Madden, Judge,
delivered the opinion of the court:
The plaintiff owned land near the seashore in California. It granted to Southwest Exploration Company the right to come on its land and drill wells slantwise to reach oil deposits which were beneath the adjoining submerged lands owned by the State. As compensation, Southwest agreed to pay the plaintiff 17.75% of Southwest's net profits from the sale of the oil taken from the wells. During the year 1948 the plaintiff received large sums of money from Southwest under this arrangement. It claimed, but the Commissioner of Internal Revenue denied to it, the right to a depletion deduction on those receipts, under sections 23 (m), 53 Stat. 14, and 114 (b), 53 Stat. 45, of the Internal Eevenue Code of 1939. It paid its corporate income taxes without the benefit of the deduction, and here sues for the refund of $182,802.98 of taxes and interest which it paid, and for interest on that sum as provided by law.
When the owner of solid minerals or of oil and gas deposits receives money as a result of the mining or production of these commodities, what he receives is treated, for tax purposes, as income, and not as a return upon the sale of a capital asset. But the income is different from interest or rent in that the production of the income depletes the source from which the income is derived. For this reason the tax statutes permit the receiver of such income to deduct, in his tax return, 27%% of his gross income from the production of oil.
When the oil produced or the income from its production is, by the arrangements of the parties, to be divided among two or more persons, the basic reason for the depletion allowance is applicable to each of them in his proper proportion. In the usual arrangement whereby the landowner is to have one-eighth of the oil and the operator is to have seven-eights, the prospect of each for future receipts is diminished as present receipts are obtained. Section 23 (m) of the Internal Eevenue Code says that in the case of leases the depletion deductions shall be equitably apportioned between lessor and lessee.
Transactions looking to the production of oil and gas have taken a great variety of forms. The landowner leases, reserving a royalty. The lessee may sublease, reserving a royalty. Or he may "assign" his lease, the assignee promising to pay a consideration only out of oil produced, and measured by the amount of production. These are only simple illustrations of the various forms which such transactions take. The statutes do not specifically provide for the application of the depletion allowance to these various forms of transactions. But the Supreme Court of the United States has decided many cases involving the depletion allowance, and has thereby developed principles helpful in the solution of other cases not covered by that Court's decisions.
Southwest Exploration Company, the operator which produced the oil from wells on the plaintiff's land, claimed the depletion deduction on all of the oil income. The plaintiff, at the same time, claimed the deduction on its 17% % of Southwest's net profits. In order to protect the revenue against the loss which would result if these competing claims to the same deduction were both successful, the Commissioner of Internal Revenue took inconsistent positions and denied the disputed portion of the deduction to both parties. Southwest contested the Commissioner's denial in the Tax Court, and that court held in Southwest Exploration Co. v. Commissioner, 18 T. C. 961, that the plaintiff did not possess a depletable interest and that Southwest was entitled to the deduction on all its gross income from the oil wells during the years 1939 through 1945. The United States Court of Appeals for the Ninth Circuit, in a per curiam opinion affirmed, on the basis of the Tax Court's opinion. Commissioner v. Southwest Exploration Co., 220 F. 2d 58. If that decision is correct, the plaintiff cannot prevail in this case. It is not legally permissible for both companies to have the same deduction.
The fact that in the instant situation the plaintiff received a share in the net profits from the production of oil, rather than a share of the oil produced regardless of the expense of production, is not a reason to deny the plaintiff a depletion deduction. In Kirby Petroleum Co. v. Commissioner, 326 U. S. 599, a landowner leased his land for the production of oil and gas in return for a cash bonus, a fractional royalty, and 20% of the net profits realized from the production. The Court held that the lessor was entitled to a depletion deduction on the percentage of net profits payment, as well as on the bonus and the royalty. The Court held that the net profits provision gave the taxpayer an additional economic interest in the oil. The Court, at page 603, said:
By this is meant only that under his contract he must look to the oil in place as the source of the return of his capital investment. The test of the right to depletion is whether the taxpayer has a capital investment in the oil in place which is necessarily reduced as the oil is extracted.
The Court, at page 604, further said, in explaining why no distinction was to be made between a retained royalty interest in gross production, and in the operator's net profits:
In both situations the lessors' possibility of return depends upon oil extraction and ends with the exhaustion of the supply. Economic interest does not mean title to the oil in place but the possibility of profit from that economic interest dependent solely upon the extraction and sale of oil.
In the language from the Kirby Petroleum case first quoted above, the reference to the taxpayer's "capital investment" in the oil in place should be noted. It surely cannot mean that it would make any difference that the land had been bought by the lessor for a song as practically worthless desert land, and with no thought of the possibility that it might be a source of oil. In Burton-Button Oil Co. v. Commissioner,, 328 U. S. 25, 34, the Court said:
The cost of that investment to the beneficiary of the depletion under § 114 (b) (3) is unimportant. Through retention of certain rights to payments from oil or its proceeds in himself, each of these assignors of partial exploitation rights in oil lands has maintained a capital investment or economic interest in the oil or its proceeds.
It is apparent that in the Supreme Court's view, the economic interest is the essential thing, regardless of what, if anythin"' it cost to acquire it.
In the Burton-Button case, supra, the question was whether one G, who was in a chain of title from the original lessor, but who had in turn transferred his rights to another, who had transferred his rights to an operator under a contract requiring the operator to pay 50% of the profits of the operation to G, was entitled to the depletion deduction. The Government, in arguing against the deduction, urged that the decision in the Kirby Petroleum case, supra, was based on the fact that the taxpayer there had, in addition to his right to a percentage of profits, a right to an oil royalty and a bonus. The Government urged that a right to a percentage of profits, standing alone, should not entitle the taxpayer to the depletion deduction. The Court rejected that argument and said at page 32:
We do not agree with the Government that ownership of a royalty or other economic interest in addition to the rights to net profits is essential to make the possessor of a right to a share of the net profit the owner of an economic interest in the oil in place. The decision in Kirby did not rest on that point.
We must, then, determine the nature and extent of the plaintiff's economic interest in the oil from which it derived the income here in question. Under the California law, the oil under the State's submerged lands could not be recovered except by drilling in the upland. As a condition precedent to obtaining a lease from the State to drill for oil, an operator had to obtain the consent of the owner of the upland to such drilling. The plaintiff owned the upland. The Government says in its brief, "The plaintiff is, from a pure legal viewpoint, a stranger to the oil which is being extracted from the submerged lands." From a legal viewpoint, the plaintiff, because of its ownership of the strategic upland, had a legal right to say to the prospective operator, "You cannot produce oil from these lands of the State unless you pay me 17%% of your net profits." That would seem to mean that the plaintiff, far from being a stranger, was almost as intimately related to the oil as is the ordinary landowner on whose land vertical drilling may be done. An oil operator does not give strangers a percentage, large or small, of his net profits. In this case the plaintiff was in such a legal and geographical position of control with regard to the oil under the State's submerged lands that it could, and did, in exchange for its consent to the recovery of the oil, require that it be paid 17%% of the operator's net profits, which, in the single year 1948, brought a payment to the plaintiff of $1,298,222.85.
Suppose A owns land in fee simple. He grants to á golf club an easement to use the surface of the land for a golf course. Oil is discovered in the neighborhood. A grants to C the oil in the land, reserving a royalty. But C cannot drill upon the land, since to do so would be incompatible with the easement of the golf club. The golf club grants to C the right to drill upon the land, in return for a royalty, or a percentage of net profits. Should C or the golf club get the depletion allowance upon the golf club's receipts from this source ?
The golf club never owned the oil in place, nor any right to produce it. What it owned was an interest in the surface of the land of such a nature that no one could recover the oil by usual and economical methods without first obtaining from it the right to use the surface for drilling. The discovery of oil in the neighborhood increased the value of its interest in the surface. Under the royalty agreement which it made with the operator, its income from its interest in the land would rise and fall with oil production. As oil was taken out, its prospects for future income would diminish, because of the depletion of the source of its income.
It would seem that, by any realistic standard, the golf club must be said to have an economic interest in the production of the oil. Its physical and legal relation to the situs of the oil puts it into a position to prevent the production of the oil, or permit its production on prescribed terms. That power gave value to its interest in the land. That value was depleted as the oil was taken out.
We think the plaintiff was in the same situation, with regard to the oil under the water, as was the golf club in our illustration. Its land, being the only available site from which a well could be drilled to reach the oil, was in economic relation to the oil. It could, no doubt, have sold its land for a much higher price, after the discovery of oil which could be recovered only through its land. It chose to make the arrangement whereby its return would depend upon the recovery of oil through wells on its land, and its prospects for future return would diminish as the oil was taken out. In all reality, the plaintiff had an economic interest in the oil. The feature that makes this case unique, the fact that the drilling was done slantwise instead of vertically, is surely immaterial.
The cases in which the Supreme Court has held that the taxpayer claiming the depletion deduction did not have the required economic interest are distinguishable. In Helvering v. Elbe Oil Land Co., 303 U. S. 372, the taxpayer, the owner of oil land, sold it for a fixed consideration, part of which was paid at once and the balance payable in succeeding years if the purchaser should not elect to abandon the transaction. In addition, the vendor was to receive one-third of the net profits which the transferee might earn after having been fully reimbursed for its expenditure in the acquisition, development, and operation of the property. The money on which the taxpayer sought the depletion deduction was the fixed sum payments it had received. The Court held that the money was income from the sale of the oil and gas properties themselves, and not income from the operation of wells on the property.
In Helvering v. O'Donnell, 303 U. S. 370, the Court held that a taxpayer who had transferred shares of corporate stock to an operating company in return for its promise to pay him one-third of the net profits of its oil operations on certain properties, did not have an economic interest entitling him to the depletion deduction. The taxpayer there, unlike the plaintiff in the instant case, had no relation to or control over the production of the oil before he bought and paid for a right to share the profits. He was, factually and legally, a stranger to the oil property.
In Anderson v. Helvering, 310 U. S. 404, the taxpayer purchased, for a fixed consideration certain royalty interests, fee interests, and oil payments in designated properties. He paid a part of the consideration in cash, and promised to pay, on the balance, one-half of the proceeds of oil and gas produced from the properties, and one-half of his re ceipts from the sale of the fee properties. During the taxable year, the taxpayer received income from the production of oil and gas, and paid one-half of it over to his vendor. He sought to exclude these payments from his taxable income. The Court held that he could not do so. If the transferor had been entitled to be paid only out of oil and gas production, it would have continued to have an economic interest in the property. But since it was entitled to be paid also from the sale of the fee interests, the transaction was a sale to the vendee taxpayer and the payments which he sought to exclude from his income were payments on the purchase price.
In Helvering v. Bankline Oil Co., 303 U. S. 362, the taxpayer had contracts with oil producers to separate the wet gas from the dry gas as it flowed from the wells, thereby producing casinghead gasoline. The taxpayer was to keep two-thirds of the gasoline and give one-third to the oil producers. It claimed the right to depletion deductions with respect to its income from these contracts. The Court denied the claim. It said that through its contracts the taxpayer obtained an economic advantage from the production of the gas, but that it had no interest in the gas in place. It would seem that the taxpayer in that case was in a situation comparable to one who has a contract to buy oil or gas from producers at the wells, for the purpose of reselling it at a profit. As production falls off, his resales and profits will fall off. But his relation to the production is merely collateral. Before he made his contract, he had no relation to the oil, factual or legal. His contract gave him only somewhat the same kind of an interest in continued production which employees, merchants, homeowners, and others in an oil producing area have in continued production.
For a landowner to have a degree of control over what may be done on neighboring land is not unusual. There is a large body of law relating to jura in alieno solo. The recognized natural rights to light and air, lateral support, and the flow of streams exist merely by reason of physical location. Easements, affirmative and negative, are created by grant or by prescription. Bestrictive covenants, nearly always negative in nature, are recognized and enforced in equity. All of these are interests, short of ownership, in the land whose use is affected by them. Because of the applicable law, and the location of the plaintiff's land, its economic interest in the oil here in question was just as real and just as legally well-grounded as those in the ordinary cases of rights in the land of another.
Our conclusion is that the plaintiff had an important economic interest in the oil under the State's submerged lands, by reason of its control over the recovery of the oil; that it could have surrendered its control by an outright sale, but instead took in exchange a share of the possible net profits; and that the reasons on which the depletion allowance is based are present in the plaintiff's situation. We will therefore award the plaintiff a judgment for $182,802.98, with interest according to law.
It is so ordered.
LaRasioRe, Judge; WhitakeR, Judge; and Littleton, Judge, concur.