(2) In the case of oil and gas wells the allowance for depletion shall be 272 per centum of the gross income from the property during the taxable year. Such allowance shall not exceed 50 per centum of the net income of the taxpayer (computed without allowance for depletion) from the property, except that in no case shall the depletion allowance be less than it would be if computed without reference to this paragraph.

The theory of depletion is simple, viz., provision must be made for the return of capital invested in natural resources which are being exhausted. The general rule is that the capital to be returned is limited to original cost, or value as at March 1, 1913, if acquired prior thereto, whichever is greater. There are two exceptions to the general rule. One exception, available only to mines, substitutes for the ordinary basis in certain cases, a "discovery value." The second exception, available only to oil and gas wells, substitutes for the ordinary allowance, in certain cases, a deduction equal to a fixed percentage of the income. 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, in the case of mines acquired after February 28, 1913,2 the value within thirty days after "discovery"; 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. In the case of gas and oil wells, however, there may be substituted a deduction computed on the basis of the income from the property.

In the case of mines and timber lands, 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. In the case of gas and oil wells, the limitation on the aggregate deductions for depletion has been removed. (See page 1104.)

The regulations (Art. 201, et seq.) reflect the general principles to be observed in arriving at proper valuation. It is a heavy task,

[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.

however, 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 to the effect that the value established for depletion may have on the distributions to stockholders in the form of dividends free from tax (see page 449) and on gains or losses, if any, upon sale of stock, as well as to the provision of the law whereby distributions from discovery depletion reserves in the case of mines are tax-free. [Section 201 (d).]

Practically, it will be found in every case that when 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 a quite simple matter.

The flat rate of 271⁄2 per cent given in the 1926 law to owners of oil and gas wells is the first device to be made available which may be used to avoid the necessity of a valuation.

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, in the case of mines, at the "discovery" date, if acquired after February 28, 1913, and a “discovery" is claimed. If a property was acquired after February 28, 1913, and a "discovery" is not claimed, the basis is cost. In the case of a gas or oil well, the option of the flat 271⁄2 per cent of gross income is available.

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 would reasonably write off the cost before the tract was exhausted. If the value of the unmined coal appreciated, and it could be demon

strated 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." The property 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.3

REGULATION. Sections 214 (a) (9) and 234 (a) (8) provide that taxpayers shall be allowed as a deduction in computing net income in the case of natural deposits a reasonable allowance for depletion of mineral and for depreciation of improvements. See section 204 (c) and articles 1602 and 221 with reference to the basis for computing depreciation and depletion.

The essence of these provisions of the statute is that the owner of mineral deposits, whether freehold or leasehold, shall, within the limitations prescribed, secure through an aggregate of annual depletion and depreciation deductions the return of either the cost of his property, or the value of his property on the basic date plus, in either case, subsequent allowable capital additions. . . . . But not including land values for purposes other than the extraction of minerals. . . . . (Art. 201.)

The following definitions indicate some of the conditions attending a proper valuation, and make the distinction between (1) the "minerals" which, as shown hereinafter, are valued on one basis; (2) the physical equipment which is usually taken at depreciated cost; and (3) the value of the land, which in some cases may be available for agriculture. The value of land for other than mineral purposes is not to be recovered through depletion charges. (See Art. 201, below.)

covering de

pletion and depreciation(a) The term "basic date" indicates: March 1, 1913, in the case of property acquired prior thereto, if the cost was less than the fair market value on March 1, 1913; the date of acquisition in the case of property acquired on or after March 1, 1913, or in the case of property acquired before March 1, 1913, if the cost of such property was greater than its fair market value on March 1, 1913; or the date of discovery, or a date within 30 days thereafter, in the case of the discovery of a mine.

3 [Former Procedure] For discussion of realized appreciation as affecting invested capital, see Income Tax Procedure, 1924, page 1214.

FAIR MARKET VALUE.

(b) The "fair market value" of a property is that amount which would induce a willing seller to sell and a willing buyer to purchase. MINERAL PROPERTY.—

(c) A "mineral property" is the mineral deposit, the development and plant necessary for its extraction, and so much of the surface only as is reasonably expected to be underlaid with the mineral. The value of a mineral property is the combined value of its component parts.

MINERAL DEPOSIT.—

(d) A "mineral deposit" refers to minerals only, such as the ores only in the case of a mine, to the oil only in the case of an oil well, and to the gas only in the case of a gas well, and to the oil and gas in the case of a well producing both oil and gas. The value of a mineral deposit is the value of the mineral property, less the value of the plant and equipment, and less the value of the surface of the land for purposes other than mineral production. The cost of a mineral deposit is that proportion of the total cost of the mineral property which the value of the deposit bears to the value of the property at the time of its purchase.*

MINERALS.

(e) "Minerals" include ores of the metals, coal, oil, gas, and such nonmetallic substances as abrasives, asbestos, asphaltum, barytes, borax, building stone, cement rock, clay, crushed stone, feldspar, fluorspar, fuller's earth, graphite, gravel, gypsum, limestone, magnesite, marl, mica, mineral pigments, peat, potash, precious stones, refractories, rock phosphate, salt, sand, silica, slate, soapstone, soda, sulphur, and talc.

OPERATING profit.

(f) "Operating profit" is the net amount received from the sale of minerals before depletion and depreciation are deducted. It is distinct from net income. . .

DEPLETION SUSTAINED.

(g) "Depletion or depreciation sustained" means (except in cases where a discovery has been established as to which see (h) below) depletion or depreciation actually sustained, whether legally allowable or not, based on the cost or value as at the basic date,. . . . (Art. 201.)

Except in the case of gas and oil wells, when the depletion. sustained equals the basic value of the property, no further deduc

4

[Former Procedure] The corresponding article in Regulations 65 contained the following sentence in place of the last two quoted above: "The value of a mineral deposit is its cost or it is the value of the mineral property, less the value of the plant and equipment, and less the value of the surface of the land for purposes other than mineral production."

6

See page 101.

For purpose of determining gain or loss on sale, see Section 202 (b-2).

tion for depletion may be taken, irrespective of whether the full amount has previously been allowed in computing taxable net income.

RULING. . . . . The fact that the working of a mine carries with it a depletion of its mineral content is a fact that can not be disregarded, however, irrespective of whether Congress recognized the desirability of a deduction by reason thereof. It follows that for the years 1913, 1914, and 1915 the mine was depleted to the full extent of the mineral extracted, even though Congress permitted a deduction only to the extent of 5 per cent of the gross value at the mine of the output for the year, and, in determining for further years the depletion to be allowed on the March 1, 1913, value, there must be deducted the full depletion sustained for those three years. .. (C. B. III-1, 184; I. T. 1893.)

...

Cost when used as basis must be bona fide.—

REGULATION. 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 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 in fact as well as in form to an owner other than 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.)

Valuation of Mines

The valuation of mines for purposes of depletion has been the subject of lively dispute during the last few years. It was not until the passage of the 1918 law that it became entirely plain that definite valuations as of March 1, 1913, would be required for the purpose of arriving at taxable income. During 1919, the mines made such valuations and in the course of the next year or two the Treasury made a series of decisions and established its "fair market valuations." In 1923 it was announced that the Commissioner of Internal Revenue had instructed the Income Tax Unit "to proceed to the revaluation of the copper and silver mining companies for the purpose of determining their tax liability for 1919 and subsequent years in accordance with the recommendations heretofore made by it." It was also stated that the same procedure would be followed