Hugh Hodges Drilling Co. v. Commissioner

HUGH HODGES DRILLING COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Hugh Hodges Drilling Co. v. Commissioner Docket Nos. 94782, 99115. United States Board of Tax Appeals 43 B.T.A. 1045; 1941 BTA LEXIS 1416; March 20, 1941, Promulgated *1416 During or prior to the taxable years 1934 and 1935, petitioner acquired various interests in oil and gas mining leases in consideration of the drilling and equipping of wells thereon. In some instances, petitioner acquired ownership of undivided fractional interests in the leaseholds; in others, petitioner acquired oil payment rights, that is, the right to receive a specified sum out of oil production; and in some instances, petitioner acquired an oil payment of an agreed amount, together with the ownership of a lesser undivided fractional interest in the leasehold thereafter. Some of the contracts contained words of assignment, while in other cases separate assignments of petitioner's interests were executed. In some of the assignments it was recited that the conveyance was intended as security to insure payment of the deferred amounts. However, in respect of all the leases, petitioner was required to look solely to the oil production for payment. Held that, in the case of each lease involved, petitioner acquired by investment an economic interest in the oil in place; that the amounts received therefrom during the taxable years constituted gross income to petitioner, upon*1417 which it is entitled to statutory allowances for depletion; that the consideration paid by petitioner for such interests consisted of the aggregate costs of drilling and equipping the wells; and that petitioner is not entitled to deduct intangible drilling expense, cost of equipment, or depreciation on lease equipment sustained or incurred prior to completion of the wells. Tom F. Carey, C.P.A., for the petitioner. J. E. Marshall, Esq., for the respondent. HILL *1046 These proceedings are for the redetermination of deficiencies in income and excess profits taxes determined by respondent to be due from petitioner as follows: Docket No. Year Income tax Excess-profits tax 94782 [1934] $8,007.18 $1,349.20 99115 [1935] 8,510.54 1,519.80 The issues presented for decision, generally stated, involve (a) the nature of the interests acquired by petitioner in numerous oil and gas leases for the drilling of wells thereon under drilling contracts and other instruments, and how income derived by petitioner therefrom should be treated for tax purposes; (b) whether certain intangible drilling costs are deductible as expense, or*1418 whether such costs must be capitalized and recovered through depletion; (c) whether petitioner is entitled to additional depreciation on equipment used on some of the leases; and (d) whether or not depreciation sustained on drilling tools in some instances should be capitalized. Petitioner also alleges that the statute levying the excess profits tax is unconstitutional and void. FINDINGS OF FACT. Petitioner is a corporation, organized under the laws of the State of Oklahoma on November 18, 1931, and during the years 1934 and 1935 it was engaged in business as an oil well drilling contractor. In connection with its drilling operations, petitioner at times entered into contracts for the drilling of oil wells from which it received or was to receive a share of the oil produced. Petitioner's books of account were not kept strictly on the basis of cash receipts and disbursements, nor strictly on an accrual basis; *1047 no receivables were accrued; cash receipts were recorded in the month in which received, while costs or items of expenditures were recorded as incurred. Petitioner filed its income tax returns for 1934 and 1935 purportedly on the basis of cash receipts*1419 and disbursements. These returns did not show items of gross income or deductions on their face, but the return for 1934 disclosed a net loss of $44,471.30, and the return for 1935 reflected a net loss of $43,006.98, taken from an "income and profit and loss statement" attached to the respective returns. Inventories were not used in determining income. Buchanan Lease. On November 16, 1931, petitioner (called contractor) entered into an agreement with the Refiners Production Co. (called owner) to drill an oil and gas well, fully completed and equipped for operation as a turnkey job, on a certain community oil and gas lease known as the Buchanan lease, covering lands located in Oklahoma City, Oklahoma, upon the terms and for the consideration set forth in the agreement, reading in material part as follows: The CONTRACTOR agrees to drill an oil and gas well for OWNER upon said premises and fully complete and equip 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, * * * * * * The OWNER for and in consideration of the performance by the CONTRACTOR of the work undertaken under*1420 this contract by CONTRACTOR agrees to pay to the CONTRACTOR the agreed consideration of One Hundred Fifteen Thousand Dollars ($115,000), 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) when the well is completed and oil run to tanks, and the balance of $95,000 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% of the total oil produced from said well) which three-quarters working interest is the interest of OWNER above named over 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. The title to the personal property constituting the permanent equipment of said lease furnished by CONTRACTOR shall remain and vest in*1421 CONTRACTOR until the contract price payable in cash and crude production 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 the same to the OWNER. On March 1, 1932, the Refiners Production Co. executed an instrument reading in part pertinent here as follows: WHEREAS, REFINERS PRODUCTION COMPANY, a corporation of the State of Oklahoma, hereinafter called OWNER, has entered into a drilling contract with *1048 HUGH HODGES DRILLING COMPANY, an Oklahoma Corporation, hereinafter called CONTRACTOR, for the drilling of an oil and gas well on said community leases covering Block 11, South Highlands Addition to Oklahoma City, to be known as Buchanan #1, said contract bearing date November 16, 1931; and WHEREAS, said OWNER has on this 1st day of March, 1932, executed and delivered to daid CONTRACTOR an assignment of oil runs to secure the payment of that portion of the consideration to be paid by the OWNER to the CONTRACTOR for the drilling and equipping of said oil and gas well out of oil as and when the same shall be produced from the said well, said agreement setting forth in*1422 detail the terms and conditions of said oil payment to be made out of five-eighths (5/8ths) of three-fourths (3/4ths) of the oil as and when produced for the account of the working interest in the above described lease (which fiveeighths interest is equivalent to 0.46875% of the total oil produced from said well) and which said drilling contract and assignment are hereby made a part of this assignment as fully as if set forth herein in full, and WHEREAS, for the further security of said CONTRACTOR the OWNER has agreed to and with the CONTRACTOR to assign to said CONTRACTOR 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 amount of the contract price, payable in crude, for the drilling of said well has been fully paid. 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 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*1423 said lease and drilling contract between the parties hereto the said OWNER doth hereby assign, set over and convey unto said 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 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. For drilling the well on the Buchanan lease, fully completed and equipped for operation as a turnkey job, petitioner acquired an oil payment of $95,000, payable out of five-eighths of three-fourths of the oil as and when thereafter produced. Petitioner expended, during the years 1931 and 1932, the sum of $40,961,63 in drilling and equipping this well, and the well began production in 1932. During the year 1934 petitioner received the sum of $15,213.52 from the sale of oil from its fractional interest in the oil production of the Buchanan lease. During the year 1935, *1424 petitioner received the sum of $26,541.69 from the same source. Knowles Lease. On Januray 28, 1933, petitioner entered into a contract with J. F. Lucey, ancillary receiver of National Securities Oil Co., to drill two wells on a certain lease known as the Knowles lease, covering 7.16 *1049 acres in the Mary Van Winkle Survey in the city of Kilgore, Texas, such contract reading in material part as follows: Said drillers agree to drill said wells for the production of oil to the necessary depth of approximately 3700 feet or to the woodbine sand, and to finish the same in every respect whatsoever in a first class workmanlike manner as fully completed oil wells into the tanks. * * * The contract price for said completed wells is to be the sum of forty eight thousand ($48,000.) dollars, to be paid out of the proceeds of all of sevensixteenths (7/16ths) of the total oil runs from said wells Nos. 2 and 3. * * * Receiver agrees to operate said wells continuously, failing which such drillers shall have the right to operate said wells until full payment to them of all sums hereinbefore provided and repayment to them of the reasonable cost of such operation, excluding*1425 any over-head charge. For drilling and completing the two wells on the Knowles lease, petitioner acquired an oil payment of $48,000, payable out of the proceeds of all of seven-sixteenths of the total oil runs from said wells. Petitioner expended during the year 1933 the sum of $18,475.50 in drilling and completing the wells on the Knowles lease, and the wells began production in 1933. During the year 1934, petitioner received the sum of $5,987.87 paid out of the proceeds of the fractional interest of the total oil runs from the wells drilled on the Knowles lease. During the year 1935, petitioner received the sum of $4,707.22 paid out of the proceeds of the fractional interest of total oil runs from the wells on the same lease. Burroughs Lease. On January 31, 1933, petitioner (called second party) entered into a contract with the Refiners Production Co. (called first party) to drill an oil and gas well, fully completed and equipped for operation as a turnkey job, on a certain oil and gas lease known as the Burroughs lease, covering land located in Oklahoma City, Oklahoma, upon the terms and for the consideration set forth in the agreement, the material provisions*1426 of which are as follows: In consideration of all of which, first party on its part agrees as follows: * * * (b) First party agrees to pay second party the sum of One Hundred and Fifty-eight Thousand ($158,000.00) Dollars therefor, payable out of 3/4ths of 7/8ths of the oil as and when produced therefrom. (c) It is further agreed that the title to the personal property constituting the permanent equipment on said lease, furnished by second party, shall be and remain and vest in second party until the full contract price aforesaid has been fully paid, after which, second party shall execute release of this contract and title shall thereupon automatically vest in first party. * * * *1050 Under date of January 31, 1933, the Refiners Production Co. executed an instrument entitled "ASSIGNMENT OF OIL RUNS TO SECURE PAYMENT OF DRILLING CONTRACT PRICE OUT OF OIL", reading in material part as follows: WHEREAS, on the 31st of January, 1933, a certain drilling contract was entered into by and between Refiners Production Company, a corporation, and Hugh Hodges Drilling Company, a corporation, providing for the drilling and equipping an oil and gas well on the above described*1427 premises; and WHEREAS, the said Hugh Hodges Drilling Company has now completed said well in accordance with the terms of the afore-mentioned drilling contract and is entitled to be paid under said drilling contract the sum of One Hundred Fiftyeight Thousand ($158,000.00) Dollars, payable out of three-fourths (3/4) of seven-eighths (7/8) of the oil as and when produced from said well. Now THEREFORE, for and in consideration of One ($1.00) Dollar in hand paid, the receipt of which is hereby acknowledged, and other good and valuable consideration, REFINERS PRODUCTION COMPANY does hereby assign, set over and convey unto HUGH HODGES DRILLING COMPANY, its successors and assigns an undivided three-fourths (3/4) of seven-eighths (7/8) of the oil as and when produced from the said well until the full sum of One Hundred Fifty-eight Thousand ($158,000.00) Dollars has been paid, whereupon this assignment shall be void and have no further force or effect and said Hugh Hodges Drilling Company shall execute all necessary releases and satisfactions to discharge this assignment. For drilling the well on the Burroughs lease, fully equipped for operation as a turnkey job, petitioner acquired*1428 an oil payment of $158,000, payable out of three-fourths of seven-eighths of the oil, as and when produced therefrom. Petitioner expended the sum of $42,103.70 during 1933 in drilling the well on the Burroughs lease, and the well began production in 1933. During the year 1934 petitioner received the sum of $16,374.21 from its fractional part of the oil as and when produced from the Burroughs lease, and during the year 1935 received from the same source the sum of $14,882.60. Day-Roff Lease. On September 23, 1929, C. L. Roff and wife, as lessors, and T. B. Slick, as lessee, executed an oil and gas lease known as the Day-Roff lease, covering land located in Oklahoma County, Oklahoma. The lease was to remain in force for a term of not less than 10 years, and the lessors retained a one-eighth royalty interest. Ralph W. Day later acquired the rights of the lessee under this lease. On February 2, 1933, petitioner (called contractor) entered into an agreement with Ralph W. Day (called operator) to drill, at petitioner's sole cost and expense, an oil and gas well as a completed turnkey job on the Day-Roff lease, upon the terms and for the *1051 consideration set*1429 forth in the agreement, reading in material part as follows: FIFTH: If and when Contractor has drilled, cased and completed a producing well as a complete "turn-key" job, Contractor shall be entitled to receive, as full contract price hereunder, (a) All the oil and/or gas out of 3/4ths of the 7/8ths working interest oil and/or gas, if, as and when produced, saved and sold from said leased premises, commencing with the date of first production, until the sum of Eighty-four Thousand ($84,000.00) Dollars shall have been run to the credit of the Contractor into the purchasing pipe line company. Both parties hereto shall execute such division orders, transfer orders or other documents required by the purchasing pipe line company to run this production direct to the credit of the Contractor until said well has produced from said 3/4ths of the 7/8ths working interest the sum of Eighty-four Thousand ($84,000.00) Dollars. (b) When said well shall have produced oil and/or gas in the sum of Eighty-four Thousand ($84,000.00) Dollars, and run to the credit of the Contractor, out of 3/4ths of the 7/8ths working interest oil and/or gas, as and when produced, saved and sold from the leased*1430 premises, then the Contractor shall be entitled to an undivided 3/8ths vested interest in said oil and gas lease covering said land, which interest is evidenced by an assignment from the Operator to the Contractor, of even date herewith and made a part hereof. SIXTH: Afther completion of said well as a "turn-key" job, as herein provided, the Contractor shall pay 3/4ths of the operating cost and expense of the leased premises and well, and the Operator shall pay 1/4th of such cost and expense during the period of time required for this well to run to the credit of the Contractor into the purchasing pipe line the sum of $84,000.00 out of 3/4ths of the 7/8ths working interest; but the Contractor shall have sole management of operations of the leased premises during this period. The operating expense always shall be the actual cost necessary and required to operate said leased premises according to the best customs of the business, and shall be mutually agreed upon between the Contractor and the Operator, and there shall be no charge for salaries, overhead and office expense during this period. The Operator, his agent or employees shall at all times have the right and privilege to*1431 go upon the leased premises for all purposes, and the Contractor shall account to Operator, upon request, for all products produced, saved and sold and shall furnish duplicate run tickets to Operator, without charge, as and when oil and/or gas is run. SEVENTH: In the event said well fails to produce a sufficient amount of oil and/or gas to be run to the credit of the Contractor in the purchasing pipe line to the amount of $84,000.00 out of 3/4ths of the 7/8ths working interest, the Contractor shall be entitled to 3/4ths of the 7/8ths working interest oil and/or gas actually produced, saved and sold from said property; and in the event no production is obtained the Operator and the leased premises shall not be obligated to pay the Contractor any sum or sums whatsoever, and in such event the Contractor shall own and have all the equipment, paraphernalia and salvage of the leased premises. EIGHTH: If, as and when said well has produced oil and/or gas in the amount of $84,000.00 out of 3/4ths of the 7/8ths working interest to the credit of the Contractor in the purchasing pipe line, then the leased premises shall be under the joint management of the Operator and Contractor, and the*1432 operating cost and expense of the well and leased premises during the continuance and life of said lease shall be borne proportionately by the respective working interests of record in the leased premises and/or be paid by the respective owners thereof. *1052 On February 2, 1933, Ralph W. Day executed an instrument entitled "ASSIGNMENT OF INTEREST IN OIL AND GAS LEASE," reading in material part as follows: WHEREAS, The said lease and all rights thereunder or incident thereto are now owned by Ralph W. Day of Oklahoma City, Oklahoma 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 Hugh Hodges Drilling Company, (an Oklahoma corporation), an undivided present owner in and to said lease and rights thereunder insofar as it covers present owner in and to said lease and rights thereunder insofar asit covers the land above described - together with three-eighths (3/8ths) of the personal property used or obtained in connection*1433 therewith to Hugh Hodges Drilling Company, its successors and assigns, subject to Contract between Assignor and Assignee herein, of even date herewith and made a part hereof, as though fully incorporated herein. And for the same consideration, the undersigned for himself and his heirs successors and representatives does covenant with the said assignee its successors or assigns that he is the lawful owner of the said lease and rights and interests thereunder and of the personal property thereon or used in connection therewith; that the undersigned has good right and authority to sell and convey the same, and that said rights, interests and property herein conveyed are free and clear from all liens and incumbrances, and that all rentals and royalties due and payable thereunder have been duly paid. For drilling a well on the Day-Roff lease, as a fully completed turnkey job, petitioner acquired a three-fourths of seven-eighths working interest in the lease until $84,000.00 had been run to the credit of petitioner into purchasing pipe line company, and an undivided three-eighths of the seven-eighths working interest thereafter. The well was completed as a turnkey job in January 1934*1434 and began production in the same year. Before production was begun petitioner assigned one-tenth of its working interest to Neal Day, which reduced its $84,000 share of gross production to $75,600, and on February 1, 1934, the owners of the working interest executed a division order, reciting the working interest of each to be as follows: Slick-Urschel Oil Company, 1/8 until it has been paid. $12,500.00 less gross production tax, then 1/4 until it has been paid the further sum of $50,000.00, less gross production tax. Ralph W. Day 1/8 until $12,500.00, less gross production tax, has been paid out of 1/8, then none until $84,000.00 has been paid out of 3/4 of 7/8, then 3/8 until the oil payment of Slick-Urschel Oil Company, above set out, is paid, then 5/8. Hugh Hodges Drilling Company 27/40 until it has been paid the sum of $75,600.00, then 3/8. Neal Day 3/40 until he has received the sum of $8,400.00. Petitioner expended the sum of $62,263.21 as cost of drilling and completing the well on the Day-Roff lease prior to the beginning of production in 1934, of which amount $36,188.64 represented intangible *1053 drilling expense and $26,074.57 represented cost of*1435 equipment. After completion of the well and during the year 1934, petitioner paid operating expenses in the amount of $6,366.07, and also paid $8,816.61 for additional pumping equipment. During the year 1934, petitioner received the sum of $58,761.27 out of oil from its interest in the Day-Roff lease. During the year 1935 petitioner incurred and paid operating expenses in connection with the Day-Roff lease in the amount of $7,546.89, and received the sum of $28,586.27 from its fractional working interest therein. Davis Lease. On June 21, 1933, petitioner (called second party) entered into an agreement with the Beverly Hills Oil & Gas Co., an Oklahoma corporation (called first party), to drill and equip at its own expense an oil and gas well on an oil and gas mining lease known as the Davis lease, covering land situated in Oklahoma County, Oklahoma, which agreement provided in material part as follows: IN CONSIDERATION of all of which, first party further agrees and binds itself, its heirs, executors and assigns, that second party shall have and receive the sum of Eighty Thousand Dollars ($80,000.00) to be paid out of Three eighths (3/8ths) of Seven-eighths (7/8ths) *1436 working interest in and to said leasehold and the production of oil and/or gas due from them, same to be held by second party until it shall have received the net sum of Eighty Thousand Dollars ($80,000) thereof with no reduction on account of gross production tax thereon. It is understood between parties hereto that the party of first part has entered into a contract with the Monarch Derrick Company for the derrick now on the above described property, wherein the Monarch Derrick Company is to receive Twenty-six hundred dollars ($2600.00), payable from one-sixteenth (1/16th) of all the oil produced until said Twenty-six Hundred Dollars ($2600.00) has been paid; and party of second part hereby agrees to accept said derrick and to deduct this said Twenty-six Hundred Dollars ($2600.00) from its Eighty Thousand Dollars ($80,000.00) and set over and assign the said One-sixteenth (1/16th) interest to the Monarch Derrick Company from the interest conveyed to it. It is further agreed that upon completion of said sell that it shall be operated jointly by the parties hereto until the aforesaid oil payment of Eighty Thousand Dollars ($80,000.00) has been fully paid second party, after which*1437 time the entire control and operation thereof shall be returned to first party, and that all material and equipment (other than the drilling tools and equipment of second party) located on said lease which have been used in the operation of said well, shall be and become the absolute property of said first party. It is agreed that during said joint operation of said well that the operating cost of said well shall be limited to the actual operating cost and shall not include any office or official supervision or expense other than the employees actually necessary to do the work upon the lease, and that the books and records shall be kept in the office of the first party, which shall be available to the inspection of secong party at all reasonable times. First party further agrees that at any time after the execution of this contract that should second party deem it necessary to have an assignment in addition to the one herein to cover the oil payment, that they will execute and deliver immediately a valid assignment covering the oil payment aforesaid. *1054 It is further agreed that until the completion of said well, second party shall have the full and complete control*1438 of the operation and management of said leasehold estate, of the drilling, equipping, and completion of said well without any right of interference on the part of first party therewith, except in furnishing of the surface pipe, casing, separator and tanks. In further consideration of the premises, first party agrees to pay second party the sum of Twenty-two Thousand Five Hundred Dollars ($22,500.00) in cash. The payment of $600.00 previously made by Beverly Hills Oil and Gas Company, a Business Trust, to party of second part, covering the construction and erection of a derrick, etc., is to be deducted from the Twenty-two Thousand Five Hundred Dollars ($22,500.00). It is further agreed that the following payments will be made: On moving in of tools and rigging up $1,000.00 When surface pipe is cemented 2,500.00 Upon drilling first 2500 feet 4,000.00 Upon drilling first 4000 feet 5,000.00 Upon drilling first 6000 feet 2,500.00 On completion of well, the balance 6,900.00 Party of first part agrees that upon request of party of second part the Sixth-nine Hundred Dollars ($6900.00) above mentioned, will be placed in the First National Bank in escrow, *1439 to guarantee the payment upon completion of the well. It is further agreed, however, that there is no personal liability upon first party to pay in cash any sums of money for work, labor or material, other than hereinbefore provided. On October 7, 1933, Beverly Hills Oil & Gas Co. executed an instrument entitled "ASSIGNMENT OF OIL AND GAS LEASE," reading in material part as follows: WHEREAS, Beverly Hills Oil and Gas Company desires to make an assignment as security for the payment of said sum of Eighty Thousand ($80,000.00) Dollars out of three-eighths of seven-eighths working interest in said well, Now, THEREFORE, in consideration of the sum of One ($1.00) Dollar in hand paid and for other good and valuable consideration, receipt of which is hereby acknowledged, and in compliance with the provisions of said contracts, Beverly Hills Oil and Gas Company, a corporation, does hereby bargain, sell, transfer, assign and convey unto Hugh Hodges Drilling Company, a corporation, three-eighths of seven-eighths working interest in and to said lease insofar as it covers the well known as Davis No. 1 and the oil and/or gas that may be produced therefrom, being equivalent to 84/256 of*1440 all of the oil and/or gas produced from said well, as security for the payment of said sum of Eighty Thousand ($80,000.00) Dollars, it being understood that Hugh Hodges Drilling Company will from time to time reimburse Beverly Hills Oil and Gas Company for all payments that may be made by or through said company or on account of the payments to it out of 1/16 of the oil and gas produced from said well until said total payments shall amount to Twenty-six Hundred ($2600.00) Dollars, and thereafter no further reimbursement payments shall be made to said Beverly Hills Oil and Gas Company; and that said total indebtedness of Eighty Thousand ($80,000.00) Dollars shall be payable only out of said net working interest hereby assigned and transferred, after the payment of the proper proportionate part of the expenses of equipping and operating said well and producing the oil and/or gas therefrom, that may be properly chargeable to said interest, subject, however, *1055 to the provisions of said contract of June 21, 1933, in reference to the payment of expenses, and after said sum of money shall have been paid, this assignment shall become null and void. TO HAVE AND TO HOLD the same*1441 unto the said High Hodges Drilling Company, a corporation, its successors and assigns forever, under the terms and conditions herein stated. For drilling and equipping the well on the Davis lease, petitioner acquired a three-eighths of seven-eighths working interest in the lease until such interest netted petitioner the sum of $80,000. During the year 1933 petitioner expended $23,958.29 in drilling and equipping the well on the Davis lease; and the well began production in 1933. The further consideration of $22,500, mentioned in the agreement above set out, was paid during the year 1933. During the year 1934 petitioner received $16,039.97 from the sale of oil from the Davis lease, and paid operating expenses of $9,677.76. During the year 1935, petitioner received $7,505.96 from its interest in the Davis lease, and paid operating expenses of $2,232.62. Rucker No. 8 Lease. On November 9, 1933, petitioner (called second party) entered into a contract, designated "DRILLING CONTRACT AND OIL ASSIGNMENT," with the Gulf Production Corporation (called first party) to drill and equip an oil and gas well on a certain oil and gas lease known as the Rucker No. 8 lease, which*1442 agreement provided in part as follows: First party covenants that it is the sole owner of twelve-sixteenths of the seven-eighths working interest of the leasehold estate hereinafer conveyed, free and clear of all assignments, charges, liens or encumbrances of any kind or character whatsoever, and does warrant the title thereto as herein assigned and agrees at all times, forever, to defend the title to second party, its successors and assigns, and that until payment in full of said $200,000.00, to second party, that it will not drill or permit to be drilled, any other well on any part of the within described premises. * * * IN CONSIDERATION of all of which, first party doth covenant and agree to pay second party the first $200,000.00 income derived from the sale of oil and/or gas produced from the 12/16ths of the 7/8ths working interest of and in said leasehold estate and the well to be drilled thereon; and to insure and protest second party in the payment thereof, said first party doth hereby assign and transfer and set over unto second party all of the income and proceeds from the 12/16ths of the 7/8ths working interest in and to said leasehold and the production of oil and/or*1443 gas therefrom; the same to be had, held, and retained by second party until it shall have received the net sum of $200,000.00, therefrom, without deduction on account of gross production tax thereon. It is agreed in this connection, however, that there shall be first deducted from the gross income of the entire 7/8ths of said production the necessary and reasonable operating expenses of said well but that thereafter second party will receive the entire income and/or production from the full 12/16ths of the 7/8ths working interest in said well until it has been entirely paid the aforesaid sum of $200,000.00 net. *1056 IT IS FURTHER AGREED that until the completion of said well, that second party shall have the full and complete control, operation and management of said leasehold estate, (without any right of interference on the part of the first party in connection therewith) in the drilling and equipping of said well. It is agreed, however, that as soon as said well is completed, equipped and on production, that the same shall thereafter be jointly operated by the parties hereto, which joint operation shall remain and continue until second party shall have received from*1444 said well the net sum of $200,000.00, as aforesaid. The operating expenses, however, shall not include any salaries or superintendence to either of the parties hereto, but shall include only the actual labor, expense and material thereon. IN IS FURTHER, AGREED that there is no personal liability of first party to pay in cash any sums of money for the work, labor and equipment undertaken herein by second party other than as may be herein expressly provided. IT IS FURTHER AGREED that in case said well is not completed for any reason or is a dry hole, that second party reserves the right and is hereby granted the exclusive title to all equipment placed by it on said premises, and that it may remove the same therefrom free and discharged of any right, title or claim thereto of any kind on the part of the first party. For drilling and equipping a well on the Rucker No. 8 lease, petitioner acquired all the income and proceeds from twelve-sixteenths of seven-eighths working interest until it had been paid the net sum of $200,000, without deduction of gross production tax. On Junuary 19, 1934, petitioner assigned a $100,000 oil and gas payment to I.A. O'Shaughnessy, Inc., payable*1445 out of three-eighths of the seven-eighths working interest, for a consideration payable either in pipe or cash equal to one-half of the cost of the Rucker No. 8 well but not in excess of $30,000. The well was completed and began production during 1934. During the year 1934 petitioner received $8,702.56 from its fractional interest in the Rucker No. 8 lease, and expended $17,771.01 for drilling and equipping the well, of which $7,587.77 represented cost of drilling and $10,183.24 represented cost of equipment. Petitioner also expended in 1934 the sum of $3,619.28 as its share of operating expense. During the year 1935, petitioner received $11,207.67 from its working interest in the Rucker No. 8 lease, and paid operating expense of $8,578.90. Little No. 2 Lease. On December 1, 1933, the Nebo Oil Co., an express trust (called party of the first part), owner of an oil and gas mining lease known as the Little No. 2 lease, covering certain land located in Oklahoma County, Oklahoma, executed a written instrument entitled "CONTRACT," in which petitioner was referred to as party of the second part, containing the following pertinent provisions: AND, WHEREAS, Party of the First*1446 Part has heretofore, and is now using certain drilling equipment owned by the Party of the Second Part in the drilling of a well for oil and gas on said above described leasehold; and, whereas the Parties have heretofore orally agreed that the Party of the First *1057 Part will, in consideration of the use of said equipment, and the drilling and completing of a well on said premises, execute to the Party of the Second Part, an assignment or conveyance of a two-eighths (2/8ths) of the seven-eighths (7/8ths) working interest in said oil and gas lease, to be held by the Party of the Second Part until he shall have netted from the proceeds of the sale of oil and/or gas produced from the said two-eighths (2/8ths) of the said seven-eighths (7/8ths) working interest in said well drilled on said leasehold the sum of Fifty Thousand Dollars ($50,000.00). NOW, THEREFORE, in consideration of said covenant and of the furnishing of said equipment, and the drilling and completing of said well by the Party of the Second Part, and all claims of any kind of nature, which the Party of the Second Part may have or claim against the Party of the First Part by reason of any materials, supplies, *1447 labor or supervision furnished by the said Party of the Second Part to the Party of the First Part, the Party of the First Part does here by sell, assign, transfer and convey an undivided two-eighths (2/8ths) of the seven-eighths (7/8ths) working interest to the Party of the Second Part to have and to hold until the Party of the Second Part shall have received from the proceeds of the sale of all oil, gas or casinghead gas produced, saved and sold from said undivided interest, the sum of Fifty Thousand Dollars ($50,000.00) net to the said Party of the Second Part, and when said Fifty Thousand Dollars ($50,000.00) shall have been received as agreed, then this assignment shall become void and title to said two-eighths (2/8ths) shall immediately revest in the Party of the First Part, and this assignee shall, upon demand, immediately execute an instrument of reconveyance to the Party of the First Part. For the use of drilling equipment and completion of the drilling of a well on the Little No. 2 lease, petitioner acquired a two-eighths of seven-eighths working interest in the lease until its share of production netted $50,000. The well was completed and began production in 1934. *1448 During the year 1934 petitioner received the sum of $22,501.45 from the sale of oil from its interest in this lease, and expended the sum of $2,700.09 in fulfillment of its obligations under the instrument dated December 1, 1933, above referred to. During the year 1935, petitioner received from the sale of oil from its interest in this lease the sum of $11,596.62. Little No. 3 Lease. On March 22, 1934, the Nebo Oil Co., an express trust (called party of the first part), owner of an oil and gas mining lease known as the Little No. 3 lease, covering certain lands situated in Oklahoma County, Oklahoma, executed an instrument entitled "CONTRACT", in which petitioner was referred to as party of the second part, containing the following material provisions: WHEREAS, said oil and gas lease is now owned by the party of the first part; and, whereas, party of the first part has heretofore, and is now using certain drilling equipment owned by the party of the second part, in the drilling of a well for oil and gas on said above described leasehold; and, whereas, the parties have heretofore agreed that the party of the first part will, in consideration *1058 of the use of said*1449 equipment, and the drilling and completing of a well on said premises, execute to the party of the second part an assignment or conveyance of a two/eighths (2/8) of the seven/eighths (7/8) working interest in said oil and gas lease to be held by the party of the second part until he shall be netted from the proceeds of the sale of oil and gas produced from the said two/eighths (2/8) of the said seven/eighths (7/8) working interest in said well drilled on said leasehold, the sum of Fifty Thousand Dollars ($50,000.00). NOW, THEREFORE, in consideration of said covenant and of the furnishing of said equipment and the drilling and completing of said well by the party of the second part, and all claims of any kind or nature which the party of the second part may have or claim against the party of the first part by reason of any materials, supplies, labor or supervision furnished by the party of the second part to the party of the first part, the party of the first part does hereby sell, assign, transfer and convey an undivided two/eighths (2/8) of the seven/eighths (7/8) working interest of said oil and gas leasehold to the party of the second part to have and to hold until the party*1450 of the second part shall have received from the proceeds of the sale of all the oil, gas and casinghead gas, produced, saved and sold from said undivided interest, the sum of Fifty Thousand Dollars ($50,000.00) net to the party of the second part; and when said Fifty Thousand Dollars ($50,000.00) shall have been received as agreed, then this assignment shall become void, and title to the said two/eighths (2/8) of the seven/eighths (7/8) working interest shall immediately revest in the party of the first part, and this assignee shall, upon demand, immediately execute an instrument of reconveyance to the party of the first part. It is understood that the interest above assigned shall be subject to the operating expense or cost of said leasehold, but for the convenience of the parties and of the pipeline company or companies which may subsequently purchase oil from said lease, it is agreed that all of the proceeds from said interest above described shall be paid direct to the party of the second part, and that the party of the second part will, upon receipt of a statement from the party of the first part, as to the entire expense of operating and producing said well for the previous*1451 month, pay to the party of the first part two/eighths (2/8) of said expense as shown by said statement, upon receipt of a check from said pipeline company or companies paying for the oil produced from said above described portion of said oil and gas lease for the previous month, the interest herein assigned shall remain the property of the party of the second part until there has been received the sum of Fifty Thousand Dollars ($50,000.00) net, over and above the expenses so paid. For the use of drilling equipment and completing the drilling of the well on Little No. 3 lease, petitioner acquired a two-eighths of seven-eighths working interest in the lease until such interest netted $50,000. The well was completed and began production in 1935. During the year 1934 petitioner expended the sum of $513.92 in fulfillment of its obligations under the instrument dated March 22, 1934, above referred to. During the year 1935 petitioner received the sum of $11,028.80 from the sale of oil from its interest in this lease, and paid operating expenses of $5,636.99. Community No. 1 Lease. On January 3, 1934, the Nebo Oil Co. (called party of the first part), the owner of an oil and*1452 gas mining lease known as Community *1059 No. 1 lease, covering certain land situated in Oklahoma County, Oklahoma, executed a written instrument designated "CONTRACT," in which petitioner was called party of the second part, containing the following provisions: WHEREAS, said oil and gas lease is now owned by the party of the first part; and, whereas, party of the first part has heretofore, and is now using certain drilling equipment owned by the party of the second part, in the drilling of a well for oil and gas on said above described leasehold; and, whereas, the parties have heretofore agreed that the party of the first part will, in consideration of the use of said equipment, and the drilling and completing of a well on said premises, execute to the party of the second part an assignment or conveyance of a two/eighths (2/8ths) of the seven/eighths (7/8ths) working interest in said oil and gas lease to be held by the party of the second part until he shall have netted from the proceeds of the sale of oil and gas produced from the said two/eighths (2/8ths) of the said seven/eighths (7/8ths) working interest in said well drilled on said leasehold, the sum of Forty Thousand*1453 Dollars ($40,000.00). NOW, THEREFORE, in consideration of said covenant and of the furnishing of said equipment and the drilling and completing of said well by the party of the second part, and all claims of any kind or nature which the party of the second part may have or claim against the party of the first part by reason of any materials, supplies, labor or supervision furnished by the party of the second part to the party of the first part, the party of the first part does hereby sell, assign, transfer and convey an undivided two/eighths (2/8ths) of the seven/eighths (7/8ths) working interest of said oil and gas leasehold to the party of the second part to have and to hold until the party of the second part shall have received from the proceeds of the sale of all the oil, gas and casinghead gas produced, saved and sold from said undivided interest, the sum of Forty Thousand Dollars ($40,000.00) net to the party of the second part; and when said Forty Thousand Dollars ($40,000.00) shall have been received as agreed, then this assignment shall become void, and title to said two/eighths (2/8ths) shall immediately revest in the party of the first part, and this assignee shall, upon*1454 demand, immediately execute an instrument of reconveyance to the party of the first part. It was further provided in the above instrument that the interest assigned to petitioner should be subject to the operating expense, but that for convenience of the parties all of the proceeds from the assigned interests should be paid to petitioner; that petitioner would pay two-eighths of the operating expense, and that the interest assigned should remain the property of petitioner until it had received the sum of $40,000 net, over and above the expense so paid. For the use of drilling equipment and completion of the drilling of a well on the Community No 1 lease, petitioner acquired a two-eighths of seven-eighths working interest in the lease until it had received therefrom the sum of $40,000 net. The well was completed and began production in 1934. During the year 1934 petitioner (a) received $10,727.56 from the sale of oil from its interest in this lease, (b) expended $937.26 in fulfillment of its obligations under the contract dated January 3, *1060 1934, above referred to, and (c) paid operating expense of $4,012.18. During the year 1935, petitioner received $7,940.05*1455 from the sale of oil from its interest in this lease. Hembree No. 1 Lease. On October 25, 1934, petitioner (called second party) entered into an agreement with one George H. Hannum (called first party) to drill and equip an oil and gas well on a certain oil and gas mining lease known as the Hembree No. 1 lease, owned by Hannum, covering land in the county of Pottawatomie, Oklahoma. This contract provided in material part as follows: In consideration of all of which, First Party on his part agrees as follos: First Party covenants that he is the sole owner of the seven-eighths working interest covering said land, free and clear of any and all assignments, charges, liens and incumbrances of any kind and character whatsoever. First Party further agrees to assign and has assigned to Second Party an undivided fifteen-sixteenths (15/16ths) of the seven-eighths working interest, covering said land and guarantees title to same to be one acceptable to any major pipe line company, and free and clear of all incumbrances. First Party further agrees to pay Second Party the sum of Five Thousand ($5000.00) Dollars, within two weeks after derrick is erected, provided drilling operations*1456 are started. It is understood by the parties hereto that when Second Party has received the sum of Thirty-two Thousand ($32,000.00) Dollars net, out of the proceeds of the same of oil and/or gas from the fifteen-sixteenths (15/16ths) of seven-eighths (7/8ths) interest above referred to, then Second Party shall assign to the First Party an undivided seven-sixteenths (7/16ths) of the seven-eighths (7/8ths) interest in and to said lease. For drilling and completing the well on Hembree No. 1 lease, petitioner acquired a fifteen-sixteenths of seven-eighths working interest in the lease until paid the sum of $32,000 net therefrom, and an eight-sixteenths interest thereafter. The well was completed and began production in 1934. During the year 1934 petitioner received $2,500 in cash, being one-half of the cash payment mentioned in the contract, and also received $2,052.99 from the sale of oil from its fractional working interest. During the year 1934, before completion of the well, petitioner expended $20,122.78 in drilling and equipping the well on the Hembree No. 1 lease, of which $11,840.48 represented intangible drilling costs and $8,282.30 represented cost of equipment. *1457 During 1934, after completion of the well, petitioner expended $149.11 for operating expense. During the year 1935 petitioner received $3,800.68 from the sale of oil from its interest in this lease, and during the same year expended $1,702.34 for operating expense. Jones-Brandenburg No. 1 and No. 3 Leases. On May 21, 1934, petitioner (called second party) entered into an agreement with E. W. Jones, Inc. (called first party), whereby said *1061 parties agreed to join in the drilling of a well on a certain oil and gas mining lease known as the Jones-Brandenburg No. 1 lease, covering land located in Pottawatomie County, Oklahoma, referred to as tract No. 1. Also petitioner was given an option therein to join in the drilling of a second well on another tract of land known as the Jones-Brandenburg No. 3 lease and referred to as tract No. 2, both of which leases were owned by E. W. Jones, Inc. The contract provided in part material here as follows: II. And in consideration of the matters and things to be performed and done by Second Party as enumerated in the above and foregoing paragraph, the First Party shall assign to the Second Party, an undivided one-half interest*1458 in the oil and gas mining lease covering the property herein described, warranting and guaranteeing the title to same to be merchantable and acceptable to any major pipeline company, and on completion of said first well, said assignment is to be delivered unconditionally, and the Second Party to own a one-half interest in and to said oil and gas mining leasehold. * * * VII. That is to say, that in summarizing this Agreement, First Party is now the owner of the oil and gas leases on the properties hereinabove described, and for the considerations herein named, to be performed by the Second Party in the drilling of the first well, the Second Party is to receive an undivided one-half interest in and to said oil and gas mining leases, and after the completion of said first well, as hereinabove mentioned, First Party and Second Party are to be the joint and equal owners of said oil and gas mining leases, and the First Party is to, by good and sufficient assignments, transfer to the Second Party, an undivided one-half interest in and to said oil and gas mining leases, warranting the titles thereto, and from then on, this shall be and is a jointly owned property to be operated by the*1459 First Party under an operating agreement, to be entered into between the Parties, in the event this is a producing lease, in accordance with the terms and provisions of the operating agreement hereinabove referred to. VIII. IT IS EXPRESSLY UNDERSTOOD AND AGREED, that each time the date arrives for the commencement of a well, that the Second Party shall have the right to elect whether or not it will join with the First Party in the drilling of the first well on each particular tract, and then, when and if it makes the election to join with the First Party in the drilling of said well, which first well on each separate tract of land so undertaken, to be drilled by Second Party, same shall be controlled by and the terms and conditions set forth in this agreement shall prevail as to each tract upon which the Second Party has elected to join with the First Party in the drilling of the first well; and, the Second Party shall have the first option and right, and the sole right to elect upon which of said tracts it will join with the First Party in the drilling of the first well. On July 16, 1934, E. W. Jones, Inc., executed an instrument entitled "ASSIGNMENT OF INTEREST IN OIL AND*1460 GAS MINING LEASE," covering the Jones-Brandenburg No. 1. lease, reading in part as follows: NOW, THEREFORE, for and in consideration of one dollar and other good and valuable considerations, the receipt of which is hereby acknowledged, the said E. W. Jones, Inc., does hereby bargain, sell, transfer, assign and convey unto Hugh Hodges Drilling Company, a corporation, an undivided one-half interest *1062 in and to the said oil and gas mining lease and all rights thereunder, together with all personal property used or obtained in connection therewith: to have and to hold the same unto the said Hugh Hodges Drilling Company, a corporation, and to its successors and assigns, subject, however, to all the terms, conditions and provisions thereof, and especially subject to the $20,000.00 oil payment therein provided for, which oil payment is to run with the lease and the interest conveyed hereby is to bear its proportionate part of such payment. For drilling a well on each of the Jones-Brandenburg No. 1 and No. 3 leases, petitioner acquired a one-half interest in the respective leases. The well on the Jones-Brandenburg No. 1 lease was drilled and completed in 1934, and the well*1461 on the Jones-Brandenburg No. 3 lease was drilled and completed as a producer in 1935. During the years 1934 and 1935, petitioner received gross income from its interest in the Jones-Brandenburg No. 1 lease in the amounts of $5,170.40 and $5,839.09, respectively. During the year 1935, petitioner derived gross income from its interest in the Jones-Brandenburg No. 3 lease in the amount of $1,151.10. Liddell Lease. On November 7, 1934, E. W. Jones, Inc. (called party of the second part) entered into a contract and agreement with El Bar Oil Co. and others (called parties of the first part) to develop a certain oil and gas lease owned by the parties of the first part, known as the Liddell lease, covering a tract of land located in Pottawatomie County, Oklahoma, the agreement reciting that the parties of the first part, for the purpose of procuring the development of the leasehold for oil and gas, did thereby set over, transfer, sell, assign, and convey the leasehold estate to the party of the second part, and as consideration for such assignment, the party of the second part agreed to drill an oil and gas well on the property, beginning within a specified time, free from any*1462 cost or expense to first parties. It was further agreed that the party of the second part was to have the full seven-eighths working interest of the production until it had received the sum of $25,000, from and after which time the cost of operation should be borne equally by the parties, and each party should receive one-half of the seven-eighths working interest of the total production. Thereafter, petitioner entered into an agreement with E. W. Jones, Inc., as evidenced by a letter from petitioner to the latter corporation dated November 21, 1934, reading as follows: With reference to the Liddell Brandenberg lease covering thirty acres described as follows: * * * it is our agreement as evidenced by this letter that we are taking over this property and drilling it on a fifty-fifty basis as to cost and interest. We are *1063 taking such half of your deal and together we are drilling the well. Hugh Hodges Drilling Company will drill the well using its rotary rig and tools. The total expense and cost of such well shall be paid equally by you and us, and such expenses shall include the labor, insurance, casing, fuel, water, derrick and incidentals for supplies and other*1463 expenses, and also in that connection Hugh Hodges Drilling Company is furnishing its rotary tools without a charge or rental, but the expenses for bits and replacements necessary to keep said rig in good operating condition shall be charged as a cost of drilling said well to be borne by E. W. Jones, Inc. and Hugh Hodges Drilling Company. The cost of this well and expenses are to be paid by the parties as above set out promptly upon submission of statements for expenses sustained by either party. It is further understood that E. W. Jones, Inc. will have the operation of the property if said well is a commercial producer, and the operating agreement heretofore executed by us with reference to the off-set well on the Brandenberg land shall be extended to cover this property in such event. If this is acceptable, you will please sign one of the duplicate copies for our file. The agreement set forth in the above letter was accepted by E. W. Jones, Inc. For drilling and equipping the two wells on the Liddell lease, petitioner acquired an interest in the lease equal to one-half of the interest of E. W. Jones, Inc., as provided in the contracts above referred to. Well No. 1*1464 was completed in 1934, and Well No. 2 was completed in September, 1935. Petitioner's share of the drilling expense on Well No. 1 amounted to $5,640.51, and it expended for equipment $5,500.95. Petitioner's share of the cost of drilling and equipping Well No. 2 was $7,031.81 and $6,675.90, respectively. Watson Lease. On January 30, 1935, petitioner (called second party) entered into an agreement with Phil A. Watson (called first party) to drill a well fully completed and equipped for operation on a certain oil and gas lease covering a tract of land located in Pottawatomie County, Oklahoma, which agreement contained the following provisions: NOW, THEREFORE, IN CONSIDERATION of the premises and of the mutual agreements and covenants hereinafter contained, it is hereby agreed by and between first party and second party that (1) First party shall, upon the execution of this agreement, assign to the second party an undivided 14/16 interest in said lease, and generally warrant the title thereto * * * * * * Second party shall, only after receiving the sum of forty-five thousand dollars net, after all operating costs, all gross production taxes, Federal or State assessments*1465 are paid out of the proceeds of the sale of oil and/or gas from the undivided 14/16 of said lease above referred to, assign to the first party an undivided 5/16 of said lease upon said premises. It is the intention of this paragraph to procure to second party the sum of forty-five thousand dollars net, free and clear of all operating expenses, gross production and *1064 other tax or assessment of whatsoever nature prior to the reassignment provided for. On the same date, January 30, 1935, Phil A. Watson executed an instrument entitled "Assignment of Oil and Gas Lease" in respect of the Watson lease, containing the following provisions: 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 Hugh Hodges Drilling Company, a corporation of Oklahoma City, Okla., right, title and interest of the original lessee and present owner in and to the said lease and rights thereunder in so far as it covers the undivided 14/16 interest, *1466 together with all personal property used or obtained in connection therewith to Hugh Hodges Drilling Company, a corporation, and its successors and assigns. For drilling a well on the Watson lease, fully completed and equipped for operation, petitioner acquired an interest in the lease as defined by the terms of the contract and assignment above referred to. Harris Lease. On February 23, 1935, petitioner (called non-operator) entered into an agreement with Barnsdall Oil Co., a corporation (called operator), to drill a well on a certain oil and gas lease known as the Harris lease, covering a tract of land in Seminole County, Oklahoma, which contract contained the following provisions: 2. Upon the completion of said well by NON-OPERATOR in accordance with the terms hereof (and the plugging thereof if a dry hole), OPERATOR agrees to execute, acknowledge and deliver, without warranty of title, a good and valid assignment of an undivided one-fourth (1/4) of all of OPERATOR'S right, title and interest in and to the aforesaid lease insofar as it covers the above described premises and in addition thereto shall pay to NON-OPERATOR the sum of Ten Thousand ($10,000.00) Dollars*1467 in cash. * * * 4. In the event the said test well shall prove to be a well producing oil, gas or casinghead gas in paying quantities, NON-OPERATOR shall reimburse OPERATOR for one-fourth (1/4) of the cost of the casing, derrick, tankage, flow lines, valves, tubing, rods and equipment furnished by OPERATOR and necessary to be left in and about said well to recover the production therefrom, and thereupon the parties hereto shall become the owners of said oil and gas lease and leasehold, the production therefrom, and all of the tools, equipment and supplies located thereon and used in connection therewith, in the following proportions to-wit: Operator, three-fourths (3/4); Non-Operator, one-fourth (1/4). * * * 6. It is further agreed that OPERATOR shall have, and is hereby given the right at all times to purchase, any part or all of NON-OPERATOR'S production from said premises at the then average prevailing market price in that vicinity for production of like grade and quality. *1065 On May 29, 1935, Barnsdall Oil Co. executed an assignment in respect of the Harris lease, containing the following provisions: NOW, THEREFORE, for and in consideration of One Dollar*1468 ($1.00), and other good and valuable considerations, the receipt of which is hereby acknowledged, the undersigned does hereby bargain, sell, transfer, assign and convey unto the HUGH HODGES DRILLING COMPANY, a corporation, an undivided interest in and to said leases equal to and the equivalent of an undivided one-fourth interest in and to the full 7/8ths of the production from said Northwest quarter of the Southeast quarter of Section 15, Township 8 North, Range 5 East, Seminole County, Oklahoma, without warranty of title. This assignment is expressly made subject to all of the terms and conditions of the contract made by and between Barnsdall Oil Company and Hugh Hodges Drilling Company, dated February 23, 1935. For drilling a well on the Harris lease, petitioner acquired an interest in the lease in accordance with the provisions of the instrument above referred to. During the year 1935 petitioner received gross income from its interest in this lease amounting to $3,488.44. Harrod Lease. On May 3, 1935, petitioner (called second party) entered into an agreement with the Nemaha Oil Co. (called first party) to drill a well on an oil and gas lease known as the Harrod*1469 lease, covering land situated in Oklahoma County, Oklahoma. The contract was subject to an undivided one-eighth overriding royalty interest owned by one Frank Russell, also an undivided one fifty-sixth overriding royalty interest owned by the Townsite Oil Corporation, and contained the following additional provisions: 5. First party, upon execution of this contract, shall pay second party for the drilling of said well the sum of $10,000.00 in cash or its equivalent. In addition thereto the first party shall furnish to second party $12,500.00 in credit with some oil field supply house satisfactory to second party for the purpose of miscellaneous supplies to be used in the drilling of said well. In addition thereto first party shall pay second party $25,000.00 out of the proceeds of an undivided one-fourth interest in the leasehold estate upon Block 30, Oak Park Addition to Oklahoma City, Oklahoma, as more particularly set out hereinafter. * * * (B) First party shall execute and deliver unto second party upon the execution of this contract a good valid and sufficient assignment of an overriding toyalty of an undivided one-fourth interest in and to the leasehold estate covering*1470 the following described land situate in Oklahoma County, State of Oklahoma, to-wit: * * * until the net sum of $25,000.00 has been paid to second party therefrom, said interest to be free and clear of all drilling, operating and maintaining costs of whatsoever nature. * * * *1066 For drilling a well on the Harrod lease, petitioner acquired an overriding royalty interest until the net sum of $25,000 had been paid to petitioner therefrom. OPINION. HILL: The principal issue submitted for decision in this case involves the proper basis for determination of the amounts of taxable income derived by petitioner during the years 1934 and 1935 from oil payments or interests in the production from oil and gas mining leases acquired by petitioner in consideration of the drilling of wells. Other questions arising in connection with the main issue involve petitioner's right to deductions for depletion, depreciation, and intangible drilling expense. In an extended and detailed amendment to his original answer, respondent set up claims inconsistent in many details with the computation of the deficiencies determined by him, and on brief has again changed his position in some*1471 respects. In his brief, respondent now contends that petitioner had a depletable interest in all of the leases or wells referred to in our findings of fact hereinabove, and must recover its capitalized costs of drilling and equipping the wells through depletion. Petitioner's contentions respecting the determination of taxable income and the recovery of costs are not uniform in respect of all the leases. As to some, petitioner concedes that it had a depletable interest; in others, petitioner contends that it had no depletable interest, and is entitled to recover costs through other methods, which will be referred to below. As to the Buchanan, Burroughs, Davis, Knowles, Little No. 2, Little No. 3, Community No. 1, Rucker No. 8, Day-Roff, Hembree No. 1, Richolson No. 1, 1 and Cary Nos. 4 and 5 1 leases, petitioner contends that it had no ownership in the oil and gas in place, but only the right to receive a fixed amount out of the proceeds of a portion of the oil produced by each; that its rights essentially were no more than those of a mortgagee; that as to these leases the amounts received from the so-called oil payments should first be applied against operating expenses incurred*1472 and paid in connection with the production of oil from which the payments were derived; that any amounts remaining should then be applied to the return of costs; in other words, that the amounts to be taken into gross income are only those remaining after deduction of expenses and costs. *1067 As to the Davis lease, petitioner further contends that the assignment conveyed to it a fractional working interest only as security for the payment of a specified sum of money. Substantially the same contention is made as to the Rucker No. 8 lease, and, in the alternative, that intangible drilling expense and depreciation sustained on drilling equipment should be deducted from gross income. In respect of the Day-Roff lease, petitioner contends that, under its contract, it drilled and equipped a well for which it was to receive a consideration of $75,600 net, *1473 payable out of oil from three-fourths of the seven-eighths working interest if, as, and when oil was produced, saved, and sold from the premises; that when the full amount of the oil payment was paid out there should then vest in petitioner an undivided three-eighths of the seven-eighths working interest and at that time petitioner would become a joint owner in the leasehold estate to such extent. Petitioner argues, therefore, that since the payments out of oil were wholly contingent, the amounts received from the "in oil payments" should first be applied to expenses and costs and only the excess over expenses and costs constituted taxable income; further that the unreturned cost when the oil payment is finally paid out represents the cost to petitioner of its interest in the leasehold estate. In the alternative, petitioner says that if its interest in the Day-Roff lease was an interest in the leasehold, then petitioner is entitled to deduct intangible drilling expense, depletion, and depreciation on equipment. As to the Hembree No. 1 lease, petitioner concedes that for the drilling of a well under its contract it acquired fifteen-sixteenths of the seven-eighths working interest*1474 until it had received $32,000 net, and seven-sixteenths of the seven-eighths working interest thereafter, and argues that it is entitled to deductions for depletion and intangible drilling expense. In this connection, it is noted that both respondent and petitioner state in their respective briefs that for drilling the well on the Hembree No. 1 lease, petitioner acquired fifteen-sixteenths of the seven-eighths working interest until such interest netted $32,000, and seven-sixteenths of the seven-eighths working interest thereafter. However, the contract introduced in evidence recited that the owner of the lease agreed to assign and had assigned to petitioner an undivided fifteen-sixteenths of the seven-eighths working interest, and that it was understood by the parties that when the petitioner had received the sum of $32,000 out of the proceeds from the fifteen-sixteenths of the seven-eighths working interest, then petitioner should assign to the owner the seven-sixteenths of the seven-eighths interest. It seems apparent, therefore, that, if the fifteen-sixteenths of the seven-eighths working interest was first assigned to petitioner, petitioner retained *1068 eight-sixteenths*1475 of such interest, and not seven-sixteenths, after it had assigned back to the owner seven-sixteenths of the seven-eighths working interest upon receipt in full of the $32,000 payment. Petitioner admits that it is the owner of a depletable interest in the Jones-Brandenburg No. 1 and No. 3 leases, but says that it is entitled to deduct as expense its share of the intangible drilling costs. In respect of the Liddell lease, petitioner argues that it was the owner of an interest therein prior to the drilling of the wells, and is entitled to deduct intangible drilling expense and depreciation sustained on equipment. As to the Watson, Harris, and Harrod leases, petitioner contends that it is entitled to deduct intangible drilling expense from gross income. Recent decisions of the Supreme Court of the United States, we think, have definitely established the basic principles applicable under the facts to the issues presented in respect of all of the oil and gas leases involved in these proceedings. In Palmer v. Bender,287 U.S. 551, the Court said: It will be observed that the statute directs that reasonable allowance for depletion be made as a deduction in*1476 computing net taxable income, "in the case of * * * oil and gas wells, * * * according to the peculiar conditions in each case." The allowance to the taxpayer is not restricted by the words of the statute to cases of any particular class or to any special form of legal interest in the oil well. * * * The language of the statute is broad enough to provide, at least, for every case in which the taxpayer has acquired, by investment, any interest in the oil in place and secures, by any form of legal relationship, income derived from the extraction of the oil to which he must look for a return of his capital. [Italics supplied.] Thomas v. Perkins,301 U.S. 655, held that where oil and gas leases were assigned for a consideration payable partly in cash and an additional sum out of proceeds from the production of oil, such part of the proceeds from the production as was paid to the assignors was not taxable income to the assignees. It was further held that an assignor was entitled to deduct depletion from income received from his interest in the oil, and that an assignee was not entitled to deduct from income received from his share an allowance for depletion*1477 attributable to the assignor's interest. In Anderson v. Helvering,310 U.S. 404, the facts show that the Oklahoma City Co. in 1931 entered into a contract for the conveyance of certain royalty interests, fee interests, and deferred oil payments in properties in Oklahoma to one Pritchard, acting for himself and one Anderson. The agreed consideration for the conveyance was $160,000, payable $50,000 in cash and $110,000 from one-half of the proceeds derived from oil and gas from the properties and from the sale of the fee title to any or all of the land conveyed. The Oklahoma City Co. was to have in addition a first lien and claim against "that one-half of all *1069 oil and gas production and fee interest * * * from which the $110,000" was payable. The Court held that the purchasers were taxable upon the gross proceeds from the oil production, notwithstanding their obligation to pay a part of such proceeds to the seller, for the reason that the seller had reserved an interest in the fee as well as an interest in the oil production, and was not required to look solely to the oil production for payment. Such reservation of an interest in the fee was*1478 considered similar to a reservation in a lease of oil payment rights together with a personal guarantee by the lessee that the payments should at all events equal the specified sum. It was further held that, in the interest of a workable rule, Thomas v. Perkins, supra, must not be extended beyond the situation in which, as a matter of substance, without regard to formalities of conveyancing, the reserved payments are to be derived solely from the production of oil and gas. In that connection, the Court said: It is settled that the same basic issue determines both to whom income derived from the production of oil and gas is taxable and to whom a deduction for depletion is allowable. That issue is, who has a capital investment in the oil and gas in place and what is the extent of his interest. * * * The holder of a royalty interest - that is, a right to receive a specified percentage of all oil and gas produced during the term of the lease - is deemed to have an economic interest in the oil in place which was depleted by severance. * * * The holder of an oil payment right, as an original proposition, might be regarded as having no capital investment in the*1479 oil and gas in place. * * * Yet it does depend upon the production of oil, ordinarily can be realized upon only over a period of years, and permits of a simple and convenient allocation between lessor and lessee of both the gross income derived from production and the allowance for depletion. * * * Accordingly, this court in Thomas v. Perkins decided that the provision in the lease for payments solely out of oil production should be regarded as a reservation from the granting clause of an amount of oil sufficient to make the agreed payments, and should be given the same tax consequences as a provision for oil royalties. * * * Similarly, the retention of a lien, if it were construed as a lien only upon the oil and gas production, and nothing more, would not make Oklahoma Company any the less dependent upon such production for payment of the amounts reserved. The reservation of an interest in the fee, in addition to the interest in the oil production, however, materially affects the transaction. Oklahoma Company is not dependent entirely upon the production of oil for the deferred payments; they may be derived from sales of the fee title to the land conveyed. The principles*1480 enunciated in the foregoing decisions, so far as pertinent here, may be briefly summarized as follows: (1) A lessor or the owner of oil payment rights, who is required by the terms of the contract to look solely to the oil and gas or the proceeds from production for the agreed payments, has an economic interest in the oil and gas in place, is taxable upon the gross income derived from his interest, and is entitled to an allowance for depletion thereon. This rule is applicable in all cases where, as a matter of substance, *1070 without regard to formalities of conveyancing, the reserved or deferred payments are to be derived solely from the production of oil and gas. (2) The retention of a mortgage or other lien, if it be a lien only upon the oil and gas production, and nothing more, does not prevent application of the stated rule, since the owner of the oil payment is not thereby made any the less dependent upon the oil production for payment of the agreed amounts. Without attempting to discuss in detail the provisions of the several drilling contracts and assignments in evidence in these proceedings relating to the leases involved, it seems apparent to us that all the*1481 leases come within the rules above stated. In some of them, as the consideration for drilling and equipping a well or participating therein jointly with the owner, petitioner acquired ownership of a fractional interest in the leaseholds; as to others, petitioner acquired an oil payment right, that is, the right to receive a specified sum out of the oil production if, as, and when oil was produced, saved, and sold. Some of the drilling contracts contained words of assignment, while in other cases separate assignments were executed. In some instances petitioner acquired an oil payment of an agreed amount, and also the ownership of a lesser undivided fractional interest in the leasehold thereafter. In some contracts it was stated that the assignment of the fractional interest was intended as security for the payment of the agreed amount. However, in respect of all of the leases involved, petitioner was required to look solely to the oil production for payment. While it is true, as argued by petitioner, that the owners agreed to pay specific amounts, as consideration for drilling the wells, yet the fact remains that the owner in each case agreed to pay only out of the oil if, as, *1482 and when produced. So far as disclosed by the record, in no instance was there a personal guarantee by an owner that the payments should at all events equal the specified sum. Nor is it shown in any case that petitioner was given a lien on anything other than the oil and gas production. In the contract covering the Davis lease it was affirmatively provided that there should be no personal liability upon the owner in respect of the oil payment, and a like intention of the parties, we think, may be fairly inferred from the provisions of the contracts relating to the other leases. The right of petitioner to share in the oil produced under the various contracts and assignments constituted interests in the oil in place. Ortiz Oil Co.,37 B.T.A. 656; affd., 102 Fed.(2d) 508. Such interests represented capital investments, consisting of the costs and expenses of drilling and equipping the wells, which costs and expenses are not allowable deductions from current gross income, but are returnable only through deductions for depletion. *1483 United States v. Sentinel Oil Co., 109 Fed.(2d) 854; Dearing v. Commissioner, 102 Fed.(2d) 91, *1071 affirming 36 B.T.A. 843; State Consolidated Oil Co. v. Commissioner, 66 Fed.(2d) 648; Nunn-Stubblefield Oil Co.,31 B.T.A. 180. In two of the leases here involved petitioner acquired undivided fractional interests in the working interests until it had received specified amounts from oil production and lesser fractional interests in the leaseholds thereafter. These are the Day-Roff and Hembree No. 1 leases. Petitioner contends that the first undivided fractional interest in each such lease represented an "in oil" payment and that it acquired no interest in the oil in place until such payments had been made in full out of oil; hence, that it is entitled to deduct from gross income the amounts of its intangible drilling expenses and depreciation on equipment. Petitioner's contention on this point can not be sustained. In our opinion, petitioner did not acquire two separate and distinct interests in each lease, but acquired a single right measured by the two undivided fractional interests. *1484 Under the contract covering the Day-Roff lease such interest consisted of three-fourths of the seven-eighths working interest until $84,000 (later reduced by assignment to $75,600) had been received by petitioner, and a three-eighths interest in the leasehold thereafter. Similarly, for drilling a well on the Hembree No. 1 lease, petitioner acquired fifteen-sixteenths of the seven-eighths working interest until such interest netted $32,000, and eight-sixteenths of the working interest thereafter. Cf. Kiesau Petroleum Corporation,42 B.T.A. 69. In both cases, petitioner looked only to the oil to satisfy its contractual rights, and the costs and expenses of drilling the wells constituted the consideration paid by petitioner for those rights. Petitioner, therefore, is not entitled to deduct either intangible drilling costs or depreciation on equipment, which constituted component elements of its capital investment, returnable through depletion. Petitioner makes substantially the same contention in respect of the Liddell lease, but based upon a different ground. Petitioner argues that it owned an interest in this lease prior to the drilling of the wells, and that, *1485 since it drilled the wells on land in which it owned an interest, it is entitled to deduct intangible drilling expense and depreciation on lease equipment. The rule applicable on this point, we think, is correctly stated by the court in United States v. Sentinel Oil Co., supra. In that case it was held that expenditures made by the taxpayer in drilling a dry hole on land in which it owned an undivided interest were not deductible as a loss but constituted a capital investment, where it appeared that the consideration for the transfer of the undivided interest to the taxpayer was the taxpayer's agreement to drill. Since the cost of drilling was the purchase price paid for the conveyance of the undivided *1072 interest in the land, and since the land was not worthless, it was held that no deductible loss had been sustained. The court pointed out that, in such a case, it was immaterial whether title to the undivided interest was not to pass until the owner or vendor had received a specified sum from the proceeds of the well, or whether the undivided interest passed to the purchaser upon execution of the contract. "In both cases the drilling expenditures*1486 were the consideration for the passing of title to the land." We can see no controlling distinction between the situation considered in the cited case, where the cost of drilling a well constituted the consideration paid for an undivided interest in the land, and the present case, where the cost of drilling constituted the consideration paid for an undivided interest in the oil production. In our opinion, the reasoning of the court compels application of the rule in both situations. In respect of the Rucker No. 8 lease, petitioner states that this is the same property that is referred to as the "Hugh Hodges Drilling Co. No. 1" in the Board's decision in I. A. O'Shaughnessy, Inc., Docket No. 93151 (memorandum opinion entered May 17, 1940). It appears that I. A. O'Shaughnessy, Inc., acquired by assignment one-half of petitioner's interest in this lease, and in the decision of the Board just mentioned it was held that the petitioner there did not have a "capital investment in the mineral deposit which suffered depletion." It was further held that the petitioner was not entitled to depletion, but to recover its costs from receipts, and was taxable on only the excess of such*1487 receipts over cost. Petitioner in the present proceedings urges that the same rule should be made here on the same property, now designated as Rucker No. 8. Our opinion in the O'Shaughnessy case was entered prior to the decision of the Supreme Court in Anderson v. Helvering, supra, and to the extent that it is in confiict therewith must be regarded as overruled. It will, therefore, not be followed here. For the reasons indicated above, we hold, in respect of the 16 oil and gas mining leases set out or referred to in our findings of fact, that petitioner acquired in each an oil payment right, overriding royalty, or ownership of a fractional interest in the leasehold, representing an economic interest in the oil in place; that the respective amounts received therefrom during the taxable years constituted gross income to petitioner, upon which it is entitled to statutory allowances for depletion; that the consideration paid by petitioner for such interests consisted of the aggregate costs of drilling and equipping the wells, and constituted capital investments in depletable assets; and that hence petitioner is not entitled to deduct intangible drilling expense, *1488 cost of equipment, or depreciation on lease equipment sustained or incurred prior to completion of the wells. *1073 Considerable discussion appears in briefs of both parties concerning deductions allowable for depreciation and depletion, the differences between the parties arising mainly from their respective interpretations of the legal principles applicable under the facts. It is not apparent from the record that there is any serious controversy as to the proper method of computing such amounts, and, under the views expressed herein, neither the amounts allowed by respondent in determining the deficiencies, nor the amounts claimed by petitioner may be allowed in whole. In any event these are matters which may by settled properly under Rule 50, and they do not require consideration here. Petitioner contends, finally, that the deficiencies in excess profits taxes were determined by respondent under an Act of Congress which is arbitrary and void, in that it is violative of the Fifth Amendment to the Constitution. Such taxes were imposed by section 702(a) of the Revenue Act of 1934. The validity of this and similar statutes has been sustained both by this Board and the*1489 courts. See Chicago Telephone Supply Co. v. United States (Ct. Cls.), 23 Fed.Supp. 471; certiorari denied, 305 U.S. 628; Patrick McGovern, Inc.,40 B.T.A. 706; Brockway Glass Co.,43 B.T.A. 267. The deficiencies in controversy will be redetermined in accordance with the foregoing opinion. Decisions will be entered under Rule 50. Footnotes 1. No lease, contract or assignment covering the Richolson and Cary leases was offered in evidence, and we have found no facts pertaining to these leases. However, it would seem that any controversy between the parties involving these leases will be settled in principle by our decision in respect of the other leases. ↩