HOLMES, Circuit Judge.
This appeal involves income taxes of the Kirby Petroleum Company for the year 1940. The question presented for review is whether the taxpayer is entitled, under Sections 23(m) and 114(b) (3) of the Internal Revenue Code, 26 U.S.C.A. Int.Rev. Code, §§ 23(m), 114(b) (3), to a depletion deduction of 27% per cent on the amount received by it as its share of the net profits realized by its lessees from operations under an oil and gas lease.
The taxpayer owned a tract of land in Texas upon which a % mineral interest had been retained by a former owner. It leased the tract to an oil company for exploration and production, reserving a % toyaltv in the minerals, (which included the % held by the former owner) and receiving a bonus. It was stipulated that all obligations of the lessees were to be understood as covenants and not as conditions or limitations. Contemporaneously with the execution of the lease, the parties executed an agreement under which the taxpayer was to receive 20 per cent of the net profits realized by the lessees from their operations under said lease.
During the year 1940, the taxpayer received $26,223.70 as its share of the net profits. In its income tax return for that year, it deducted 27% per cent depletion on this amount. There was no dispute as to the depiction allowances on the cash bonus and royalty payments. The Commissioner allowed these items, but disallowed the depletion deduction on the amount of the net profits. The Tax Court ruled that depletion on the profits should have been allowed since the lessor had an economic interest in the oil in place.
Gross income from the property, as used in Section 114(b) (3), means gross income from the oil and gas.1 The allowance is to the recipients of this gross income by reason of their capital investment in the minerals.2 The allowance of percentage depletion is made only to the persons who would be entitled to claim cost depletion on account of their ownership of a depletable capital asset, the fundamental theory of the allowance not having been altered by the provisions for percentage depletion.3 The existence of a capital interest in the minerals is the sine qua non for claiming the deduction for depletion; otherwise the taxpayer has no capital investment that has suffered depletion, and is not entitled to the statutory allowance.4
The percentage depiction cannot exceed 27% per cent of the gross value of the captured minerals. The nature of the interest in the deposit does not turn upon the form of the conveyance, but upon the particular consequences of the provisions for payments.5 It is immaterial that the transfers here were accomplished by means [82] of a lease; what is material is that the right of the taxpayer to share in the net profits was not derived from the retention of any depletable interest in the oil and gas in place.
Prior to the execution of the lease and the agreement here involved, the taxpayer (with exception of the % interest mentioned) had .the entire capital investment in the underlying oil and gas. To the extent of the cash bonus and the right to royalty payments, it retained a proportionate economic interest in the oil and gas in place, and to that extent the lessees did not acquire a depletable interest;6 but to the extent that the taxpayer granted exploration rights and an interest in the minerals in place to producers in exchange for their personal covenant to pay a share of their net profits, there was a conveyance of the taxpayer’s interest in a wasting capital asset, and the producers acquired a proportionate depletable interest in the oil and gas conveyed.7 By surrendering a partial interest in the oil and gas produced from the property, the taxpayer converted a portion of its economic interest into a mere- chose in action or economic advantage.8 Thus in Helvering v. O’Donnell, 303 U.S. 370, 58 S.Ct. 619, 82 L.Ed. 903, if was held that the taxpayer who had only a contractual right to share in the net profits did not have a depletable interest.
In Helvering v. Elbe Oil Land Co., 303 U.S. 372, 58 S.Ct. 621, 82 L.Ed. 904, the reservation of the right to share in net profits by the former owner of the mineral deposits was ruled not to constitute a retention of a capital investment in the oil in place. In Anderson v. Helvering, 310 U.S. 404, 60 S.Ct. 952, 84 L.Ed. 1277, the reservation of the right to share in net profits was held not to entitle the holder of such interest to a depletion allowance even though continued production was essential to the realization of such profits. There are good reasons for the rule; the depletion deduction is granted in recognition of the fact that the person having the requisite economic interest received a partial return of his capital investment when production took place.9
A taxpayer who leases solely for net profits no longer has a direct interest in the production of mineral deposits; his interest is in the ability of the operators to earn profits. It is true that there would be no net profits if there were no production; but since production could take place without there being any net profits, the taxpayer’s income accrues after, no.t at the time of, the extraction of the oil and gas from the deposits. These principles have been given concrete application by this court.10 The single depletion allowance is subject to apportionment among the parties in accordance with ¡their economic interests.11 Therefore, the retention of a partial interest in production necessarily results in the retention of only a proportionate capital investment in the oil and gas in place.
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HOLMES, Circuit Judge.
This appeal involves income taxes of the Kirby Petroleum Company for the year 1940. The question presented for review is whether the taxpayer is entitled, under Sections 23(m) and 114(b) (3) of the Internal Revenue Code, 26 U.S.C.A. Int.Rev. Code, §§ 23(m), 114(b) (3), to a depletion deduction of 27% per cent on the amount received by it as its share of the net profits realized by its lessees from operations under an oil and gas lease.
The taxpayer owned a tract of land in Texas upon which a % mineral interest had been retained by a former owner. It leased the tract to an oil company for exploration and production, reserving a % toyaltv in the minerals, (which included the % held by the former owner) and receiving a bonus. It was stipulated that all obligations of the lessees were to be understood as covenants and not as conditions or limitations. Contemporaneously with the execution of the lease, the parties executed an agreement under which the taxpayer was to receive 20 per cent of the net profits realized by the lessees from their operations under said lease.
During the year 1940, the taxpayer received $26,223.70 as its share of the net profits. In its income tax return for that year, it deducted 27% per cent depletion on this amount. There was no dispute as to the depiction allowances on the cash bonus and royalty payments. The Commissioner allowed these items, but disallowed the depletion deduction on the amount of the net profits. The Tax Court ruled that depletion on the profits should have been allowed since the lessor had an economic interest in the oil in place.
Gross income from the property, as used in Section 114(b) (3), means gross income from the oil and gas.1 The allowance is to the recipients of this gross income by reason of their capital investment in the minerals.2 The allowance of percentage depletion is made only to the persons who would be entitled to claim cost depletion on account of their ownership of a depletable capital asset, the fundamental theory of the allowance not having been altered by the provisions for percentage depletion.3 The existence of a capital interest in the minerals is the sine qua non for claiming the deduction for depletion; otherwise the taxpayer has no capital investment that has suffered depletion, and is not entitled to the statutory allowance.4
The percentage depiction cannot exceed 27% per cent of the gross value of the captured minerals. The nature of the interest in the deposit does not turn upon the form of the conveyance, but upon the particular consequences of the provisions for payments.5 It is immaterial that the transfers here were accomplished by means [82] of a lease; what is material is that the right of the taxpayer to share in the net profits was not derived from the retention of any depletable interest in the oil and gas in place.
Prior to the execution of the lease and the agreement here involved, the taxpayer (with exception of the % interest mentioned) had .the entire capital investment in the underlying oil and gas. To the extent of the cash bonus and the right to royalty payments, it retained a proportionate economic interest in the oil and gas in place, and to that extent the lessees did not acquire a depletable interest;6 but to the extent that the taxpayer granted exploration rights and an interest in the minerals in place to producers in exchange for their personal covenant to pay a share of their net profits, there was a conveyance of the taxpayer’s interest in a wasting capital asset, and the producers acquired a proportionate depletable interest in the oil and gas conveyed.7 By surrendering a partial interest in the oil and gas produced from the property, the taxpayer converted a portion of its economic interest into a mere- chose in action or economic advantage.8 Thus in Helvering v. O’Donnell, 303 U.S. 370, 58 S.Ct. 619, 82 L.Ed. 903, if was held that the taxpayer who had only a contractual right to share in the net profits did not have a depletable interest.
In Helvering v. Elbe Oil Land Co., 303 U.S. 372, 58 S.Ct. 621, 82 L.Ed. 904, the reservation of the right to share in net profits by the former owner of the mineral deposits was ruled not to constitute a retention of a capital investment in the oil in place. In Anderson v. Helvering, 310 U.S. 404, 60 S.Ct. 952, 84 L.Ed. 1277, the reservation of the right to share in net profits was held not to entitle the holder of such interest to a depletion allowance even though continued production was essential to the realization of such profits. There are good reasons for the rule; the depletion deduction is granted in recognition of the fact that the person having the requisite economic interest received a partial return of his capital investment when production took place.9
A taxpayer who leases solely for net profits no longer has a direct interest in the production of mineral deposits; his interest is in the ability of the operators to earn profits. It is true that there would be no net profits if there were no production; but since production could take place without there being any net profits, the taxpayer’s income accrues after, no.t at the time of, the extraction of the oil and gas from the deposits. These principles have been given concrete application by this court.10 The single depletion allowance is subject to apportionment among the parties in accordance with ¡their economic interests.11 Therefore, the retention of a partial interest in production necessarily results in the retention of only a proportionate capital investment in the oil and gas in place.
The instant case cannot be distinguished from the O’Donnell, Anderson, and Elbe Oil Co. cases on the ground that in those the right to share in the net profits was not accompanied by an interest in the minerals. Here the retention of an oil royalty in addition to a share of the net profits operated to reserve an interest in the oil in place, but it was a partial interest that was not enhanced by the personal covenant to pay a percentage of net profits. Here at the instant of production, % of the oil belonged to ¡the former owner, (plus an amount sufficient to pay the cash bonus) [83] was owned by the taxpayer, and the balance belonged to the lessees. The value of each proportionate share was the gross income of each, as to which amount each was entitled to take a 27% per cent deduction for depletion. As the court said in Thomas v. Perkins, 301 U.S. 655, 661, 57 S.Ct. 911, 914, 81 L.Ed. 1324, construing its opinion in Helvering v. Twin Bell Syndicate, 293 U.S. 312, 55 S.Ct. 174, 79 L.Ed. 383, “Our opinion shows that the phrase, ‘income from the property,’ means income from oil and gas only; that, where the lessee turns over royalty oil in kind to the lessor, the amount retained by .the lessee is the basis for his computation of depletion and the royalty oil is the basis for that allowable to lessor.”
The respondent claims, and the Tax Court held, that its gross income from the property was “clearly the proceeds from the % [should be ]4t] royalty interest which petitioner retained in the lease and the 20 per cent annual profits which it received from the operator of .the lease under the contemporaneous agreement amounting in 1940 to $26,223.70.” In other words, the claim is that a net profit is gross income if paid by the lessee to the lessor of oil property. This would not he so, it is admitted, if the lessor had not reserved in the lease a royalty interest that entitles it to some percentage depletion. The argument is that this reservation converts a net profit into a bonus and distinguishes this case from the O’Donnell and similar cases above cited; but there is no difference in the controlling legal principle that underlies them all. The payment of net profits to the lessor is not the payment in kind of royalty oil or its equivalent.
A bonus is subject to percentage depletion upon the theory that it is an advance royalty; but net profits are not paid in advance, and cannot be paid until they are earned and ascertained. Gross income, under .the statute, is exclusive of any rents or royalties paid or incurred by the taxpayer. If, therefore, net profits are held to he rents or royalties within the meaning of Section 114(b) (3), the depletable gross income thereunder cannot be ascertained until we determine the amount of the net income. Under the present state of the law, tile depletion allowance of 27% per cent is granted upon the gross income from every barrel of oil captured, which allowance is apportioned pro rata among those who own the oil itself.12 Gross income of the royalty owners is the full amount of their royalty, and gross income of the lease operator is the total production less the royalties. Under the terms of the lease here involved, % of the oil and gas was owned by the producers, % by the former owner, by the taxpayer; and the depletion upon gross production was, and should have been, apportioned accordingly.
If net profits, which cannot be computed or paid until they are earned, are rents and royalties within the meaning of Section 114(b) (3), the depletion allowances on the working interest cannot be ascertained until the amount of net income is determined. This poses an abstruse problem instead of the rule of thumb that the arbitrary percentage-depletion allowance was intended to be.13 To extend the allowance to include 27% per cent of the net profits paid to the lessor by the lessees “would give rise to problems of considerable perplexity and would create administrative difficulties which it was intended to overcome by laying down a simple rule which could he easily applied.”14
In addition, it would be a departure from the theory upon which bonus payments are depletable, since no economic interest in the oil in place was reserved by the lessor to represent the contingency of net profits that might be earned. On the contrary, the lessor accepted the personal covenant of the lessees to pay whatever ■amount of net profits became due by the lessees. This entailed upon the lessor the financial risk of the lessees’ personal ability to earn profits and to account for them. For these reasons we conclude that the doctrine of advance royalty payments cannoi be extended to net profits.
The decision of the Tax Court is reversed, and the cause remanded for further proceedings not inconsistent with this opinion.