5 to 10 percent per year. The parties have tipulated relative to this point as follows:
* * * is is agreed that the undepreciated balance or unrecovered cost of said drilling equipment as per the books as of December 31, 1930 was $15,087.79, and that a reasonable depreciation rate on that equipment was 25 percent per year.
Upon the basis of this stipulation the respondent contends that the drilling equipment that was on hand at December 31, 1930, was fully depreciated prior to 1935 and that, even though the 25 percent annual rate was intended to apply only while the drilling equipment was in use, the facts show that the obsolescence deduction based upon original cost would show that the drilling equipment was fully depreciated at the end of 1934.
We sustain the respondent's contention upon this point.
There is no question between the parties but that the petitioner is entitled to some depreciation allowance in 1935 in respect of purchases of drilling equipment during the years 1934 and 1935. The*986 respondent computed the depreciation allowance at $1,008.85. We are of the opinion, however, from the evidence, that a rate of 25 percent per year is reasonable and that the equipment purchased in 1935 should be considered as having been in use for a period of only six months. Upon this basis the correct depreciation allowance on drilling equipment for 1935 is $1,257.94.
3. Depreciation allowance in respect of San Joaquin lease equipment. - In the determination of the deficiency the respondent determined a depreciation allowance of $4,745.97 in respect of this equipment for 1935. On brief he admits that the depreciation allowance is in a greater amount. Both parties are agreed that the depreciation allowance for 1935 should be computed upon units of production. During 1935 it was determined that the total amount of recoverable oil from the San Joaquin lease was 750,000 barrels, 94,959 of which were produced in 1934 and 331,654 barrels in 1935. The total cost of lease equipment at December 31, 1934, was $52,637.01. The salvage value of the lease equipment was stipulated to be 10 percent of the original cost. As we understand the respondent's argument, *667 it*987 is that a reasonable allowance for depreciation for 1935 is 331,654/750,000 of the cost of the lease equipment to be recovered through depreciation allowances. The petitioner contends, however, that the allowance should be 331,654/655,041, the denominator representing the oil reserves on January 1, 1935, and that the depreciation of $747 taken on the lease equipment in 1934 is not to be affected by the fact that in 1935, pursuant to an agreement of the parties, the depreciation allowance for 1935 and subsequent years is to be taken on units of production.
We are of the opinion that the correct depreciation allowance for lease equipment for 1935 should be computed as follows:
| Total cost of equipment | $52,637.01 |
| Less equipment in well No. 2 abandoned in 1935 | 8,437.86 |
| 44,199.15 | |
| Less salvage value of 10% | 4,419.92 |
| Net depreciable cost | 39,779.23 |
| Less 1934 depreciation | 747.00 |
| 39,032.23 | |
| Depreciation allowance on 1935 production 331,654/655,041 of $39,032.23 | 19,762.43 |
We therefore hold that a reasonable allowance for the depreciation deduction on lease equipment for 1935 is $19,762.43.
4. The final question for consideration is whether the petitioner*988 is entitled to deduct from gross income of 1935 the cost of casing, etc., which was lost in well No. 2, which became valueless to the petitioner in 1935. The respondent contends that the petitioner is not entitled to the deduction of this loss for the reason that it did not in 1935 notify the California authorities that it had anandoned well No. 2 and did not comply with the California statutes, which require that in the case of the abandonment of a well it must be cemented so as to prevent the penetration of water into oil sands. In reply to this argument the petitioner points out that the loss was actually sustained by the petitioner in 1935 and that the cementing of the well as required by the California authorities would simply mean an additional investment or loss to it in the completion of the abandonment.
The evidence conclusively shows that the petitioner had a loss of $8,437.86 on its equipment in well No. 2 in 1935. The well had turned to water and was valueless. We think that the loss was sustained by *668 the petitioner in 1935 and that it is a legal deduction from the gross income of that year. In our determination of the depletion allowance in respect of*989 the lease equipment above we have eliminated from the total cost of lease equipment ($52,631.01) the $8,437.86 loss sustained in 1935.
Decision will be entered under Rule 50.