A. T. Jergins Trust v. Commissioner

A. T. JERGINS TRUST, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

A. T. Jergins Trust v. Commissioner

Docket No. 29940.

United States Board of Tax Appeals

22 B.T.A. 551; 1931 BTA LEXIS 2100;

March 5, 1931, Promulgated

---

1. Petitioner's income from an oil and gas lease upon lands owned by a municipal corporation is not exempt from Federal income and profits taxes.

2. Evidence held insufficient to establish the worthlessness of an oil and gas lease where it appeared that petitioner continued to pay the rentals necessary to prevent forfeiture.

3. Expenditures for fuel, wages, repairs, hauling, etc., in connection with the drilling of oil and gas wells are capital expenses recoverable through depreciation rather than depletion.

Thomas R. Dempsey, Esq., and A. Calder Mackay, Esq., for the petitioner.

Mason B. Leming, Esq., and C. A. Ray, Esq., for the respondent.

---

PHILLIPS

Respondent has determined deficiencies in income and profits taxes against petitioner for the years 1922, 1923, and 1924, in the respective amounts of $1,126.62, $3,368.92, and $61,458.34. It is alleged (1) that respondent erred in determining that the income of petitioner derived from the land owned by the city of Long Beach, Calif., constituted taxable income, and in refusing to hold that such income was exempt from Federal tax; (2) that he erred in denying to petitioner a loss in 1924 on account of the abandonment of one of its wells; (3) that he erred in denying petitioner the right to deduct from gross income expenditures made by it for labor, fuel, supplies, repairs, and kindred items in drilling and operating its wells; (4) that he erred in determining that petitioner made, in 1922, a binding election to capitalize such expenditures; and (5) that he erred in treating such expenditures as chargeable to capital account and returnable through depreciation. At the hearing petitioner abandoned contentions (3) and (4) and respondent amended his answer and claimed an additional deficiency on the ground that petitioner had no depletable interest in the land leased by it from the city of Long Beach.

FINDINGS OF FACT.

Petitioner is an association which was organized in April, 1922, by virtue of a declaration of trust executed pursuant to the laws of California. It was created for the purpose of entering into an oil and gas lease with the city of Long Beach, hereafter referred to as the city, which is and for many years has been a municipal corporation organized under the laws of California. The charter of said city authorized it to acquire and own its own water system and to purchase, hold, lease, use, and enjoy property of every kind and description and control and dispose of the same for the common good.

For some years prior to 1911 the city had obtained its water supply from two or more independent water companies, which in turn obtained their water from subterranean sources through wells which they had bored. The water mains of these companies were made of such material that water escaped therefrom and caused mud holes in the streets, which at that time were of dirt construction. When it was necessary to shut the water off from the mains, outside water would seep back into them and contaminate the water which thereafter came through them for the use of the city and its citizens. The escaping water became stagnant and created unsanitary conditions. Tules grew along one of the main streets for about a mile and a half. The mains were of such construction that they could not resist sufficient pressure to enable the fire department to fight fires. Under these conditions the city, in 1911, after having once rejected the proposition, by popular vote authorized a bond issue for the purpose of acquiring these water systems. With the money thus obtained the city acquired about 600 acres of land about three miles north of the city and the equipment and mains of the water companies. The land so acquired has ever since been used by the city for the purpose of a water plant and for the other purposes hereafter set forth. The city obtains its water from subterranean sources. In connection with this water system the city employed in 1922, 1923, and 1924, about fifty men, whose headquarters were on the said 600 acres, and now employs about 75 men on the premises. It maintains thereon a pumping plant service department, blacksmith shop, salvage yards, a garage, and a residence, all of which are used in connection with the water plant. At the time the city acquired this property there were on it three reservoirs, one of which has since been discontinued for the reason that it did not possess sufficient elevation. In addition to two oil and gas leases, of one of which petitioner is the lessee, the said tract of 600 acres has on it about 60 tenants who hold under leases or permits from the city. The business of these tenants includes airplane repair, hangars for aircraft, oil-well supplies, telephone, storage plants, cracking plants, oil-skimming plants, dehydration plants, gasoline absorption plants, and farming. These leases and permits were then and are of a temporary nature; can be terminated on short notice and are made subject to the right of the city to use the property for water purposes. Many of these leases and permits were granted by the city by reason of political and business pressure brought to bear on the city authorities.

On April 3, 1922, the city, as lessor, and the petitioner, as lessee, entered into an oil lease on about 140 acres of its water system property, the pertinent parts of which read:

WITNESSETH: Lease Term and Description of Land: For and in consideration of * * * the lessor does hereby lease, demise and let unto the lessee, and the lessee does hereby take and accept from the lessor for the term and time and for the purposes and under and in accordance with the stipulations, agreements and conditions hereinafter set forth, all that certain real property situated in the County of Los Angeles, State of California, and particularly described as follows: [Here follows a description of the property leased with certain exceptions and encumbrances which it is not necessary to set forth.] and finally subject to the reservation that no derrick shall be erected, no well drilled, no pipe line laid, no excavation made, no improvement placed and no work done upon the west half of Farm Lot fifty-nine (59) without first having obtained the consent of the city manager of the lessor, or his successor, to the location thereof, and that no building, or other structure, shall be constructed or placed on any land within one hundred fifty (150) feet of any of the reservoirs, whether in use or not, upon said lands.

This lease is granted by the lessor and accepted by the lessee for the purpose and with the exclusive right, subject to the terms, provisions and conditions hereof to explore and drill for, develop, collect, obtain, take, save, remove, market and otherwise use, enjoy and dispose of any and all kinds of oil, gas and other hydrocarbon substances which may be found in, upon or beneath the surface of said lands; together also with the rights, subject to compliance with the terms, provisions and conditions hereof, to use and enjoy the necessary rights of way for ingress and egress in, upon and across said lands for operation thereon under this lease; together also with the rights, subject to compliance with the terms, provisions and conditions hereof, to build, erect, operate, maintain and enjoy derricks, rigs, boilers, tanks, tankhouses, pumping stations, pipe lines, telephone, power and light lines and other structures, apparatus and equipment suitable for use only in connection with the drilling for, developing, producing, collecting, saving, disposing of and transporting from said lands of said substances produced therein or therefrom, for the term of five (5) years from and after the date hereof, and so long thereafter as oil, gas or other hydrocarbon substances are produced, collected and saved from said lands in paying commercial quantity.

Possessory Rights: The possession by the lessee of the lands herein described, with the exception of those portions of the lands herein expressly excepted or reserved by the lessor, shall be solely and exclusively for the purposes hereof, excepting that the lessor, in addition to the reservations herein contained, reserves the right to occupy and use the same for agricultural, grazing and such other purposes as the lessor may deem necessary or desirable insofar as same shall not at any time of use interfere with any of the rights or necessary operations of the lessee; and the lessee shall conduct his operations upon said lands so as to interfere as little as possible with the reserved uses of said lands in the lessor.

Property Protection: The lessee shall, during the full term hereof, or during such part of said term as he shall continue to occupy the herein demised lands for the purposes hereof, protect all works, structures and improvements of the lessor, together with all water stored in reservoirs or tanks, situated and located upon said lands against any and all damage and injury of whatsoever kind or character resulting from any of the operations conducted on said lands by the lessee.

* * *

Drilling Obligations: The lessee shall, within five (5) days following the date hereof, actively commence the work of erecting a derrick on some portion of said lands not reserved to use of lessor as hereinabove provided for, and shall actively and continuously, in a good and workmanlike manner, complete such derrick and install therein and on said lands the necessary drilling equipment, power plant and apparatus for the drilling of an oil well and thereupon shall at once commence the actual drilling of a well for the discovery and production of oil and other hydrocarbon substances; and after commencing the drilling of such well, the lessee shall drill continuously without interruption, except such interruptions as may be caused by strike, lockout, act of God, unavoidable accident, or other cause beyond the control of the lessee, until such well shall have been drilled to a depth of thirty-seven hundred (3700) feet or until oil, gas or other hydrocarbon substances shall be produced therefrom in paying and commercial quantity; and the lessee shall upon said condition continue to drill at least one well on said lands each year until there shall have been so drilled upon said lands at least one well for each ten (10) acres in area thereof; provided that if oil shall have been produced in paying and commercial quantity from any offset well drilled, as herein provided, during any of the said one-year periods, then and in that event the lessee shall be excused from drilling the additional well herein otherwise required to be drilled upon said lands during such one-year period.

Offset Drilling Obligations: When and as often as any well shall be drilled within a distance of six hundred (600) feet of any portion of said lands and shall produce oil at the rate of one hundred fifty (150) barrels, or more, per days of twenty-four hours, following an elapsed period of fifteen (15) days from and after the time such well shall have been brought to the point of production, the lessee shall, within forty-five (45) days thereafter commence the actual drilling of an offset well at the most advantageous place on said lands to offset the well so drilled within six hundred (600) feet of said lands, and shall drill such offset well continuously without interruption, except such interruptions as may be caused by strike, lockout, act of God, unavoidable accident, or other cause beyond the control of the lessee, until such well shall have been drilled to a depth of thirty-seven hundred (3700) feet or until oil, gas or other hydrocarbon substances shall be produced therefrom in paying and commercial quantity.

* * *

Gas - Its Sale and Disposition: If gas is produced from said lands in paying and commercial quantity and the same can be sold and marketed to advantage, the lessee shall sell and market the same, in which event the lessee shall, at its own cost and expense, provide the necessary traps and other means of segregating and separating the oil from the gas and for the collection of the gas; and it shall supply the lessor, monthly, with the registered meter readings showing the production of gas and will, monthly, supply the lessor with a complete record and account of the volume of gas sold, together with a statement from the purchaser, or purchasers, of such gas showing the amount of gas received by said purchaser, or purchasers, and the price paid therefor.

* * *

Refineries and Topping Plants: The lessee shall not erect or construct upon said lands, or any part thereof, any refinery or topping plant; provided, however, that the lessee is permitted to install a casing head gas plant thereon, at its option or election, for the purpose of converting into gasoline the gas produced on the lands.

The lessee shall not erect or construct any tanks upon said lands for the storage of oil not produced therefrom.

Taxes: The lessee shall pay all taxes and assessments which are levied or assessed upon any property which it may place on the said above described lands during the term hereof; and/or upon the oil or other hydrocarbon products stored on said lands by the lessee and not belonging to the lessor, and upon the mineral rights and interest of the lessee in said lands. All charges, taxes and assessments imposed by the State of California, United States of America, or any political subdivision of either thereof, upon said lands, or upon any part or parcel thereof, except upon the improvements placed thereon by the lessee, shall be paid in the following proportions: Forty (40%) per cent thereof by the lessor, and sixty (60%) per cent thereof by the lessee; provided, however, that the lessee shall at its sole and exclusive expense, pay and discharge all fees which are now or may hereafter be required to be paid by the State of California through the State Mining Bureau and the office of the State Oil and Gas Supervisor, or through such other department of the State of California which may be created for that purpose by legislative enactment.

* * *

Rents and Royalties: The lessee shall pay to the lessor, as rent, royalty for the use of said lands for the purposes aforesaid forty (40) per cent of all oil, gas and other hydrocarbon substances produced and saved from said lands, including casing head gas, except oil, or gas, or both used for fuel purposes, as herein provided; the payments of royalty to be made in money or in kind, at the lessor's option. If the rental is paid in kind it shall be stored, free of charge to the lessor, in tanks to be provided by the lessee, for a period of thirty (30) days following the calendar month in which said oil is produced. [Here follow detailed provisions respecting the payment.]

Contracts for sale of oil: The lessee shall, at least ten (10) days prior to the time when it shall sign any contract for the sale of oil or gas, or both, give written notice to the lessor of its intention to sign such contract and shall accompany such notice with a copy of the proposed contract, thus giving opportunity to the lessor to join in such contract for the sale of its royalty oil, if it shall elect so to do; and in the event that the lessor shall join in said contract, then the lessee shall be released from any and all obligations to pay the royalty of forty (40%) per cent in money, and the said contract shall provide that the purchaser under the terms of said contract shall pay the royalty of forty (40%) per cent direct to lessor.

Log and Measurements: The lessee shall keep a correct and accurate log and record of each well drilled on said lands and shall, weekly, supply the lessor with a full, true and correct copy of the log of each well then in course of drilling. * * *

The lessor shall have the right at all times, in the presence of the lessee, or of the duly authorized representative of the lessee, and in a reasonable manner, to test the accuracy of all gauges and measuring devices and to take copies of all accounts and records of production.

The lessee shall also furnish to the lessor, on or before the 20th day of each calendar month, a statement in writing, of the volume of casing head gas produced from the premises, if any, together with the price received for such product sold during the next preceding calendar month.

The lessor, through any of its agents or servants, is further granted the right to at all times inspect the works and operations of the lessee on said lands.

Forfeiture: If the lessee shall be in default in the payment of the royalty or in the performance of any covenant or agreement herein contained by it to be kept or performed and shall continue in such default for a period of thirty (30) days following written notice of the respect in which such default exists or is claimed, then the lessee shall forfeit all rights granted it hereunder.

Subsequent to 1924 the above lease was amended and in 1929 it was again amended providing for the drilling of deeper wells, and the city's royalty reduced to 30 per cent. For the protection of its rights under the above lease the city maintained and maintains on the property a laboratory for the purpose of testing all oil and gas produced. It employed and employs an oil engineer whose duty it is to see that petitioner performs and does not violate its contractual duties and to see to it that the city obtains the maximum amount which can be obtained from its share in the oil and gas. The oil has been sold under a joint contract of the city and petitioner as provided in the lease. Tests are made of runs of oil; the gas is measured and petitioner's reports and the reports of the purchasers checked up. The city kept and keeps a man on the leased property at all times whose duty it is to keep the Superintendent of the Water Department constantly informed of petitioner's activities. Conferences between petitioner's representatives and the city authorities have been generally held whenever the location of a new well is to be determined. The purpose of all the above was that the city might obtain the maximum results from their share of the oil and gas.

All of petitioner's gross income for the year 1922 was derived from oil and gas produced under the above lease from the city and from its capital invested and from labor employed by it. Of petitioner's gross income for 1923 the amount of $985,790.34 was derived from the same source, and of petitioner's gross income for 1924 it derived from the same source the amount of $1,935,376.82. In his deficiency letter respondent overstated the intangible cost of developing the oil and gas leases upon the city leaseholds for the year 1923 by the amount of $91,000, and for the year 1924 in the amount of $41,878.39.

The total of the above two amounts, to wit: $132,878.39 was expended by petitioner on oil leases in Oklahoma and, of the latter amount, $68,207.04 was spent in connection with what is hereafter referred to as the Davis and Menifee lease. By a contract dated June 14, 1923, it was agreed between petitioner and one Ramsey, who was the owner of certain oil and gas leases in the State of Oklahoma, including the Menifee and Davis leases, that Ramsey would execute an assignment to petitioner of a one-half interest in said leases, said assignment to be placed in escrow and delivered to petitioner when it had performed the requirements imposed upon it by the contract. Petitioner agreed to commence within 30 days from said date the drilling of a test well on said property and to complete the well, the well to be drilled with promptness and dispatch to a depth of 3,300 feet unless oil or gas in paying quantities should be found at a lesser depth, and was to be drilled and equipped wholly at the expense of petitioner. Any further development of the property was to be at the equal expense of both parties, and each was to be entitled to an equal share of all the oil and gas produced. By a supplemental contract dated June 27, 1923, the contract of June 14, 1923, was modified to provide that petitioner would earn the delivery of the assignment when it had performed its contract to drill a test well irrespective of whether oil and gas was found in paying quantities. By another contract dated June 14, 1923, between Ramsey and one Buttram of the first part and petitioner of the second part, as modified by a further contract between the same parties dated June 27, 1923, it was agreed that since the drilling of the test well provided for in the first contract would benefit certain other adjacent property leased by the first parties, the first parties would execute to petitioner an assignment of a one-half interest in their lease on said property, said assignment to be placed in escrow and delivered to petitioner when it had performed its contract with Ramsey. In the summer of 1924 petitioner's president, who was an oil man of long experience, visited the property referred to and found that two wells had been drilled upon the Menifee and Davis leases, both of which were dry and worthless. One had been abandoned and the drillers had ceased to work on the other and were preparing to leave. Under these conditions a contract dated July 17, 1924, was entered into between petitioner as party of the first part and Ramsey as party of the second part, which recited that party of the first part was the owner of certain leaseholds, including the Davis and Menifee leases, that by reason of a contract with Boggs Oil Corporation the party of the first part would become entitled to a one-half interest in another oil and gas lease when it should have drilled a test well upon such leased property, that the party of the first part desired the party of the second part to drill such a test well upon such lands, that the party of the first part had theretofore expended large sums of money in drilling wells upon other leases therein described which had been nonproductive and was desirous of selling to the party of the second part its right, title and interest in and to said oil and gas leases and said contract with Boggs Oil Corporation and set out the agreement of the parties in substance as follows:

(1) The party of the second part should within thirty days commence operations for the drilling of an oil well upon the lands covered by the Boggs Oil Corporation lease and continue operations until the well had been drilled to a depth of 3300 feet.

(2) That the party of the second part would pay $4,435.94, the balance due to one Mabee by the party of the first part for the drilling of a well upon one of the properties described.

(3) That the party of the first part would pay the rentals and royalties which might thereafter become due and payable under the terms and provisions of the leases mentioned in order to keep such leases in effect and avoid a forfeiture thereof.

(4) That the party of the first part does sell and convey all properties owned by the party of the first part and situated upon the lands described.

(5) That the party of the first part, upon demand, would execute and deliver to the party of the second part an assignment of its right, title and interest in and to all said leases and in and to its contract with Boggs Oil Corporation.

(6) That if, as and when oil or gas are produced in paying amounts from any of the lands described, the party of the second part pay to the party of the first part one-fourth of all moneys received from the sale thereof after deducting rentals and royalties payable to the lessors until party of the second part shall pay the sum of $132,893.89, said payment to be wholly contingent upon the discovery and production of oil and gas.

Petitioner had not, at the time of the hearing, May 21, 1930, received the amount of $132,893.89 referred to in the contract, or any part thereof.

During the year 1922 the petitioner expended in the conduct of its business the sum of $161,885.81, of which the sum of $59,376.86 represented expenditures made for physical equipment, and the balance thereof, to wit, the sum of $102,508.85, represented expenditures made for wages, fuel, repairs, hauling, etc., in connection with development and drilling; the full amount of $161,885.81 was capitalized in the determination of the deficiency for the year 1922. During the year 1923 the petitioner expended in the conduct of its business the sum of $691,706.73, of which the sum of $260,313.62 represented expenditures for physical equipment and the balance, to wit, the sum of $431,393.11, represented expenditures for wages, fuel, repairs, hauling, etc., in connection with development and drilling; the full amount of $691,606.73 was capitalized in the determination of the deficiency for the year 1923. During the year 1924 the petitioner expended in the conduct of its business the sum of $755,471.44, of which the sum of $303,244.69 represented expenditures made for physical equipment and the balance thereof, to wit, the sum of $452,226.75, represented expenditures made for fuel, repairs, hauling, etc., in connection with development and drilling; that the full amount of $755,471.44 was capitalized in the determination of the proposed deficiency for 1924. The aforesaid amounts of $431,393.11 and $452,226.75, expended for drilling and development expenses in 1923 and 1924, respectively, and capitalized in respect of the city lease, should be reduced by the amounts of $91,000 and $41,878.39. Respondent has allowed depreciation only on the above amounts expended for physical equipment and he has added the drilling and development expenses to the sums recoverable through depletion. Respondent computed petitioner's depletion allowance for 1924 based upon cost of leaseholds and of development cost plus discovery value at the amount of $1,228,864.99, and, applying the statutory limitation, allowed a deduction of $771,982.99.

OPINION.

PHILLIPS: The first and major question presented is whether so much of the income of petitioner as was derived from its oil and gas lease on lands owned by the city of Long Beach was exempt from Federal income and profits taxes. It is pertinent to point out that we do not have before us the issue whether the income of the city from the same lease is subject to such taxation. Petitioner vigorously contends that a tax upon its income from the lease constitutes a burden on the city's right to lease and on the property itself, and is in fact a tax upon the municipality in violation of the rule that neither the Federal Government nor any State may tax an agency of the other. A similar case was carefully considered by the Board in Coronado Oil & Co.,14 B.T.A. 1214, where we held that income derived by a private lessee from oil and gas leases on lands owned by a State was subject to Federal taxation even though the leased lands were held for public school purposes. Petitioner seeks to distinguish the Coronado case from this proceeding. It is urged that the lands leased by petitioner were acquired for governmental purposes, viz., to furnish water to the city and that having been so acquired the city was bound to use them so as to produce the greatest benefit to its citizens. Conceding this to be true, this proceeding would still be governed by the Coronado case, where the lands leased were held for public school purposes. There is no basis for doubt that education is at least as much of a governmental function as the supply of water. Furthermore, it should be pointed out that the petitioner was not furnishing water to the city and therefore was not an instrumentality through which the city was performing that function.

The income sought to be taxed is not the income of the city from the lease. It is the income of the lessee. Neither was it derived from the pumping and distribution of water, but from an oil and gas lease on land which was originally acquired for water purposes, but which is now used by the city not only for such purposes, but for many others. Besides granting to petitioner an oil and gas lease on this property, the city has granted another such lease and there are on the property approximately 60 other tenants who hold under leases and permits, all subject to the city's water rights, who engage in business ranging from farming to oil plants and whose income under petitioner's reasoning would be exempt or at least partially exempt from income tax. The fact that the city officers may have been coerced by political or other pressure into granting these leases and permits is immaterial. All such public officers are subject to such pressure. The fact remains that the city is largely using this property for purely commercial purposes. But whatever may be the nature of the city's functions with respect to these lands, it is clearly apparent that they are no more governmental in character than the maintenance of a public school system as in the Coronado case. Petitioner's position in this respect is no stronger than that of the taxpayer in that case.

Next, it is asserted that petitioner was under the control of the city authorities to such an extent as to render it an agency or instrumentality of the city in the development of its lands. If this is true, so also is it true of all the remaining city tenants and licensees. It is not pointed out how such control can change a business into a governmental function, nor is it clearly pointed out how this conclusion is reached. It is true that in Metcalf & Eddy v. Mitchell,269 U.S. 514, the Court referred to the question of control in arriving at the conclusion that the firm was not an employee, but rather an independent contractor. Here it is clear that petitioner is not an employee of the city, but is a lessee under an oil and gas lease and is liable just as any other lessee under the terms of its lease. Operating in the midst of a water plant, it was restricted to a greater extent than an ordinary lessee, but all these restrictions are set forth in the lease and are purely contractual. That the city kept strict watch in order that it might receive all to which it was entitled, does not differentiate the city from any other lessor who was equally desirous of such returns, neither was the city's interest in its return any greater than the interest of the State of Oklahoma in securing the best returns it could from its school lands. On authority of Coronado Oil & Gas Co., supra, we find for respondent on this issue. See also Bass v. Group No. 1 Oil Corp., 38 Fed.(2d) 483.

Petitioner asserts that it lost in the year 1924 the amount of $68,207.04, which it is stipulated was expended by it in connection with the Davis and Menifee leases. The evidence on this issue, which was partly stipulated, is quite meager. By the contracts of June, 1923, Ramsey and Buttram agreed to assign to petitioner, in consideration of its drilling one test well, a one-half interest in several leases owned by Ramsey and also a one-half interest in a lease owned by Ramsey and Buttram jointly. The assignments were to be placed in escrow and to be delivered when petitioner drilled the test well. Petitioner's president testified that the assignments were never delivered, but it is recited in the contract of July 17, 1924, that petitioner was the owner of an undivided one-half interest in the leases. There is also testimony that two test wells were completed upon these premises. The conclusion seems clear that the petitioner fulfilled its contract and became entitled to receive the assignments of a one-half interest in the several leases. Whether or not the assignments were delivered seems immaterial.

The petitioner having received this one-half interest in these leases as a consideration for drilling the test well, would not be entitled to deduct such cost until it was established that the leases were worthless. The fact that two wells came in dry, coupled with the testimony of the president of the petitioner would, perhaps, have been sufficient to have established the worthlessness of these leases, were it not for the contract which was entered into between Ramsey and the petitioner on July 17, 1924. The conclusion must be drawn from this contract that Ramsey and the petitioner, both of whom were experienced oil men, regarded the leases as still having some value. This contract provided for the assignment of all these leases to Ramsey, who agreed as a consideration therefor to pay a balance of $4,435.95 due upon one of the wells, to drill a well upon another of the leased properties, and to pay to the petitioner 20 per cent of the oil and gas recovered. The property upon which Ramsey was to drill the new well was not the same property upon which wells had been drilled by the petitioner. The petitioner contracted to make the payments necessary to keep all of the leases in existence. These undertakings, particularly the latter, indicate that the parties did not consider the leases to be worthless. It may be that they were regarded as of little value but, if the parties were willing to continue to pay the rents and royalties necessary to keep such leases alive despite two dry holes, they evidence their opinion of some value. In a case such as this it would be more reasonable to fix the date of worthlessness as being the date when the parties refused to pay further rents and royalties.

We appreciate that this conclusion is opposed to the testimony of the president of the petitioner. That testimony undertook to state the recollection and opinion of the witness several years after the fact and appears to be contradicted by the terms of the agreement entered into on July 17, 1924. The action of the Commissioner in refusing to allow the cost of acquiring the one-half interest in these leaseholds is approved.

The final contention of petitioner is that respondent erred in adding its drilling and development expenses to the amounts recoverable through depletion. Petitioner has waived its contention that these costs are proper subjects for annual deductions and apparently concedes that they should be capitalized. We believe that this is the proper solution of the problem. Cf. Consolidated Mutual Oil Co.,2 B.T.A. 1067, Old Farmers' Oil Co.,12 B.T.A. 203. Both parties agree that these capital expenditures are returnable to petitioner during the life of its lease and they differ only as to the character of the deduction. Respondent has allowed it as depletion, while petitioner claims it as depreciation. Respondent has added these expenditures to amounts recoverable through depletion and has thus determined a larger depletion unit. Ordinarily, where there is no difference as to the rate, it would become immaterial whether the capital cost was recovered as depreciation or as depletion. But section 234(a)(8) of the Revenue Act of 1924 as restricted by section 204(c) of the same act places certain limitations on the deduction for depletion while the deduction for depreciation is subject to no such restrictions. In the present case the restriction operates to deny to petitioner the full amount of the deduction for depletion to which it would otherwise be entitled. Under these conditions it becomes necessary to discuss the character of the deduction. Section 234(a)(9) of the Revenue Act of 1921 and section 234(a)(8) of the Revenue Act of 1924 permit the deduction in cases such as this of "a reasonable allowance for depletion and for depreciation of improvements * * *." As we understand the stipulation, the amounts in controversy were expended in drilling wells and in operations preparatory and relating to such drilling, all of which would constitute a part of the cost of the structure recoverable through depreciation. On the other hand, the concept of the term "depletion" is the exhaustion of the mineral content of a mine or an oil well. United States v. Ludey,274 U.S. 295. The precise wording of the statute indicates clearly that Congress has in mind the distinction between the exhaustion of the natural resources and the recovery of the capital invested in the improvements necessary to work the property. It can not be seriously contended that the exhaustion of petitioner's investment in preparing for and in drilling its wells constitutes any part of the exhaustion of its oil reserves.

The Commissioner relies upon article 223 of Regulations 62 which provides:

Such incidental expenses as are paid for wages, fuel, repairs, hauling, etc., in connection with the exploration of the property, drilling of wells, building of pipe lines, and development of the property may at the option of the taxpayer be deducted as a development expense or charged to the capital account returnable through depletion. If in exercising this option the taxpayer charges these incidental expenses to capital account, in so far as such expense is represented by physical property it may be taken into account in determining a reasonable allowance for depreciation. * * * (Italics supplied.)

If this regulation is susceptible of the construction which has been placed upon it in this case, it is in conflict with the provisions of the statute, which allows improvements to be depreciated. It seems to us, however, that the regulation has not been properly applied in this case. The construction used in computing the deficiency was that tangible assets which go upon the property, such as lumber, cement, casing, tubing, etc., are all charges that "are represented by physical property while other costs were not." The cost of labor for erecting the derrick or drilling the well, the fuel used in such operation, the cost of hauling such materials are all "represented by physical property." The Commissioner in his brief recognizes that such is the case and now urges that we sustain his action upon the ground that the stipulated facts are insufficient to show what part of the amounts disallowed were represented by physical property. The stipulation shows that the Commissioner has allowed as the cost of improvements (the word used in the statute) only the amounts expended for physical equipment and has refused to treat as cost of improvements amounts expended for wages, fuel, repairs and hauling "in connection with development and drilling." This terminology excludes the idea that any part of such amount was expended in discovery or exploration work or in operating the leased property. Amounts expended in development and drilling operations convey to us the impression of expenditures for improvements of the property upon which the statute permits the taxpayer to deduct depreciation. The adjustment of taxable income will be accomplished by allowing as depreciation the amounts previously treated as depletion allowances upon these expenditures.

At the hearing petitioner's president testified that he had been informed that the officers of the city were without authority to grant it a lease for a term exceeding three years, whereupon respondent amended his answer and alleged that petitioner did not have a depletable interest in the property leased. The lease was granted in April, 1922, for a term of five years and so long thereafter as oil and gas were produced in paying quantities. During all the years involved, 1922, 1923, and 1924, the leases were operated and the city received its share of the oil and gas produced wholly at petitioner's expense. There is nothing in the record which indicates that the city has questioned petitioner's rights, much less that the city has attempted to oust it. Whether the conclusion of the witness, a layman, was or was not sound in law, we have no way of determining from the record. Under these circumstances it would be presumptuous on our part to attempt to decide a question which the city has not raised.

Upon recomputation of the deficiency, respondent's overstatement of petitioner's intangible costs attributable to its city lease should be taken into consideration.

Reviewed by the Board.

Decision will be entered under Rule 50.