as a deduction from gross income as a loss, provided such amounts have been recorded in the books following the condemnation and withdrawal from use of the obsolete property. The amount of obsolescence that may be claimed as a deduction shall be ascertained by deducting from the cost of the property the total amount that has been previously claimed and deducted on account of the depreciation of the property, plus residual value at time of obsolescence, or plus the amount received from the sale of the property. The obsolescence deduction must not include the accumulated depreciation applicable to prior years. (Reg. 33 Rev., Art. 178.)

Obsolescence When no Depreciation is Deducted. If no depreciation has been charged off against such property and deducted from gross income of prior years, the amount allowable as a deduction for the year in which the property becomes obsolete shall be ascertained by deducting from the cost of the property its residual value plus an amount equal to the depreciation actually sustained during the prior period and which might have been deducted when computed at the rate applicable to the same or similar property. The amount of depreciation thus arrived at as applicable to former years may be made the basis of amended returns and a claim for the refund of taxes overpaid by reason of the fact that no depreciation deduction was claimed in those years. (Reg. 33 Rev., Art. 179.)

Loss on Inventory by Obsolescence or Damage. No deductions from the inventory value of merchandise or material will be allowed except in cases in which the inventory includes goods or materials which by reason of obsolescence or damage are unsalable. When such deduction is claimed the facts connected there

with, including a statement of the cost of the goods, the value at which they were inventoried, and their present condition, must be filed with the return. (Reg. 33 Rev., Art. 160.)

CHAPTER 32

DEDUCTION FOR ALLOWANCE FOR DEPRECIATION

[Page 348.]

Merchandise. Depreciation computed on total invoice cost of merchandise in stock is not an allowable deduction, except that if any portion of the merchandise in stock is unsalable by reason of obsolescence or damage, a depreciation deduction not in excess of the decline in value during the taxable year will be allowed. (Reg. 33 Rev., Art. 169.)

[Page 355.]

Rate of Depreciation. If it develops that by reason of underestimating the life of the property or by overestimating the rate of deterioration an amount in excess of the yearly depreciation has been taken, the rate applicable to future years should at once be reduced and the balance of the cost of the property not provided for through a depreciation reserve should be spread over the estimated remaining life of the property. (Reg. 33 Rev., Art. 165.)

[Page 355.]

Annual Allowance Must be Entered on Books. Within the purview of this item depreciation, to an amount measuring the decline in value due to exhaustion, wear and tear of property arising out of its use, is a loss.

This loss, in order to constitute an allowable deduction from gross income, must be charged off. The particular manner in which the amount shall be charged off is not material, except that the amount measuring a reasonable allowance for depreciation must be either deducted directly from the book value of the assets or credited to a depreciation reserve account, and as such shall be reflected in the annual balance sheet. (Reg. 33 Rev., Art. 159.)

[Page 358.]

Diversion of Fund. If a corporation at the end of the year finds it has a certain net income, and, without making any provision for depreciation, distributes such net income among its stockholders as dividends, it will be estopped from claiming in its returns of annual net income for such year any deduction on account of depreciation unless it is shown conclusively that the property account has been reduced by the amount of depreciation claimed, or unless such amount has been credited to a depreciation reserve account, and such amount was in fact a reasonable allowance.

The depreciation allowance authorized by section 12 is intended to provide a fund out of which the loss due to use, wear, and tear may be made good, and the fund thus created can not be diverted to the payment of dividends; that is to say, a deduction made under the guise of depreciation can not measure a loss and at the same time be used in the payment of dividends.

The fact that no reserve was made for depreciation indicates that there is no loss on this account to be provided for. (Reg. 33 Rev., Art. 161.)

CHAPTER 33

DEDUCTION OF ALLOWANCE FOR DEPLETION OF OIL

AND GAS DEPOSITS

The rulings relating to depletion of oil and gas deposits have been very materially changed. Under the new rulings depletion is allowed to lessees as well as owners in fee and the amount of the annual allowance may be measured by the number of units removed from the deposit instead of by the reduction in flow and production. Regulations 33 Revised, Articles 170 to 172 inclusive, are in full as follows:

Art. 170. Oil and Gas Properties.-Sections 5 and 12 of the act of September 8, 1916, as amended by the act of October 3, 1917, authorize individuals and corporations owning and operating gas or oil properties, to deduct from gross income

"A reasonable allowance

duction in flow and production,

that when the allowance authorized

for actual re

* provided * shall equal

the capital originally invested, or in case of purchase made prior to March 1, 1913, the fair market value as of that date, no further allowance shall be made."

The essence of this provision of law is that the owner or operator of this character of properties shall secure through an aggregate of annual depletion deductions, the return of the amount of capital actually invested, or an amount not in excess of the fair market value as of March 1, 1913, of the properties owned prior to that date.

For the purpose of determining the amount of capital to be returned through annual deductions, operators may be divided into two classes, (a) operators who own the fee, and (b) operators who own a lease or leases.

In the case of the operating fee owner, the amount

returnable through depletion deductions is the fair market value of the property (exclusive of the cost of physical property) as of March 1, 1913, if acquired prior to that date, or the actual cost of the property if acquired subsequent to that date, plus, in either case, the cost of velopment (other than the cost of physical property incident to such development) up to the point at which the income from the developed territory equals or exceeds the deductible expenses.

In the case of a lessee, the capital thus to be returned is the amount paid in cash or its equivalent as a bonus or otherwise by the lessee for the lease, plus also all expenses incurred in developing the property (exclusive of physical property (prior to the receipt of income therefrom sufficient to meet all deductible expenses, after which time as to both owner and lessee, such incidental expenses as are paid for wages, fuel, repairs, hauling, etc., in connection with the drilling of wells and further development of the property, may, at the option of the operator, be deducted as an operating expense or charged to capital account.

If, in exercising this option, the individual or corporation charges the expense of drilling wells or further development to capital account, the same, in so far as such expense is represented by physical property, may be taken into account in determining a reasonable allowance for depreciation during each year until the property account thus augmented has been extinguished through annual depreciation deductions, after which no further deduction on this account will be allowed. In the case of a going or producing business, the cost of drilling nonproductive wells may be deducted from gross income as an operating expense.