These four appeals present the same question: The taxpayers own royalty interests under ordinary oil and gas leases; during, the taxable years, they received their contract share of the oil produced and have sold: it. Are the proceeds of such sales taxable as" ordinary income, or are they taxable as capital gains arising from the sales of capital assets held by the taxpayers for more than two years? The trial court held to the latter view, and the collector has appealed.
Helene Walker King filed three suits against the collector, onе to recover taxes paid by her for the year 1925, one for the-year 1926, and one for the year 1927. She alleged that the taxes so paid arose out of.' the sale of oil and gas produced from three tracts of land, on which lands and the oil and gas so produced her right was acquired for-profit more than two years prior to January 1, 1925; that such oil was not a part of her stock in trade, nor was it held by her primarily for sale in the course of her trade or business; that the oil and gas was produced-in the course of development under three leases; the plaintiff and/or her husband owned two оf the tracts of land, and she and her husband were tbe lessors, the plaintiff owning, during the taxable years, one-half of the one-eighth royalty interest therein; the third tract was owned by one Schroeder and/or his wife, and,they were the lessors, the plaintiff having acquired, in 1920, one-thirteenth of the lessor’s one-eighth interest therein. These leases are, in substance, tbe same, and grant, let, and lease, for the period of five years or as long thereafter as oil or *236 gas is produced therefrom, the land described “for the sole and only purpose of mining and operating for oil and gas” and purposes incidental thereto. In consideration whereof, the lessee agreed to “deliver to the credit of the lessor, free of cost, in the pipe line to which he may connect his wells, the equal one-eighth part of all oil produced and saved from the leased premises.” A cash rental was stipulated for gas used off the premises; there are other covenants unimportant here; the royalty right is without burden or obligation upon plaintiff’s part. The plaintiff then alleges that the collector wholly computed her tax in conformity with sections 210 and 211 of the Revenue Acts of 1924 and 1926 (26 USCA §§ 951 note, 952 note), and deniеd to her the election of paying the 12% per cent, of the capital net gain provided by section 208 (26 USCA § 939 note). She filed a claim for refund of the difference in tax, and upon its disallowance brings these suits. Plaintiff’s recomputation of the tax is attached to her petition, which discloses that she returned the full sale price of oil sold, and deducted therefrom, not the cost to her, ■or the March 1, 1913, value, of the capital asset alleged to have been sold, but deducted •27% per cent, óf the sale price as depletion.
A general demurrer to the petition was filed in one of the cases, argued and overruled. Answers by way of general denials were filed, and the cases were ■ submitted on stipulations which the trial court treated as admitting the allegations of the petitions. The stipulations only admit that the taxes were assessed under sections 210 and 211, and that, if they are legally calculable under section 208, there was an overpayment in sums stated. The stipulations do not admit the income arose as alleged. These records are carelessly prepared; -the collector filed general denials without admitting the citizenship of plaintiff, his own official capacity, the оwnership of the royalty interests, or the sources of the income. The cases were tried on stipulations which cover none of the es- • sential facts except the amount recoverable. But, since the trial court and the parties treat the allegations of the petitions as admitted, and since it is important that the law be determined, we take the petitions as true.
In No. 306, Anna Ruzek had owned the land from which the oil was produced since 1905, and she was the lessor under a lease substantially identical with those above described.- She sues to recover taxes paid for the year 1923, and her case is governed by the corresponding sections of the act of 1921. In her ease, a demurrer was filed and overruled, an answer was filed, and the same stipulation made as above set out.
Prior to 1921, gain realized from the sale of capital assets was treated as all other income, and subject to the same tax rates. The tax rates were high in the upper surtax brackets, and the gain from such sales often reached into such brackets. Because of such high rates, sales were not made and business was stagnating. Accordingly, the Ways and Means Committee reported out section 206 of the Revenue Act of 1921, 42 Stat. 232 (section 208 in the Revenue Acts of 1924 and 1926 [26 USCA § 939 note]) to relieve this situation, and in explanation thereof'stated:
“The sale of farms, mineral properties, and other capital assets is now seriously retarded by the fact that gains and profits earned over a series of years are under the present law taxed as a lump sum (and the amount of surtax greatly enhanced thereby) in the year in which the profit is realized. Many such sales, with their possible profit taking and consequent increase of the tax revenue, have been blocked by this feature of the present law. In ordеr to permit such transactions to go forward without fear of a prohibitive tax, the proposed bill, in section 206, adds a new section (207) to the income tax, providing-that where the net gain derived from the sale or other disposition of capital assets would, under the ordinary procedure, be subjected to an income tax in excess of 15 per cent, the tax upon capital net gain shall be limited to that rate. It is believed that the passage of this provision would materially increase the revenue, not only because it would stimulate profit-taking transactions but because the limitation оf 15 per 'cent is also applied to capital losses. Under present conditions there are likely to be more losses than gains.”
Section 208(a), 26 USCA § 939 note, provides that the term “ ‘capital gain’ means taxable gain from the sale or exchange of capital assets”; and “the term ‘capital assets’ means property held by the taxpayer for more than two years (whether or not connected with his trade or business), but does not include stock in trade of the taxpayer or other property of a bind which would properly be included in the inventory of the taxpayer if on hand at .the close of the taxable year, or property held by the taxpayer primarily for sale in the course of his trade or business.”
Section 208(b), 26 USCA § 939 note, provides that — ■ .
*237 “In the case of any taxpayer (other than a corporation) who for any taxable year derives a capital net gain, there shall (at the election of the taxpayer) be levied, collected, and paid, in lieu of the taxes imposed by sections 951 and 952, a tax determined as follows : A partial tax shall first be computed upon the basis of the ordinary net income at the rates and in the manner provided in sections 951 and 952, and the total tax shall be this amount plus 12% per centum of the capital net gain.”
Section 210 provides for the levy of the normal tax on income, and 211 for the levy of the surtax. Section 214 (26 USCA § 955) authorizes the allowance of certain deductions from income, and included therein is the following:
“In the ease of mines, oil and gas wells, other natural deposits, and timber, a reasonable. allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each ease; such reasonable allowance in all cases to be made under rules and regulations tо be prescribed by the commissioner, with the approval of the Secretary. In the ease of leases the deduction allowed by this paragraph shall bo equitably apportioned between the lessor and lessee.”
Section 204(c), 26 USCA § 935, provides that the basis upon which depletion is to bo allowed shall be the same as is provided for the purpose of determining gain or loss upon sale, with certain exceptions; in 1926, the section was amended by providing that in case of oil or gas wells the allowance for depletion shall be 27% per cent, of the gross income, but not to exceed 50 pеr cent, of the net income from the property, nor be less than it would be if computed without reference to this paragraph.
The position of the plaintiffs is that the oil which they sold was property which they had held for more than two years, and thus is within the definition of “capital assets” in section 208, and that, in truth and fact, the oil is a part of the substance of the land and is limited in amount, and when they sell it, even in installments, they are parting with a part of their capital. The collector asserts that the moneys realized by a royalty owner from the operation of an oil property is ordinary incomе, and not within either the letter or the spirit of the exception contained in section 208; that the plaintiffs did not own the oil until it was reduced to possession, which took place within the two-year period fixed by the statute; that, prior to reduction to possession, all they owned was an incorporeal right to reduce to possession, which right was not sold during the taxable year, and the sale of which plaintiffs do not allege was the source of the income. The collector further contends that the returns of the plaintiffs do not disclose either the cost or value of the properties sоld, and thus do not disclose a capital gain; and, furthermore, that the plaintiffs deducted 27% per cent, as a depletion allowance, which is a proper deduction from income but not from a capital gain. The collector further asserts that, by binding analogies, the question has been determined by the Supreme Court of the United States.
Plaintiffs rely largely upon the two decisions of the Board of Tax Appeals upon which the trial court rested its opinion. The first is Murphy v. Commissioner, 9 B. T. A. 610. Murphy owned land in Arkansas, upon which he made divers oil and gas leases. In addition to the one-eighth royalty reserved in the lеases, he received a cash consideration, or bonus, of $52,062.70 for their execution. He then transferred, by warranty deed, an undivided one-half interest “in and to all of the oil, gas and other minerals” under his land, subject to the outstanding leases, the deed reciting an intention to convoy “one-half of the one-eighth royalty to come to the lessors in the leases above described.” For this transfer he received $12,925. Murphy claimed that both sums should be taxed as capital gain under section 206 of the Revenue Act of 1921. The Board held that’the bonus was not capital gain, following Berg v. Commissioner, 6 B. T. A. 1287, but held that the cоnsideration received for the warranty deed was a capital gain. This decision lends no support to the claim of plaintiffs, for Murphy sold outright one-half of his reserved royalty, which represented the landowner’s property right in the oil and gas. In the cases at bar, the taxpayers retain that property right, and the income in question is their return for the use thereof. The distinction is similar to that between the proceeds from the sale of a farm, and the proceeds from a rental on shares.
The other ease relied on is Reynolds v. Commissioner, 10 B. T. A. 651. The facts are identical with the Murphy Case, and thе decision the same. The Board of Tax Appeals has, however, decided the precise question here involved, since the decision of the court below. The case is Ferguson v. Commissioner, 20 B. T. A. 130. The taxpayer owned the land and received a bonus for the execution of oil leases in the years 1922,
*238
1923, and 1924. During each of those years, and in 1925, he received a large income from the “rentals and royalties”'reserved-in such leases. ’The Board referred to its prior decisions, and- the -decisions of the Supreme Court hereafter discussed, and held that 'neither the income from royalty reserved nor the cash bonus was a capital gain within the intendment of section 206. The Court of Appeals of the Fifth Circuit reversed this decision as to the bonus, but affirmed it as to the question here 'involved, the royalties from operations. Ferguson v. Commissioner (C. C. A. 5)
The petitions allege that the income, arose from “the sale of oil and gas produced” which had been owned by them for more than two years. Plaintiffs did own the land, or mineral rights therein, for more than two years; but did they own the oil thereunder until it was reduced to possession, which was within two years? The answer must be found in the decisions of the Supreme Court of Oklahoma. Poe v. Seaborn,
“By virtue of, such ownership they had, on account of the ‘vagrant and fugitive nature’ of £he substances constituting ‘a sort of subterranean ferae naturae’ * * * no absolute right or title to the oil or gas which might permeate the strata underlying the surface of their land, as in the case of coal or other solid minеrals fixed in, and forming a part of, the soil itself. * * * But with respect to such' oil and gas, they had certain rights designated by the same courts as a qualified ownership thereof»- but which may be more aeeurátely stated as exclusive'right, subject,.to legislative control against waste and the like, to erect structures on the surface' of their land, and explore therefor by drilling wells through’ the underlying strata, 'and to take theréfrom and reduce to possession, and thus acquire absolute title as personal property to such as Might be found and obtained thereby/ • This fight is the proper subject of sale, and may be granted or resеrved. * * * The right so granted or reserved, and held separate and apart from the possession of the land itself, is an incorporeal hereditament; or more specifically, as, designated in the ancient French, a profit a prendre, analogous to a profit to hunt and fish on the land of another.”
Turning then to the rights granted under a lease similar to the ones here involved, the court said:
“In other words, it was a grant of the exclusive right, for the time specified, to take all the oil and gas that could be found by drilling wells upon the particular tract of land, with the accompanying incidental right to occupy so much of the surface as rеquired to do those things necessary to the discovery of and for the enjoyment of the principal right so to take oil or gas. No more nor greater right, except perhaps as to duration, with respect to oil and gas, could be granted. Although there had been in terms a purported conveyance of all the oil and gas in the place, yet, by reason of the nature of these substances, no title thereto or estate (¡herein would have vested, but only the right to search for and reduce to possession such as might be found; and when reduced to pos-; session, not merely discovered, title thereto and an estate therein as corporeal property would vest.”.
In Carter v. Rector,
Rich v. Doneghey has been repeatedly followed in Oklahoma. Dunlap v. Jaсkson,
“Without pausing to weigh the reasoning •of the opinions of the Indiana court in order to ascertain whether they in every respeet harmonize, it is aрparent that the cases in question, in accord with the rule of general law, settle the rule of property in the state of Indiana to be as follows: Although in virtue of his proprietorship the owner of the surface may bore wells for the purpose of extracting natural gas and oil until these substances are actually reduced by him to possession, he has no title whatever to them as owner. That is, he. has the exclusive right on his own land to seek to acquire them, but they do not become his property until the effort has resulted in dominion and control by actual possession.”
The Supreme Court of Califоrnia has recently explored the same question and reached a conclusion in accord with Rich v. Doneghey, and Ohio Oil Company v. Indiana. People ex rel. Stevenot v. Associated Oil Company et al. (Sup.)
“The ordinary and legal meaning of the word ‘royalty,’ as applied to an existing oil and gas lease, is the compensation provided in the lease for the privilege of drilling and producing oil and gas, and consists of a share in the oil and gas produced. It does not include a perpetual interest in the oil and gas in the ground.”
Authorities might be multiplied, but Rich v. Doneghey exhausts the prior Oklahoma decisions; Ohio Oil Company v. Indiana cites many authorities then existing; and in the Stevenot and Bandini Cases, the California Supreme Court has gathered the recent cases from oil-producing states. Further citation here would duplicate work already well done. '
From these authorities the conclusion is clear that the plaintiffs did not own the oil before it was reduced to possession; their ownership of the oil arose within the two-year limitation of the statute, and they are not entitled to exercise the electiоn afforded by section 206 of the Revenue Act of 3921, or by section 208 of the 1924 and 1926 acts. It is true that, through ownership of the land, they owned a property interest in the oil and gas, the right to search for and appropriate, clearly defined in the above cases and aptly described by Judge Phillips in his dissenting opinion in Leydig v. Commissioner (C. C. A. 10)
While the question presented seems not to be difficult on principle, the ease of Ferguson v. Commissioner, supra, is the only ease directly in point; but there are other cases which present close analogies. Under the Act of June 28, 1906 (34 Stat. 539), which dealt with the Osage Tribe of Indians, the mineral rights were reserved for the use of the tribe, but the income therefrom was distributable to the individual members of the tribe. In Work v. Hosier,
“The bonus which was the result of bidding for desirable and profitable oil and gas leases secured for the members of the Osage Tribe the just value of the use of their property which the fixing of royalties in advance by the President was not adapted to give them. It was in effect a supplement to the *240 royalties already determined. It was really part of the royalty or rental in a lump sum or down payment. We do not see how it can he classified as anything else. It was income from the use of the mineral resources of the land. Of course, it involved a consumption and reduction of the mineral value of the land, but so does a royalty. This is an inevitable characteristic of income from the product of the mine. What was intended to be distributed to the members of the tribe was the income from the mineral deposits in their lands, and the bonus was part of that. Doubtless Congress had in mind regular annual or quarterly equal payments when it used the word ‘royalties/ and did not anticipate such large down payments. ■ But in the unexpected event, we must decide under what head the bonus is to be treated, whether as capital or income, and it seems clear to us that, in view of the entire statute, it is more aptly described by the latter term.”
Again; the Eighth Circuit Court of Appeals and the Court of Appeals of the District of Columbia have held that the cash eon.sideration or bonus received in consideration Of the execution of an oil lease is not a- capital gain within sectiоn 208. Certiorari was "denied in both eases. • Burkett v. Commissioner,
Pertinent and persuasive authority is found iñ thé line of cases déeided by the .Supreme Court of the United States, dealing with the operation of mines of minerals in place, such as iron or coal. Here again, the cases are stronger against plaintiffs, for the rights of the surface owner to ore in place are more tangible than his right to fugacious minerals. The Supreme Court has dealt, with nearly all the aspects of such mining operations, and has steadfastly declined to treat them as conversions of capital assets. In Stratton’s Independence v. Howbert,
“We have no difficulty, therefore, in concluding that the proceeds of ores mined by a corporation from its own premises are to be taken as a part of the gross income of such corporation. Congress no doubt contemplated that such corporations, amongst others, were doing business with a wasting capital, and for such wastage they made due provision in declaring that from the gross income there should be deducted (inter alia) ‘all losses actually sustained within the year/ including ‘a reasonable allowanсe for depreciation of property, if any/ etc.”
Stanton v. Baltic Mining Co.,
Von Baumbach v. Sargent Land Co.,
“We think that the payments made by the lessees to the corporations now before the court were not in substance the proceeds of an outright sale of a mining property, but, in view of the terms of these instruments, were in fact rents or royalties to be paid upon entering into the premises and discovering, developing, and removing the mineral resources thereof, and as such must be held now, as then, to come fairly within the term 'income’ as intended to be reached and taxed under the terms of the Corporation Tax Act.”
In United States v. Biwabik Mining Co.,
Plaintiffs distinguish these decisions of the Supremo Court of the United States because the royalties wore payable in cash instead of in kind. The Supremo Court rests its decisions on no such narrow ground, and in the Stratton Case no cash rental was involved. What difference in the quality of the transaction exists on account of the medium in which the rental is paid? A landowner who rents his farm on shares should not be treated differently than one who rents for cash. It is true that most of these cases dealt with the Corporation Tax Aet, as pointed out in the Eerguson Case, supra; but the excise levied by that aet was measured by income, and not by the sale price of properties owned. And, as we read these decisions, they hold that the profit from mining operations is income from the use of, as distinguished from a sale of, a capital asset.
Section 206 of the Act of 1921 and section 208 of the Acts of 1924 and 1926 apply only where there has been a conversion of сapital assets by a sale or exchange. But the Supreme Court has established the rule that the revenues derived from mining royalties do not arise from a conversion of capital assets. No reason appears why an exception should be made where the minerals happen to be oil and gas.
It follows that the judgments appealed from are erroneous. Since the eases were tried on stipulations, there is no occasion for a new trial. Howbert v. Penrose (C. C. A. 10)
Reversed.