The Southwest Exploration Co., respondent in No. 286, contracted to develop certain oil deposits lying off the coast of California by whipstock drilling from sites located on the property of adjacent upland owners. Southwest agreed to pay to such owners 24 1/2% of the net profits for the use of their land. Both Southwest and the upland owners sought to take the statutory depletion allowance of 27 1/2% on this share of the profits. The Tax Court decided that Southwest was entitled to the depletion allowance, 18 T.C. 961, and the Ninth Circuit affirmed, 220 F.2d 58. In the other case, the Court of Claims held that one of the upland owners, Huntington Beach Co., respondent in No. 287, was entitled to the depletion allowance on its share of the net income, 132 F.Supp. 718, 132 Ct.Cl. 427. We granted certiorari in both cases, 350 U.S. 818, 76 S.Ct. 83, because both the drilling company and the upland owners cannot be entitled to depletion on the same income. We agree with the Court of Claims.
The California State Lands Act of 1938 provided that the State's offshore oil might be extracted only from wells drilled on filled lands or slant drilled from upland drill sites to the submerged oil deposits. Other provisions of the same statute required that 'derricks, machinery, and any and all other surface structures, equipment and appliances' be located only on filled lands or uplands. It was further provided that the state commission might require each prospective bidder for such a state lease to furnish, as a condition precedent to consideration of his bid, satisfactory evidence of 'present ability to furnish all necessary sites and rights of way for all operations contemplated under the provisions of the proposed leased.'
In 1938 California published notice of its intention to receive bids for the lease of certain oil lands pursuant to this statute. At the time Southwest-a corporation organized in 1933 but completely inactive until the transaction at issue here-did not own, lease, operate or control any of the uplands adjacent to the area of oil deposits. It is agreed that there were no filled lands available. Southwest entered into three agreements with the upland owners, and was granted the right of ingress to and egress from the designated uplands and the right to construct, use and maintain all equipment necessary for drilling on the same lands. The upland owners reserved to themselves the right to give easements or subsurface well crossings in the uplands, except that they would not allow such easements for the purpose of drilling into the off-shore oil deposits while Southwest retained an interest granted to it by state easement. Southwest's rights were expressly subject to all rights previously granted by the upland owners. The agreements defined 'net profits' and provided that Southwest would pay a total of 24 1/2% of its net profits from extraction and sale of oil to the upland owners. It was also provided that the upland owners did not acquire a share in the lease or oil deposit by virtue of the last agreement and that it was not the intention of the parties to create a partnership relationship.
As a result of these agreements, the upland owners endorsed Southwest's bid for a lease submitted to the State of California. Southwest, as the only bidder, was granted 'Easement No. 392' by the State in consideration of the 'royalty to be paid, the covenants to be performed, and the conditions to be observed by the Grantee.' One such condition was that set out in paragraph (1):
'That each well drilled pursuant to the terms of this agreement shall be slant drilled from the uplands to and into the subsurface of the State lands. Derricks, machinery, and any and all other surface structures, equipment and appliances shall be located only upon the uplands and all surface operations shall be conducted therefrom.'
The agreement further provided that if Southwest should 'default in the performance or observance of any of the terms, covenants and stipulations hereof', the State might re-enter, cancel the agreement or close down wells not being operated according to the agreement.
The wells drilled pursuant to this lease have produced oil continuously since 1939. In No. 286, Southwest Exploration Co., the tax years 1939 through 1945 are involved. If Southwest may claim the depletion allowance on the upland owner's share of the profits during this period, its tax liability is reduced by approximately $175,000. In No. 287, Huntington Beach Co., the upland owner is claiming a tax refund of $135,000 for the year 1948 alone.