Herndon Drilling Co. v. Comm'r of Internal Revenue, Docket No. 4193.

• Decision Date: 03 April 1946
• Docket Number: Docket No. 4193.
• Parties: HERNDON DRILLING COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: U.S. Tax Court

6 T.C. 628

HERNDON DRILLING COMPANY, PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket No. 4193.

Tax Court of the United States.

Promulgated April 3, 1946.

1. Cash payments and certain costs of drilling and equipping a test well on an oil and gas lease were consideration for the acquisition of an ownership interest in such lease and are recoverable only through depletion and depreciation allowances.

2. Certain expenditures made in drilling and equipping oil and gas wells in consideration for the right to receive payments from the proceeds of oil and gas if, as, and when produced until such payments should equal the amount of such expenditures plus a bonus and interest were not loans secured by such oil payments, but were a capital investment in an economic interest in oil and gas in place, and they are recoverable only through depletion allowances.

3. Under various agreements, petitioner paid the owners of an oil and gas lease an amount in cash, cleaned out an existing oil well on the lease, drilled and equipped two additional wells, and advanced to the owners $250 in cash. Controversies arose as to the resulting rights of the parties in the leasehold. In settlement thereof a new agreement was made annulling the prior agreements and stipulating that petitioner was the owner of an undivided one-third of the leasehold and in addition had the right to receive $50,000 with interest out of oil from the entire leasehold, if, as, and when produced. Held, that petitioner acquired such ownership in the lease and an in-oil payment interest in the remaining undivided two-thirds of the lease at the date of the agreement last made; that each such interest is a separate capital asset; and that the cost of each such interest is a capital investment recoverable only through depletion allowances.

4. Held, as to each lease here involved, petitioner's undivided fractional interest therein and an in-oil payment in the remaining fractional interest are separate properties in computing percentage depletion. John E. Curran, Esq., and P. W. Fitzkee, C.P.A., for the petitioner.

Frank B. Schlosser, Esq., for the respondent.

This proceeding is for the redetermination of a deficiency in petitioner's income tax for the calendar year 1941. The return for that period was filed with the collector of internal revenue at Oklahoma City, Oklahoma. Respondent determined a deficiency of $6,450.21, which petitioner contests only to the extent of $3,406.86. At the trial an amendment to petition was filed, and respondent filed an amended answer asking that the deficiency determined be increased by the amount of $4,739.12, bringing the total of the deficiency determined and claimed to $11,189.33 and the amount in controversy to $7,782.47.

The determinative questions presented are: (1) Whether for purposes of computing allowance for depletion the interests of petitioner in each of two oil and gas leases comprise two properties or only one property; (2) whether intangible drilling and development costs of certain oil and gas wells are deductible as expenses or must be capitalized as the cost of a capital asset, recoverable only through depletion allowances; and (3) whether the right to receive payments from the proceeds of oil and gas if, as, and when produced, limited to the recovery of a specified sum of money, was security for the repayment of a loan or was a capital asset the cost of which is recoverable only through depletion allowances.

FINDINGS OF FACT.

Petitioner, an Oklahoma corporation with its principal office in Tulsa, Oklahoma, was engaged during the year 1941 in business as an oil and gas well drilling contractor. In connection with that business it entered into contracts for the drilling of wells in the testing and development of oil and gas leases referred to as the Stumps and Warner leases. Under these contracts petitioner received, or was to receive, certain interests in such leases and the oil production therefrom.

Stumps Lease.

On June 27, 1941, petitioner (called contractor) entered into an agreement with Branine and Goering (called owners) to drill, equip, and complete a test well and thereafter to drill such other well or wells, if any, as might be agreed upon, on a certain oil and gas lease then owned by the latter and known as the Stumps lease, covering land located in Ellsworth County, Kansas.

Pertinent provisions of the contract are:

1. Subject to examination and approval of the title in the manner hereinafter provided, Contractor agrees within fifteen (15) days after acceptance thereof to commence operations for the drilling of a test well for oil and gas (on certain described land) and to thereafter drill the same to a depth sufficient in the judgment of Contractor to test the Arbuckle Sand horizon usually found in said locality at an approximate depth of thirty-three hundred (3300) feet, said drilling cost to be advanced and paid by Contractor, and if said well, in the sole judgment of Contractor, does not justify running pipe and testing after reaching the depth above mentioned, then and in such event Contractor may plug and abandon said well and this agreement shall be thereafter terminated and at an end.

2. It is further understood, however, that if Contractor shall deem it advisable to run pipe and test said well, then and in such event the cost of running pipe, cement, acidizing, shooting, equipping or otherwise testing and putting said well on production shall be advanced and paid by Contractor. If the well is not completed as a commercial producer, Contractor shall have the right to plug and abandon the same, pulling pipe and salvaging all recoverable material, retaining title thereto, Owners not to be chargeable with any part of said advanced costs or expense. If, however, said well is completed as a producer of oil or gas in paying quantities, then the cost of testing, completing and equipping said well shall be sustained as hereinafter provided.

3. After the completion of the first well upon the leasehold premises above described, such additional wells may be drilled upon said leasehold premises as may be mutually agreed upon by the parties hereto. The entire cost of drilling and the entire cost and expense of completing, testing and equipping of such additional wells shall be likewise sustained and paid in the manner hereinafter provided. * * *

4. Upon approval and acceptance of title Owners agree to make, execute and deliver to Contractor assignment of an undivided one-half (1/2) interest in and to the aforementioned oil and gas mining leases, which shall be an absolute conveyance. Concurrent with the execution and delivery of the aforementioned assignment, owners shall also make, execute and deliver to Contractor an additional assignment of the remaining one-half (1/2) interest in and to the aforementioned oil and gas mining leases, together with the production of oil, gas and casinghead gas which may hereafter be produced from any wells located upon said acreage, said assignment to be in the nature of a mortgage to secure Contractor against the cost and expense advanced by Contractor hereunder for the account of owners. Contractor shall reassign said undivided one-half (1/2) interest and to said leases and the production therefrom to Owners when and in the event Contractor shall have been fully reimbursed in the manner hereinafter provided for its expense incurred in performing the operations provided herein. Owners further covenant and agree to in no manner encumber said mortgaged undivided one-half (1/2) interest in any of said leases or wells which may be located thereon, or the production therefrom, during the life of this agreement.

5. For all wells drilled by Contractor hereunder (except the first well), it shall be entitled to charge Owners one-half (1/2) of the footage charge for drilling, and for day work, * * * together with one-half (1/2) of the actual cost otherwise incurred by Contractor for labor, material, equipment, acidizing and various types of testing which may be deemed advisable, and other miscellaneous charges * * * . Upon the completion of each well Contractor shall prepare a statement reflecting such expense, including all items properly included therein, to which total the sum of six (6) per cent shall be added, the same constituting a part of Contractor's profit for the performance of said drilling and the furnishing of said services, material and equipment.

6. It is further understood and agreed that Contractor shall have the operation of all leases and wells which may be drilled upon the above described leasehold premises hereunder, Contractor to charge Owners one-half (1/2) of the amount necessarily laid out and expended for such operations, statements and supporting papers reflecting the same for the preceding calendar month to be furnished Owners by Contractor monthly, the amounts so paid currently to become a part of the obligation payable to Contractor hereunder in the manner herein provided. * * *

7. Owners agree to make, execute and deliver to Contractor proper division or transfer orders, effective with first production, designed to allow Contractor to collect and receive the proceeds of all of the production of oil, gas and casinghead gas accruing to the interest of Owners from all of said leases and the wells hereafter completed thereon. The monies so received shall be applied monthly on the amount becoming due to Contractor hereunder, Contractor being permitted to charge said account interest at the rate of six (6) per cent per annum, computed monthly on current balances. It is further agreed and understood that if Owners shall desire to sell and dispose of their retained interest in and to any undeveloped lease they shall have the privilege of doing so, and Contractor shall release its mortgage thereon, provided, however, that Contractor shall receive the proceeds of any such sale to apply on the amount due it accruing hereunder....