*776 1. A contract and agreement of sale entered into by and between petitioner and the Standard Oil Co. of Louisiana in August 1928, held to be a contract for the sale of all the gas to be produced during the life of the field by petitioner under its oil and gas leases covering certain lands and not a sale of the gas in place or an assignment of a portion of petitioner's leasehold rights.
2. The lump-sum consideration received by petitioner in 1928 from the sale of its entire gas production over the life of the field constituted "gross income from the property" for the taxable year and petitioner is, therefore, entitled to a deduction for depletion computed in accordance with the provisions of section 114(b)(3) of the Revenue Act of 1928.
3. Held, that petitioner is not entitled to any deduction from income received in the taxable year for estimated expenses of operation or for anticipated depreciation on its plant and equipment in subsequent years.
*1130 This proceeding is for the redetermination of a deficiency in income tax for the*777 year 1928 in the amount of $5,844.29. The issues for determination are: (1) Whether a contract and agreement of sale executed by and between petitioner and the Standard Oil Co. of Louisiana under which petitioner received $140,000 in the taxable year is for the sale of a capital asset or for the sale of gas to be produced by petitioner; (2) whether the consideration received should be treated as gross income in the year received or spread over the estimated life of the field; (3) whether petitioner is entitled to depletion of 27 1/2 percent on the total sale price received; and (4) whether unexhausted cost of plant and equipment and estimated operating expenses during remaining estimated life of field may be deducted from consideration received.
FINDINGS OF FACT.
The petitioner is a Delaware corporation, organized in 1924, with its principal office at Tulsa, Oklahoma. Petitioner is engaged in the production of oil and gas, and during the taxable year it held certain leases giving it the right to extract oil and gas and the gas content of the oil from certain lands situated in the south field, Union County, Eldorado, Arkansas. Petitioner owned a 49/64 interest in these leases, *778 there being outstanding in all the leases a 7/64 working interest *1131 and a 1/8 royalty interest. An important product obtained from that field has been casinghead gas, a wet gas containing gasoline, which is produced from oil wells by the application of vacuum.
Prior to 1928 petitioner had, under contract, delivered to the Standard Oil Co. of Louisiana all of the casinghead gas produced from these properties, payment therefor having been received on a monthly basis. The contract under which casinghead gas was being sold and delivered to the Standard Oil Co. of Louisiana, prior to 1928, was unsatisfactory to the petitioner because of certain technical provisions which rendered it difficult to compute the amount which the petitioner was entitled to receive thereunder and negotiations were entered into which led to the execution of a new contract and agreement of sale between the parties in August 1928. This contract provides that:
For and in consideration of $1 and other valuable considerations, and in consideration of the mutual covenants and agreements herein set out, Malloy & Company does hereby grant, bargain, sell and convey to the Standard Oil Company of Louisiana*779 forty-nine sixty-fourths (49/64ths) of all the gas of whatever kind, whether produced from oil wells or otherwise, from the present oil producing horizon, known as the Natchitoches sand, in, under and upon all of the lands described in the list hereto attached and made part hereof * * *, said lands being situated in Union County, Arkansas.
This grant was the full, undivided interest in the gas held by the petitioner under the oil and gas leases covering said lands.
So long as the petitioner operated these leases and the wells drilled on the lands under the leases, the gas therefrom was to be delivered, free of cost, by the petitioner to the grantee. Equipment for receiving the gas was to be furnished and maintained by the grantee.
In the event the petitioner should voluntarily abandon the operation of any well or wells, and such abandonment should continue for a period of 20 days, the petitioner agreed to sell and assign to the grantee all of its interest in such well or wells and the oil equipment therewith connected so abandoned.
Should the grantee desire to operate such abandoned well or wells it agreed to pay the petitioner the salvage value for the equipment thereon, *780 provided, however, that in the event the petitioner thereafter drilled upon said premises a gas well that did not produce any oil, then the grantee, if it so elected, could take over the operation of said gas well by paying to the petitioner the actual cost of drilling the well; the cost not to include any overhead expense.
The petitioner was to furnish all vacuum plants and equipment necessary to maintain vacuum on all wells then drilled, or to be thereafter drilled, on the property, and was to maintain on each and every one of said wells a vacuum of not less than 20 inches.
*1132 If the petitioner should fail to maintain the required vacuum for a period of 20 successive days, such failure was to be construed as a voluntary abandonment of the particular well or wells on which said vacuum was not maintained.
As an additional consideration of this sale the grantee agreed to return to the petitioner each day residue gas for fuel purposes in an amount exceeding by 25 percent the amount of gas taken from the well or wells on the property.
This contract and agreement of sale was to become effective August 1, 1928, and all gas received from the property by the grantee*781 after that time was received subject to the terms and conditions set out in the contract.
Petitioner received a lump sum consideration of $140,000 in 1928 for the gas sold under the contract.
There has been continuous performance of this contract by the parties thereto since the date of its execution. The contract was modified in October 1933 by reducing from 125 percent of production to 70 percent of production the amount of fuel gas to be returned to the petitioner.
The properties covered by this contract have been exclusively operated by the petitioner under the direct supervision of its vice president and general manager. All of the gas produced from the Natchitoches sand in that field is casinghead gas. The Standard Oil Co. of Louisiana has had no part in the operation, management, or maintenance of these properties. Petitioner purchased all materials and supplies, employed all labor, and paid all other expenses in connection with the production of the gas. The gas is piped from the oil wells on the properties of the petitioner through pipe lines owned by the Standard Oil co. of Louisiana to the plant of the latter company. The method of producing casinghead gas, *782 the operation of the properties, and the delivery of the gas to the Standard Oil Co. of Louisiana were identical prior and subsequent to the execution of the contract in August 1928.
Petitioner's vacuum plants and equipment were necessary to its production of gas and oil. It is not possible to allocate any part of the operating expenses to the production of casinghead gas. Oil may be produced without it but the application of vacuum for the production of casinghead gas results in the increased production of oil. In this particular field vacuum plants are essential to raise the oil, in order to equalize the pressure in petitioner's wells against the wells of other producers.
The books of the petitioner are kept on an accrual basis. The sum of $140,000, received by the petitioner from the Standard Oil Co. of Louisiana under the above quoted contract, was entered on its books *1133 and was reported in its income tax return for 1928 as income from the sale of casinghead gas. Depletion was claimed thereon at the rate of 27 1/2 percent, limited to 50 percent of the net income from the properties. The respondent disallowed the deduction claimed for depletion and treated*783 the $140,000 as proceeds from the sale of a capital asset.
OPINION.
MATTHEWS: The respondent has taken the position that the contract executed in August 1928 constituted the sale of a capital asset; that the full amount of $140,000 received by the petitioner in 1928 should be taxed as income in that year, diminished only by that portion of the leasehold costs attributable to the gas leases; that the petitioner is not entitled to any deduction for depletion based on the total sale price of $140,000; and that the petitioner is not entitled to deduct therefrom the unexhausted cost of plant and equipment, or expenses incurred and to be incurred in the performance of the contract.
Although the petitioner originally reported the sum of $140,000 as income for 1928, and claimed depletion of 27 1/2 percent, limited to 50 percent of the net income from the property, it is now claiming that the $140,000 should be spread or prorated over a period of 10 years representing the estimated life of profitable production of the gas field from the effective date of the contract, and that the cost of plant and equipment and operating expenses should likewise be prorated and allowed as deductions*784 annually over the same period; or if it should be held that the entire amount of $140,000 constituted income for 1928, then such amount should be reduced by the estimated expenses of operation and the unexhausted cost of plant and equipment as of August 1, 1928, plus the sums later expended in constructing additional plants. Regardless of the method by which the net income for 1928 is computed, the petitioner earnestly contends that it is entitled to a deduction for depletion on the total sale price at the rate of 27 1/2 percent, in accordance with the provisions of section 114(b)(3) of the Revenue Act of 1928.
We construe the contract of August 1928 to provide for the sale of all the gas to be produced during the life of the field by the petitioner under certain oil and gas leases which it held. Under its leases petitioner had the right to extract gas and oil and the gas content of the oil. Under such leases, petitioner did not become the owner of these products until they were extracted and possessed. ; *785 . Furthermore, petitioner was required under the contract to extract and deliver the gas to the purchaser at its own expense. Since the petitioner was not the owner of the gas in place, the contract *1134 can not be construed to convey any title or interest which did not belong to the petitioner. Under these circumstances we hold that the contract was for the sale of gas to be produced during the life of the field and not a sale of the gas in place or an assignment of a portion of the petitioner's leasehold rights.
The petitioner correctly included in its income for 1928 the sum of $140,000 which it received in that year in payment of the gas produced after August 1, 1928, and as an advance payment for the gas to be produced during the life of the field and delivered by it to the Standard Oil Co. of Louisiana. This amount clearly constitutes gross income within the meaning of section 22(a) of the Revenue Act of 1928 and since it was received in 1928, must be included in income for that year, section 42. Under petitioner's method of accounting, it was properly accounted for in the year 1928.
In the view we take of the case, it is not necessary*786 to determine the life of the field and we have therefore made no finding of fact as to this.
If the petitioner had extracted and sold the gas from month to month, as had been its previous practice, there could be no doubt that it would be entitled to deduct percentage depletion, as provided in section 114(b)(3) of the Revenue Act of 1928, set out in the margin.1 So far as its right to a deduction for depletion is concerned, we think it is immaterial that petitioner sold all the gas to be produced for a lump-sum consideration which was paid to the petitioner during the taxable year. The amount thus received by the petitioner is no less "gross income from the property" and it is, therefore, entitled to a deduction for depletion computed in accordance with the provisions of section 114(b)(3). The respondent's action on this issue is reversed. Cf. .
*787 There remains for our determination the question whether the petitioner may offset against the total consideration of $140,000 the unexhausted cost of its plants and equipment and operating expenses to be incurred in later years in connection with the performance of the contract. Petitioner continued to own these properties and subsequently constructed two additional plants to be used in the operation of its business. The plants and equipment were used for the production of oil as well as for the production of casinghead gas. It is impossible to allocate any part of the operating *1135 expenses to the production of the gas. In each year of operation, therefore, the petitioner will be entitled to a deduction for depreciation on these physical properties and for operating expenses incurred in that year. Petitioner may not anticipate these deductions but they must be charged against income from the sale of future products derived from the petitioner's wells. The petitioner's contention on this point is denied.
Reviewed by the Board.
Judgment will be entered under Rule 50.
MURDOCK dissents.
TRAMMELL, dissenting 2: I am unable to agree*788 that the entire amount of $140,000 is gross income in 1928. The fact is that it can not be determined what part, if any, of said amount constituted gross income, or certainly net income.
The petitioner sold the gas output, which it would require several years to produce and deliver, for $140,000, received in advance. If the expenses of production, including the exhaustion of physical equipment used for that purpose, equaled the amount received, there would have been no income at all. If a contractor receives an amount in one year as a contract price for building a house, obviously the total amount received is not income. There must be offset against the amount received what it cost to build the house. The illustration is applicable to this case in that petitioner received $140,000 in 1928 for the production and delivery of gas in future years. What it cost to produce and deliver the gas, certainly, would reduce the profit the taxpayer received.
The respondent takes the position that the contract constituted a sale of a capital asset; that the full amount received by petitioner in 1928 should be taxed*789 as income for that year, diminished only by that portion of the leasehold cost applicable to the gas leases; that the petitioner is not entitled to any deduction for depletion based on the amount of $140,000 so received; that petitioner is not entitled to deduct the unexhausted cost of plant and equipment nor expenses incurred or to be incurred in the performance of the contract.
In my opinion, the amount received should either be spread or prorated over the estimated period representing the life of profitable production from the effective date of the contract. In other words, the amount received should be allocated in accordance with the amount of gas delivered each year, and against that should be deducted expenses of operation, depreciation of plant, etc.; or the determination of the amount of taxable gain should be deferred until it could be determined what the actual amount of the taxable gain was. It is entirely possible that the taxpayer at the expiration *1136 of the contract had no gain whatever from the receipt of $140,000. While the taxpayer reported upon the accrual basis, that method clearly did not reflect income and some method should be used which would*790 clearly reflect the income of the taxpayer. I see no objection to the use of the completed contract method in the determination of income in this case. In my opinion, it is immaterial that the respondent's regulations restrict the long term contract method of reporting income to building, installation, or construction contracts. Neither the Commissioner's regulations nor the taxpayer's erroneous method of accounting as to this transaction can operate to nullify the mandatory requirements of the statute that the computation of net income shall be made in accordance with such method as will clearly reflect the income.
We applied the long term contract method in the case of . In that case the taxpayer received money for passage and freight in advance of the voyage, which occurred during portions of two accounting periods. We held that the receipts or gross income should be offset by the expenses of the voyage subsequently incurred, and that the net income be reported for the year in which the voyage was completed. This decision was cited with approval in *791 . The same principle is involved in , affirmed on this point, .
All receipts obviously do not constitute income. Before income can be received the cost of producing it must be returned. That is not true in this case.
MELLOTT agrees with this dissent.
Footnotes
1. SEC. 114. (b) Basis for depletion. -
* * *
(3) PERCENTAGE DEPLETION FOR OIL AND GAS WELLS. - In the case of oil and gas wells the allowance for depletion shall be 27 1/2 per centum of the gross income from the property during the taxable year. 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 be less than it would be if computed without reference to this paragraph. ↩
2. This dissent was filed during Mr. Trammell's term of office. ↩