*1496 During the taxable year 1932 petitioner acquired working interests in certain oil and gas mining leases covering lands located in the State of Oklahoma. It thereafter assigned to others, as consideration for the drilling of wells and furnishing of materials and as security for loans, undivided fractional interests payable in oil if, as, and when produced and saved. Other interests of a future and contingent nature were also assigned. The interests retained by petitioner, and the income therefrom taxable to petitioner, determined from the evidence.
*482 This proceeding is for the redetermination of a deficiency in income tax for the year 1932 in the amount of $6,000.95, as originally determined by respondent in the deficiency notice. By amended answer respondent alleged that the true deficiency was $8,750.95, and asserted claim for such increase. The principal questions for decision are (a) whether or not petitioner is entitled to an additional expense deduction of $2,100, (b) whether or not respondent has correctly determined the amount of petitioner's*1497 share of production from two certain oil and gas mining leases, and (c) whether or not there was a final settlement of petitioner's tax liability in 1936, which precluded respondent from asserting a further deficiency.
FINDINGS OF FACT.
Petitioner is a corporation, organized under the laws of the State of Oklahoma on June 3, 1931. Its incorporators were Walter G. Johnson, B. F. Green, and Louis W. Pratt. During the year 1932 petitioner had income from two certain oil and gas mining leases, known as the Katy and Buchanan leases, and from the sale of oil purchased from other producers for resale.
Prior to June 3, 1931, the incorporators of petitioner had negotiated with the Missouri-Kansas-Texas Railroad Co. for an oil and gas lease on land owned by that company in Oklahoma City, Oklahoma. On June 17, 1931, the railroad company executed such lease in favor of petitioner, covering 5.37 acres. This is known as the Katy lease, and the lease contract contained the following pertinent provisions:
ARTICLE II.
This agreement shall remain in force for a period of five (5) years and as long thereafter as oil, gas, casinghead gas, casinghead gasoline or any of them is produced*1498 from said premises by Oil Company, its successors or assigns.
ARTICLE III.
Oil Company shall deliver to Railroad Company in shipping tanks on the premises the equal one-eighth (1/8) part of all oil produced and saved from such premises, at which point Railroad Company agrees to accept and remove the same currently as produced, or, at the option of the Railroad Company, Oil Company will deliver said one-eighth (1/8) of the oil to the credit of Railroad Company in the pipe line to which Oil Company may connect its wells, or pay Railroad Company for said one-eighth (1/8) the market price for oil of like grade and gravity prevailing in said locality on the day such oil is run into the pipe line, or into storage tanks.
ARTICLE IV.
Oil Company shall pay Railroad Company one-eighth (1/8) of the proceeds from the sale of the gas, as such, for gas from wells where gas only is found, and, where not sold, shall pay Fifty ($50.00) Dollars per annum as royalty *483 from each such well, and, while such royalty is so paid, such well shall be held to be a producing well under Article II hereof, Railroad Company shall have and is hereby given a prior right to take from gas wells*1499 on said premises by making its own connections at the wells, so much gas as Railroad Company requires for use as fuel in connection with its operations for railroad purposes on said premises, Railroad Company to pay Oil Company for all gas so taken by Railroad Company the market price for similar gas prevailing in said locality on the day such gas is taken by Railroad Company.
* * *
ARTICLE VI.
In addition to the one-eighth (1/8) of the oil to be delivered to the Railroad Company as provided in Article III hereof, it is agreed that if, when and in the event oil in paying quantities is found and produced on and from said premises, Oil Company will pay to Railroad Company the proceeds from the sale of one-fourth (1/4) of seven-eighths (7/8) of the oil produced, saved and marketed from said premises until the Railroad Company has been paid thereby the sum of Fifteen Thousand ($15,000.00) Dollars.
Later in the month of June 1931 petitioner and the railroad conpany entered into a supplemental agreement reading in part material here as follows:
The parties hereto have entered into an agreement in writing, dated the - day of June, 1931, wherein and whereby the Oil Company has*1500 agreed to prospect for and produce, if there found, in paying quantities, oil and/or gas from approximately 5.37 acres of land on the Railroad Company lying and being situate in * * * Oklahoma City, Oklahoma County, Oklahoma, as more particularly described in said agreement, upon the terms and conditions therein set forth. By Article VI of said agreement the Oil Company has agreed, in addition to the one-eighth (1/8th) of the oil to be delivered to the Railroad Company as provided in Article III, to pay to the Railroad Company the proceeds from the sale of one-fourth (1/4th) of seven-eighths (7/8ths) of the oil produced, saved and marketed from said premises until the Railroad Company has been thereby paid the sum of Fifteen Thousand Dollars ($15,000.00). The Oil Company desires to pay, and the Railroad Company desires to receive payment, for said one-fourth (1/4th) of seven-eighths (7/8ths) of the oil produced to the amount of Fifteen Thousand Dollars ($15,000.00) in fuel oil instead of in cash, and the purpose of this Supplemental Agreement is to provide for such payment in fuel oil.
AGREEMENT
It is, therefore, agreed by and between the parties hereto that in lieu of paying*1501 to the Railroad Company the proceeds from the sale of one-fourth (1/4th) of seven-eighths (7/8ths) of oil produced to the amount of Fifteen Thousand Dollars ($15,000.00) in cash, as provided in said Article VI, Oil Company shall deliver to Railroad Company in Railroad Company's storage tanks or tank cars at Oklahoma City, residuum fuel oil, conforming to Railroad Company's specifications for fuel oil, equal in value to the said one-fourth (1/4th) of seven-eighths (7/8ths) of the oil produced on the day the same is run into the pipe line with which the Oil Company may connect its wells. Said fuel oil shall be taken to have a value equal to sixty percent (60%) of the then established posted price of crude oil at Oklahoma City * * * and shall be delivered to the Railroad Company within one hundred and twenty (120) days after the completion of the well, if the allowable production from such well under proration regulations of *484 lawful authorities is sufficient to enable production of the required quantity within that period. * * *
Petitioner did not produce fuel oil, and fulfilled its supplemental agreement by purchasing fuel oil and turning it over to the railroad company.
*1502 Petitioner borrowed $20,000 from one Frank Russell, and on January 23, 1932, in connection with such loan, executed a written instrument entitled ASSIGNMENT OF OIL AND GAS LEASE, reading in pertinent part as follows:
WHEREAS, On the 17th day of June, 1931, a certain oil and gas mining lease was made and entered into by and between Missouri-Kansas-Texas Railroad Company, a Missouri corporation, Lessor, and Refiners Production Company, an Oklahoma Corporation, Lessee, covering the following described land in the County of Oklahoma and State of Oklahoma, to-wit:
* * *
WHEREAS, The said lease and all rights thereunder or incident thereto are now owned by Refiners Production Company, a corporation,
NOW, THEREFORE, For and in consideration of One Dollar (and other good and valuable considerations), the receipt of which is hereby acknowledged, the undersigned, the present owner of the said lease and all rights thereunder or incident thereto does hereby bargain, sell, transfer, assign and convey unto Frank Russell all of the right, title and interest of the original lessee and present owner in and to said lease and rights thereunder insofar as it covers an undivided one-fourth interest*1503 in the above described property; said undivided one-fourth interest to be held by Frank Russell until he shall have been paid the sum of $25,000.00 from all the proceeds of said undivided one-fourth interest of said oil and gas lease; and when said Frank Russell shall have received said $25,000.00 then, and in that event said undivided one-fourth interest shall revert to said Refiners Production Company, an Oklahoma corporation, and said Frank Russell shall have no further claim on said undivided one-fourth interest. It is definitely understood and agreed that Refiners Production Company shall in no way sell, mortgage, borrow money on, or obligate in any way said undivided one-fourth interest until said Frank Russell shall have received the sum of $25,000.00 * * *
This assignment shall be construed as a first mortgage for $25,000.00 on said undivided one-fourth interest of said oil and gas lease; and Refiners Production Company hereby warrant there are no claims or liens against this undivided one-fourth interest at the present time.
On March 10, 1932, petitioner (called owner) and the Hugh Hodges Drilling Co. (called contractor) entered into a drilling contract relating to the*1504 Katy lease covering 5.37 acres of land, hereinabove referred to, which contract contained the following provisions:
WHEREAS, the OWNER is the assignee of a certain oil and gas lease covering property situate in the City, County and State of Oklahoma, described as follows, to-wit:
* * *
WHEREAS, the OWNER has made application to the City of Oklahoma City for a permit to drill an oil and gas well upon said above described property, and the issuance of same has been authorized by the Board of Adjusters.
*485 NOW, THEREFORE, the CONTRACTOR agrees to drill an oil and gas well for the OWNER upon said premises and fully equip the said well and said leasehold and turn over to the OWNER said well and said leasehold fully completed and equipped for operation as a turn-key job within One Hundred Twenty (120) days from the date of the issuance of said permit, and the OWNER agrees to furnish the material and to pay the consideration hereinafter specified in the several amounts and according to mode, terms, times of payment and conditions mutually agreed upon as follows, to-wit:
OWNER shall furnish the permit for the drilling of said well and * * * shall furnish, at its own expense, *1505 all casing to be used in said well. * * *
OWNER for and in consideration of the performance by the CONTRACTOR of the work undertaken under this contract by CONTRACTOR agrees to pay to CONTRACTOR the agreed consideration of One Hundred Eighteen Thousand, Seven Hundred Fifty Dollars ($118,750.) payable as follows: Five Thousand Dollars ($5,000) cash when CONTRACTOR has erected derrick, receipt of which is hereby acknowledged; Ten Thousand Dollars ($10,000) cash when CONTRACTOR starts drilling and the balance of One Hundred Three Thousand, Seven Hundred Fifty Dollars ($103,750.) to be payable to the CONTRACTOR our of one-half (1/2) of seven-eighths (7/8ths) of the oil as and when thereafter produced for account of the working interest in said lease (which one-half of the working interest is equivalent to 0.4375% [sic] of the total oil produced from said well) the seven-eighths (7/8ths) working interest being the interest of the OWNER above named over and above the one-eighth (1/8th) royalty reserved to the lessor in said lease, of which payment in oil Ten Thousand Dollars ($10,000) is to be advanced when well is completed and oil is first run to tanks.
The title to the personal*1506 property constituting the permanent equipment of said lease furnished by CONTRACTOR shall remain and vest in CONTRACTOR until the contract price payable in cash and crude from said well shall be fully paid, when said title shall vest in the OWNER and CONTRACTOR shall thereupon execute a proper release and bill of sale of same to the owner.
Also, on March 10, 1932, the same date on which the foregoing drilling contract was executed, petitioner executed a written instrument captioned "ASSIGNMENT OF OIL RUNS TO SECURE PART PAYMENT OF DRILLING CONTRACT PRICE OUT OF OIL", reading in part as follows:
WHEREAS, REFINERS PRODUCTION COMPANY, a corporation of the State of Oklahoma, hereinafter called OWNER, has entered into a drilling contract with Hugh Hodges Drilling Company, an Oklahoma Corporation, hereinafter called Contractor, for the drilling of an oil and gas well upon the hereinabove described lease in Oklahoma City, Oklahoma, to be known as Katy Well #1, said contract bearing date of March 10, 1932;
* * *
Now, THEREFORE, for and in consideration of One Dollar ($1.00) in hand paid, the receipt of which is hereby acknowledged, and other good and valuable considerations, together*1507 with the conditions, covenants and agreements set forth and to be performed and kept by the parties hereto, their successors and assigns, in conformity to and compliance with the requirements of the said lease and drilling contract between the parties hereto and the said Owner doth hereby assign, set over and convey unto said Contractor, its successors and assigns an undivided one-half (1/2) of seven-eighths (7/8ths) of the oil as and when produced for the account of the working interest in said Katy Well #1, until the full amount of the consideration payable to the Contractor *486 for the drilling and equipping of said well has been paid, whereupon this assignment shall be void and have no further force or effect and said Contractor shall execute all necessary releases and satisfactions to discharge this assignment.
The Centrop Corporation, nominee of the North American Car Corporation, furnished a $200,000 bond required by Oklahoma City, and on March 10, 1932, petitioner and the Centorp Corporation executed an instrument pertaining to the Katy lease, designated "ASSIGNMENT", reading in part as follows:
WHEREAS, said REFINERS PRODUCTION COMPANY, hereinafter referred to*1508 as ASSIGNOR, is desirous of selling an undivided three-eighths (3/8) interest in and to seven-eighths (7/8) working interest of ASSIGNOR above named in and to the oil and gas mining lease hereinabove described and said oil and gas well known as Katy Well #1, being drilled thereon, upon the terms and conditions and for the consideration hereinafter stated, and CENTORP CORPORATION, hereinafter called CENTORP, is desirous of buying an undivided three-eighths (3/8ths) interest in said seven-eighths (7/8ths) working interest in said lease and said oil and gas well known as Katy Well #1, Refiners Production Company,
NOW, THEREFORE, for and in consideration of the sum of One Dollar ($1.00) in hand paid by said above named CENTORP, receipt of which is hereby acknowledged, and other good and valuable considerations, including the furnishing by CENTORP of a bond in the sum of Two Hundred Thousand Dollars ($200,000) required by the City of Oklahoma City, Oklahoma, in connection with the permit for the drilling of said well, and the conditions, covenants and agreements hereinafter contained, set forth and to be performed and kept by the parties hereto, their successors and assigns, said ASSIGNOR*1509 doth hereby assign, set over, transfer and convey unto said CENTORP, its successors and assigns, an undivided three-eighths (3/8ths) interest in and to the seven-eighths (7/8ths) working interest in and to said oil and gas mining lease aforesaid, and said Katy Well #1, Refiners Production Company thereon, subject nevertheless to the payment out of one-quarter (1/4) of the oil produced and saved from the seven-eighths (7/8ths) working interest in said well the sum of Fifteen Thousand Dollars ($15,000) to the lessor, according to the terms of said lease, and subject also to the payment to the Contractor aforesaid of One Hundred and Three Thousand Seven Hundred and Fifty Dollars ($103,750.) out of one-half (1/2) of the oil produced and saved from the seven-eighths (7/8ths) working interest in said well; and subject also to the payment of three-eighths (3/8ths) of CENTORP'S proportionate share of the additional cost estimated for drilling and equipping said well out of the oil produced and saved from the remaining one-fourth (1/4) of the oil produced and saved from the seven-eighths working interest in said well, as, if and when produced therefrom.
The purpose and intent of this agreement*1510 is to transfer to CENTORP an undivided three-eighths (3/8ths) interest in the seven-eighths (7/8ths) working interest in said oil and gas mining lease and said Katy Well #1, Refiners Production Company, subject to the charge against said three-eighths (3/8ths) working interest hereby assigned of its proportionate three-eighths (3/8ths) share of the entire cost of said lease and the drilling and equipment of said well, but payable only out of CENTORP'S share in the oil produced and saved and sold therefrom, and ASSIGNOR is hereby authorized and directed to apply the proceeds of sale of CENTORP'S three-eighths (3/8ths) of the oil produced and saved from the seven-eighths (7/8ths) working interest in said well until the aforesaid *487 three-eighths (3/8ths) share of all costs of said lease and well and equipment thereof shall have been paid, and in the event that said Katy Well #1, should not produce oil or gas in paying quantities or sufficient to cover the cost of said lease and the drilling of said well then said CENTORP, its successors and assigns, will not be liable for any unpaid part or share thereof. Provided, however, that CENTORP shall be liable for its proportionate*1511 share of the cost of operation of said Katy Well #1, and ASSIGNOR is hereby appointed to act as Trustee or Agent for said CENTORP, its successors and assigns, until written notice terminating such authority is delivered or mailed by CENTORP to said ASSIGNOR, in reference to the operation, caring for, producing, storing and marketing oil and gas from said well, and shall have the power to do all things necessary and expedient in the management and operation of said property.
On October 31, 1931, petitioner acquired by assignment from C. L. Norris an oil and gas lease known as the Buchanan lease, covering certain tracts of land in Oklahoma City. Under the terms of the assignment, Norris retained a one-eighth overriding royalty.
On November 16, 1931, petitioner (called owner) and the Hugh Hodges Drilling Co. (called contractor), entered into a contract for the drilling of an oil and gas well on the land covered by the Buchanan lease, generally similar in its terms and conditions to the contract for the drilling of the well on the Katy lease, hereinabove referred to in detail. The contract relating to the Buchanan lease, briefly summarized, provided that the contractor should drill*1512 an oil and gas well on the described premises and turn same over to the owner fully completed and equipped for operation as turnkey job, the owner to furnish the permit for the drilling of the well and all casing to be used in the well. The contract further provided:
The OWNER for and in consideration of the performance by the CONTRACTOR of the work undertaken under this contract by CONTRACTOR agrees to pay to the CONTRACTOR the agreed consideration of One Hundred Fifteen Thousand Dollars ($115,000.00) payable as follows: $2500.00 cash when CONTRACTOR starts work; $2500.00 when surface casing is set; $2500.00 when the 9 inch string of casing is set; $2500.00 when the 6-5/8ths inch string of casing is set; $10,000.00 to be advanced against the balance of $105,000.00 when the well is completed and oil run to tanks, and the balance of $95,000.00 to be payable to the contractor out of five-eighths (5/8ths) of three-quarters (3/4ths) of the oil as and when thereafter produced for account of the working interest in said lease (which five-eighths working interest is equivalent to 0.46875% [sic] of the total oil produced from said well) which three-quarters working interest is the*1513 interest of the OWNER above named and above the one-eighth (1/8th) royalty reserved to the lessor in said lease, and the one-eighth (1/8th) over-riding royalty reserved to the assignor of this OWNER under her assignment of the said community leases.
Additional provisions respecting title to the personal property constituting the permanent equipment furnished by the contractor are substantially identical to those contained in the drilling contract relating to the Katy lease, above quoted.
On March 1, 1932, petitioner executed a written assignment of oil runs to the Hugh Hodges Drilling Co., pursuant to the terms of the *488 contract last above mentioned, which instrument recited that the owner did thereby assign, set over and convey to the contractor, its successors and assigns, "an undivided five-eighths (5/8ths) of three-fourths (3/4ths) of the oil as and when produced for the account of the working interest in said lease until the full amount of the consideration payable to the contractor for the drilling and equipping of said well" should be paid, whereupon this assignment should be void and the contractor should execute all necessary releases.
The Centorp Corporation*1514 furnished the casing for the well on the Buchanan lease, amounting to approximately $22,500, and also furnished a $200,000 bond required by Oklahoma City. In this connection, on February 17, 1932, petitioner (called assignor) and the Centorp Corporation (called Centorp) executed a written instrument designated "ASSIGNMENT," generally similar in its terms to the assignment relating to the Katy lease hereinabove quoted and referred to.
The assignment relating to the Buchanan lease provided that, for and in consideration of $1 and other good and valuable considerations, the assignor did thereby "assign, set over, transfer and convey unto said CENTORP, its successors and assigns, an undivided three-eighths (3/8ths) in and to the three-quarters (3/4ths) working interest in and to all the oil and gas mining leases aforesaid, and all rights thereunder or incident thereto, in so far as the same cover the above described real estate, including the drilling of said Buchanan Well #1."
The instrument further provided that Centorp should furnish and pay for all casing to be used in the Buchanan well, and the $200,000 bond to Oklahoma City; also to pay to the assignor and to C. L. Norris and*1515 the Hugh Hodges Drilling Co., as their interests might appear, $32,500 in oil out of three-sixteenths of the six-eighths working interest in the oil, as and when produced, from one-half of Centorp's interest in the leased premises. The purpose and intent of the agreement was to transfer to Centorp an undivided three-eighths interest in the six-eighths working interest in the leases and in Buchanan Well #1; one-half thereof or a three-sixteenths interest in such working interest being assigned in consideration of the furnishing by Centorp of the casing to be used in the well, and the furnishing by Centorp of the $200,000 bond to Oklahoma City; and the balance, or three-sixteenths interest in such working interest being assigned subject to the payment, out of the oil as and when produced and saved from such three-sixteenths working interest, of $32,500 as Centorp's agreed share of the remaining cost of drilling and equipping Buchanan Well #1, and in the event the well should not produce oil or gas sufficient to pay the cost of drilling, then *489 Centorp should not be liable for any part or share therof beyond its share of the oil or gas produced.
It was further provided, *1516 however, that Centorp should be liable for its full proportionate share of the cost of operating the well, and assignor was appointed to act as trustee and agent for Centorp (until such authority was terminated by written notice) in reference to the operation and management of the property.
On April 5, 1932, a special meeting of the directors of petitioner corporation was held, at which the directors ordered that assignments of nine-sixteenths interest in the working interest in the Buchanan and Katy leases should be executed by the president and secretary at that time to the three stockholders and directors of the company, or their nominees, in equal shares of three-sixteenths each, subject to the payment by the company of all obligations incurred in the acquisition and development of the leases theretofore made and entered into. In the minutes of the director's meeting it was stated that the nine-sixteenths interest so to be assigned to the stockholders and directors would consist of nine-sixteenths of the working interest in each of the leaseholds upon and after the payment and cancellation of the prior and outstanding obligations of the company, either absolute or conditional, *1517 given or reserved to secure payment of the cost of the leases and the development and equipment thereof, but that the assignees did not assumen any of such obligations and would acquire no beneficial interest under the proposed assignments except if, as, and when the obligations of the company were fully paid and satisfied in cash or out of oil produced, the obligations mentioned to include the sums reserved to the company's lessors or assignors and secured by existing assignments of fractional interests.
On April 7, 1932, in accordance with the foregoing authorization of petitioner's directors, assignments of future and contingent interests in the Katy and Buchanan leases were executed by petitioner, as assignor, to B. F. Green and/or wife, W. G. Johnson and/or wife, and to the Saybrook Corporation, nominee of Louis W. Pratt, as assignees. These assignments were to take effect so as to convey beneficial interests only when production of each of the wells had paid for the drilling, the casing, and the Frank Russell loan. Under the contractual arrangements between petitioner and the Hugh Hodges Drilling Co., the Centorp Corporation, the fee owner, and the overriding royalty interest*1518 of Norris, all of the income from both the Katy and Buchanan leases in 1932 was entirely absorbed, so that there was no income for that year to distribute to the assignees of the future and contingent interests.
The gross production from the seven-eighths working interest in the Katy lease during the year 1932 amounted to $58,969.92, and the *490 gross production from the three-fourths working interest in the Buchanan lease during the same year amounted to $21,915.52.
From the production from the working interest in the Katy lease in 1932, the Hugh Hodges Drilling Co. received one-half or $29,484.96, and petitioner received one-half, or the same amount, as its own income. Out of its share of such income petitioner paid to Frank Russell $2,966.55 on the loan of $20,000, and also purchased fuel oil which it turned over to the railroad company, lessor, in lieu of the $15,000 oil payment or bonus under the supplemental agreement hereinabove referred to, which was thereby paid up in full.
From the production from the working interest in the Buchanan lease in 1932 the Hugh Hodges Drilling Co. received five-eighths or $13,697.20; the Centorp Corporation received three-sixteenths*1519 or $4,109.16; and petitioner received three-sixteenths or $4,109.16 as its own income.
In its original income tax return for 1932 petitioner reported gross income from the sale of oil in the amount of $254,613.29, which included $3,685.62 and $1,369.72 received by petitioner from the sale of oil from the Katy and Buchanan leases, respectively, on the basis of a one-sixteenth working interest. The balance of such gross income was derived from the sale of oil purchased from other producers for resale.
Upon audit of petitioner's income tax return for 1932 respondent increased petitioner's income from the Katy and Buchanan leases by $43,643.32, arrived at by treating as petitioner's income amounts referred to as "distributions" to the Centorp Corporation and the holders of future and contingent interests assigned under authority of petitioner's board of directors, hereinabove set out, in the total amount of $63,366.52, less percentage depletion of $19,723.20. The percentage depletion so deducted was 27 1/2 percent of $71,720.74 "total income."
In addition to increasing petitioner's income from the two leases in question, the deficiency of $6,000.95 determined by respondent in*1520 the deficiency letter was also based upon the disallowance of $2,100 of a deduction claimed in petitioner's original return in the amount of $4,200 on account of expenses paid to Pratt, Johnson, and Green, petitioner's stockholders and directors. The computation of the deficiency started with net income of $50,507.94 reported on an amended return filed by petitioner for the taxable year.
This expense deduction of $4,200 was the subject of a conference between petitioner's attorney and the Bureau of Internal Revenue at Washington on November 12 and 15, 1935. Inder date of December 20, 1935, the Deputy Commissioner addressed a letter to petitioner's attorney in which it was stated that expenses in the amount of $2,100, or one-half of the amount claimed, was held to be an allowable deduction *491 from gross income, and it was suggested that, if petitioner desired to effect a settlement of the case on that basis without the necessity for the issuance of a final notice of deficiency, it should execute and return the enclosed Form 870. Such form was designated "Waiver of Restrictions on Assessment and Collection of Deficiency in Tax" and stated on its face that it was not "a*1521 final closing agreement under Section 606 of the Revenue Act of 1928", and, therefore, did not preclude the assertion of a further deficiency in the manner provided by law should it subsequently be determined that additional tax was due. Petitioner executed Form 870 on December 31, 1935, and an additional tax of $288.75 was thereafter assessed and paid in January 1936, prior to the mailing of the deficiency notice on Paril 10, 1936.
OPINION.
HILL: The first question for decision in this case involves a deduction of $4,200 claimed by petitioner in its original return on account of expenses alleged to have been incurred and paid by petitioner's three stockholders and directors, and which was repaid to them by petitioner in equal amounts of $1,400 each. The Commissioner first proposed to disallow the entire amount of the claimed deduction, but, after conferences were held in the latter part of 1935, it was agreed between the parties that one-half of the amount should be allowed and that additional tax should be assessed and paid on the basis of the disallowance of one-half. Accordingly, on December 31, 1935, petitioner signed a waiver of restrictions on assessment and collection*1522 (Form 870) and an additional tax of $288.75 was assessed, which petitioner paid in January 1936, all prior to the mailing of the deficiency notice on April 10, 1936.
The deficiency here in controversy was computed by respondent as follows:
| Net income reported on amended return | $50,507.94 |
| Add: | |
| (1) One-half expenses paid Messrs. Pratt, Johnson and Green disallowed | 2,100.00 |
| (2) Income from Katy and Buchanan leases | 43,643.32 |
| Adjusted net income | 96,251.26 |
On brief petitioner contends that respondent's action in computing the deficiency results in the disallowance of that portion of the claimed deduction which was allowed in the settlement in 1935, and argues that "The settlement of the controversy by the allowance of $2,100.00 and the payment of the tax on the balance of $2,100.00 should be allowed to stand." In his brief respondent refers to the settlement in 1935, and says: "In view of the evidence, it is submitted that the allowance of $2,100 of the claimed deduction, and no more, is proper. This *492 will conform to the agreement of the parties reached before the mailing of the deficiency notice." Thus, it appears that the controversy here arises*1523 from the misconception by petitioner of the effect of respondent's computation of the present deficiency. This item in the full amount of $4,200 was claimed as a deduction in petitioner's original return, and no change in that respect is shown to have been made in the amended return. Therefore, since respondent started his computation of the deficiency with the net income shown on the amended return, it was necessary to add to such net income the amount of expenses theretofore disallowed. Otherwise, the deficiency would have reflected in effect an allowance of the entire deduction claimed, which petitioner does not here contend for. Respondent's determination on this point is approved.
Petitioner further contends that respondent was without lawful authority to determine the deficiency in controversy, in view of the agreed settlement of tax liability in 1935. Petitioner has cited no statute or other authority in support of its contention, and we find it is without merit. Form 870, which petitioner executed at the time mentioned, constituted merely a waiver of restrictions on assessment and collection of additional tax, and plainly stated on its face that it was not a final*1524 closing agreement under section 606 of the Revenue Act of 1928.
Petitioner also pleads that assessment and collection of the deficiency in controversy are barred by limitation. The statute applicable is section 275(a) of the Revenue Act of 1932, which provides that "the amount of income taxes imposed by this title shall be assessed within two years after the return was filed." Petitioner's return was not offered in evidence, and there is no proof in the record as to when it was filed. The burden is upon petitioner to prove the facts necessary to show that the period provided in the statute had expired prior to the mailing of the deficiency notice, and for lack of such proof its plea must be denied. ; ; ; ; ; .
The second and principal issue involves the amounts of income taxable to petitioner as its shares of production from the Katy and Buchanan oil and gas leases. *1525 Petitioner contends that it owned only one-sixteenth of the working interest of each lease, and so was taxable only on that proportion of the production, which it reported in its income tax return. Respondent takes the position that during the taxable year petitioner owned one-half of the working interest in the Katy lease and three-sixteenths of the working interest in the Buchanan lease. There is now no controversy respecting the amount *493 of the proceeds from production in the taxable year, since respondent accepts petitioner's own figures, which show that the total gross production from the seven-eighths working interest in the Katy lease was $58,969.92, and that the amount derived from the three-fourths working interest in the Buchanan lease was $21,915.52. Thus, the issue submitted requires us to determine only the amount or proportion of the gross production from each well which constitutes income taxable to petitioner.
We shall consider first the ownership of the working interest in the Katy lease during the taxable year. In its brief petitioner says that it erroneously reported in its amended return one-sixteenth of the proceeds from the working interest in*1526 the Katy well; that it was the agent or trustee only for the owners of fifteen-sixteenths of such working interest, and in fact distributed the entire taxable income for 1932 from the working interest to those legally entitled to it, that is, one-fourth to the railroad company as bonus for the lease, one-half to the drilling company under the drilling contract and assignments, and one-fourth to Frank Russell on his assignment as security for the repayment of a loan. The facts disclosed by the record, we think, do not support petitioner's contentions.
Under its original contract with the railroad company, the pertinent provisions of which are set out hereinabove, petitioner acquired a seven-eighths working interest in the Katy lease, subject to the provisions of article VI of the contract to the effect that, in addition to the one-eighth royalty reserved to the railroad company, that company should be paid the proceeds from the sale of one-fourth of seven-eighths of the oil produced until the sum of $15,000 had been paid thereby. However, the provisions respecting the payment of the bonus of $15,000 out of proceeds from the sale of oil were eliminated by a supplemental agreement*1527 subsequently entered into during 1931 between petitioner and the railroad company, whereby it was stipulated that in lieu of such payment out of oil petitioner should deliver fuel oil to the railroad company equal in value of one-fourth of seven-eighths of the oil produced on the day the same was run into the pipe line with which petitioner connected its well. Petitioner did not produce fuel oil, but during the taxable year purchased fuel oil in the amount agreed upon and delivered it to the reailroad company.
From the recital of the foregoing facts, we think it is clear that the railroad company owned no interest in the oil production so far as concerns the $15,000 bonus to be paid in fuel oil. The supplemental agreement was in lieu of the provisions of article VI of the original contract, pursuant to which the railroad company had acquired an oil payment of $15,000 out of one-fourth of seven-eighths of the gross production. Such oil payment the railroad company relinquished by the supplemental agreement and accepted in lieu thereof the promise of petitioner *494 to deliver fuel oil to the value of $15,000 in proportion to or as measured by the daily gross production*1528 of the well. The railroad company was not required to look to production from the Katy lease for payment of the $15,000 bonus, and petitioner was not required to purchase fuel oil out of the proceeds from such production. It could have discharged this obligation by the sue for that purpose of any funds available to it. Cf. , affirming . We conclude, therefore, that the income derived from the one-fourth of the seven-eighths working interest, mentioned in article VI of the contract above referred to, was taxable to petitioner. .
On March 10, 1932, petitioner entered into a contract with the Hugh Hodges Drilling Co. to drill an oil and gas well on the Katy lease, and as part consideration therefor transferred to the drilling company a one-half interest of the seven-eighths working interest thereof until $103,750 had been paid out of oil therefrom as and when produced. It follows that one-half of seven-eighths of the proceeds from production in the taxable year was not income to petitioner. *1529 . Cf. . The parties are in agreement on this point, and further discussion is deemed unnecessary.
However, petitioner contends that of the proceeds from the remaining one-half of seven-eighths of production from the Katy well, one-fourth was owned by Frank Russell. The evidence shows that petitioner borrowed $20,000 from Russell, and on June 17, 1931, executed an instrument entitled "Assignment of Oil and Gas Lease", which purported in terms to assign and convey to Russell a one-fourth of seven-eighths undivided interest in the Katy lease until he should have been paid the sum of $25,000 from the proceeds of such interest; but the instrument contained the further provision that, "This assignment shall be construed as a first mortgage of $25,000.00 on said undivided one-fourth interest of said oil and gas lease." This would indicate that the relation between petitioner and Russell was that of debtor and creditor. Such conclusion is further strengthened by the following extract quoted from the report of proceedings at the hearing:
The Member. * * * I take it, from this instrument*1530 here (the so-called assignment above mentioned), what has been read to me, and the testimony, it is probably security for the repayment of money. Is that what it is?
Mr. Pratt. [Petitioner's counsel.] Yes.
Mr. Marshall [Respondent's counsel]. The parties will admit that.
Under this construction of the so-called assignment, certainly Russell owned no present interest in the production of the Katy well during the taxable year. His interest was contingent; it was merely collateral security for the loan, and Russell had no enforceable interest unless *495 and until petitioner defaulted in the payment of its obligation. There is nothing in the record to indicate that Russell was to look to production of oil for repayment of the loan, and no part of the proceeds from such production constituted income taxable to him. He had no depletable interest therein during 1932. Hence, the proceeds from the one-fourth of the working interest in the lease mentioned in the Russell "assignment" was petitioner's income and taxable to it, whether or not petitioner paid over the whole or any portion thereof to Russell in satisfaction*1531 of its obligation to him.
Since the Hugh Hodges Drilling Co. owned one-half half of seven-eighths of the oil produced from the Katy well in 1932, the proceeds of which the parties now agree did not constitute income to petitioner, and neither the railroad company nor Frank Russell owned any interest in any portion of the oil produced, it follows that the remaining one-half of the proceeds, or the sum of $29,484.96, constituted income taxable to petitioner.
In this connection it is to be noted that there is no contention that any portion of the proceeds of production from the Katy well in the taxable year was either distributed or distributable to the Centorp Corporation or the other assignees of future and contingent interests referred to in our findings of fact above.
On October 31, 1931, petitioner acquired a three-fourths working interest in the Buchanan lease by assignment from C. L. Norris, the original lessors having retained a one-eighth royalty interest and Norris a one-eighth overriding royalty interest. On November 16, 1931, petitioner entered into a contract with the Hugh Hodges Drilling Co. for the drilling of a well on this lease, and as part payment therefor*1532 assigned on March 1, 1932, to the drilling company five-eighths of its three-fourths working interest until $95,000 had been paid out of oil as and when produced. The parties now agree that five-eighths of three-fourths of the proceeds from gross production from the Buchanan lease during 1932 was not income to petitioner. The question for decision is whether or not any portion of the proceeds from production of the remaining three-eighths of the three-fourths working interest was taxable to petitioner.
There is no contention that any portion of the income from the Buchanan well in 1932 was paid or payable to Green, Johnson, and Pratt, petitioner's stockholders and directors, under the assignments of future and contingent interests executed April 7, 1932. It is petitioner's contention that three-eighths of the proceeds from production, or the full amount remaining over and above that assigned to the drilling company, belonged to the Centorp Corporation and that no part thereof constituted income taxable to petitioner.
*496 Centorp furnished the casing for the Buchanan well, amounting to about $22,500, and also a bond of $200,000 required by Oklahoma City. In consideration*1533 therefor, petitioner assigned to Centorp on February 17, 1932, an undivided three-eighths of its three-fourths working interest, but the instrument evidencing such assignment specifically provided that three-sixteenths, or one-half of the interest so assigned, was subject to the payment out of oil, as and when produced and saved, of $32,500 of the cost of drilling and equipping the well. Since the total production during 1932 amounted to only $21,915.52, it is apparent that three-sixteenths, or one-half of the undivided interest assigned to Centrop, was during the taxable year a future and contingent interest, and that Centorp was the unconditional owner in that year of only a three-sixteenths interest in petitioner's three-fourths working interest. There being no other assignments, it follows that three-sixteenths of three-fourths working interest belonged to petitioner, and three-sixteenths of three-fourths of the proceeds from the gross production, or the amount of $4,109.16, was income taxable to petitioner. We so hold.
The amounts derived from gross production from the Katy and Buchanan leases which we hereinabove found to constitute income taxable to petitioner represent*1534 its total proportionate shares and will be reduced by the amounts reported as income from such sources by petitioner in its original or amended income tax returns for 1932. The deficiency will be recomputed accordingly.
Decision will be entered under Rule 50.