*1815 1. A transaction by which petitioner purchased certain oil and gas leases from another corporation in consideration of part cash and part in petitioner's fully paid and nonassessable capital stock was not a transaction falling within section 204(a)(8) of the Revenue Act of 1926, because after the transaction was completed, the corporation receiving petitioner's stock in payment for the leases was not in control of petitioner.
2. Where petitioner entered into contracts for the drilling of oil wells and agreed to pay one-half the expense solely from the production of them, such expense is contingent on the production and is not deductible as an accrued liability in a year when production was not sufficient to pay such expenses.
3. Petitioner's claim of a loss, growing out of a purchase and cancellation of a contract with another corporation for the purchase of crude oil to supply its refinery, disallowed for want of evidence to sustain it.
4. Consideration paid for reconveyance of oil lease and uncompleted oil well held a capital expenditure and not an ordinary business expense.
5. Erroneous entry increasing income in a prior year should be corrected in year in*1816 which made, and not in the taxable year. 6. Expenditures to clear or correct title to real estate are capital expenditures and not ordinary and necessary business expenses.
*829 The petitioner seeks redetermination of a deficiency in income tax of $5,205.20 for the year 1926. In redetermining said efficiency, respondent made the following adjustments in petitioner's income as shown by its return for the calendar year 1926.
| Income Adjustments | ||
| Net loss reported | ($39,274.53) | |
| Additional income: | ||
| 1. Adjustment of costs of leases and royalty interests disposed of | $29,092.80 | |
| 2. Contingent liabilities | 27,670.92 | |
| 3. Contract written off | 5,000.00 | |
| 4. Well purchase written off | 7,000.00 | |
| 5. Donations | 145.00 | |
| 6. Adjustment of profit and loss of prior year | 6,000.00 | |
| 7. Cost of perfecting title | 2,092.50 | |
| 8. Interest earned | 982.62 | |
| $77,983.84 | ||
| Net income as adjusted | $38,709.31 |
*830 Explanation of Adjustments
1. As before*1817 explained the adjustment of the cost of leases and royalty interests disposed of is in accordance with the provisions of Section 204(a)(8) of the Revenue Act of 1926. The computation is set forth in detail in Schedule 1-A(a) of the revenue agent's report.
Schedule 1-A(a) of the Revenue Agent's report above referred to is as follows:
On May 20, 1922, this corporation acquired from the Stevenson Consolidated Oil Co., a number of leases and royalty interests, paying therefor $50,000 in cash and 194,000 shares of its own capital stock of a par value of $1.00 per share. Immediately thereafter, the said Stevenson Co., owned and controlled more than 80% of the outstanding stock of this corporation. These leases and royalty interests were put on the books of this corporation at the amount paid therefor, $244,000. During 1926, transactions were had in such leases and interests that had a book cost of $36,590.94. In computing the profit or loss by reason of these transactions, as reported in the 1926 return, these book costs were used as a basis, as follows: [Here follows a description of the leases sold and their cost as per the books of petitioner.]
The cost of all these leases*1818 so transferred, to the Stevenson Consolidated Oil Co., was less than $50,000, and that corporation showed a taxable profit on the transaction in the difference between its cost and $50,000. The 194,000 shares of the stock of this corporation was considered as having no readily realizable market value, and under the provisions of Sec. 202(c)(3), Rev. Act of 1921 no profit accrued to the Stevenson Co., on the receipt of these shares.
Under the provisions of Sec. 204(a)(8) of the Revenue Act of 1926, the basis for computing profit or loss on the disposition of property received in the manner in which this property was received, is the basis as in the hands of the transferor, increased by the amount of gain recognized to the transferor upon such transfer under the law applicable to the year in which the transfer was made. The basis to this corporation for all the property so received on May 20, 1922, from the Stevenson Consolidated Oil Co., is $50,000, and inasmuch as the book cost of such property was $244,000, the basis for income tax purposes is 50/244 of the book cost.
*831 There has therefore been disallowed as a deduction in computing profit or loss on the disposition*1819 of the property described above, 194/244 of the book costs of such property, or $29,092.80.
Petitioner alleges that respondent erred in making the above adjustments in the following particulars:
(a) The Commissioner erred in computing and finding the cost of acquisition of oil and gas leases and royalty interests purchased and acquired by petitioner, and sold and disposed of by petitioner and in denying to the petitioner credit for its actual, just and proper costs of such acquisition in computing the income from such disposition.
(b) The Commissioner erred in denying to petitioner the right of adjusting the costs of leases and royalty interests disposed of and in holding that the adjustments made by the Revenue Agent were in accordance with the provisions of Section 204(a)(8) of the Revenue Act of 1926, which adjustments the petitioner had contended were improperly computed and were not in accordance with said Section and which the petitioner now avers were not in accordance with Section 204(a)(8) of the Revenue Act of 1926, thereby erroneously adding $29,092.80 to the taxable net income of petitioner.
(c) The Commissioner erred in holding that transactions under drilling*1820 contracts payable out of production were contingent liabilities and that deduction of $27,670.92 for the year 1926 was neither paid nor accrued or paid or incurred during or in the year 1926; and further holding that petitioner is not entitled to such losses, deduction or expense under Section 200(d) of the Revenue Act of 1926; and further holding that "under the terms of the various agreements under which the payments were made by the Ohio and Mid-Northern companies, none of the amount claimed by this deduction was incurred, and there being no definite liability of payment, the amount could not be accrued as a set off or deduction for income tax purposes."
(d) The Commissioner erred in disallowing loss of $5,000.00 claimed by petitioner on a contract of no value determined to be worthless and written off by petitioner in the year 1926.
(e) The Commissioner erred in disallowing a deduction of $7,000.00 reimbursement made by petitioner for costs incurred by another operator in drilling a dry hole and in unsuccessful development operations carried on upon leases in which petitioner held and acquired an interest.
(f) The Commissioner erred in disallowing deduction of ordinary*1821 and necessary expenses by classifying an item of $145 as donations.
(g) The Commissioner erred in disallowing deduction of $6,000.00 on adjustment of profit and loss of prior year made by petitioner in the year 1926 and in holding that such was a deduction for the year 1925.
(h) The Commissioner erred in disallowing a deduction of $2,092.50 amount of interest paid to a dissatisfied stockholder to clear title under pressure of threat to cloud title and prevent holding of $153,000.00 of forfeited option payments, where, as an incident thereto, the $153,000.00 became income and was duly returned for taxation.
(i) The Commissioner erred in holding that $982.62 of interest earned was taxable income of the year 1926 rather than of the year 1927 as returned by petitioner, in the year 1927.
(j) The Commissioner erred in computing the net loss properly applicable to the reduction of the taxable net income of the year 1926.
*832 FINDINGS OF FACT.
We make the following findings of fact bearing upon petitioner's respective assignments of error:
(a) and (b). The petitioner is a Montana corporation with its principal office and place of business at Great Falls, Mont.*1822 It was engaged in the production and refining of mineral oils, and in the purchase and sale of oil bearing properties. Prior to January 20, 1926, its name was Sunburst Oil and Gas Company, but on that date was changed to Sunburst Oil and Refining Company.
On November 12, 1921, petitioner offered to purchase from the Automobile Credit Company, which subsequently changed its name to Stevenson Consolidated Oil Company, certain oil and gas leases and agreed to pay therefor 65,000 shares of its stock of the par value of $1 each and $33,200 in money, evidenced by note.
The petitioner will be subsequently referred to as petitioner or "Sunburst Company" and the Automobile Credit Company and the Stevenson Consolidated Oil Company as the "Stevenson Company."
The offer above mentioned was accepted by the Stevenson Company and in pursuance thereof certain leases were conveyed to the petitioner on November 23, 1921. On that same date the contract was amended to include several additional leases to be conveyed and the money consideration to be paid by petitioner was increased from $33,200 to $50,000, payable by notes due in from one to four years. The 65,000 shares of stock mentioned*1823 as part of the consideration were issued to the Stevenson Company December 28, 1921, and the notes were subsequently paid.
On April 10, 1922, the contract between petitioner and Stevenson Company was modified so that certain leases and properties were substituted for some of those formerly agreed to be conveyed. On May 15, 1922, it was further agreed that the Stevenson Company would convey and assign certain other additional leases and properties to the petitioner, amounting to about 12,000 acres in all, for 126,000 shares of its paid-up stock of the par value of $1 each, provided the petitioner would increase its capital stock from $135,000 per value to $385,000 par value of $1 per share. The capital stock of petitioner was increased as agreed upon and the assignment and transfers of the various additional leases were made in several conveyances between May 24, 1922, and July 24, 1922. On May 24, 1922, there were outstanding 142,182 shares of stock in petitioner, including 65,000 issued to the Stevenson Company December 28, 1921. On June 28, 1922, the outstanding stock in petitioner had increased to 274,831 shares, and on November 29, 1922, it was approximately 384,980 shares. *1824 The 126,000 additional shares to which *833 the Stevenson Company was entitled under the contract hereinbefore referred to were issued November 29, 1922, giving it a total of 191,000 shares and an additional 3,000 shares were issued to Homer G. Murphy as nominee of the Stevenson Company for another lease, making 194,000 shares to petitioner in all.
During the year 1926 certain of the lease and royalty interests conveyed to petitioner under the assignment of June 28, 1922, were sold by petitioner. As a basis for computing the gain or loss on these sales, petitioner used the cost set up on its books for the leases in question, viz., $36,590.94. This cost was based upon a cost to petitioner of all leases and royalties purchased from the Stevenson Company of $244,000 made up as follows: 194,000 shares of stock of the par value of $1 per share and $50,000 in cash.
The leases and royalties transferred to petitioner by the Stevenson Company in consideration of payment to it of 194,000 shares of petitioner's stock and $50,000 in cash, had a fair market value of at least $244,000 at the time they were so transferred.
(c). Petitioner during the period from June, 1922, to*1825 the taxable year entered into a number of drilling contracts with other companies by which the petitioner as party of the first part conveyed and assigned various leases to other oil companies as party of the second part, by which the other oil companies agreed to drill and operate oil wells on the properties assigned and to pay all the expenses of drilling and operation. It was further agreed that the petitioner should be entitled to 50 per cent of the production and that it should pay 50 per cent of the expenses, but solely from its share of the production. All of these contracts contained the following provision:
Party of the second part agrees to advance and pay all costs and expenses of testing, developing and operating said lands for oil and gas purposes, subject to conditions herein stated, and shall charge party of the first part fifty (50) per centum thereof. * * * The said party of the second part shall be reimbursed by said party of the first part solely from the first party's proportion of the oil and gas produced and sold from said land. Application of proceeds derived from sale of said oil and gas will be made to the credit of the first party's account upon the*1826 first day of the month following that in which said oil and gas is sold, but in no case shall said party of the first part be finally held or charged beyond its share or interest in the production and equipment from, in or upon said lands. The party of the second part shall be entitled to and shall charge the party of the first part eight per centum (8%) interest upon all moneys so advanced for the development and operations upon said land for the account of the interest of the first party until the same shall have been paid out of the proceeds of the party of the first part's proportion of the oil and gas produced and sold as herein provided, said interest payments to be also paid out of production: PROVIDED, HOWEVER, that the party of the first part shall always have the right to advance its proportion of the development and operation costs and expenses and thereby avoid said interest charges.
*834 During the taxable year 1926 under the operation of these contracts the petitioner was charged for expenses and interest the sum of $113,454.59 and during the same period was credited the sum of $85,783.67 as its share from the production, leaving an excess of charges over credits*1827 of $27,670.92. Petitioner kept its accounts on an accrual basis and accrued this excess of $27,670.92 as an expense for 1926 and took a deduction therefor on its income-tax return. The amount was not paid in 1926 by the petitioner from production, nor from any other source. The respondent disallowed the claim for deduction.
(d). On February 15, 1924, the Stevenson Company and the Sunburst Refining Company entered into a contract for an assured supply of crude oil for a period of nine years, by which the Sunburst Refining Company agreed to purchase from 500 to 3,000 barrels of crude oil daily and pay the regular market price therefor and in addition to pay an additional 10 cents per barrel bonus, payable in capital stock of the Sunburst Refining Company. In November, 1926, the petitioner acquired the plant and business of the Sunburst Refining Company. About the same time it purchased from the Stevenson Company a large number of leases, large blocks of shares in several other oil companies, and the crude-oil contract above mentioned, for a total lump consideration of 637,500 shares of the petitioner's capital stock. When petitioner acquired the contract it canceled it and*1828 allocated 5,000 shares of its capital stock at $5,000 par value as the cost thereof and claimed same as a deductible loss, which respondent disallowed.
(e). In 1921, petitioner entered into a contract with the Kia-Ora Oil Company by which the Kia-Ora Company agreed to perform drilling operations on certain property which petitioner conveyed to the Kia-Ora Company, at its own expense and pay the petitioner the sum of $8,000 and a certain per cent of the production as consideration therefor. The Kia-Ora Company started one well, but did not complete it. In March, 1926, petitioner made an agreement with Robert A. Lockerby, who had become the owner of the Kia-Ora Company, by which Lockerby reconveyed the lease back to petitioner and also certain drilling machinery and supplies on the property for a consideration of $9,316 paid in the stock of petitioner. Of this amount it was agreed that $7,000 represented payment for work done on the well, and $2,316 for the machinery and supplies. The well was completed and brought into production by petitioner at an additional cost of $2,162.61. There is no controversy as to the cost of the additional work or the cost of drilling machinery. *1829 Petitioner claimed the $7,000 as deductible for business or development expense, but respondent disallowed it on the ground that it was a capital expenditure.
*835 (g). In 1925 petitioner made a contract with Ernst and Boop, by which they were to develop certain acreage for petitioner and pay $6,000 to petitioner. Petitioner charged Ernst and Boop that amount and credited its income the same sum for 1925, though it was not paid. In 1926 it was discovered that the $6,000 was payable solely from production and, as there was no production for 1925, the entries in that year were erroneous. The amount was charged to profit and loss in 1926 in order to adjust the matter and correct the mistake. The respondent refused to allow this as a deduction for 1926.
(h). Prior to the taxable year the petitioner's predecessor, Sunburst Refining Company, purchased a parcel of land for its refinery from the Great Falls Townsite Company and paid therefor 4,249 shares of its capital stock of the par value of $1 per share. In the subsequent mergers petitioner acquired the parcel of land. In 1926 the petitioner made an optional contract with S. C. Lewis to sell him the land and refining*1830 plant. It was discovered that the title was defective because of an erroneous description. In order to obtain a deed of correction petitioner had to redeem the stock issued, with interest, and in so doing claims a cost to it of $2,092.50 more than the fair market value of the stock which it redeemed, and which $2,092.50 it claimed as a deductible expense. The respondent disallowed it and held it to be a capital expenditure.
OPINION.
BLACK: No evidence was introduced to sustain petitioner's alleged errors numbered (f), (i) and (j). These relate to claimed deductions for donations of $145, interest added to income in the sum of $983.62, and improper application of net loss to the year 1926. The action of the respondent relative to these items is approved. We shall discuss petitioner's remaining assignments of error in their order.
(a) and (b). In his determination of the profit realized by the petitioner on the sale of certain oil and gas leases acquired by petitioner from the Stevenson Consolidated Oil Company in prior years, the respondent proceeded upon the theory that immediately after the transfers of the leases were made to the petitioner the transferor, Stevenson*1831 Company, was in control of petitioner, owning 80 per centum of petitioner's stock, and that under sections 203 and 204, Revenue Act of 1926, and particularly 204(a)(8), the cost basis of these leases must be their cost to the transferor. The facts show that the Stevenson Company was not the owner of 80 per centum of petitioner's stock at the time of the assignment of these leases to it, nor at any time subsequent thereto. It follows that the method *836 used by the respondent in arriving at his determination was incorrect. It seems that the respondent disregarded the $194,000 stock consideration entirely and based his estimate of cost on the cash consideration of $50,000 as the cost of all the leases purchased from the Stevenson Company. The amount which respondent determined as the cost of the leases in question has already been given in our preliminary statement preceding the findings of fact. This amount was subtracted from the cost basis as used by petitioner, resulting in an additional profit of $29,092.80, which was added to petitioner's income. We hold this action of the respondent is not justified. Petitioner proved its cost of the leases and respondent's action*1832 in adding $29,092.80 to petitioner's income because of disallowed cost of these leases was error.
(c). Petitioner next complains of respondent's refusal to allow $27,670.92 as expenses incurred by it under certain contracts which it had with producing oil companies, which were engaged in developing its leases. None of this deduction of $27,670.92 was paid by petitioner in 1926, and under the terms of the various agreements under which the expenditures were made by the producing companies, none of this deduction was incurred by petitioner as a liability in 1926. The contracts provided, "Said party of the second part shall be reimbursed by said party of the first part solely from the first party's proportion of the oil and gas produced and sold from said land." Respondent held that said $27,670.92, not having been incurred and there being no definite liability of payment, the amount could not for income-tax purposes be accrued, "Having been neither paid, incurred, or properly accrued as a liability in 1926, the amount, under the law, is not an allowable deduction in 1926, and is therefore disallowed," said respondent. We approve respondent's disallowance of this item as a proper*1833 deduction. Contingent liabilities are not accruable for income-tax purposes. Petitioner was only liable for this $27,670.92 if and when sufficient oil was produced from the wells to pay it.
An applicable case to the facts in the instant case, we think, is that of , in which the taxpayer sought to accrue contingent liabilities in a year before they became fixed. In disallowing the deduction, the District of Columbia Court of Appeals said:
It will be observed that under the contract as set forth in the resolution all sums to which the employees, might become entitled during the period of five years should remain in the business, and should be subject to pro rata deductions in the event of losses incurred in the business during the 5-year period. Appellant paid out nothing. It took nothing from its business. The entry on the books represented only a possible future liability. In other words, the profits and losses credited and charged to the account of each of the employees *837 should be accounted at the end of the 5-year period, and if the credits exceed the losses the excess would represent the*1834 amount to which the employee would be entitled. On the other hand, if the losses exceeded the credits, the employee would be entitled to nothing. It follows that the events which were to determine and fix appellant's liability to its employees could not occur until the expiration of five years; and, by the terms of the agreement, if an employee was discharged or left the employ during the period of five years, he should take nothing under the agreement, whether the credits were in his favor or not. It follows, therefore, that the events which were to determine and fix appellant's liability did not occur in the year 1919, and could not occur so as to admit of a final determination until the end of the 5-year period, at which time the definitely fixed and accrued expense could be deducted and credit taken on its tax in the current year.
See also ; ; ; ; *1835 ; ; ; .
(d). In 1924, prior to the reorganization and consolidation of several corporations into the petitioner, the Sunburst Refining Company, one of the merged corporations, made a contract with the Stevenson Company for the purchase of 500 to 3,000 barrels of crude oil daily for a period of nine years, at the posted market price plus a bonus of 10 cents a barrel, payable in stock of the corporation. Sunburst Refining Company sold its plant and business to the petitioner, which succeeded to the obligations under this crude oil contract to take the specified amount of oil at the designated price. Subsequently it acquired the contract from the Stevenson Company as part of a trade involving 637,500 shares of its capital stock and the conveyance to it of large blocks of shares of stock in other corporations. It canceled the contract and allocated on its books 5,000 shares of stock as the cost thereof and claims a loss. We see no basis for a deduction*1836 of a loss.
The transaction was strictly a capital one and petitioner has offered no evidence showing the loss which it claims. If it be the theory of petitioner that the contract which it had with the Stevenson Consolidated Oil Company for the purchase of crude oil was a burdensome one and that petitioner was justified in paying the Stevenson Company $5,000 to get rid of the contract and in charging same as an ordinary and necessary business expense, that was not done, and we are not called upon to decide that question. Besides, we have no evidence before us that this contract which petitioner had with the Stevenson Company for the purchase of crude oil was a burdensome one. In this state of facts we approve respondent's action in disallowing this claimed loss of $5,000.
*838 (e). Petitioner's assignment of error (e) must be disallowed. We hold with the respondent that this item was a capital expenditure and the fact that the well was not entirely completed when the lease was retransferred is immaterial. It added to the value of the lease, as it was completed at small expense after petitioner secured repossession of the lease. *1837 ; ; .
(g). Petitioner's assignment of error (g) must be disallowed. Petitioner's effort to adjust in 1926 an error which occurred in 1925 was erroneous. The mistake should have been corrected in the year in which made, viz., 1925.
(h). The last item for consideration is petitioner's assignment of error (h), wherein it contends respondent erred in disallowing an expenditure of $2,092.50 for a deed of correction to perfect its title to its refinery property. We have uniformly held that such expenditures are capital expenditures, and are not deductible as ordinary and necessary business expenses. Such expenses are added to the cost of the property. The fact that the amount was paid under pressure does not alter its character. .
Decision will be entered under Rule 50.