Oil properties, including fee interests, were sold for a
specified money consideration payable part in cash and the balance,
Page 310 U. S. 405
from one-half of the proceeds to be received by the vendee from
the oil and gas to be produced from the properties and from the
sale by him of the fee of any or all of the land conveyed. The
vendor was to have a first lien and claim against the one-half of
oil and gas production and fee interests from which the balance was
payable. The proceeds from production and sales were to go directly
to the vendee, who was to deposit one-half to the credit of the
vendor. The agreement recited the vendor's desire to sell all
interest in the properties, and, immediately upon its execution,
they were conveyed to the vendee without reservation.
that the part of the gross proceeds which the
vendee received from production and sale of oil from the properties
and paid over to the vendor pursuant to the contract should be
included in the gross income of the vendee in computing his income
tax under the Revenue Act of 1932. P. 310 U. S.
107 F.2d 459 affirmed.
Certiorari, 309 U.S. 645, to review a judgment affirming a
ruling of the Board of Tax Appeals.
MR. JUSTICE MURPHY delivered the opinion of the Court.
Oklahoma City Company, in 1931, owned certain royalty interests,
fee interests, and deferred oil payments in properties in Oklahoma.
During that year, it entered into a written contract with
petitioner Prichard providing for the conveyance to him of these
interests for the agreed consideration of one hundred sixty
thousand dollars, payable fifty thousand in cash and one hundred
ten thousand from one-half of the proceeds received by him which
might be derived from oil and gas produced from the properties and
from the sale of fee title to any or all of
Page 310 U. S. 406
the land conveyed. Interest at the rate of 6% per annum was to
be paid from the proceeds of production and of sales upon the
unpaid balance. Oklahoma Company was to have, in addition, a first
lien and claim against "that one half of all oil and gas production
and fee interest . . . from which the $110,000 is payable," the
lien and claim
"not in any way [to] affect the one-half interest in all oil and
gas production and fee interest or the revenue therefrom which . .
. [it] is to have and receive under this agreement."
The proceeds derived from the oil and gas produced and from
sales of the fee interests were to be paid directly to Prichard,
who was to deposit one-half of them at a designated bank at
intervals of 90 days, to the credit of Oklahoma Company. The
agreement recited that Oklahoma Company desired "to sell all of its
right, title and interest of whatsoever nature" in the described
properties, and provided that a copy of the agreement and a release
be placed in escrow for delivery to Prichard upon payment in full
of the one hundred ten thousand dollars and interest. Immediately
upon the execution of the contract, the properties were conveyed to
Prichard without reservation. [Footnote 1
] In entering into the agreement, Prichard acted
not only for himself, but also for petitioner Anderson, each of
them having a 45% interest. [Footnote 2
The gross proceeds derived from the production and sale of oil
from the properties [Footnote
] during 1932 amounted to
Page 310 U. S. 407
some eighty-one thousand dollars. Prichard, upon receiving this
sum, distributed one-half to Oklahoma Company pursuant to the
contract. The question for decision is whether the proceeds thus
paid over to Oklahoma Company should be included in the gross
income of petitioner for the tax year 1932. [Footnote 4
] The ruling of the Board of Tax Appeals
against petitioners was affirmed by the Circuit Court of Appeals.
107 F.2d 459. Because of an asserted conflict with the applicable
decisions of this Court, we granted certiorari. March 4, 1940.
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. Helvering v. Bankline Oil Co.,
303 U. S. 362
303 U. S. 367
Helvering v. O'Donnell, 303 U. S. 370
Helvering v. Elbe Oil Co., 303 U.
; Thomas v. Perkins, 301 U.
, 301 U. S. 661
301 U. S. 663
Helvering v. Twin Bell Oil Syndicate, 293 U.
, 293 U. S. 321
Palmer v. Bender, 287 U. S. 551
Compare Helvering v. Clifford, 309 U.
Oil and gas reserves, like other minerals in place, are
recognized as wasting assets. The production of oil and gas, like
the mining of ore, is treated as an income-producing operation, not
as a conversion of capital investment as upon a sale, and is said
to resemble a manufacturing
Page 310 U. S. 408
business carried on by the use of the soil. Burnet v.
Harmel, 287 U. S. 103
287 U. S.
-107; Bankers' Coal Co. v. Burnet,
287 U. S. 308
United States v. Biwabik Mining Co., 247 U.
; Von Baumbach v. Sargent Land Co.,
242 U. S. 503
242 U. S.
-522; Stratton's Independence v. Howbert,
231 U. S. 399
231 U. S. 414
The depletion effected by production is likened to the depreciation
of machinery or the using up of raw materials in manufacturing.
United States v. Ludey, 274 U. S. 295
274 U. S.
-303; Lynch v. Alworth-Stephens Co.,
267 U. S. 364
267 U. S. 370
Compare Von Baumbach v. Sargent Land Co., supra,
242 U. S.
-525. The deduction is therefore permitted as an act
of grace and is intended as compensation for the capital assets
consumed in the production of income through the severance of the
minerals. Helvering v. Bankline Oil Co., 303 U.
, 303 U. S.
-367. The granting of an arbitrary deduction, in the
interests of convenience, of a percentage of the gross income
derived from the severance of oil and gas, merely emphasizes the
underlying theory of the allowance as a tax free return of the
capital consumed in the production of gross income through
severance. Helvering v. Twin Bell Oil Syndicate,
293 U. S. 312
293 U. S. 321
United States v. Dakota-Montana Oil Co., 288 U.
, 288 U. S. 467
The sole owner and operator of oil properties clearly has a
capital investment in the oil in place, if anyone has, and so is
taxable on the gross proceeds of production and is granted a
deduction from gross income as compensation for the consumption of
his capital. See Burnet v. Harmel, supra,
at 287 U. S.
-108; Helvering v. Clifford, 309 U.
. By an outright sale of his interest for cash,
such an owner converts the form of his capital investment, severs
his connection with the production of oil and gas and the income
derived from production, and thus renders inapplicable to his
situation the reasons for the depletion allowance.
"The words 'gross income from the property,' as used in the
statute governing the allowance for depletion,
Page 310 U. S. 409
mean gross income received from the operation of the oil and gas
wells by one who has a capital investment therein -- not income
from the sale of the oil and gas properties themselves."
Helvering v. Elbe Oil Land Co., 303 U.
, 303 U. S.
Other situations, falling between the two mentioned, have been
put on one side or the other as the cases arose. 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 is depleted by severance. Palmer v. Bender,
287 U. S. 551
287 U. S. 557
Murphy Oil Co. v. Burnet, 287 U.
; Burnet v. Harmel, 287 U.
. See Lynch v. Alworth-Stephens Co.,
267 U. S. 364
Cash bonus payments, when included in a royalty lease, are regarded
as advance royalties, and are given the same tax consequences.
Burnet v. Harmel, 287 U. S. 103
Murphy Oil Co. v. Burnet, 287 U.
; Bankers' Pocahontas Coal Co. v. Burnet,
287 U. S. 308
Compare Helvering v. Elbe Oil Land Co., 303 U.
, 303 U. S. 375
A share in the net profits derived from development and operation,
on the contrary, does not entitle the holder of such interest to a
depletion allowance even though continued production is essential
to the realization of such profits. Helvering v.
O'Donnell, 303 U. S. 370
Helvering v. Elbe Oil Co., 303 U.
. Similarly, the holder of a favorable contract to
purchase wet gas at the mouth of the well is denied a depletion
allowance on the difference between the contract price and the fair
market value. Helvering v. Bankline Oil Co., 303 U.
. Such an interest has been characterized by us as
a "mere economic advantage derived from production, through a
contractual relation to the owner." Helvering v. Bankline Oil
at 303 U. S.
Thomas v. Perkins, 301 U. S. 655
relied upon by petitioners, presented the issue whether the right
to oil payments
Page 310 U. S. 410
-- that is, the right to a specified sum of money, payable out
of a specified percentage of the oil, or the proceeds received from
the sale of such oil, if, as, and when produced -- should be
treated for tax purposes like the right to oil royalties or like
the right to cash payments upon a sale. In that case, the
assignment of lease provided for payments in oil only without the
reservation of a royalty interest. The question was whether the
assignees' gross income should include moneys paid to the assignors
by purchasers of the oil. We stated (p. 301 U. S.
"The granting clause in the assignment would be sufficient, if
standing alone, to transfer all the oil to the assignee. It does
not specifically except or exclude any part of the oil. But it is
qualified by other parts of the instrument. The provisions for
payment to assignors in oil only, the absence of any obligation of
the assignee to pay in oil or in money, and the failure of
assignors to take any security by way of lien or otherwise
unmistakably show that they intended to withhold from the operation
of the grant one-fourth of the oil to be produced and saved up to
an amount sufficient when sold to yield $395,000."
Under these circumstances, the money received by the assignors
from the sale of the oil were deemed not to be income to the
assignees. See also Palmer v. Bender, 287 U.
The holder of an oil payment right, as an original proposition,
might be regarded as having no capital investment in the oil and
gas in place. The value of the right, even though dependent upon
the extent of the oil reserves, is fixed at the moment of creation,
and does not vary directly with the severance of the mineral from
the soil. In this sense, it resembles the right to cash payments
more closely than the right to royalty payments. 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
Page 310 U. S. 411
convenient allocation between lessor and lessee of both the
gross income derived from production and the allowance for
depletion. Compare Burnet v. Harmel, 287 U.
, 287 U. S.
-107. Accordingly, this Court, in Thomas v.
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. The decision did not turn upon the
particular instrument involved, or upon the formalities of the
conveyancer's art, but rested upon the practical consequences of
the provision for payments of that type. See Palmer v.
Bender, 287 U. S. 551
287 U. S.
-557; Burnet v. Harmel, 287 U.
, 287 U. S.
The Government maintains that the present case is
distinguishable from Thomas v. Perkins
for the reason that
the basis for decision there was that ownership of sufficient oil
to make the payments had not been conveyed to the assignee, but
remained in the assignor. It asserts that the terms of the contract
and the instruments of conveyance here negative any intention on
the part of the parties to withhold from the operation of the grant
an amount of oil equal to the oil payments. The following factors,
among others, are relied upon as supporting this contention: (1)
the contract contains no qualifying language reserving from the
grant any interest in the oil and gas in place; (2) the deferred
payments of one hundred ten thousand dollars were payable in cash
and not directly in oil; (3) the deferred payments drew interest
until paid; (4) Oklahoma Company had a first lien and claim against
one-half of the oil and gas production and fee interest; (5)
petitioner Prichard had the right to sell the fee interest covered
by the contract and discharge the deferred payments out of the
proceeds of such sale, rather than out of the proceeds of the oil
and gas production.
Page 310 U. S. 412
Several of the distinctions urged upon us by the Government are
without substance. The economic consequences of the transaction are
not materially affected by the circumstance that the provision for
oil payments is not phrased in terms of a reservation from the
conveyance to Oklahoma Company of an interest in the oil and gas in
place. And the fact that the payments to Oklahoma Company are in
cash, rather than directly in oil, is of no moment in determining
the issues presented for decision. Compare, however, General
Utilities Co. v. Helvering, 296 U. S. 200
Similarly, the retention of a lien, if it were construed as a lien
only upon the oil and gas production, and nothing more, [Footnote 5
] 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. It is clear that
payments derived from such sales would not be subject to an
allowance for depletion of the oil reserves, for no oil would
thereby have been severed from the ground; an allowance for
depletion upon the proceeds of such a sale would result, contrary
to the purpose of Congress, in a double deduction -- first, to
Oklahoma Company; second, to the vendee owner upon the production
of oil. Helvering v. Twin Bell Oil Syndicate, 293 U.
, 293 U. S. 321
We are of opinion that the reservation of this additional type of
security for the deferred payments serves to distinguish
Page 310 U. S. 413
this case from Thomas v. Perkins.
It is similar to the
reservation in a lease of oil payment rights together with a
personal guarantee by the lessee that such payments shall at all
events equal the specified sum. In either case, it is true, some of
the payments received may come directly out of the oil produced.
But our decision in Thomas v. Perkins
does not require
that payments reserved to the transferor of oil properties shall,
for tax purposes, be treated distributively, and not as a whole,
depending upon the source from which each dollar is derived. An
extension of that decision to cover the case at bar would create
additional, and in our opinion unnecessary, difficulties to the
allocation for income tax purposes of such payments and of the
allowance for depletion between transferor and transferee. In the
interests of a workable rule, Thomas v. Perkins
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. The deferred payments reserved by Oklahoma Company,
accordingly, must be treated as payments received upon a sale to
petitioners, not as income derived from the consumption of its
capital investment in the reserves through severance of oil and
Petitioners, as purchasers and owners of the properties, are
therefore taxable upon the gross proceeds derived from the oil
production, notwithstanding the arrangement to pay over such
proceeds to Oklahoma Company. See Helvering v. Clifford,
309 U. S. 331
Reinecke v. Smith, 289 U. S. 172
289 U. S. 177
Old Colony Trust Co. v. Commissioner, 279 U.
* Together with No. 683, Prichard v. Helvering, Commissioner
of Internal Revenue,
also on writ of certiorari, 309 U.S. 645,
to the Circuit Court of Appeals for the Tenth Circuit.
Petitioners state that "the instruments of transfer of those
properties were absolute and unqualified assignments and
conveyances" and that there was "no reservation of any sort of
interest, much less any legal interest, specified in those
assignments and conveyances."
The remaining 10% interest was acquired for one Olsen, whose
case was consolidated with those of Prichard and Anderson, and
disposed of in the same opinion below, but who has not sought
The record does not indicate what portion of the gross proceeds
was derived from the production and sale of oil and gas and what
portion, if any, was derived from sales of fees and from royalties
on leases. The Commissioner in determining deficiencies against
petitioners, however, added $11,276.39 to the gross income of each
with the explanation that this amount represented "In-oil payments
received in connection with the Patterson [Oklahoma Company] Deal"
not reported by petitioners. Respondent, in view of this
explanation by the Commissioner and the omission from the record of
any disclosure of the method of computing the $11,276.39 addition
to gross income, accepts petitioners' statement that "the only
income from the properties here in dispute is from oil
Revenue Act of 1932, c. 209, 47 Stat. 169.
The lien here appears to cover both the oil and gas production
and the fee interest from which the deferred payments were to be