*283 Decisions will be entered for the respondent.
Petitioners on March 2, 1937, acquired an oil and gas lease providing conveyance of the property for oil and gas mining purposes, for a period of 10 years or as long as oil or gas was produced, providing that if no well be commenced by March 2, 1938, the lease would terminate unless the lessee should have paid a cash rental for the privilege of deferring commencement of a well, and providing for similar delay by rental payment for 10 years. The rental was paid before March 2, 1938. In September 1938 oil was discovered and six wells were drilled and a large amount of oil was produced. On January 31, 1939, petitioners sold and assigned their rights to another. The oil already produced was not included. Held, that the property sold was acquired on March 2, 1937, and not when oil was discovered in September 1938; therefore gain on the sale was long term gain excludible under section 711 (b) (1) (B) in the computation of excess profits net income. Held, also, that a petitioner and a corporation, 75 per cent of the stock of which it acquired in 1945, were a "chain" under section 713 (g) (5) (B) resulting in a net capital reduction*284 in the computation of excess profits credit and unused excess profits credit for 1945 and 1946.
*277 These cases, duly consolidated, involve, after concessions made, eliminating consideration of certain deficiencies in income tax and declared value excess-profits tax, taxes as follows:
| Excess profits | ||
| Petitioner | Year | tax deficiency |
| Petroleum Exploration Docket No. 24698. | 1941 | $ 66,494.91 |
| 1942 | 29,545.85 | |
| 1943 | 39,102.61 | |
| 1944 | 76,389.98 | |
| Petroleum Exploration Docket No. 25213. | 1945 | $ 1,206.40 |
| Wiser Oil Co. Docket No. 24699. | 1941 | $ 51,048.60 |
| 1942 | 7,112.85 |
In addition, by amended answer, the respondent claimed additional deficiencies against Petroleum Exploration as*285 follows: $ 78,715.40 instead of $ 66,494.91 for 1941, and $ 31,122.03 instead of $ 1,206.40 for *278 1945. Claims for refund were filed as to 1941 and 1942 by both petitioners. Two questions are presented: (a) The time petitioners had held oil property sold on January 31, 1939; and (b) whether the acquisition of certain stock by Petroleum Exploration in 1945 causes capital reduction for purposes of excess profits credit, and of any unused excess profits credit.
FINDINGS OF FACT.
Facts were stipulated by the parties, and such stipulation is by reference made a part of our findings. We set forth here, with findings of facts not stipulated, only such portion of the stipulated facts as are considered necessary for outlining the facts involved.
The petitioners are corporations.
The excess profits tax returns here involved were filed with the collector for the West Virginia district at Parkersburg, West Virginia.
On March 2, 1937, one Laura Maxwell executed to petitioner Wiser Oil Company an oil and gas lease on 70 acres of land in Marion County, Illinois. The lease provided, in pertinent part, that in consideration of $ 35 paid, and the covenants and agreements of the lease, the*286 lessor "has granted, demised, leased and let, and by these presents does grant, demise, lease and let unto the said lessee for the sole and only purpose of mining and operating for oil and gas and of laying of pipe lines, and of building tanks, powers, stations and structures thereon, to produce, save and take care of said products," 70 acres of land in Marion County, Illinois, (consisting of tracts of 10, 20, and 40 acres) for 10 years from date "and as long thereafter as oil or gas or either of them is produced from said land by Lessee"; that one-eighth of oil or gas should be paid to the lessor; that "If no well be commenced on said land on or before the 2nd day of March, 1938 this lease shall terminate as to both parties, unless the Lessee shall on or before that date pay or tender to the Lessor or to the Lessor's credit" in a named bank $ 17.50, "which shall operate as a rental and cover the privilege of deferring the commencement of a well for twelve (12) months from said date. * * * In like manner and upon like payments or tenders, the commencement of a well may be further deferred for like periods of the same number of months successively. And it is understood and*287 agreed that the consideration first recited herein, the down payment, covers not only the privilege granted to the date when said first rental is payable as aforesaid, but also the Lessee's option of extending that period as aforesaid, and any and all other rights conferred"; that the lessee should have the right to use, free of cost, gas, oil, and water produced on the land for lessee's operations, except water from the wells of lessor, and that:
Lessor hereby warrants and agrees to defend the title to the lands herein described, and agrees that the Lessee shall have the right at any time to redeem *279 for Lessor, by payment, any mortgage, taxes or other liens on the above described lands, in the event of default of payment by Lessor; and be subrogated to the rights of the holder thereof, and the undersigned Lessors, for themselves and their heirs, successors, and assigns, hereby surrender and release all rights of dower and homestead in the premises described herein, insofar as said right of dower and homestead may in any way affect the purposes for which this lease is made, as recited herein.
No well was commenced by March 2, 1938, but the rental was paid on February 23, *288 1938, by Wiser Oil Company, the petitioners contributing the amount in equal portions. The lease was recorded on April 22, 1938.
By instrument entitled "Mineral Deed," dated July 20, 1937, Laura Maxwell conveyed to B. J. Dining one-half of the oil and gas that might underlie the 40 acres and 10 acres above mentioned, subject to any recorded oil and gas lease theretofore executed. This instrument was recorded on the date of its date, July 20, 1937.
By like instrument entitled "Mineral Deed," dated July 20, 1937, B. J. Dining conveyed to F. L. Kelley fifteen-thirty-seconds of the oil and gas that might underlie the 40 acres and 10 acres above mentioned. This instrument was recorded on July 22, 1937.
By like instrument entitled "Mineral Deed," dated September 30, 1937, F. L. Kelley and wife conveyed this fifteen-thirty-seconds to Tuesday Oil Company.
By instrument entitled "Mineral Deed," dated February 26, 1938, Laura Maxwell conveyed one-seventh of the oil and gas that might underlie the 10 acres, 20 acres and 40 acres above mentioned to A. R. Thompson, subject to any recorded oil and gas lease. This instrument was recorded March 2, 1938.
On August 20, 1938, A. R. Thompson and *289 wife executed to F. L. Kelley an instrument entitled "Oil and Gas Lease," on the 10 acres and 40 acres above mentioned.
By instrument entitled "Assignment of Oil and Gas Lease," dated September 29, 1938, F. L. Kelley, by the name of Forrest L. Kelley, and wife, assigned all right, title and interest under the instrument mentioned next above to Tuesday Oil Company.
On August 24, 1938, The Wiser Oil Company entered into an agreement with Kingwood Oil Company, whereby the latter agreed to drill a test well on the 20 acres above mentioned. Pursuant to this agreement, Kingwood Oil Company located a test well on the 20 acres on August 30, 1938, and completed the same on September 14, 1938. Thereafter two additional wells were completed on the 20 acres, one on September 24 and the other on October 6, 1938. Oil was found in all three of these wells which were equipped for production and oil produced therefrom. Production therefrom commenced on September 22 and 30, and October 11, 1938, respectively. Pursuant to this *280 agreement, The Wiser Oil Company assigned one-half of its interest in the 20 acres to Kingwood Oil Company on September 20, 1938.
On September 7, 1938, The Wiser*290 Oil Company entered into a similar agreement with Kingwood Oil Company with respect to the 10 acres and 40 acres. Pursuant thereto, Kingwood Oil Company thereafter commenced (a) one well on the 40 acres, and completed it on September 30, 1938; and (b) two wells on the 10 acres, and completed them, one on October 14 and the other on October 20, 1938. Oil was found in all three of these wells which were equipped for production and oil produced therefrom. Production therefrom commenced on October 4, 24, and 26, 1938, respectively. Pursuant to this agreement, The Wiser Oil Company assigned one-half of its interest in the 10 acres and 40 acres to Kingwood Oil Company on January 5, 1939.
To and including January 31, 1939, when the property was sold to The Texas Company, 160,336.36 barrels of oil had been produced from these six wells. The portion thereof of each of Petroleum Exploration and The Wiser Oil Company was 35,073.74 barrels, none of which was included in the sale of the property to The Texas Company.
On October 1, 1938, Tuesday Oil Company, plaintiff, filed its complaint against The Wiser Oil Company and Kingwood Oil Company, defendants, in the District Court of the United*291 States for the Eastern District of Illinois, claiming superior title to the majority interest in the oil underlying the 10 acres and 40 acres above mentioned, and praying that the defendants be enjoined from further operating the premises and that the plaintiff be admitted to the sole operation thereof. The defendants answered on October 21, 1938. Afterward, on December 19, 1938, the action was dismissed on motion of the plaintiff. Upon payment of $ 5,000 to Tuesday Oil Company by Petroleum Exploration and The Wiser Oil Company, in equal portions, Tuesday Oil Company (a) executed and delivered a ratification dated December 30, 1938, of the lease by Laura Maxwell on March 2, 1937; (b) executed and delivered an assignment dated December 30, 1938, to The Wiser Oil Company, of all interest in the lease from A. R. Thompson and wife to F. L. Kelley, and (c) moved the entry of the order of dismissal.
The Wiser Oil Company in the transactions above referred to in which it took part was acting in behalf of both itself and Petroleum Exploration as joint adventurers.
On January 31, 1939, the petitioners and Kingwood Oil Company assigned their interest to The Texas Company, including the operating*292 equipment. Each petitioner received as gross sales price $ 138,112.50, resulting in capital gain of $ 136,583.10, after deduction of $ 4,688.73 cost and $ 3,159.33 depreciation. The $ 4,688.73 cost consisted of one-half of: $ 5,000 paid to Tuesday Oil Company in connection with the *281 ratification above recited, $ 1,175.46 attorneys' fees and expenses in the litigation with Tuesday Oil Company, and $ 3,202 for miscellaneous tanks, pipes and fittings for running oil. In its excess profits tax return for the taxable years each petitioner determined excess profits credit by including in excess profits net income its capital gain from the transaction of January 31, 1939, as short term capital gain. The Commissioner, in the determination of deficiency, treated it as long term capital gain and excluded it in computing excess profits credit.
On April 17, 1945, Petroleum Exploration received from Southern Petroleum Exploration $ 825,000 par value of the latter's preferred stock for $ 183,000 in cash and $ 642,000 of the notes of the latter held by the former. The circumstances under which this exchange was made are as follows:
(a) On April 17, 1945, Petroleum received, and on *293 every subsequent day up to and including December 31, 1946, continued to hold, 8,250 shares of the preferred stock of Southern Petroleum Exploration, a domestic corporation, which 8,250 shares constituted at all times material hereto 75 per cent of the preferred stock outstanding. For all purposes material hereto, the adjusted basis (for determining loss upon sale or exchange) of such shares is $ 825,000. Petroleum, for said 8,250 shares of preferred stock of Southern Petroleum Exploration, paid Southern Petroleum Exploration $ 183,000 in cash and cancelled $ 642,000 face value of notes of Southern Petroleum Exploration payable to Petroleum.
(b) On April 17, 1945, Petroleum already held, and on every subsequent day up to and including December 31, 1946, continued to hold, 375 shares of common stock of Southern Petroleum Exploration, which shares had been acquired on April 1, 1925. At all times material hereto such 375 shares of common stock constituted 75 per cent of the common stock outstanding. For all purposes material hereto, the adjusted basis (for determining loss upon sale or exchange) of such shares is $ 18,750.
(c) At no time material hereto was any class of stock of Southern*294 Petroleum Exploration issued or outstanding other than the classes described in subparagraphs (a) and (b) immediately above.
(d) At no time material hereto did Petroleum have more than one class of stock and Southern Petroleum Exploration did not own any of it.
(e) At no time material hereto did any corporation whatever own as much as 50 per cent of Petroleum's stock.
During the period from the beginning of the calendar year 1940 to and including December 31, 1946, Petroleum did not acquire or dispose of any stock of any corporation, other than Southern Petroleum Exploration, in which it owned more than 50 per cent of the total combined voting power of all classes of stock entitled to vote, or *282 more than 50 per cent of the total value of shares of all classes of stock.
On no day within the period from April 17, 1945, to and including December 31, 1946, did the adjusted basis (for determining loss upon sale or exchange) of the 8,250 shares of preferred stock of Southern Petroleum Exploration described in paragraph (a) above exceed the excess of the aggregate of the adjusted basis (for determining loss upon sale or exchange) of stock in all domestic corporations and of obligations*295 described in section 22 (b) (4) of the Internal Revenue Code held by Petroleum on such day over the aggregate of the adjusted basis (for determining loss upon sale or exchange) of stock in all domestic corporations and of obligations described in section 22 (b) (4) of the Internal Revenue Code held by Petroleum as of the beginning of the calendar year 1940.
In the oil industry, the principal bases upon which oil-producing properties are bought and sold are (1) the estimated recoverable reserves of oil in place and (2) the expected rate of their recovery. There is no now known method of obtaining oil from a subterranean stratum other than by piercing it with a well drilled from the surface.
OPINION.
(a) For what period had the petitioners held the oil property sold by them to The Texas Company on January 31, 1939? 1 The petitioners' view is that under the lease of March 2, 1937, it was optional with the lessee to explore the leased premises; that it had no interest in the oil, if any, that might underlie the premises until it had exercised the option to explore and found the oil; that according to the economic and practical consequences of the transaction the property sold by petitioners*296 to The Texas Company on January 31, 1939, was their interest in the oil in place under the premises, together with the operating equipment which had been installed for its recovery, and that the property so sold was not acquired earlier than September 14, 1938, when the oil in place was first found. The respondent contends that the property sold on January 31, 1939, was the oil and gas lease made on March 2, 1937; that the property had been held since March 2, 1937, and that the capital gain on the sale was therefore long term capital gain.
The parties have briefed*297 this question at length, and many cases have been cited showing the thought, not always consistent, devoted by the courts to theories as to the fugacious nature of oil and gas, *283 the interpretation of "unless" and "or" leases, with more particular reference to the law of Illinois, the situs of the land here involved, and the nature of rights to oil and gas as related to such questions as depletion, conveyance, etc. It is not considered necessary to discuss the many citations accumulated. No case involving exactly the question here posed is presented. After study of the authorities cited, and others not suggested, we are of the opinion that the petitioners have not shown that what was sold on January 31, 1939, was (for purposes of sections 711 (b) (1) (B) and 117 of the Internal Revenue Code, as to capital gains and losses and exclusion of long term capital gains and losses from excess profits net income) not the same as acquired on March 2, 1937, and therefore have not shown that the sale resulted in short term capital gain. Though discussing the "option" involved in the "unless" lease here involved, the petitioners on brief argue that there is little difference save in*298 form between an "unless" lease and an "or" lease with a surrender clause. Analysis of the many cases on the general nature of oil and gas leases, with recognition that in Illinois, as in other states except Texas, oil in place is not recognized as the subject of ownership, leads us to the conclusion that the petitioners on January 31, 1939, disposed of essentially the same basic rights as acquired when the lease was made, and that the petitioners' theory of change to a property in the oil and gas in place upon the discovery of oil late in 1938 can not be sustained. The petitioner cites Bonwit Teller & Co. v. Commissioner, 53 Fed. (2d) 381, for the statement that "upon the lessee's electing to exercise its option to explore and its discovery of oil, the delay rentals ceased and it acquired a new term for a new consideration, that is, as long as the oil should be produced, for one-eighth thereof." The Bonwit Teller case is no authority for such view. It involved no oil and gas lease, but a lease upon improved premises in New York City and the question whether, in computing exhaustion for tax purposes, the exhaustion could be extended beyond *299 the 19-year term of the lease because of an option to renew for 21 years at a rental to be determined by appraisal, which "renewal privilege had not been exercised and may never be." We find nothing in the case helpful here. Upon execution of the leases here the lessees acquired the right to explore for, produce, remove and sell oil and gas. That right was assigned by them on January 31, 1939. It is to be noted that the conveyance carefully did not cover the oil which had been produced up to that time. In short, there was not conveyance of oil reduced to possession, but of the right in futuro to reduce it to possession. That right was obtained in the lease on March 2, 1937. It is true that at that time there was also the right to delay the search for oil by payment of annual rentals, for 10 years, the necessity for payment of which rentals ceased with development of oil; but from the inception of *284 the lease, to the assignment, there inhered in the contractual relations of the parties the right of the lessee at any time to explore for oil or gas for 10 years, and if exploration was successful to continue to so explore, and to take and sell the products, so long as*300 oil or gas was produced. This right was not essentially altered by the discovery and production of some oil about September 1938. Thereby, in strict accord with the rights conferred by the lease, some oil was reduced to possession. But that does not mean, as the petitioners contend, that then and thereby the petitioners acquired a new and different right to the remainder of the oil, in place, so that they could and did on January 31, 1939, sell a property right not owned prior to September 1938. The lessees' right, as to oil in the ground, remained one merely to explore for, bring it to the surface and dispose of it. Because six wells had produced oil did not necessarily mean that others would do so. A "dry hole" may be encountered a short distance from a producing well. Though a well, or six wells, may demonstrate the probability of underlying oil, such oil may, unless earlier secured by extraction from the ground, be depleted and taken to some extent at least by offsetting wells on adjoining land, so far at least as the oil lies near boundary lines, and the lessee must protect against this. 2 This demonstrates that the lessee by discovering oil does not become the owner*301 thereof in place, but merely continues to have his lease-given right to reduce to possession the oil, which, by lack of diligence, if it is near boundaries, he may never possess.
The petitioners appear to think that merely because one or more wells are drilled on a lease to oil sands and oil is found that the entire subterranean oil in place has become the property of the lessee. It is true that the word "find" as used in some cases refers to ownership of oil found; but it is clear from the weight of authority that ownership of the oil reservoir under a lease results not merely from discovery but by its reduction to possession. The Supreme Court in Ohio Oil Co. v.Indiana (No. 1), 177 U.S. 190">177 U.S. 190, finds such ownership "after the result *302 of his borings has reached fruition to the extent of oil and gas by himself actually extracted and appropriated," and later "when they [oil and gas] escape and go into other land or come under another's control the title of the former owner is gone." In Jones v. Forest Oil Co., 44 Atl. 1074, it is thus expressed: "actually in his grasp and brought to the surface" and "actually reduced by him to possession." Of course, oil brought to the surface belonged to the lessees here; but that was not the subject of the sale on January 1, 1939. We can not agree that, except as to oil reduced to possession, the lessees *285 had, merely by discovery of some oil, become the owners of the other oil, in place. That the Federal revenue law allows a right to depletion proves nothing different. Depletion is based upon economic interests and not on "oil in place." Though, of course, the discovery of oil about September 1938 increased the value of the lessees' rights, that was only because of demonstration of the increased probability of profitable extraction of oil from the wells drilled, or others, over the previous uncertainty as to production, but there was*303 no new right to the oil in place. It has often been held that the object of a lease is development and that failure to continue reasonable development after discovery may be ground for cancellation of lease, at least as to undeveloped portions. 3 This indicates that the lessee owns, not the underlying oil in place by finding some oil, but the contractual right to produce it. But this right he had from the day of execution of the lease; and this is the right which the petitioners assigned to The Texas Company. One of the leading cases on the nature of oil and gas leases is Rich v. Doneghey, 71 Okla. 204">71 Okla. 204, 177 Pac. 86. It points out that mere discovery does not give title to oil in place and at the same time defines the essential nature of a lease, as follows:
* * * Although there had been in terms a purported conveyance of all the oil and gas in the place, yet, by reason of the nature of these substances, no title thereto or estate therein would have vested, but only the right to search for and reduce to possession such as might be found; and when reduced to possession, not merely discovered, title thereto and an estate therein*304 as corporeal property would vest, * * * [Citations] Though denominated a lease, and in deference to custom will be so referred to herein, the instrument before us, strictly speaking, is not such, but is in effect a grant in praesenti of all the right to the oil and gas to be found in the lands described, with the right for a term of five years to enter and search therefor, and, if found, to produce and remove them, not only during said term, but also as long thereafter as either is produced, and to occupy so much of the surface of the land as may be necessary for the purpose of exploration or production, or both. [Emphasis added.]
Cases such as Helvering v. San Joaquin Fruit & Invest. Co., 297 U.S. 496">297 U.S. 496, involving mere options, later exercised to purchase property, are found of no help here. In common parlance petitioners bought a lease, and sold it. They might have sold it before finding oil. They received more for it because they had made discovery. But they assigned no right or property not possessed before discovery. They did not possess title to oil in place, except when reduced to possession, either before or after discovery of oil in*305 one well, or six wells, but only the original right to extract and sell it. Triger et al. v. Carter Oil Co., 372 Ill. 182">372 Ill. 182, 23 N. E. (2d) 55; Ohio Oil Co. v.Indiana, supra. In the recent case of Phillips Petroleum Co. v. Jones, 176 Fed. (2d) 737, *286 it was held that an "unless lease," such as here involved, "is a chattel real, a profit a prendre, or an incorporeal hereditament, which grants only the exclusive right * * * to explore by drilling operations; to reduce the possession, and thus acquire title to the oil and gas, which is personalty." Pointing out that an oil and gas lease is within the statute of frauds as to real estate, is a conveyance within homestead laws, and a grant of real property with reference to breaches of covenants as to real property, and possesses many other attributes of realty, the court concludes that the lease is realty for stamp tax purposes, when executed conveying lands, tenements and other "realty." Though of course not involving this particular question, the case is in principle opposed to the idea that prior to production*306 an "unless" lease is nothing more than an option for any purpose, as in effect petitioners contend. In Ewert v. Robinson, 289 Fed. 740, a lease is called more than a mere license. Gloyd v. Midwest Refining Co., 62 Fed. (2d) 483, relied upon by the petitioners, says that an "unless" lease is "more than a mere option to acquire a right." If based on a consideration it gives the lessee a present right or license to enter upon the leased premises and explore for and develop oil or gas therein and the right, on the performance of certain conditions, to extend that license to enter and explore. "* * * it is a present existing right which he may exercise with respect to the leased premises, and not a mere option to acquire such a right." Equitable relief was granted against an attempt to cancel the lease for failure to pay rental on time. After reviewing many cases, none precisely in point but involving principles here of interest, we conclude and hold that the petitioners held the property sold on January 31, 1939, from March 2, 1937, therefore that the capital gain upon the sale was long term and properly excluded*307 from computation of excess profits net income as to the years involved here.
(b) There remains for consideration the question whether the acquisition and holding by Petroleum Exploration of $ 825,000 in stock of Southern Petroleum Exploration, in 1945, resulted in a net capital reduction under section 713 (g) (5) of the Internal Revenue Code. The issue was raised by respondent's affirmative answer. The facts were stipulated, as set forth above, but need not be again recited here, for the parties are in tacit if not verbal agreement that the answer depends only upon whether two corporations constitute a "chain" within section 713 (g) (5). It is not suggested that the facts do not*308 otherwise come under the statute. Petitioners merely suggest that, though mindful of our opinion in Morganton Full Fashioned Hosiery Co., 14 T.C. 695">14 T. C. 695, that two links form a chain, they do not agree that Petroleum Exploration as parent corporation and Southern Petroleum Exploration as "offspring" can be a chain. No distinction is suggested and in the Morganton case the two links were the petitioner as *287 parent corporation and its wholly owned subsidiary, and we specifically held that "chain" included parent and subsidiary. We hold that the Morganton case controls here, therefore that net capital reduction resulted from the acquisition and holding of the stock in 1945.
Decisions will be entered for the respondent.
Footnotes
1. This fact is of prime importance here because it determines whether, in computing petitioners' excess profits credits (including any unused excess profits credits of Petroleum Exploration), the gain on the sale on January 31, 1939, represents long term capital gain not to be included in excess profits net income for 1939. In other words, this question affects the amount of excess profits credit under section 711 (b) (1) (B) of the Internal Revenue Code↩.
2. Coffinberry v. Sun Oil Co., 67 N.E. 1069">67 N. E. 1069; Cooper v. Ohio Oil Co., 108 Fed. (2d) 535; Phillips Petroleum Co. v. Taylor↩, 116 Fed. (2d) 994.
3. Sauder v. Mid-Continent Petroleum Corp., 292 U.S. 272">292 U.S. 272; Thomason v. United Gas Public Service Co., 98 Fed. (2d) 526; Myers v. Shell Petroleum Corp., 110 Pac. (2d) 810; Huggins v. Daley, 99 Fed. 606↩.