*155 Decisions will be entered under Rule 50.
First year payments on noncompetitive oil and gas leases issued by the United States and various State governments, held, deductible as "rentals" under section 23(a)(1)(A), Internal Revenue Code.
*763 The following deficiencies in income tax were determined by the respondent:
| Petitioner | Docket No. | 1946 | 1947 | 1948 |
| Olen F. Featherstone | 37809 | $ 1,738.86 | $ 3,460.07 | |
| Martha Featherstone | 37810 | 1,738.86 | 3,502.84 | |
| Olen F. Featherstone and | 37811 | $ 84,327.82 | ||
| Martha Featherstone. |
*157 The single issue presented is whether certain first year payments made by petitioners with respect to leases issued by the United States and various States constituted nondeductible capital expenditures or deductible rentals.
*764 Respondent has conceded that all payments made by petitioners with respect to leases issued in a year prior to payment are deductible, with the result that respondent concedes error as to the deficiency for 1946.
FINDINGS OF FACT.
Part of the facts were stipulated and are found accordingly.
Petitioners, Olen F. Featherstone and Martha Featherstone, were husband and wife and lived in New Mexico during the taxable years here involved. For the years 1946 and 1947, petitioners filed separate individual income tax returns, but for 1948 they filed a joint return as husband and wife. All returns were filed with the collector of internal revenue for New Mexico.
During the foregoing years, petitioner Olen F. Featherstone was in the business of assembling blocks of oil and gas leases for development by the major or independent oil operators. In disposing of an interest in a leasehold, petitioners normally obtained an overriding royalty and a commitment for*158 the development of the property subject to the leases. Petitioners would also dispose of leasehold interests without retaining any economic interest.
During the years in question, petitioners had leasehold interests in oil and gas leases of which the lessors were variously the United States and the States of Colorado, Utah, and Wyoming.
Petitioners made payments for the first year of the lease term of the aforementioned leases to the lessors and in the amounts as follows: 1
| Lessors | 1947 | 1948 |
| Wyoming | $ 120 | $ 1,672.50 |
| Utah | 18 | 237.88 |
| Colorado | 400 | |
| U. S. A. | 23,563.87 |
In 1948 the Federal Government issued 92 oil and gas leases in which petitioners had percentage interests as follows:
| No. of | Percentage |
| leases | interest |
| 3 | 100.0 |
| 34 | 90.0 |
| 1 | 66.666 |
| 6 | 50.0 |
| 30 | 45.0 |
| 1 | 40.0 |
| 11 | 33.333 |
| 1 | 31.663 |
| 1 | 30.0 |
| 1 | 25.0 |
| 3 | 10.0 |
Of the above*159 92 leases, only 10 were issued in the name of one or the other of the petitioners.
In many instances petitioners had an undivided interest in a lease and an associate had the balance of the undivided interest. If the lease was in the name of one of the petitioners, petitioners would, by *765 prearrangement with the associate, pay all filing fees and so-called rentals due on the lease, and the associate would reimburse petitioners for his share. Conversely, if the lease was in an associate's name, the associate would make the necessary payments and receive reimbursement from the petitioners for their share.
Except for instances where petitioners had a 45 per cent or a 90 per cent interest in a lease, petitioners made payments in respect of the lease which were in exact proportion to their percentage interest in the lease. With respect to the leases in which petitioners had either a 45 per cent or a 90 per cent interest, petitioners followed the practice of having key employees apply, on petitioners' behalf, for oil and gas leases with the lessors herein involved. The purpose of this practice, under which petitioners would make 100 per cent (on leases in which petitioners retained*160 a 90 per cent interest) of all necessary payments, was to encourage employees to take a greater interest in the business. If petitioners had an associate in a lease taken in the name of an employee, petitioners would carry the employee free for a 5 per cent interest and petitioners' associate would carry the other 5 per cent. If such a lease in the name of an employee, or any portion of such lease, was subsequently disposed of, the employee would receive 10 per cent of gross proceeds less 10 per cent of abstract and similar expenses, and petitioners and their associate, assuming there was one in the particular lease, would each receive 45 per cent, less 45 per cent of similar expenses.
Petitioners had operated their business in the above described manner for at least 5 years prior to the issuance of the leases here in question.
All of the 92 Federal leases issued in 1948 were issued pursuant to the authority of the Leasing Act of 1920 (41 Stat. 437) as amended by the Act of August 8, 1946 (60 Stat. 950, 30 U. S. C. 181 et seq.). Portions of section 3 of the 1946 Act are set forth below:
When the lands to be leased are within any known geological*161 structure of a producing oil or gas field, they shall be leased to the highest responsible qualified bidder by competitive bidding under general regulations, in units of not exceeding six hundred and forty acres, which shall be as nearly compact in form as possible, upon the payment by the lessee of such bonus as may be accepted by the Secretary and of such royalty as may be fixed in the lease which shall not be less than 12 1/2 per centum in amount or value of the production removed or sold from the lease. When the lands to be leased are not within any known geological structure of a producing oil or gas field, the person first making application for the lease who is qualified to hold a lease under this Act shall be entitled to a lease of such lands without competitive bidding. Such leases shall be conditioned upon the payment by the lessee of a royalty of 12 1/2 per centum in amount or value of the production removed or sold from the lease * * *. All leases issued under this section shall be conditioned upon the payment by the lessee in advance of a rental of not less than 25 cents per acre per annum. A *766 minimum royalty of $ 1.00 per acre in lieu of rental shall be *162 payable at the expiration of each lease year beginning on or after a discovery of oil or gas in paying quantities on the lands leased: Provided, That in the case of lands not within any known geological structure of a producing oil or gas field, the rentals for the second and third lease years shall be waived unless a valuable deposit of oil or gas be sooner discovered.
In 1946, 1947, and 1948, the Bureau of Land Management of the Department of Interior required that each application for a Federal lease be accompanied, along with the filing fee, by a deposit of 25 cents per acre, which sum represented one-half of the first lease year payment. In the event of a rejection of the application by the Bureau of Land Management, a withdrawal of the application, or a refusal of the lease by the applicant, a refund of the deposit was made. All refunds were made through the applicant. It was not unusual for 2 or 3 years to elapse between the filing of the application and the issuance of the lease.
Each of the Federal leases in respect of which the first-year payments here involved were made contained the following pertinent language:
Sec. 1. Rights of Lessee. -- That the lessor, in *163 consideration of rents and royalties to be paid, and the conditions and covenants to be observed as herein set forth, does hereby grant and lease to the lessee the exclusive right and privilege to drill for, mine, extract, remove, and dispose of all the oil and gas deposits except helium gas in or under the following-described tracts of land * * * together with the right to construct and maintain thereupon all works * * * or other structures necessary to the full enjoyment thereof, for a period of 5 years, and so long thereafter as oil or gas is produced in paying quantities; * * *
Sec. 2. In consideration of the foregoing, the lessee hereby agrees:
* * * *
(d) Rentals and royalties. -- (1) To pay the rentals and royalties set out in the rental and royalty schedule attached hereto and made a part hereof.
* * * *
Schedule "A"
RENTALS AND ROYALTIES
Rentals. -- To pay the lessor in advance on the first day of the month in which the lease issues a rental at the following rates:
(a) If the lands are wholly outside the known geologic structure of a producing oil or gas field:
(1) For the first lease year, a rental of 50 cents per acre.
(2) For the second and third lease years, *164 no rental.
(3) For the fourth and fifth years, 25 cents per acre.
(4) For the sixth and each succeeding year, 50 cents per acre.
(b) On leases wholly or partly within the geologic structure of a producing oil or gas field:
(1) Beginning with the first lease year after 30 days' notice that all or part of the land is included in such a structure and for each year thereafter, prior to a discovery of oil or gas on the lands herein, $ 1 per acre.
*767 (2) On the lands committed to an approved cooperative or unit plan which includes a well capable of producing oil or gas and contains a general provision for allocation of production, for the lands not within the participating area an annual rental of 50 cents per acre for the first and each succeeding lease year following discovery.
Minimum royalty. -- To pay the lessor in lieu of rental at the expiration of each lease year after discovery a minimum royalty of $ 1 per acre or, if there is production, the difference between the actual royalty paid during the year and the prescribed minimum royalty of $ 1 per acre, provided that on unitized leases, the minimum royalty shall be payable only on the participating acreage.
Royalty*165 on production. -- To pay the lessor 12 1/2 percent royalty on the production removed or sold from the leased lands.
Section 7 of the Federal lease form permits cancellation of the lease by the lessor in the event of default by the lessee.
None of the Federal leases issued in 1948 were within the known geological structure of a producing oil or gas field. Accordingly, no "bonus" as provided in section 17 of the Leasing Act of 1920, as amended, supra, was originally paid thereon.
The Colorado, Wyoming, and Utah leases, on which the payments here in question were made by petitioner, were with few exceptions issued in the name of others than the petitioners. These leases were issued pursuant to the authority, respectively, of sections 59 and 61, chapter 134, Colorado Statutes Annotated, 1935, as amended; section 24-701 et seq., Wyoming Compiled Statutes Annotated, 1945, as amended, and section 86-1-18, et seq., Utah Code Annotated, 1943, as amended.
The State of Colorado provides for competitive bidding on oil and gas leases on certain lands designated as "closed areas" and requires the payment of a bonus for leases on lands located within these areas. None of the Colorado*166 leases here involved were obtained by competitive bid and, therefore, no bonus was paid.
The payments to the lessor State of Colorado that are here in question were made by petitioners in pursuance of the second of the two below quoted provisions of the Colorado lease form:
Whereas, The said lessee has filed in the office of the State Board of Land Commissioners an application for an oil and gas lease covering the land herein described, and has paid the sum of Dollars ($ ) filing fee, and a further sum of Dollars ($ ) fixed by the lessor as an additional consideration for the granting of this lease, and
* * * *
Therefore, For and in consideration of the premises as well as the sum of Dollars ($ ) per annum to be paid to lessor in equal semi-annual installments on the day of and the day of of each year, and of the covenants and agreements hereinafter contained, on the part of the lessee to be paid, kept and performed, the said lessor has granted and demised, leased and let, and by these presents does grant, demise, lease and let unto the said lessee, exclusively, for the sole and only purpose of exploration, development*167 *768 and production of oil and/or gas thereon and therefrom with the right to own all oil and gas so produced and saved therefrom and not reserved as royalty by the lessor * * *.
Section 14 of the Colorado lease permits lessor to cancel the lease without notice in the event of default by the lessee, except that in the event of default "in the payment of rent or royalty payments" the lessor may not cancel unless the lessee has not remedied the default within 30 days after written notice. Section 15 provides that if no discovery of oil or gas in paying quantities is made during the primary term the lessee may renew the lease for another 5 years "by paying each year in advance, double the rental provided herein for the primary term."
The States of Utah and Wyoming have no provision for competitive bidding and, therefore, no bonus was paid upon any of the Utah or Wyoming leases involved.
The lease form under the terms of which petitioners made the payments in 1947 and 1948 to the lessor State of Utah that are here in question provides, inter alia, as follows:
The Lessee in consideration of the granting of the rights and privileges aforesaid hereby covenants and agrees as follows:
*168 FIRST: To pay to the Lessor an annual rental for each acre covered by this lease the sum of 50 cents per acre for the first year and per acre each year thereafter. All such annual payments of rental to be made in advance on the 2nd day of January of each year, except the [first year] rental, which is payable on the execution of this lease, such rental to be credited on the royalties to become due hereunder during the year for which said rental is paid.
The lease form under the terms of which petitioner made the payments in 1947 and 1948 to the lessor State of Wyoming that are here in question provides, inter alia, as follows:
SEC. 3. In consideration of the foregoing the LESSEE COVENANTS AND AGREES:
* * * *
(c) RENTALS. Prior to the discovery of oil or gas in paying quantities to pay the lessor in advance, beginning with the effective date hereof, an annual rental of 25 cents per acre or fraction thereof.
After the discovery of oil or gas in paying quantities to pay the lessor in advance, beginning with the first day of the lease year succeeding the lease year in which actual discovery was made, an annual rental of Dollars ($ ) unless changed by agreement. *169 Such rental so paid for any one year shall be credited on the royalty for that year.
Both the Utah and Wyoming leases permit cancellation by the lessor upon the violation of any of their terms by the lessee.
The granting clauses of the State leases are substantially similar to the granting clause in the Federal lease.
*769 In none of the leases herein involved was there a provision that the annual advance payments denominated as "rentals" should be terminated by, or otherwise bear any relation to, the commencement of drilling operations.
Prior to and during the taxable years there was no production on any of the lands covered by the leases here involved.
In years prior to 1948 the portion of the first-year payment deposited when the application for a Federal lease was filed by the petitioners was accounted for on the books of petitioners by entering the amount of the deposit in a suspense account entitled "Cash Advances" and thus the item was neither expensed nor capitalized at the time of the application. The petitioners followed the same practice in the years prior to 1948 of debiting "Cash Advances" with the amount of their contribution to the total deposit made on the applications*170 of others with respect to Federal leases in which the petitioners had arranged for an interest.
In years prior to 1948 when a lease was issued by the United States of America that portion of the first-year payment which the petitioners had deposited with an application filed by them or that amount which the petitioners had contributed to the total deposit made on applications filed by others was transferred from the "Cash Advances" account into an account entitled "Undeveloped Leases" and the balance of the first-year payment paid at the time of the issuance of the lease was entered directly into the "Undeveloped Lease" account. Therefore, the entire amount of the first-year payment was capitalized upon the issuance of the lease under the practice followed by the petitioners prior to 1948.
In the year 1948, the petitioners initiated the practice, effective January 1, 1948, of transferring to "Rental Expense" the portion of the first-year payments deposited by them with applications filed in their name in prior years. The transfer was made upon the issuance of the lease. The balance paid in 1948, upon the issuance of the lease, was likewise charged off as rental expense. A like*171 change in the petitioners' accounting practice was made, effective January 1, 1948, with respect to payments made on account of leases issued in the name of other applicants in 1948 and with respect to such portion of total deposits made on the applications of others as the petitioners had entered in the "Cash Advances" account.
The payments made by the petitioners applicable to the first lease year of the Federal and State leases here involved were true rentals.
OPINION.
Petitioners contend that the payments made by them for the first year of the lease term of the Federal and State *770 oil and gas leases herein involved are "rentals" within the meaning of section 23 (a) (1) (A), 1 Internal Revenue Code, and therefore deductible as business expenses from gross income. Alternatively, petitioners assert that such payments are deductible as nonbusiness expense under section 23 (a) (2), Internal Revenue Code. 1 Respondent, on the other hand, contends that such first-year payments represent the cost of acquiring economic interests in oil and gas in place and are, therefore, nondeductible capital expenditures. Respondent relies principally upon Regulations 111, section 29.23 *172 (m)-1 and section 29.23 (m)-10, which read in pertinent part, respectively, as follows:
Sec. 29.23 (m)-1. Depletion of Mines, Oil and Gas Wells, Other Natural Deposits, and Timber; Depreciation of Improvements. --
* * * *
An economic interest is possessed in every case in which the taxpayer has acquired, by investment, any interest in mineral 2 in place or standing timber and secures, by any form of legal relationship, income derived from the severance and sale of the mineral or timber, to which he must look for a return of his capital. * * *
Sec. 29.23 (m)-10. Depletion -- Adjustments of Accounts Based on Bonus or Advanced Royalty. -- (a) * * * In the case of the payor any payment made for the acquisition of an economic interest in a mineral deposit or standing timber constitutes a capital investment in the property recoverable only through the depletion allowance.
It should be noted that Regulations 111, section 29.23 (m)-10 is specifically concerned with the treatment to be accorded "bonus" or "advanced royalty." Respondent, however, has not argued here that the payments in question were in the nature of "bonus" or "advanced royalty." His position appears to be that any payment, irrespective of its characterization by the parties, for the first year of the lease term of an oil and gas lease is a capital expenditure and hence nondeductible. It is our view that respondent is inconsistent when he asserts, on the one hand, that first-year payments represent the cost of acquiring economic interests in property which should be capitalized *771 and, on the other hand, concedes the deductibility of payments for subsequent lease years and of so-called delay rentals.
The typical delay rental is normally paid at the end of the first year and of each subsequent year during which drilling has not commenced. Once drilling has begun the lessee is free to exploit the property for*174 its mineral content without having to make any further payments of this kind. Delay rentals have been described in J. T. Sneed, Jr., 33 B. T. A. 478, 482, as being "* * * in the nature of liquidated damages or penalties for failure to drill upon, or exploit, the properties" and in Commissioner v. Wilson, 766">76 F. 2d 766, 769, as accruing "* * * by the mere lapse of time like any other rent." In contrast to royalties, which are not paid for time but for oil and gas taken or to be taken out of the ground, delay rentals are not subject to depletion by the payee, J. T. Sneed, Jr., supra; Commissioner v. Wilson, supra, and are deductible by the payor as a business expense, Charles H. Merillat, 9 B. T. A. 813. Respondent would have us distinguish between delay rentals and the first-year payments involved in this proceeding. It is our opinion, however, that the two differently styled payments are nevertheless in substance the same. Both are fixed sums paid in advance to secure for the payor the right to hold the lease for the succeeding*175 year or designated period without the necessity of drilling wells or making further payments, except royalties on the mineral produced. Neither payment is deemed compensation for the mineral extracted from the soil, although, in the event of production, the first-year payment may be credited against current royalties. 3 But that would be true also of payments for subsequent lease years, which payments respondent here concedes are deductible. Moreover, even if it is true, as respondent alleges, that a lessee acquires an economic interest in oil or gas in place upon making a first-year payment, it is, in our opinion, equally true that a lessee retains a similar interest on paying a delay rental. It would seem then that the delay rentals possess no fewer attributes of a "capital investment" than do the annual payments in the case at bar. Yet for tax purposes it is undisputed that delay rentals are deductible by the payor and nondepletable by the payee. In this connection, it is interesting to note the applicability to the first-year payments here in question of the rationale behind the nondepletability of delay rentals as set forth in the following excerpt from Revenue Ruling 16, 1953-1 C. B. 173, 174:
*176 Such payments are nondepletable items of income to the lessor, since the requisite diminution in the value of his capital interest in the leased property, resulting from a conversion of capital into income to give the depletion provisions operative effect, did not occur upon such payments. Certainly, there was no diminution *772 in value attributable to the extraction and sale of the natural resource content of the land as occurs in the case of ordinary production royalty payment. Nor can such payments qualify as advance royalty payments to establish the requisite diminution in value in the lessor's interest resulting from such payments as in the case of either (1) a bonus payment upon the execution of a lease (which presumptively reduces future production royalty payments to the lessor), or (2) royalty payments in advance of production, such as minimum royalty payments which may be credited as royalty payments on production in future years. 4
See also I. T. 3401, 1940-2 C. B. 166, wherein it was stated that "* * * for Federal income tax purposes [quoting from G. C. M. 11197, XII-1 C. B. 238] 'there is no distinction*177 between the term "rent," in the sense in which that term ordinarily is used, and "delay rentals".'" It should also be noted that, in both Charles H. Merillat, supra, and Continental Oil Co., 36 B. T. A. 693, annual payments that could not have been avoided by drilling were nevertheless treated in the same way as the typical delay rental.
With respect to the Federal leases herein involved, petitioners' case is strengthened by the fact that Congress expressly characterized the first-year payment as "rental" and clearly distinguished it from the "bonus" that a lessee of a competitively bid lease was required to pay in addition to the "rental." Furthermore, it is not reasonable that *178 the Congress, presumably familiar with the provisions of section 23 (a) (1) (A), Internal Revenue Code, would denominate a payment "rental" without intending it to be a deductible expense as in the case of the ordinary rental. The leases issued by the various States are similar to the Federal leases in scheme and substance. All provide for annual payments in advance of a fixed sum and all describe such payments as "rentals." We, therefore, conclude that the first-year payments made pursuant to the leases here involved were true rentals and are deductible under section 23 (a) (1) (A).
Since these payments were made in the ordinary course of petitioners' business, we need not consider their alternative contention under section 23 (a) (2).
It should be emphasized that our decision here is not necessarily dispositive of a case in which the payment claimed by the taxpayer as a deductible expense (or determined by the Commissioner as nondepletable income) is made in respect of a year in which the mineral is produced in paying quantities. See sec. 114 (b) (3), I. R. C.; James Lewis Caldwell McFaddin, 2 T.C. 395">2 T. C. 395.
Decisions will be entered under Rule 50*179 .
Footnotes
1. Payments were also made for subsequent years of such lease terms, but they are not tabulated here since respondent has conceded their deductibility.↩
1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
(a) Expenses. --
(1) Trade or business expenses. --
(A) In General. -- All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including * * * rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.
* * * *
(2) Non-trade or non-business expenses. -- In the case of any individual, all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income.↩
2. "Minerals" are defined in Regs. 111, sec. 29.23(m)-1(d↩) to include oil and gas.
3. Of the leases here involved only the Colorado lease fails to provide for the crediting of rental against current royalties.↩
4. Note that the minimum royalty payable on the Federal lease following discovery and in advance of production is not applicable to future royalties.↩