The 1924 law changes the basis for computing depletion in two respects: (1) Property acquired prior to March 1, 1913 is to be taken at cost or March 1, 1913 value, whichever is greater; (2) in certain reorganizations and other transfers the basis is the same as in the hands of the transferor. But the deduction itself is the same, that is, “a reasonable allowance for depletion" is permitted in the case of those industries with wasting assets because of the exhaustion of the minerals, oil, timber, etc. The allowance represents a return of capital. While the provision permitting a "discovery" value as a basis for depletion (in case of properties "discovered" on or after March 1, 1913) is retained in the present law, the limitation on securing the benefit of the full amount of such depletion is now made more drastic. It limits "discovery depletion" to 50 per cent of the net income from the property. The limitation on discovery depletion was first introduced in the 1921 law, but allowed the deduction up to 100 per cent of the net income from the discovered property. The effects of this limitation are (a) to prevent carrying forward into a succeeding year (as a net loss-see section 206) any excess of depletion based on "discovery" value over depletion computed "without reference to discovery value," and (b) to deny the offsetting of such excess depletion against income from other sources, such as income from investments or from the operation of another property. In the case of oil wells, the "discovery" feature is doubtless invoked in respect of many properties acquired since March 1, 1913. As in so many of the other so-called "cushion" provisions of the income tax laws, Congress having first given the taxpayer relief in one provision, proceeds to take away, in another provision, much of the benefit. On the other hand, it may be assumed that "discovery" values may well be so high that the depletion charge, in a year of depression, may easily exceed all income from the property. In any event the taxpayer will receive the benefit of "discovery" depletion up to 50 per cent of the amount of the income from the property, should such depletion be greater than such 50 per cent of the income from the property.

LAW. Section 214 (a-9) [Individuals]; Section 234 (a-8) [Corporations.] In computing net income there shall be allowed as deductions:

In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion1 and for depreciation [Former Procedure] Under the 1909 law no deduction could be made for depletion. Von Baumbach, Collector, v. Sargent Land Co., 242 U. S. 503,

1

of improvements, according to the peculiar conditions in each case; such reasonable allowance in all cases to be made under rules and regulations to be prescribed by the Commissioner, with the approval of the Secretary. In the case of leases the deduction allowed by this paragraph shall be equitably apportioned between the lessor and lessee; . .

....

LAW. Section 204. (c) The basis upon which depletion, exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property shall be the same as is provided in subdivision (a) or (b) for the purpose of determining the gain or loss upon the sale or other disposition of such property, except that in the case of mines, oil and gas wells, discovered by the taxpayer after February 28, 1913, and not acquired as the result of purchase of a proven tract or lease, where the fair market value of the property is materially disproportionate to the cost, the basis for depletion shall be the fair market value of the property at the date of discovery or within thirty days thereafter; but such depletion allowance based on discovery value shall not exceed 50 per centum of the net income (computed without allowance for depletion) from the property upon which the discovery was made, except that in no case shall the depletion allowance be less than it would be if computed without reference to discovery value.

The theory of depletion is comparatively simple, viz., provision must be made for the return of capital invested in natural resources which are being exhausted. The capital to be returned is original cost, or value as at March 1, 1913, if acquired prior thereto, whichever is greater, or a "discovery" value in certain cases of property acquired after February 28, 1913. This involves a periodical charge against 37 Sup. Ct. 201, 61 L. Ed. 460. For a full discussion and criticism of this decision see Income Tax Procedure, 1918, pages 406-408.

The 1913 law limited the deduction to "5 per centum of the gross value at the mine of the output for the year for which the computation is made" [section II G (b)]. The Supreme Court of the United States held that this 5 per cent limitation was constitutional. Stanton v. Baltic Mining Company, 240 U. S. 103, 36 Sup. Ct. 278, 60 L. Ed. 546. For a full discussion of the procedure under this limitation of the 1913 law, see Income Tax Procedure, 1918, pages 402-406.

The 1916 law, unchanged in 1917, [section 5, Eighth (a), individuals, and section 12 (a), Second, corporations] was in part as follows:

"(a) In the case of oil and gas wells a reasonable allowance for actual reduction in flow and production to be ascertained not by the flush flow, but by the settled production or regular flow; (b) in the case of mines a reasonable allowance for depletion thereof not to exceed the market value in the mine of the product thereof, which has been mined and sold during the year for which the return and computation are made."

The 1918 and 1921 laws provided that in case of property acquired prior to March 1, 1913, value at that date should be taken "in lieu of cost." "Discovery depletion" was allowed in the 1918 law but was limited in the 1921 law to 100 per cent of the net income from the property. No limitation was imposed on securing an increased basis from reorganization as is the case under the 1924 law (Section 204 (a) and (c).)

the gross earnings realized from the product, of such amounts as will in the aggregate equal the March 1, 1913 value, the "discovery" value, or cost by the time the property shall have been exhausted. It is in the application of the theory, or rather in securing the requisite data, that the practical difficulties are encountered. Two fundamental facts must be established, as follows:

(a) Value of the property at March 1, 1913, if acquired prior thereto, or cost, whichever is greater, or value within thirty days after "discovery" if acquired after February 28, 1913;2 and

(b) The number of units of principal product in the property at valuation date.

The depletion unit [a b] multiplied by the number of units produced during the year, gives the depletion deduction for the taxable year.

As soon as the reserve for depletion equals the cost or appropriate valuation, no further charges can be made, no matter how much more product may be recovered. The excess is all income and must be so returned.

The language of the 1924 law is broad enough to permit the full deduction demanded by the theory of depletion except for the 50 per cent limitation placed on "discovery depletion.' "3

The regulations of the Treasury reflect the general principles to be observed in arriving at proper valuation, the determination of the proper number of mineral units embraced therein, and proper depletion charges.

The major problem, however, is to assemble the tremendous amount of data required to support the valuations to the satisfaction of the Treasury. Fortunately, many mining companies have excellent records from which the data regarding assay values, recovery of metal contents, costs, proper rates of discount in the case of mines, and the other factors can be compiled and stated.

In arriving at the depletion rate, consideration must also be given

2

[Former Procedure] The Treasury in some cases, where the March 1, 1913 value was less than cost, allowed depletion only on the March 1, 1913 value. As a result the taxpayer does not have returned to him all of his capital.

5

See page 1219.

4

Reg. 65, Art. 201, et seq.

Many suggestions have been made to eliminate the problem of valuation. The Solicitor of Internal Revenue, however, is quoted as saying: "There is no way of eliminating valuation for depletion unless depletion is eliminated from the law." (Bulletin 19, American Mining Congress, May 10, 1924.)

to the effect that the value established for depletion may have on the distributions to stockholders in the form of dividends free from tax and on gains or losses, if any, upon sale of stock, as well as the new provision of the 1924 law whereby distributions from discovery depletion reserves are tax-free in the case of mines. [ [Section 201 (d).]

Practically, it will be found in every case that where an attempt is being made to establish the proper depletion rate, a series of problems, as indicated above, follows in the train of what theoretically is quite a simple matter. When a company owns a series of mining claims it is often a question as to how much should be taken in, in those cases where the ore is not blocked out, and how much, if any, in the future may be brought in under the discovery provision.

Depletion, at the option of the taxpayer, is made to embrace recovery of capital expenditures other than for ore, and this gives rise to questions of what are really capital items in a business of the character peculiar to wasting assets, and what is properly chargeable to expense.

General procedure in case of depletion.

BASIS OF DEPLETION ALLOWANCE.--The first step in determining the depletion deduction is to establish the cost, and also a proper valuation of the property at March 1, 1913, if acquired prior thereto, or at the "discovery" date, if acquired after February 28, 1913, and a "discovery" is claimed, for it is on these respective values that depletion is based, except that if a property was acquired after February 28, 1913, and a "discovery" is not claimed, the depletion deduction is based on cost.

If the property was acquired prior to March 1, 1913, depletion for the period prior to March 1, 1913, would be computed on the basis of the value of the property at the date acquired, plus allowable capital additions. Beginning with March 1, 1913, depletion would be computed on the value at that date, which usually includes a large amount of appreciation in value. For instance, an individual may have purchased coal lands in 1908 at $400 per acre and thereafter may have charged off periodically against product such an allowance as

See page 826 et seq. See also Chapter XXV.

[Former Procedure] For purposes of invested capital, it is also necessary sometimes to obtain a valuation at the date the property was paid in, as the actual value of the property may have been either more or less than the par value of stock issued therefor.