5 T.C. 296">*296 The respondent has determined deficiencies in income tax for the year 1940 in the amount of $ 2,730.13 for each petitioner. Not all of the adjustments are in dispute. The issues are (1) whether the petitioners are entitled to deduct, in computing their community net 5 T.C. 296">*297 income, the sum of $ 1,933.93 representing one-fourth of the net profits from the operation of an oil and gas lease which they paid to the assignor of the lease during the taxable year, or, alternatively, whether they are entitled to exclude that amount from their gross income, and (2) whether petitioners are entitled to report as a long term capital gain the gain realized by them from the sale of stock of C. I. Drilling Co. during the taxable year. The proceedings were consolidated1945 U.S. Tax Ct. LEXIS 138">*140 for hearing.

The petitioners filed their returns for the taxable year with the collector for the first district of Texas.

FINDINGS OF FACT.

The facts have been stipulated and we adopt the stipulation of facts as our findings of fact. Only those stipulated facts which are essential to the determination of the issues are set forth herein.

Petitioner Dorothy Mahn was formerly the wife of petitioner Euleon Jock Gracey. Throughout the taxable year they resided together as man and wife in Houston, Texas. Their income tax returns for the taxable year were filed on a community basis, and all of their income and deductions in that year represented community income and community deductions. Hereinafter, Euleon Jock Gracey will be referred to as the petitioner.

Issue 1. -- Prior to October 31, 1939, petitioner was a member of a partnership, Cron and Gracey, which concern engaged in the business of drilling oil wells and producing and selling oil and gas. On October 31, 1939, the partnership was dissolved.

When the partnership of Cron and Gracey was dissolved on October 31, 1939, its assets were distributed in kind to the partners. Among the assets distributed to petitioner upon the1945 U.S. Tax Ct. LEXIS 138">*141 dissolution was an oil well drilling rig which was acquired by the partnership in 1935. The drilling rig had been used by the partnership in its business and had been subject to a depreciation allowance.

On or about February 10, 1940, petitioner and a man named DeArmand, who also owned a drilling rig, formed a corporation known as the "C. I. Drilling Co., Inc.," for the purpose of conducting a drilling business in Louisiana. On February 10, 1940, petitioner and DeArmand exchanged their drilling rigs for stock of the C. I. Drilling Co., petitioner receiving 500 shares and DeArmand receiving 250 shares. The stock of the C. I. Drilling Co. received by petitioner and DeArmand was substantially in proportion to their respective interests in the assets exchanged for the stock. The drilling rig which petitioner transferred to the C. I. Drilling Co. had an undepreciated cost or basis to petitioner of $ 29,658.18 at the time he transferred it to the drilling company. The parties have stipulated that 5 T.C. 296">*298 the exchange of the drilling rigs for the stock of the C. I. Drilling Co. was a tax-free exchange under the provisions of section 112 (b) (3) of the Internal Revenue Code, in connection1945 U.S. Tax Ct. LEXIS 138">*142 with which no gain or loss is recognizable, and that the basis for gain or loss to petitioner of the 500 shares of stock of C. I. Drilling Co. which he received in exchange for the drilling rig is $ 29,658.18, the undepreciated cost of the rig.

On March 6, 1940, petitioner sold 250 of the 500 shares of C. I. Drilling Co. stock received by him in exchange for the rig for $ 25,000. The gain realized on such sale was $ 10,170.91, since the stock had a substituted basis of $ 14,829.09. In filing their community returns for the year 1940 petitioners included $ 5,085.46, or 50 percent of the gain of $ 10,170.91, on the theory that the gain was realized from the sale of a capital asset which had been held for more than 24 months. The respondent held that the sale of the stock was a sale of assets held for not more than 18 months, and that, therefore, the entire profit of $ 10,170.91 is includible in the net taxable community income of the petitioners.

Issue 2. -- After the partnership of Cron and Gracey was dissolved on October 31, 1939, petitioner and Cron continued to own jointly and operate certain oil properties, including an oil and gas lease known as the Jarvis lease.

This 1945 U.S. Tax Ct. LEXIS 138">*143 lease was originally executed by the lessor, Jarvis, on March 4, 1931. On September 10, 1931, the lessee, Gulf Production Co., hereinafter referred to as Gulf, did "grant, bargain, sell and convey" the lease to C. B. Bunte, Inc., hereinafter referred to as Bunte, and on the same date Gulf entered into a contract with Bunte, under the terms of which Bunte agreed to account to Gulf for one-fourth of the net profits arising from operations on the leased property.

On November 20, 1931, Bunte and J. S. Wheless, Jr., who owned an interest in the Jarvis lease, agreed to assign a one-half undivided interest in the lease to Cron and Gracey in consideration of Cron and Gracey drilling two wells on the leased property at their own expense. On April 30, 1932, Bunte and Wheless, pursuant to the agreement of November 20, 1931, assigned an undivided one-half interest in the lease to Cron and Gracey, it being stated in the assignment that Cron and Gracey had drilled and completed the two wells in accordance with the terms of the agreement. Neither in the contract of November 20, 1931, nor in the assignment of April 30, 1932, did Cron and Gracey expressly assume the obligation to account to Gulf1945 U.S. Tax Ct. LEXIS 138">*144 for one-fourth of the net profits to be derived from the operation of the Jarvis lease as provided in the contract of September 10, 1931, between Gulf and Bunte.

The remaining one-half interest in the Jarvis lease was acquired by Cron and Gracey from J. S. Wheless, Jr., and R. G. Rapp under 5 T.C. 296">*299 dates of July 22, 1932, and December 10, 1937. By the terms of the assignment from Wheless to Cron and Gracey, the latter did not expressly assume the obligation to account to Gulf for one-fourth of the net profits to be derived from the operation of the Jarvis lease, as provided in the contract of September 10, 1931, between Gulf and Bunte. In the assignment from Rapp it was provided that the interest in the lease which he was assigning was subject to all existing oil payments and indebtedness against said interest and the assignee agreed to relieve Rapp from all liabilities by reason of said indebtedness.

On December 17, 1937, Cron and Gracey entered into an agreement with Gulf Oil Corporation, which was the successor to the Gulf Production Co., the provisions of which are as follows:

* * * *

Whereas, by mesne assignments and conveyances, E. J. Gracey and L. H. Cron became, and are1945 U.S. Tax Ct. LEXIS 138">*145 now, the owners of said lease in so far as said lease covers the above described 41.11 acres of land, subject to the terms of the assignments and conveyances under which they claim title to the leasehold estate created by the aforesaid oil, gas, and mineral lease, all of which assignments and conveyances, and their respective records in the Deed Records of Smith County, Texas, are made parts hereof by reference; and,

Whereas, by instrument dated September 10, 1931, Gulf Production Company assigned and conveyed to C. B. Bunte, Inc., the leasehold estate upon, among other lands, the 41.11 acres above described, and, contemporaneously with the execution and delivery of said assignment to said C. B. Bunte, Inc., Gulf Production Company entered into a concurrent agreement with the said C. B. Bunte, Inc., with reference to the leasehold estate so assigned by Gulf Production Company to C. B. Bunte, Inc., which assignment and its record and the concurrent agreement made in connection therewith are made parts hereof by reference; and,

Whereas, under the terms of the third paragraph of said concurrent agreement, it was therein provided that, after complying with certain other provisions contained1945 U.S. Tax Ct. LEXIS 138">*146 in said agreement, the said C. B. Bunte, Inc., its successors and assigns, should account to Gulf Production Company for one-fourth (1/4) of the net profits arising from operations conducted on said lease; and,

Whereas, E. J. Gracey and L. H. Cron have complied with the provisions of the said assignment and the concurrent agreement referred to and have paid all sums therein provided, with the exception of accounting to Gulf Production Company for the one-fourth (1/4) of the net profits as therein provided; and

Whereas, E. J. Gracey and L. H. Cron have heretofore operated said lease on the premises above described, and, as a result of such operations, there have accrued net profits out of which they have not paid to Gulf Production Company its one-fourth (1/4) interest therein as in said agreement provided, said net profits now being due under the terms of the assignments and concurrent agreement above referred to; and,

Whereas, it is the desire of E. J. Gracey and L. H. Cron to account to Gulf Oil Corporation (successor in interest to Gulf Production Company) for its pro rata part of the net profits which have heretofore accrued up to the date hereof, and the desire at the same time1945 U.S. Tax Ct. LEXIS 138">*147 to establish for the convenience of all parties hereto a system of accounting and a basis of charges to be made for the cost 5 T.C. 296">*300 of operations hereafter to be conducted upon the premises affected hereby; and,

Whereas, E. J. Gracey and L. H. Cron and Gulf Oil Corporation (as the successor in interest of Gulf Production Company) have reached an agreement as to the correct system of accounting and basis of charges to be made for the cost of operations hereafter to be conducted by E. J. Gracey and L. H. Cron upon the premises affected hereby:

Now, Therefore, it is agreed by and between E. J. Gracey and L. H. Cron, on the one hand, and Gulf Oil Corporation, on the other hand, as follows:

The said E. J. Gracey and L. H. Cron shall continue to operate under the terms of the aforesaid lease at the cost and expense of E. J. Gracey and L. H. Cron, and shall hereafter account monthly to Gulf Oil Corporation for one fourth (1/4) of the net profits accruing as a result of the said operations.

* * * *

Thereafter the agreement set forth a lengthy accounting procedure to be followed in determining the amount of profits derived from the operation of the lease. It was also provided in the1945 U.S. Tax Ct. LEXIS 138">*148 agreement that all the terms and conditions contained therein should run with the leasehold estate as covenants.

During the taxable year Cron and Gracey operated the Jarvis lease and produced and sold oil therefrom. They kept separate accounts and records of the proceeds derived from the sale of oil produced from the leased property and the expenses incurred in the operation of the property. During the taxable year one-fourth of the net revenue derived by Cron and Gracey from the operations of the Jarvis lease amounted to $ 3,867.86, and Cron and Gracey paid this amount to the Gulf Oil Corporation. Petitioner owned a one-half interest in the Jarvis lease, and one-half of the gross proceeds from the sale of oil from the Jarvis lease for the year 1940 was included in the community income of petitioners for that year and percentage depletion was claimed and allowed thereon. One-half of the sum of $ 3,867.86 paid by Cron and Gracey to Gulf Oil Corporation during the taxable year, or $ 1,933.93, was taken as an expense deduction in the community returns of petitioners for the year 1940. The respondent disallowed the deduction on the ground that the amount of $ 1,933.93 represented1945 U.S. Tax Ct. LEXIS 138">*149 a part of the cost of the Jarvis leasehold estate and is recoverable through depletion rather than as an expense deductible from gross income.

OPINION.

Issue 1. -- In 1940 petitioner sold some of the stock of the C. I. Drilling Co. The stock was a capital asset. The question to be determined is what percentage of the capital gain is to be taken into account in computing net income under section 117 (b) of the Internal Revenue Code. The stock was acquired in February 1940 and was sold in March 1940. Respondent determined that 100 per centum of the gain should be taken into account because the stock, a capital 5 T.C. 296">*301 asset, was held for less than 18 months. He denied petitioner's claim that the holding period of the stock was 24 months, or more, which was founded upon adding the holding period for the rig to the holding period for the stock.

Respondent's view is that the capital asset which was sold, the stock, was not held longer than the actual period of one month, because the property given in exchange for the stock was not a capital asset. It, the rig, was property which had been used in a business and was subject to the allowance for depreciation. Consequently it1945 U.S. Tax Ct. LEXIS 138">*150 was not a capital asset within the definition of section 117 (a) (1). Respondent contends that petitioner can not avail himself of the period for which he held the rig, as a member of the partnership of Cron and Gracey ( City Bank Farmer's Trust Co. v. United States, 48 Fed. Supp. 98), before the exchange of the rig for stock in the corporation, since during that period he did not hold a capital asset as defined in the statute.

Respondent's contention seems logical, but it is in conflict with subsection (h) (1) of section 117 of the Internal Revenue Code, ¹ upon the terms of which petitioner relies. The stock in question was "property received on an exchange." The exchange was one in which no gain or loss was recognized, and, therefore, the basis of the stock was the same as the basis of the rig, the property given in the exchange. Under these facts, to which the parties agree, the determination of the period for which the stock was held is prescribed by subsection (h) (1). The holding period for the stock shall include the holding period for the rig, under that section. The matter is controlled by the statutory provision. It is not stated1945 U.S. Tax Ct. LEXIS 138">*151 in that provision that its application is limited to instances where the property given in an exchange is a capital asset. The provision applies where the property received in an exchange is a capital asset. The terms of subsection (h) (1) are clear.

The precise question presented has not been brought to issue before any court, as far as can be ascertained. The Commissioner has not incorporated into his regulations, at any time, the interpretation of subsection (h) (1) which is advanced here. Respondent cites two rulings where he has taken the 1945 U.S. Tax Ct. LEXIS 138">*152 position which he took here, G. C. M. 621 (1926), C. B. V-2, p. 5 (at p. 7); and G. C. M. 11557 (1933), C. B. XII-1, p. 128. Consideration has been given to those rulings, but, under the facts of this proceeding, we must reach the conclusion stated above.

Under this issue, respondent's determination is reversed.

Issue 2. -- The principle is now well established that the income derived from the production of oil and gas is taxable to the owner of 5 T.C. 296">*302 the capital investment in the oil and gas in place. The same principle determines to whom a deduction for depletion is allowable. Anderson v. Helvering, 310 U.S. 404">310 U.S. 404; Helvering v. Bankline Oil Co., 303 U.S. 362">303 U.S. 362; Helvering v. O'Donnell, 303 U.S. 370">303 U.S. 370; Helvering v. Elbe Oil Land Development Co., 303 U.S. 372">303 U.S. 372. In order for petitioner to be sustained in his contentions, the Gulf Oil Corporation, after its assignment, must be considered as having retained an economic interest or a capital investment in the oil and gas in place. Petitioner1945 U.S. Tax Ct. LEXIS 138">*153 apparently makes this contention, relying upon a twofold argument. He attaches some importance to the fact that three of the assignments to Cron and Gracey of interests in the Jarvis lease contained no express assumption on the part of the partnership to account to Gulf Oil Corporation for one-fourth of the net profits to be derived from the operation of the lease. From this he argues that the amounts paid to Gulf in the taxable year can not be considered as additional leasehold cost. He then contends that, since the agreement of December 17, 1937, between the partnership and Gulf contained a provision that the covenants therein should run with the leasehold estate, Gulf received an economic interest in the gas and oil in place.

Substantially the same issue presented here, on very similar facts, was decided by us in Quintana Petroleum Co., 44 B. T. A. 624. In that case we held that the taxpayer was not entitled to deduct as a business expense a payment to Gulf which represented one-fourth of the net proceeds derived from the operation of leased properties. It was held that the payment constituted a capital expenditure. In affirming our decision, 1945 U.S. Tax Ct. LEXIS 138">*154 143 Fed. (2d) 588, the Circuit Court of Appeals for the Fifth Circuit said:

The obligation of the taxpayer to pay one-fourth of the net proceeds arising from its operation of the lease arose out of a personal covenant. Such obligation vested no interest in the payee in the oil and gas in place, and entitled the payee to no percentage depletion on the amount received. The taxpayer's title to the oil and gas in place was unaffected thereby. This it recognized, for it claimed (and was allowed) percentage depletion on the gross income from production without deduction for net-profit payments. An outright assignment is a sale, not a sublease. Net-profit payments are payments on the purchase price. As capital investments they may not be treated as business expenses or as rentals or as royalties. Cf. Commissioner v. Rowan Drilling Co., 130 F. (2d) 62.

It seems clear that the obligation of the partnership to account to Gulf for one-fourth of the profits derived from its operation of the leased property was a personal covenant. After the assignment of the lease by Gulf to Bunte, Gulf no longer retained any interest or capital1945 U.S. Tax Ct. LEXIS 138">*155 investment in the oil and gas in place. The assignment of the lease was a sale of all of Gulf's interest in the property, and the reservation of the right to receive one-fourth of the net profits was merely part of the purchase price on such sale. From the record, it appears that petitioner claimed and was allowed percentage depletion on the gross 5 T.C. 296">*303 income from production without deduction for net profit payments. At the time the return was filed, petitioner apparently believed that the partnership owned the full economic interest in the gas and oil in place.

The fact that some of the assignments to the partnership did not contain an express agreement on its part to account to Gulf for one-fourth of the net profits is immaterial. The law implies a legal obligation on the part of the assignee to assume the burdens imposed by the original contract where it accepts the benefits and advantages of that contract. Kirby Lumber Co. v. R. L. Lumber Co. (Tex. Civ. App.), 279 S.W. 546; Marathon Oil Co. v. Rowe (Tex. Civ. App.), 83 S. W. (2d) 1028; Jackson v. Knight (Tex. Civ. App.), 194 S.W. 844.1945 U.S. Tax Ct. LEXIS 138">*156 Nor do we think that the subsequent agreement of December 17, 1937, between the partnership and Gulf gave Gulf an economic interest in the oil and gas in place merely because of the provision that the covenants were to run with the leasehold estate. An analysis of that agreement is convincing that its real purpose was to set forth the proper accounting procedure to be used by the operators of the leased property in ascertaining the amount of net profits derived from the operations. It is in this light that the covenants are to be considered as running with the leasehold estate. In so far as the obligation of the partnership to account to Gulf for one-fourth of the net profits is concerned, Gulf had nothing after the agreement that it did not have before.

Petitioner's alternative contention that the payment made to Gulf in the taxable year should be excluded from gross income is also untenable. A similar contention was made and rejected in Burton-Sutton Oil Co., 3 T.C. 1187. See also Schermerhorn Oil Corporation, 46 B. T. A. 151. Accordingly, respondent's determination on this issue is sustained.

Decision will be 1945 U.S. Tax Ct. LEXIS 138">*157 entered under Rule 50.