pletion deduction, and when the account balances no further allowances may be claimed. The cost, or the value as of March 1, 1913, must be fixed and set up on the books before the first allowance with respect thereto is claimed. Once fixed, it cannot be changed, notwithstanding the fact that the quantity of oil or gas was underestimated at the time the value was fixed or at the time the property was acquired.*

CAPITAL ORIGINALLY INVESTED. This phrase, as used in the law, is held to mean the actual cost of the property containing the natural deposit, but not the cost of any physical property connected therewith on which depreciation may be claimed.5

FAIR MARKET VALUE AS OF MARCH 1, 1913. Where the property was purchased prior to March 1, 1913, the fair market value as of that date should be taken instead of the cost. Such fair market value must be determined by each owner, upon such basis as will not comprehend any operating profits, the estimated value in all cases being subject to the approval of the Commissioner of Internal Revenue. The estimate should be an estimate of the price at which the property as an entirety might have been sold for cash or its equivalent on March 1, 1913.6 Although the Treasury Department does not recognize the right of a lessee to claim depletion, it seems that where a lessee had a leasehold interest on March 1, 1913, he should be permitted to claim depletion on the value thereof at that time, as such value repre

4 T. D. 2447. 5 T. D. 2447. 6 T. D. 2447.

sented capital to him at the incidence of the tax, on which he sustains a loss as the deposit is removed.

Rate of Annual Deductions. The annual deductions must be reasonable in amount; that is, such sums as will in the aggregate equal the capital originally invested (or the value on March 1, 1913) at or about the time the deposit is exhausted. The allowance is for actual reduction in flow and production during the year and not on a unit value basis as in the case of mines. The Treasury Department has ruled that this decline in flow and production should be reduced to a percentage basis and a like percentage of the capital invested (or value on March 1, 1913) constitutes the allowable deduction for the year. That is, if the decline in the flow and production during the year of ten wells, costing $100,000, has been 5%, as compared with the production and flow indicated by a test made at the beginning of the period, then 5% of $100,000 will be the allowance for that year. Where the property contains more than one well, the percentage of reduction for each well may be ascertained, in which case the average percentage of reduction for all the wells would determine the percentage of original cost or value which may be taken. The depletion deduction in all cases until the capital is extinguished will be such percentage of the capital as a reduction in the flow and production of one year is a percentage of the flow or production of the previous year." It should be noted that by this method of determining depletion, no allowance can be claimed so long as the oil or gas wells show no reduction in the settled or regular flow. Thus, a well may show only a 5% reduction in flow annually for two years, and in the third year may stop altogether; the

7 T. D. 2447.

ninety per cent loss in the third year may be deducted, but is of no avail unless the taxpayer has other income sufficient to offset it. A more equitable basis would be to allow a reasonable deduction during the years that the well produces its maximum, on a per unit value basis, as in the case of mines, the allowance stopping when the capital has been returned to the owner.

The reduction

REDUCTION OF PRODUCTION AND FLOW. of production and flow in the case of a fully developed territory, where no new wells are being drilled, may be ascertained by a comparison of the quantity produced during the year with the quantity produced during the preceding year. That is, where the production in one year is 50,000 barrels and the production in the following year is 47,500 barrels, this would indicate a reduction in production of 2,500 barrels or a decline of 5%. Applying this rate to the capital or value, would determine the amount of the annual allowance. Where a property contains more than one well, the reduction may be determined with respect to each well, or with respect to groups of wells, or with respect to all the wells in the field or territory owned by the taxpayer. The taxpayer has the option of measuring the reduction by individual wells, or groups of wells, or the entire field, but is required to state the method pursued, in a statement to be attached to the return of annual net income. If wells are not so situated that their flow and production may be assembled in order to test and ascertain the reduction, as a group, it is necessary to take an accurate gauge 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 of reduction applying to each well. This having been done, the average percentage

reached for all the wells on the property will be used in ascertaining the amount of the deduction. If the depletion deduction is computed for a group of wells or an entire field and new wells are drilled, the flow from the new wells may offset the reduction of the other wells, but no allowance can be claimed so long as the flow of the unit, that is, the group of wells or the entire field, is as great for the year as it was for the preceding year. Hence, if the depletion allowance is to be availed of in the case of a field or territory in which new wells are being drilled, each individual well should be tested at the end of the year in order to determine the reduction thereof, or possibly each group of wells in operation at the beginning of the year and each group brought in during the year as separate units. 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 difference between the two tests determining the amount of reduction, if any. Subsequently in the case of producing wells the tests for reduction must be approximately one year apart and, it seems, should preferably be at the beginning or end of the calendar or fiscal year of the owner.

Deductions by Lessees. Although a lessee is not permitted by the Treasury Department to claim a deduction for depletion he may claim three deductions with respect to the property: (a) for royalties paid during the year; (b) for an aliquot part of any "bonus" paid in addition to royalties, and (c) for depreciation.

ROYALTIES. In many states, under the terms of oil and gas leases, it is the custom to pay a rental to the

8. T. D. 2447..

land owner, usual quarterly and usually at the rate of one dollar per acre, per annum, for the right to postpone or delay the drilling of oil on the land. When the well is drilled and oil is produced, the oil royalty is usually paid in kind, generally one-eighth of the oil produced and saved. In case gas is produced, the royalty is not paid in kind, but usually in cash at a certain sum per annum for each well. The delay rental is income to the owner, without any allowance for depletion, and is a proper item to be deducted as expense by the lessee. If, after production begins, the rental is paid in kind, that is, in oil or gas, the income of the owner is the amount he receives on the sale of his share, and the income of the lessee is the amount he receives on the sale of the share retained by him. From the amount the lessee receives in such cases no deduction can be made on account of the rental paid in kind. If the lessee retains the entire output of the well, and pays a rental or royalty in cash, he must report, as his income, the amount received on the sale of the entire output, but may deduct, as expense, the amount of the cash royalty paid to the

owner.

"BONUS." The regulation of the Treasury Department provides that if a lessee, 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. The word "bonus" as here used. means the amount paid by a lessee for the right to enter