REGULATION. The new stock and securities received as described in the preceding article (1567) take the place of the old stock and securities. For the purpose, therefore, of ascertaining the gain derived or loss sustained from the subsequent sale of any stock of A or of the consolidated corporation so received, the original cost to the taxpayer or the fair market value as of March 1, 1913, of the stock of B or A in respect of which the new stock was issued, less any untaxed distribution made to the taxpayer by A out of the former capital or surplus of B, or by the consolidated corporation out of the former capital or surplus of A or B, is the basis for determining the amount of such gain or loss. Similarly, the cost after reorganization, merger or consolidation of the assets of A or of the consolidated corporation is the sum of the cost (or the fair market value as of March 1, 1913) of the assets of A and of B for the purpose of ascertaining the gain or loss upon a subsequent sale. The new invested capital of A or of the consolidated corporation is to be determined as if A and B were rendering a consolidated return as affiliated corporations. (Art. 1568.)

....

Inventory system as applied to conversion or rearrangement of securities.-In some cases, particularly when shares are quoted considerably above par, a certain number of shares of lower or no par value is exchanged for one share of old stock. Sometimes shares are issued for bonds or other forms of indebtedness; while in other cases bonds or other obligations are convertible into stock.

No general rule can be laid down other than that mentioned in cases fully discussed in the preceding pages, viz., a continued investment in the same corporation, when there has been only a partial, or no realization of cash, should not be termed a closed or completed transaction and no tax should accrue thereon until a realization takes place. If the taxpayer desires, and should in the future be permitted, to report on the accrual or inventory system and the new securities indicate an increase in value, a return thereof may be the most equitable way of dealing with the case.

CHAPTER XVI

INCOME FROM ROYALTIES AND PATENTS

Income from royalties and similar sources is not specifically named in the definition of income given in the law, but is clearly included within its terms.1

REGULATIONS. . . . . gross income . . . . embraces . income such as royalties . . . . (Art. 541.)

Royalties on patents are income. (Art. 48.)

Royalties from Mines, Oil Wells, etc.

Royalties subject to depletion charges.-The owner of a mine, an oil well or other similar property operated on a royalty basis must return as income his royalties received, but is permitted to deduct expenses and to charge against receipts depletion allowances based on the full value of his property at March 1, 1913, if purchased before that date, or on the basis. of the capital originally invested if purchased thereafter,2 ex

[Former Procedure]

REGULATION. "Royalty paid to a proprietor by those who are allowed to develop or use property, or operate under some right belonging to him, is to be accounted for as income." (Reg. 33, 1918, Art. 4.)

"Von Baumbach v. Sargent Land Co., 242 U. S. 503.

[Former Procedure] Full depletion allowances have been permissible deductions only since 1916. The 1913 law contained a provision restricting such charges to 5 per cent of the gross value of the output of the mine, and in spite of the fact that this worked inequitably in some cases the courts decided that it was constitutional. The 1909 law permitted no deduction at all for depletion. As it is still frequently necessary to pass upon returns made under the 1913 law, the following decision issued February 12, 1915, is of interest:

"In the case of mines operated by a lessee on a royalty basis, it is held that the lessor in disposing of his ores or natural deposits on the basis of royalties has a measure of profit in every ton of ore disposed of in this way, and that so much of the gross receipts on account of royalties as is in excess of depletion, not exceeding 5 per cent of the gross value of the output at the mine, plus any incidental expenses to which

cept in the case of mines and oil wells discovered by the taxpayer in which case the value of the property at the date of discovery or within thirty days thereafter is the basis prescribed by law.3 For a full discussion of the topic of depletion as an allowable deduction, consult Chapter XXXI, "Depletion."

After the value at March 1, 1913, is determined, a proper calculation must be made as to how much of the royalties received is capital and how much income. The part which is capital cannot be taxed, but all royalties which accrue must be reported as gross income and the depletion allowance must be deducted in order to ascertain the taxable or net income.

Royalties from coal lands. In the anthracite fields many owners of coal lands have granted perpetual "mining leases" to operators. The Supreme Court of Pennsylvania has held these transfers to be "sales." In all cases the revenue therefrom (usually a fixed rate per ton mined) is known as "royalties." Under the 1916 and subsequent laws, the owners of coal lands, or those to whom a "royalty" is being paid, are entitled to receive in cash, free from income tax, an amount equal to the fair value of the property on March 1, 1913. This valuation is assumed to be capital. After such principal sum is provided for, the balance of the collections is income and is subject to the income tax. If the rate of royalties is a substantial one, it is probable that of the royalties received each year part is capital and part taxable income.

the corporation may be subject, is income within the meaning of the federal income tax law and should be so returned by the lessor." (T. D. 2152.)

The above ruling was obviously defective because it ignored the fact that there are many cases where royalties received have no "measure of profit" in them. Every purchaser or owner of a mine or oil well does not have a bonanza. He may have paid a high price for his property, hoping to secure royalty returns which would show a handsome profit, but his hopes may fade and disappear and he may be glad to get his original capital back without interest.

Section 214 (a-10). See Chapter XXXI.

'For citations see Sargent Land Co. case, 242 U. S. 503.

Mining (minimum) royalties received in advance.-In most mining districts it is customary for owners of the lands to execute contracts or leases under which the lessees are required to make annual payments representing a fixed per-ton compensation or royalty for a definite number of tons of ore or coal. These payments are made to the owners and are clearly understood by both parties concerned to be in full payment of royalties for an equivalent amount of ore or coal whenever it may be removed thereafter. These payments are usually designated as advance minimum royalties, and may be paid for several successive years in which no ore or coal is actually mined. In many cases the property is surrendered to the lessors before the quantities paid for have been removed.

REGULATION. Where the owner has leased a mining property for a term of years with a requirement in the lease that the lessee shall mine and pay for annually a specified number of tons or other agreed units of measurement of such mineral, or shall pay annually a specified sum of money which shall be applied in payment of the purchase price or agreed royalty per unit of such mineral whenever the same shall thereafter be mined and removed from the leased premises, the value in the ground to the lessor for purposes of depletion of the number of units so paid for in advance of mining will constitute an allowable deduction from the gross income of the year in which such payment or payments shall be made; but no deduction for depletion by the lessor shall be claimed or allowed in any subsequent year on account of the mining or removal in such year of any ore or mineral so paid for in advance and for which deduction has been once made. If for any reason any such mining lease shall be terminated before the ore or mineral therein which has been paid for in advance has been mined and removed, and the lessor repossesses the leased property, an amount equal to the aggregate deductions for depletion allowed in respect of ore or mineral not mined and removed by the lessee, but still in the ground, will be deemed income to the lessor and will be returned as such for the year in which the property is repossessed. (Art. 215.)

The foregoing regulation properly holds that when a lessor has claimed annual depletion equal to the quantity covered by the advance royalties, no further deduction shall be made when the ore is subsequently removed.

[Former Procedure] See Income Tax Procedure, 1919, page 288.

The regulation further provides that when a lessor repossesses the property, and part of the ore or mineral, in respect of which depletion was deducted has not been removed by the lessee, the aggregate of the excessive deductions will be deemed income to the lessor "and will be returned as such. for the year in which the property is repossessed.”

This latter provision might work great hardship. A lessor may lease coal lands for a period of thirty years at a stated royalty per ton for coal removed, the minimum royalty being fixed at $25,000 per annum. If the proper depletion based on the minimum royalty is $10,000 per annum there will be returned as net income $15,000 annually. If the lessee should mine only one-half the coal paid for (and in many cases the proportion is less) in the thirty-first year the lessor would be deemed to have realized a net income of $150,000 and the tax thereon might easily be $50,000. Theoretically excessive depletion, to the extent of $5,000 per annum for thirty years, has been claimed, but the tax saved by the excessive deduction may not have amounted to more than one-half of the tax which would be payable if the adjustment were made in the year of repossession.

Furthermore, the taxpayer probably would have no means of paying the tax, as a repossessed coal mine has little, if any, sales value.

In most cases the apparently excessive deductions would not be excessive at all. Depletion could only be charged from year to year on a showing as to the original value of the lease. The lessee would not relinquish possession and lose his advanced royalties if the mine retained its value. Therefore at the end of the period the lessor would have merely charged off an aggregate sum equal to the depletion of the coal removed and the depreciation in the value of his property.

In any event the actual value of the property repossessed is the maximum amount which can be deemed to be income. If amended returns for prior years are not accepted the author ventures the prediction that no court would deem the