contract that title to the property shall remain in the tenant after the lease expires; in the case contract so provides, the annual depreciation would be measured by the life of the property without regard to the period of the lease.

CHAPTER 33

DEDUCTION OF ALLOWANCE FOR DEPLETION OF OIL AND GAS DEPOSITS

The law provides that there may be deducted "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." It is also provided that when the allowance so authorized is equal to 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. The provisions for depletion are the same with respect to corporations and individuals. The Treasury Department holds that this provision of the law applies only to the owner of the property from which oil or gas is produced, and that the lessee is not entitled to any claim for depletion since one operating under a lease has no capital invested in the property. This seems to be a very narrow construction of the language of the law. But the theory on which the Treasury Department proceeds is that whatever capital the lessee may have invested is not in the deposit but in the physical property used in operating the property on which depreciation may be claimed, or, if a "bonus" has been paid, that it is in the nature of advance payment of royalties, and the amount thereof may be ratably dis1 Act of September 8, 1916, § 5 and § 12.

tributed over the life of the lease or over the productive life of the property, as is further indicated in a following paragraph on the subject of lessees. A broader construction of the law would, however, lead to the conclusion that the claim of allowance for depletion should be made with respect to the capital invested in a natural resource either by the owner, the lessee, or the operator all of whom may have capital invested in the deposit. The amount a lessee pays the owner for the right to operate a property and produce the oil or gas is capital invested by him in the natural resource. The amount a successor of a lessee pays the lessee for the rights under a lease is capital invested by such successor. A lessee who pays nothing but annual royalties to the owner may also have capital invested in the natural deposit, the amount in such case being the total of all the amounts expended in developing the property before it begins to produce (unless any such amounts are deducted from his net income from other sources), and such amounts as are expended after the property begins to produce and are not charged to expense. The Treasury Department does not disallow an annual claim for these amounts but does not permit them to be claimed under the head of depletion. The right to claim the allowance for depletion is limited strictly to the owner of the property from which the oil or gas is produced.

Depreciation Not Included in Depletion. The depletion allowance has no relation to the allowance for depreciation due to exhaustion, wear and tear of the physical property used in the discovery or removal of the natural deposit. The allowance for depreciation should be computed separately and apart from the allowance for depletion, and should be determined according

to the rules laid down with respect to depreciation. Thus, depreciation would be allowed on rigs, tools, machinery of all kinds, pipes, casing, and other equipment necessary to the operation of the wells or the field. Such deduction, for depreciation may be taken by the owner of the physical property whether he be the owner, the lessee, or the operator of the natural deposit with respect to which depletion is claimed.2

Oil Wells. The same rule is laid down by the 1916 Law for computing depletion of oil wells and of gas wells. Under the 1909 Law the regulations, prescribing the method for claiming depletion with respect to each, were different. With respect to oil wells the depletion was, at that time, based upon a unit value per barrel, as is further indicated by the paragraphs at the close of this chapter.

Gas Wells. Under the 1916 Law the depletion for gas wells is measured by the reduction in flow and production in the same manner as in the case of oil wells. Under the 1909 Law the Treasury Department ruled that depreciation of gas wells could be made on the basis of reduction in rock pressure, or reduction of volume, at the option of the tax payer. The present law has been criticized by owners of gas wells on the ground that to determine depletion by gauge of the open flow of each well necessitates a waste of gas in order to obtain an accurate test, and it is contended that the method of using rock pressure would more nearly represent the flow from year to year than any test of volume. A gas well is not, like an oil well, usually operated to get the greatest production at all times. Depletion in

2 T. D. 2447.

the case of gas wells is sometimes measured by the use of a minute pressure volume gauge, which, though not accurate, is valuable for comparative purposes. Under the present law, however, the Treasury Department recognizes only one measure of depletion and that is by the expensive process of determining the reduction in flow.

Owner Entitled to Claim Deduction. The rulings are that the owner of the gas or oil well may deduct annually "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." The owner who claims the deduction must be the owner during the period for which the deduction is claimed." Lessees are not permitted to claim an allowance for depletion as they have no capital invested in the property.

Basis of Deduction. The amount on which the annual allowance is based is either (a) the amount originally paid for the property (not including the cost of machinery, buildings, or other physical property subject to wear and tear connected therewith) or (b) the fair market value of the oil or gas deposits on March 1, 1913, if the property was purchased prior to that date. When this amount has been reached by a series of annual allowances no further allowance is permitted for depletion. In order to determine when allowances for depletion shall cease, the owner of the property must keep an accurate ledger account, in which shall be charged the value or cost, as the case may be, of the property with respect to which the allowance is claimed. This account must be credited annually with the amount allowed as a de

3 T. D. 2447.