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The exhaustion of minerals, oils, timber, etc., by mining, flow and production of any kind must be reflected annually in the accounts of the owner in order accurately to determine the profits for the taxable year. It may be that the entire production yields a net revenue sufficient only to make proper provision for the return of the capital invested. In such case there should be nothing to pay under an income tax law. In the 1913 law there was an extraordinary provision which in some cases actually resulted in a tax being levied on a net loss. This inconsistency and injustice were corrected in the 1916 law and further improvements have been made in the 1918 law, so that now the accounts may be adjusted annually by adequate reserves and capital may be reimbursed before any taxable income need be returned.

Law. Section 214. (a-10) [Individuals). Section 234 (0-9) [Corporations). That 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 depletion and for depreciation of improvements, according to the peculiar conditions in each case, based upon cost including cost of development not otherwise deducted: Provided, That in the case of such properties acquired prior to March 1, 1913, the fair market value of the property (or the taxpayer's interest therein) on that date shall be taken in lieu of cost up to that date: Provided further, That in the case of mines, oil and gas wells, discovered by the taxpayer, on or after March 1, 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 depletion allowance shall be based upon the fair market value of the property at the date of the d'scovery, or within thirty days thereafter; such reasonable allowance in all the above 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 deductions allowed by this paragraph shall be equitably apportioned between the lessor and lessee; ..

Nothing more could be asked by any owner or lessee of natural deposits than "a reasonable allowance for depletion," but the interests of lessor and lessee should be separated.

Theory of Depletion

As with depreciation, the theory which properly determines the distinction between capital and income in dealing with depletion of natural resources is that provision must be made for the return of the original capital or cost (or value March 1, 1913) before there can be any income. This involves a periodical charge, against the gross earnings realized from the product, of such amounts as will in the aggregate equal the original outlay by the time the property shall have been exhausted. Since obviously no engineer can determine within one ton or one barrel the total contents of a mine or well, a prudent owner will base his calculation upon a scale of exhaustion somewhat more rapid than is required by the maximum estimate of the total mineral content. As soon as the reserve for depletion equals the capital investment, 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 1918 law is broad enough to permit the full deduction demanded by the theory of depletion.'

'[Former Procedure] Under the 1909 law no deduction could be made for depletion. The language of the statute that "all losses sustained within the year .... including a reasonable allowance for depreciation of property" (section 38, Second) has been interpreted by the Supreme Court of the United States as not permitting the deduction of allowances of this type (Von Baumbach, Collector, v. Sargent Land Co., 242 U. S. 503). The Bureau of Internal Revenue, acting upon this decision, has reassessed corporations which under this law claimed depletion allowance. For a full discussion and criticism of this decision see Income Tax Procedure, 1918, pages 405-408.

The 1913 law permitted "in the case of mines a reasonable allowance for depletion of ores and all other natural deposits, not to exceed 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 General Procedure in Case of Depletion

Basis of depletion allowance.- In the case of properties acquired prior to March 1, 1913, the actual value on that date fixes the capital sum to be charged off thereafter. 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 would reasonably write off the cost before the tract was exhausted. If the value of the unmined coal appreciated, and it could be demonstrated that on March 1, 1913, the fair value was $800 per acre, subsequent to that date the charge for depletion should be doubled.

When such a condition exists, the proper procedure is to debit the property account and credit an account called "Surplus arising from reappraisement of property.” erty account, as so valued, will then be the basis of depletion charges. An adjustment should be made to have the account properly reflect the necessary charges to the beginning of the taxable year, and thereafter the annual charges should be accurately calculated. If such an account is created it will be

The prop

of the United States held that this 5 per cent limitation was constitutional even though it might be inadequate to provide fully for depletion and as a consequence might result in the tax being levied not only on the profit but also in part upon gross product or capital. (Stanton v. Baltic Mining Company, 240 U. S. 103.) 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 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, such reasonable allowance to be made in the case of both (a) and (b) under rules and regulations to be prescribed by the Secretary of the Treasury: Provided, That when the allowances authorized in (a) and (b) shall equal the capital originally invested, or in case of purchase made prior to March first, nineteen hundred and thirteen, the fair market value as of that date, no further allowance shall be made. ...."

desirable to transfer therefrom, once a year, to the regular surplus account an amount representing the difference between the aggregate depletion actually charged and the amount which would have been charged on the basis used before revaluation. The chief reason for making such transfer is that the item “invested capital” as defined by the excess profits tax law does not recognize appreciation arising out of revaluations unless a sale takes place, but cash realizations of any part of the assets reappraised are recognized as additions to invested capital, commencing with the dates of realization.

For method of separating ledger accounts so that surplus accrued before and after March 1, 1913, will be properly divided, see page 340.

REGULATIONS. A reasonable deduction from gross income for the depletion of natural deposits and for the. depreciation of improvements is permitted, based (a) upon cost, if acquired after February 28, 1913, or (b) upon the fair market value as of March 1, 1913, if acquired prior thereto, or (c) upon the fair market value within thirty days after the date of discovery in the case of mines, oil and gas wells discovered by the taxpayer after February 28, 1913, where the fair market value is materially disproportionate to the cost. The essence of this provision is that the owner of such property, whether it be a leasehold or freehold, shall secure through an aggregate of annual depletion and depreciation deductions a return of the amount of capital invested by him in the property, or in lieu thereof an amount equal to the fair market value as of March 1, 1913, of the properties owned prior to that date, or an amount equal to the fair market value within thirty days after the date of discovery of mines, oil or gas wells discovered by the taxpayer on or after March 1, 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; plus in any case the subsequent cost of plant and equipment (less salvage value) and underground and overground development, which is not chargeable to current operating expense, but not including land values for purposes other than the extraction of minerals. . . . . (Art. 201.)

In any case in which a depletion or depreciation deduction is computed on the basis of the cost or price at which any mine, mineral deposit, mineral right or leasehold was acquired, the owner or lessee will be required upon request of the Commissioner to show that the cost or price at which the property was bought was fixed for the purpose of a bona fide purchase and sale, by which the

property passed to an owner in fact as well as in form different from the vendor. No fictitious or inflated cost or price will be permitted to form the basis of any calculation of a depletion or depreciation deduction, and in determining whether or not the price or cost at which any purchase or sale was made represented the actual market value of the property sold, due weight will be given to the relationship or connection existing between the person selling the property and the buyer thereof. (Art. 205.)

Where the fair market value of the property at a specified date in lieu of the cost thereof is the basis for depletion and depreciation deductions, such value must be determined, subject to approval or revision by the Commissioner, by the owner of the property in the light of the conditions and circumstances known at that date, regardless of later discoveries or developments in the property or in methods of mining or extraction. The value sought should be that established assuming a transfer between a willing seller and a willing buyer as of that particular date. No rule or method of determining the fair market value of mineral property is prescribed, but the Commissioner will lend due weight and consideration to any and all factors and evidence having a bearing on the market value, such as cost, actual sales and transfers of similar properties, market value of stock or shares, royalties and rentals, value fixed by the owner for purposes of the capital stock tax,valuation for local or State taxation, partnership accountings, records of litigation in which the value of the property was in question, the amount at which the property may have been inventor ed in probate court, disinterested appraisals by approved methods, and other factors. (Art. 206.)

Evidence required to support depletion charges.-The law permits a reasonable allowance for depletion and no more. It is proper and necessary that taxpayers should comply with all reasonable Treasury requirements and furnish detailed evidence bearing on the propriety of the deductions claimed.

2“We believe we have demonstrated by the opinions of leading courts and by general reasoning, and by illustration taken from the history of the very companies involved, that to attempt to establish value of the property of the company by referring to the market value of its securities is so unreliable as to forbid its employment if a way is offered or can be devised of arriving at actual values. It is not in the discretion of the Internal Revenue Department to adopt the one or the other at its pleasure.” (Extract from memorandum submitted to the Commissioner of Internal Revenue by the Ray Consolidated Copper Company.)

*The connection of the capital stock tax law with fair values of minerals on March 1, 1913, is remote, to say the least, in view of the fact that the first report under the capital stock tax law was not due until 1917.

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