CHAPTER XVIII

THE INCOME TAX

DEPLETION OF NATURAL DEPOSITS

280.-DEPLETION DEFINED.

The Income Tax law also recognizes the loss due to depletion of natural deposits in the case of certain kinds of property and makes specific provision for taking care of such loss and thereby returning to the taxpayer the capital investment in the natural deposits which are in the end supposed to be exhausted by the operation of the properties.

Commonly, such properties are wells, tapping supplies of oil or gas, and mines, containing mineral deposits in solid form. As production proceeds, it is obvious that, in the one case the oil or the gas flow naturally diminishes and that, in the other, there must come a time when the ore will all have been extracted. And so the law allows for deduction from gross income on account of such depletion of deposits.

This allowance is entirely separate and distinct from that covering depreciation of physical property. In other words, the terms "depreciation" and "depletion" must not be confused. The allowances are computed differently, and one has no relation to the other except insofar as both represent a return of capital investment.

281.-WHAT THE LAW SAYS.

In the language of the law deduction can be claimed for

(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 allowance authorized in (a) and (b) shall equal the capital originally invested, or, in the case of purchase made prior to March 1, 1913, the fair market value as of that date, no further allowance shall be made.

282.-CAPITAL TO BE RETURNED.

From a careful reading of the above quotation from the law it will appear that the amount of capital to be returned by allowance for depletion depends on the date of acquisition of the property.

(a) If the property was acquired prior to March 1, 1913, the fair market value, as of that date, represents the capital eventually to be returned by annual deductions.

(b) If the property has been acquired within the period of time beginning March 1, 1913, the cost represents the capital eventually to be returned by annual deductions.

And by "fair market value" and "cost" are meant the fair market value and cost of the natural deposits with respect to the depletion of which deduction is claimed.

283.-DEPLETION OF OIL OR GAS.

It has been deemed advisable here to print in full the regulations made by the Treasury Department under date of February 8, 1917, in Treasury Decision 2447, relative to allowances for depletion of oil and gas. An arbitrary system of inserting subheadings has been introduced in order that attention may be the more readily directed to the various provisions of the decision. After quoting the law making provision for deduction for depletion, the Department directs as follows:

Applies to Owners.

The purpose of this provision is to afford a means whereby the individual or corporation owning oil or gas producing properties may, during the period of operation, deduct from gross income the cost of, or capital actually invested, in the natural deposits, if the investment was made subsequent to March 1, 1913, or the fair market value as of March 1, 1913, if purchased prior to that date, the measure of the deduction being the reduction in the flow and production.

Must Be Reasonable.

The annual deduction must be reasonable and not in excess of such a percentage of the cost or value as the case may be and as herein defined, of the oil or gas producing properties as is indicated by the reduction in the original flow or settled production of one year as compared with that of the preceding year.

By Individual Well or By Group.

For the purpose of this deduction note may be taken of the reduction in flow and production of such individual wells as were producing

oil or gas during or at some time within the year, of groups of wells or of all wells in the field or territory embraced in the same ownership. If tested by the aggregate flow of all of the wells in the field or territory, owned by an individual or corporation and new wells shall have been developed during the year, it is possible that at the end of the year there will have been no reduction in flow and production, in which case, under the specific provision of the law hereinbefore quoted and under which the depletion deduction is measured by the reduction in flow and production, there can be no deduction for depletion.

Hence in the case of a field or territory in course of development or in which new wells are being drilled, if the depletion deduction is to be availed of in the returns of annual net income, each individual well or possibly each group of wells in operation at the beginning of, or brought in during the year, if the flow and production of the group of wells is so assembled as to be tested, must be tested at the end of the year in order that the decline in the flow and production may be determined.

New Wells or New Groups.

New wells or new groups of wells brought in during the year may be tested as soon as they have reached the stage of settled production or regular flow, and then again at the end of the year. The decline in flow and production, if any, as indicated by these tests, will be reduced to a percentage basis and a like percentage of the capital invested in the oil or gas property (exclusive of machinery, equipment, etc.) will constitute an allowable deduction from the gross income of the year on account of depletion. Thus if the decline in the flow and production during the year of, say, ten wells, costing $100,000 has been 5% as compared with the production and flow as indicated by a test made at the beginning of the period, then 5% of $100,000 or $5,000 will, for the year for which the computation is made, constitute an allowable depletion deduction in favor of the individual or corporation owning and operating the property.

When Wells Cannot Be Grouped.

If the wells are not so situated that their flow and production may be assembled in order to test and ascertain the reduction in the output as a basis for computing depletion, it will be necessary for the corporation or individual owning the property and claiming a depletion deduction, to take an accurate gauge of the production and flow of each well at a certain same period of each year, and by comparing this gauge with that of the previous year, determine the percentage by which the production and flow has been reduced. This having been done as to all of the wells in operation, an average percentage rate of reduction in flow and production will be ascertained, and this rate will be applied to the capital invested, that is, the value of the oil or gas property as of March 1, 1913, or the cost of the same, if acquired subsequent to that date, for the purpose of determining the amount which may be allowably deducted from gross income by such owning individual or corporation, on account of depletion.

In Fully Developed Field.

In case of a field or territory fully developed and in which no new wells are being drilled, a comparison of the quantity of oil or gas produced during the year for which the computation is made with the quantity produced during the last preceding year, will disclose the reduction, and the percentage thus indicated of the reduction in flow and production of such field, will be the measure of the depletion deduction to be taken by the owner with respect to the capital invested in such field.

Flow of Unit Controls.

Notwithstanding the fact that the drilling of new wells may offset the reduction in the production and flow of the older wells in the field not fully developed, the provision of the law hereinbefore quoted, does not authorize, and this office cannot permit, a depletion deduction to be taken so long as the flow and production of the unit, be it a well or group of wells, or the entire territory, is as great during the year for which the return is made as it was for the year immediately preceding.

An Example of Depletion.

Illustrating in a general way the above rule as applied to a field or territory, the case may be taken of an oil property in which the capital invested, either actual cost or fair market value as the case may be, is $500,000 and the production during the year for which the return is made was 47,500 barrels, and for the year immediately preceding 50,000 barrels. This would indicate a reduction in production of 2,500 barrels, or a decline of 5%. Applying this rate to the capital, $500,000, the individual or corporation owning the property would be entitled to deduct from gross income as depletion for the year for which the return is made, the sum of $25,000, that is 5% of the invested capital.

Percentage of Unextinguished Capital.

The depletion deduction in all cases until the capital invested is extinguished, will be such a percentage of the unextinguished capital as the reduction in flow or production of one year is a percentage of the flow or production of the previous year.

Regarding Fair Market Value.

The estimate of the fair market value of gas and oil properties as of March 1, 1913, on which depletion deductions are based shall be the price at which the property as an entirety might have been sold for cash or its equivalent as of that date. The value hereinbefore contemplated must naturally be determined by each individual or corporation interested and who is the owner of the property, upon such basis as will not comprehend any operating profits, the estimated value in all cases to be subject to the approval of the Commissioner of Internal Revenue.

Ledger Account Required.

Every individual or corporation entitled to a deduction for depletion on account of reduction in flow or production of oil or gas shall keep an accurate ledger account, in which shall be charged the fair market value as of March 1, 1913, or the cost, if the property was acquired subsequent to that date, of the property whose value declines with the removal of the natural deposits. This account shall be credited with the amount of the depletion deduction claimed and allowed each year, to the end that when the credits to the account equal the debits, no further deduction for depletion with respect to this propery and the capital invested in it, will be allowed.

Cannot Revise Valuation.

The value determined and set up as of March 1, 1913, or the cost of the property if acquired subsequent to that date, will be the basis for determining the depletion deduction for all subsequent years during the ownership under which the value was fixed, and during such ownership there can be no revaluation for the purpose of this deduction if it should be found that the estimated quantity of oil or gas contained in the property was under-stated at the time the value was fixed or at the time the property was acquired.

The Lessee's Rights.

The provision of the law authorizing the depletion deduction, designed as it is to provide a means whereby the invested capital of an individual or corporation may not be subject to the tax imposed by this Title, does not apply to individuals or corporations who are operating oil or gas properties under lease, since in those cases the operator has no capital invested in such properties. By capital invested, as herein used, is meant the fair market value of the properties as of March 1, 1913, if acquired prior to that date, or the actual cost if acquired subsequent to that date, as it relates to the owner in fee of the properties. Lessees will, however, be permitted to deduct from gross income each year, a reasonable allowance for depreciation, which depreciation applies to the physical property including rigs, tools, machinery of all kinds, pipes, casing, and other equipment necessary to the operation of the wells or field. If lessees, in order to secure the right to enter upon, explore, develop, or operate gas or oil properties, paid or shall pay, a bonus in addition to royalties, the amount of such bonus so paid, may be ratably distributed over the life of the lease or over the productive life of the property, and the lessee may deduct annually as a rental payment, an aliquot part of the amount of the bonus so paid, until such amount has been extinguished.

Expense of Drilling.

The incidental expenses of drilling wells, that is such expenses as are paid for wages, fuel, repairs, etc., which do not necessarily enter into and form a part of the capital invested or property account, may, at the option of the individual or corporation owning and operating the property, be charged to property account subject to depreciation, or be deducted from gross income as an operating expense. If, in exercising the option, the operating individual or company charged the expense of drilling wells to property account, the same may be taken into account in determining a reasonable allowance for depreciation during each year, until the property account thus augumented has been extinguished through annual depreciation deductions, after which no further deduction on this account will be permitted. The cost of drilling dry or non-productive wells may be deducted from gross income as a loss.

Must Furnish Information.

To each return made by an individual or corporation owning and operating oil or gas properties, there should be attached a statement showing (1) (a) the fair market value of the property (exclusive of machinery, equipment, etc.) as of March 1, 1913, if acquired prior to that date, or (b) the actual cost of the property if acquired subsequent to that date; (2) how the fair market value of the property as of March 1, 1913, was ascertained; (3) the quantity of oil or gas produced during the year for which the return was made; (4) the quantity produced during the year immediately preceding; (5) how the depletion deduction claimed in the return was computed, whether upon the decline in flow and production of individual wells, groups of wells, or the entire field; and (6) any other data which would be helpful in determining the reasonableness of the depletion deduction claimed in the return.

If the operator is a lessee, that fact should be stated and an explanation given as to the basis and property upon which any depreciation deduction is claimed, it being understood as hereinbefore indicated, that depreciation relates to the loss due to the use, wear and tear of physical property, and that the lessee is not entitled to any deduction for the depletion or exhaustion of the oil or gas deposits, but may deduct annually as a rental payment, an aliquot part of any bonus paid for the right to enter upon, explore, develop and operate oil or gas territory as well as the royalty payments made to the lessor for the oil or