*911 Petitioner entered into contracts with drilling contractors for the drilling and completing of oil and gas wells on its properties for a stipulated price per well. The contractors agreed to do all of the drilling and to furnish all material and equipment, except that petitioner was to furnish some of the supplies required for drilling operations and some items of equipment, to swab certain wells in, and in some cases to furnish a man to supervise the drilling of the sand and the running of the casing. Held, that petitioner is not entitled to deduct as intangible drilling and development costs any portion of the amounts paid to the drilling contractors under these contracts.
*1058 The respondent has determined deficiencies in income tax for the years 1935, 1936, and 1937 in the respective amounts of $1,671.32, $17,480.34, and $4,816.84, and in escess profits tax for 1936 and 1937 in the respective amounts of $1,807.68 and $498.84. The only question presented is whether petitioner is entitled to deduct, as intangible drilling*912 and development costs, certain amounts paid to contractors for drilling oil wells.
FINDINGS OF FACT.
The petitioner is a Taxas corporation, engaged in the business of producing and selling oil and gas. During 1935, 1936, and 1937 the petitioner caused 18 oil wells to be drilled on its properties under contracts hereinafter described.
On July 22, 1935, the petitioner, designated as party of the first part, and F. H. Brown, designated as party of the second part, executed a written agreement relative to the drilling of an oil and gas well in Rusk County, Texas, which provided in part as follows:
IT IS THEREFORE, mutually agreed between the parties hereto that Second Party, F. H. Brown, will drill and complete said well, furnishing the drilling rig and machinery, the labor and carry workmen's compensation insurance, the surface casing, and the permanent long string of casing to be new seven inch (7") O.D. seamless and two inch (2") upset tubing and christmas tree, necessary cement for the surface casing and two hundred and twenty-five (225) sacks for the long string of casing, and pay the cost for the cementing of said well, the derrick and slush pit; and that First Party*913 will furnish the fuel and water, storage tanks and connections; and that said Second Party will commence the drilling of said well immediately and drill the same in a good and workmanlike manner with due diligence, furnishing the materials and supplies hereinbefore mentioned, and which said material and supplies used in the drilling and equipping of said well shall be subject to the approval of the First Party; and, likewise First Party will furnish the water and fuel on said well, as well as the storage tanks, connections and other material necessary and incident to the drilling and completing of said well other than that which Second Party has herein obligated himself to furnish. Second Party will do all of said work in a good and workmanlike manner and with reasonable diligence. He shall keep a straight hole, nor varying more than five degrees from vertical and take at lease three bottle tests to determine if hole is straight.
In consideration of the drilling of said well, as hereinabove set forth and the furnishing of the materials, labor and other items provided for by the Second Party, the First Party agrees to pay to the Second Party out of the oil produced from*914 said well to be so drilled by the Second Party, the following amounts, to-wit:
For all well equipment, including surface casing, tubing long string of casing, and other well equipment; Five Thousand Five Hundred ($5,500.00) Dollars; for the necessary expense of drilling said well, labor, insurance, trucking, cement and cementing and other footage items, the sum of Five Thousand ($5,000.00) Dollars; for bonus for deferred payment, the sum of Two Thousand ($2,000.00) Dollars. This is an aggregate of Twelve Thousand Five Hundred ($12,500.00) Dollars for said well. These sums shall be paid to the second party as follows: The sum of Twenty five hundred ($2,500.00) Dollars cash on completion of said *1059 well, and the balance of Ten Thousand ($10,000.00) Dollars on said well out of seven-eights of the entire production from said well so drilled, equ pped and completed by the second party under the terms of this contracts. The second party shall be paid by the pipe line company or other purchaser of oil from said well to be drilled hereunder, the entire proceeds of the leasehold estate that is to say seve eights of the entire production of oil and gas from said well until*915 the second party has been paid for this well the aggregate of the items above listed (less the cash consideration, to-wit: The sum of Ten Thousand Dollars, from the proceeds of oil and gas produced, saved and marketed from said well.
On August 12, 1935, the parties to the above quoted agreement executed a supplement thereto wherein it was provided that the expression of the consideration as recited in the last quoted paragraph be amended so as to provide that "the real consideration was and is the sum of $6,500.00 for the equipment and $6,000.00 for the labor, insurance, drilling expense, etc., and making an aggregate of $12,500.00 for each well, and to be paid as is particularly set forth in said original contract."
During 1935 the well thus contracted for, being known as Taylor well No. 2, was drilled, equipped, and completed in accordance with the terms and conditions of the contracts as amended. During the same year six additional wells, Brittain well No. 3, and Maxwell wells Nos. 6, 7, 8, 9, and 10, were drilled, equipped, and completed for the petitioner by F. H. Brown under contracts containing substantially the same material provisions as contained in the contract of*916 July 22, 1935, as amended.
On October 22, 1935, the petitioner wrote a letter to the Producers Supply & Tool Co. relative to the drilling, equipping, and completing of four oil and gas wells upon two described tracts of land in Rusk County, Texas, which letter provided in part as follows:
We will furnish, at the location, water, fuel, tanks and flow lines.
You, at your expense, are to furnish slush pits, surface pipe, new casing, new tubing, casinghead hook up and connections, float shoe, casing ring, cement and cementing (fifty sacks for surface casing and two hundred sacks for oil string), and liner. You are to furnish all drilling equipment, labor, tools and supplies incident to the drilling of said well, carry workmen's compensation and public liability insurance.
You are to drill said wells in a first class, good and workmanlike manner, keeping same not more than five degrees from vertical, tests to be made of the straightness of the hole at least three times as the wells are drilled. You are to set the casing, drill the sell in, and run liner and tubing, all at your expense.
You are to also furnish for each well, a new steel, eighty-seven foot pump derrick which*917 is to remain over the well. In other words, you are to furnish four such derricks. Flooring and sills used during drilling are not to remain with derrick.
After the plug has been drilled, we will swab the well in.
These wells will be drilled to the Woodbine Sand found at 3600'-3650' and we will furnish a man to supervise the drilling of the sand area and the running of casing.
*1060 On the two wells to be drilled on the Crosbar-Maxwell 10 acre lease, you are to furnish and run new 7" 20# seamless casing and 2" 4.70# seamless up set tubing. In the two wells to be drilled on the Lambert 8 acre lease, you are to furnish new 5 3/16" 14# seamless casing and new 2" 4.70# seamless up set tubing.
For drilling and equipping, in the manner hereinabove set forth, the two wells on the Crosbar 10 acre lease, we agree to pay you for each well, the sum of $11,600.00. And for the drilling and completing of each of the two wells on the Lambert 8 acre lease, we agree to pay you the sum of $10,350.00.
* * *
You are to proceed with the drilling of these wells immediately, and to complete all four of them as speedily as same can be completed in a first class, good and workmanlike*918 manner.
If this proposition is satisfactory to you, then you may sign one copy of this letter and return it to us, and same shall constitute our contract.
The Producers Supply & Tool Co. accepted the terms and conditions set forth in the letter, and during 1935 two wells, Maxwell Nos. 11 and 12, were drilled in accordance with the terms and conditions thereof. During 1935 and 1936 nine additional wells, designated as Maxwell wells Nos. 13, 14, 15, 19, 20, 21, 23, 24, and 25, were drilled, equipped, and completed under an oral extension of the aforesaid agreement.
In accordance with the terms of the contracts the petitioner supplied the fuel and water used in the drilling of all the wells. All of the water and a portion of the fuel supplied was produced from its own oil and water wells. A portion of the fuel, to the extent of $1,097, was purchased from outside sources. Petitioner also incurred certain additional expenses in connection with the swabbing in of certain wells.
For the taxable years, the petitioner, in accordance with its consistent practice in prior years, elected to charge off all of its intangible drilling and development costs incurred in drilling operations. *919 On its returns for 1935, 1936, and 1937, it deducted, as intangible drilling and development costs, the respective amounts of $58,941.53, $71,635.85, and $5,951.53. Of those amounts the respondent disallowed a portion thereof for each year in the respective amounts of $34,917.24, $63,966.71, and $4,847.84. The amounts disallowed for 1936 and 1937 and the amount disallowed for 1935, except as hereafter stated, represented portions of the stipulated payments made by the petitioner to the drilling contractors under the contracts described above. Of the $34,917.24 disallowed for 1935, $1,644.54 represented amounts actually paid or incurred by petitioner for repairs and supplies, surveying and permits, swabbing and trucking, while $8.92 and $807.50 were apparently expended in connection with the drilling and completing of Taylor well No. 3 and Nathan well No. 2, respectively, which wells were not drilled under any of the contracts in evidence.
*1061 OPINION.
TURNER: That a completed oil well is a capital item seems to be well settled, *920 ; , affirming ; ; ; and : certiorari denied, , and certainly the rule is general, if not fundamental, that the cost of a capital asset, whether expended as purchase price or for construction, creation, or development, must be capitalized and may not be deducted as expense in determining gross income, unless definitely and clearly provided by statute or valid regulation. The income tax statutes contain no such provision for the deduction of any of the amounts expended in drilling and equipping oil wells, and if such expenditures are allowable as deductions, it is because they fall within the rovisions of article 23(m)-16 of Regulations 86 and 94, which has been recognized as valid and which reads in part as follows:
(a) (1) Option with respect to intangible drilling and development costs in general: All expenditures for wages, fuel, repairs, *921 hauling, supplies, etc., incident to and necessary for the drilling of wells and the preparation of wells for the production of oil or gas, may, at the option of the taxpayer, be deducted from gross income as an expense or charged to capital account. Such expenditures have for convenience been termed intangible drilling and development costs. * * * Drilling and development costs shall not be excepted from the option merely because they are incurred under a contract providing for the drilling of a well to an agreed depth, or depths, at an agreed price per foot or other unit of measurement.
The petitioner does not question the soundness of the decisions of the Board and the courts to the effect that payments made to a contractor under what are commonly known as turnkey contracts are not deductible under the above regulation. , and other cases previously cited. It is argued, however, that, since petitioner in the case of wells drilled by F. H. Brown agreed to furnish fuel, water, storage tanks, and connections and in the case of wells covered by the contract with the Producers Supply & Tool Co. was to furnish water, *922 fuel, tanks, flow lines, and a man to supervise the drilling of the sand area and the running of the casing, and also to swab in the wells, the said contracts are not turnkey contracts and therefore such portions of the amounts paid under those contracts as may be said to have covered the cost of intangibles are deductible. The sum and substance of petitioner's argument is that the test of deductibility of intangible drilling costs is whether the particular contract is a turnkey contract and not whether it falls within the letter and spirit of the regulation. No discussion is required to demonstrate the fallacy of such an argument. If any part of *1062 the amounts expended for drilling, equipping, and completing an oil well is to be deducted, it must meet the test of the statute and regulation, and it is not enough to say that such expenditures are deductible because the contract under which they were made is not, strictly speaking, a turnkey contract.
The contracts here were not contracts for the employment of labor and the purchase of various items of material and equipment but were contracts for the drilling and completing of oil wells. In other words, the petitioner*923 was contracting for a finished job and the mere fact that it agreed to furnish some of the items needed by the contractors for use in the operations does not convert the contracts here into contracts for the employment of labor and the purchase of equipment.
What was said in , is equally applicable here. In that case the court said:
* * * They cannot trace part of the price paid to a contractor for a capital asset of that kind through his hands and deduct as their ordinary business expense any part of the amount which the contractor paid for intangible drilling and development costs. It may be inequitable and seemingly harsh to allow one taxpayer to exercise the option where he purchases the material, employs workmen, and drills and equips the well, and to deny another taxpayer the privilege where he lets a turnkey contract for a completely drilled and fully equipped well for a fixed price. But taxation is a matter of statutes and valid regulations promulgated under authority of law. Equitable considerations are no warrant for courts to override governing statutes and regulations, to make insertions in their*924 provisions, or to supply omissions in them.
The petitioner argues that a segregation of costs can and should be made, and in support of that argument, points to the supplemental agreement with F. H. Brown under date of August 12, 1935, wherein it is stated that "the real consideration was and is the sum of $6,500.00 for the equipment and $6,000.00 for the labor, insurance, drilling exenses, etc., and making an aggregate of $12,500.00 for each well * * *." The original contract, dated July 22, 1935, had provided that of the aggregate amount of $12,500 to be paid, $5,500 was for equipment, $5,000 for labor, insurance, etc., and $2,000 was a bonus. With respect to the wells drilled by the Producers Supply & Tool Co., petitioner points out that the respondent's agent, in connection with his investigation of petitioner's liability herein, has made an allocation of the amounts paid for the various wells between equipment and intangible drilling costs and that the respondent may not now be heard to argue that the intangible drilling costs to petitioner are not determinable for the purpose of applying article 23(m)-16, supra. Such allocatation or segregation of costs is, in our opinion, *925 of no moment here. In practically all of the turnkey cases which have been called to our attention the parties have agreed upon an allocation of the amounts paid to the contractors between cost of equipment and intangible drilling *1063 costs and for all we know the allocation so made and agreed upon may have reflected in some instances the exact dollars and cents expended by the contractors for items of the same nature and character as those termed by the regulation as "intangible drilling and development costs." Nevertheless it was held in those cases that the amounts paid by the contractor for intangible drilling and development costs did not retain their identity for the purpose of applying article 23(m)-16 to the payments made by the taxpayer to the contractor. See particularly , and Similarly the contracts here were not contracts for the employment of labor and the purchase of supplies, material, and equipment. The relationship between the parties was not that of employer and employee, but that of independent contractors. The petitioner did not hire labor or buy*926 materials and supplies, but agreed to pay an independent contractor a stated sum for a finished job, leaving it to the contractor to make his own deal for labor and equipment, and the fact that the petitioner may have furnished some of the supplies and some items of equipment does not change the contracts so as to bring any portion of the amounts paid to the contractors within the provisions of article 23(m)-16.
The petitioner makes the further contention, relying strongly on , that the contracts here under consideration were footage contracts and that amounts allocable to intangible development and drilling costs are deductible under the last sentence of the excerpt previously quoted from article 23(m)-16. The claim that the contracts are footage contracts is based on the provision contained in the contract with the Producers Supply & Tool Co. to the effect that the wells were to be drilled to the Woodbine Sand found at "3600'-3650'" and testimony that the producing sand in the East Texas field could be estimated to within a few feet. Obviously those contracts were not footage contracts. In the I. Rudman case, the contractor was required*927 to drill "to a depth of 2,950 feet" and we said that "the contract was no less a 'footage' contract because it recited a total stipulated lump sum consideration for drilling to a depth of 2,950 feet instead of an agreed price per foot." The obligation here was to drill completed wells in a proven field, or to a designated sand, and not to a depth of so many feet, and the fact that the parties may have had a fairly definite idea as to the approximate depth of the producing sand and may have so indicated in the contracts does not make the contracts footage contracts.
Bearing in mind that the expenditures here in question constituted part of the costs to petitioner of capital assets, namely, completed oil wells, we find nothing in the statute, the decisions of the Board or the courts, or the regulation itself to justify any extension of article 23*1064 (m)-16, supra, to cover any part of the payments made to the contractors under contracts of the character here considered. It is accordingly our conclusion that no part of the amounts paid by petitioner to F. H. Brown or to Producers Supply & Tool Co. in respect of the wells described in our findings of fact constituted expenditures*928 by the petitioner for intangible drilling and development cost within the meaning of article 23(m)-16, supra, and the respondent is sustained in his disallowance of the deductions claimed therefor.
The respondent admits on brief that of the $34,917.24 disallowed as deductions for intangible drilling costs for 1935, the petitioner actually paid or incurred $652.44 for repairs and supplies, $414.60 for surveying and permits, $420 for swabbing, and $157.50 for trucking, a total of $1,644.54. Accordingly the petitioner was within its rights under the regulation in electing to deduct as expenses the items enumerated.
The petitioner presented no evidence relative to the contracts under which the Taylor well No. 3 and the Nathan well No. 2 were drilled, and on brief it presented no argument to contest the respondent's disallowance of the deductions claimed in respect of those two wells. The respondent's action is accordingly sustained.
An issue involving percentage depletion for the year 1935 has been abandoned by the petitioner. Another issue for 1935, involving the respondent's action in including in petitioner's income $1,093.15 representing the proceeds of oil produced*929 and paid over to petitioner's grantor under an oil and gas lease, has been abandoned by the respondent. The petitioner has abandoned another issue for 1937 involving allowance for depreciation on lease and well equipment.
Decision will be entered under Rule 50.