Before PHILLIPS, Chief Judge, and HUXMAN and MURRAH, Circuit Judges.
This action was brought by Group No. 2 Oil Corporation*fn1 against Jones, as Collector of Internal Revenue, to recover refunds of income taxes paid for the years 1940 and 1941 and excess profit taxes paid for the year 1941.
After trial, but before judgment, the taxpayer having merged with Continental Oil Company, the latter was substituted as plaintiff.
From a judgment in favor of Jones, Continental has appealed.
The taxpayer was incorporated on October 22, 1921, under the laws of Delaware. Its entire capital stock was issued to Texon Oil & Land Company,*fn2 a Delaware corporation, in consideration of which Texon transferred and assigned to the taxpayer certain permits issued by the state of Texas to prospect for and develop oil and natural gas on 16 sections of land situated in Reagan County, Texas, and obligated itself at its own cost and expense to drill and complete for taxpayer a well for oil and gas to a depth of 4,000 feet on one of such sections of land at a location to be agreed upon, referred to as Well No. 1. The cost of the permits to Texon was $1,100.45 and they were transferred to and received by the taxpayer in a nontaxable transaction.
Texon employed Carl G. Cromwell, a drilling contractor, to drill the well. On or about January 25, 1925, Cromwell completed the well. It was a dry hole and was plugged and abandoned upon completion. The cost to the contractor of drilling and completing the well was $50,359.20.
In the year 1924, Texon agreed to drill and equip or cause to be drilled and equipped for the taxpayer two additional wells on the block of leases, at locations to be mutually agreed upon, for which taxpayer agreed to pay $200,000. Texon caused the two additional wells, known as Wells Nos. 2 and 3, to be drilled and completed by Cromwell during the year 1925. In subsequent years, the taxpayer paid Texon the contract price of $200,000. Both wells were completed as dry holes and were plugged and abandoned. The taxpayer recovered salvage materials therefrom of the value of $13,427.38, leaving the net cost to it of Wells Nos. 2 and 3 of $186,572.62.
The oil and gas permits covering the 16 sections transferred to taxpayer by Texon were converted into oil and gas leases after oil was discovered on other lands included in such permits. The leases were for terms of 10 years, renewable for successive terms of 10 years so long as production continued. Each of the leases was at the end of the original 10-year term renewed for another 10-year term and remained in force and effect until released and surrendered. In 1938, the taxpayer surrendered and wrote off on its books the renewal oil and gas leases, in so far as they covered 5 sections of such lands, which included Section 22, upon which Well No. 1 was drilled. In the year 1940, it surrendered and wrote off on its books the renewal oil and gas leases covering the remaining 11 sections, which included the sections upon which Wells Nos. 2 and 3 were located.
In its tax return for the fiscal year ended June 30, 1925, the taxpayer claimed the cost of drilling the three wells as an expense. The election was made in its first return after the drilling of the wells was completed and the deductions were allowed by the Commissioner under Article 225 of Treasury Regulations 65, then in force and effect.
The taxpayer had no income and did not report income or pay income taxes for the fiscal year ended June 30, 1925.
In its return for the year 1940, the taxpayer deducted the sum of $214,734.92 on account of the leases surrendered in that year. The deduction was based on the cost of Texon of the permits acquired by taxpayer from Texon, plus the net cost of drilling the three wells. The Commissioner allowed a deduction of $687.77 and, in disallowing the remainder, held that the cost of the three wells was a deductible expense in taxpayer's fiscal year ended June 30, 1925. The Commissioner determined the taxpayer had earned a normal taxable income during the year 1940 of $33,648.37 and assessed a deficiency of $7,441.25, which the taxpayer paid, with interest.
In its fiscal year ended March 31, 1927, taxpayer received 544 shares of common stock of Reagan County Producing Company, Inc.,*fn3 of the value of $244.31 per share, which constituted income taxable to it in that fiscal year. It reported such shares as of the value of $1 per share. Because the stock was reported at a value of $1, a net loss of $39,133.97 was shown in the return of income of the taxpayer for the year 1927.
The shares of stock in Reagan had been issued to taxpayer, Big Lake Oil Company, Texon, and Group No. 1 Oil Corporation in connection with an agreement entered into in 1924 with the Marland Oil Company. The stock was placed in escrow when issued, and was to be ...