upon, explore, develop, or operate gas or oil properties. In other words, it is the amount he may pay for the lease in addition to the annual royalties. One purchasing a lease from the previous lessee should consider the amount paid for such lease as a "bonus" to be deducted ratably each year. Thus, if A acquires a lease from the owner of the land, upon agreement to pay an annual royalty of one-eighth of the oil produced, he can neither claim an annual allowance for royalty nor a pro-rata allowance for "bonus," and his income from the property will be what he receives upon the sale of seven-eighths of the oil produced. If, however, A sells his leasehold to B for one million dollars, B may deduct as "bonus" a pro-rata part of one million dollars, as that sum is an amount paid by him to secure the right to enter upon, explore, develop, or operate the property. The pro-rata amount of "bonus" to be deducted annually is determined by dividing the amount of the "bonus" by the number of years constituting the life of the lease, or if the lease has partially expired when it is acquired, by the number of years it then has to run. If, however, the productive life of the property is estimated to be less than the life of the lease the amount of the "bonus" may be divided by the number of years estimated to be the productive life of the property, in order to determine the annual deduction. That is, the purpose is to permit the return to the lessee of the full amount of "bonus" in the shorter of the two periods of time.

DEPRECIATION. Although the lessee is not entitled to any allowance for depletion of the natural resources, he may deduct as "depreciation" the incidental expenses of drilling wells, that is, such expenses as are paid for wages, fuel, repairs, etc. Such expenses do not neces

F. I. Tax.-24

sarily enter into and form a part of the capital invested or property account and they may, at the option of the one operating the property, be charged either to property account or deducted from gross income as an operating expense. The practice among many operators seems to be to charge such expenses to property account until the field begins to produce, and thereafter to charge the cost of drilling additional wells in the same field to expense, that is, so long as the property is not producing income the expenditure is properly added to the property account, and depreciation claimed in subsequent years against the income of the property but after the property commences to produce the amount is properly charged against the current income from production. The cost of drilling dry or non-productive wells may be claimed as a loss. Depreciation may also be claimed on the cost of all physical property connected with the operation, such as rigs, tools, machinery of all kinds, pipes, casing, and other equipment, unless repairs and renewals are made each year to such an extent that no depreciation occurs and such repairs and renewals are charged to expense.

Statement to Be Attached to Annual Return. Where depletion is claimed under the above rules there should be attached to each return made by the individual or corporation owning and operating oil or gas properties, a statement showing; (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; how the fair market value of the property as of March 1, 1913, was ascertained, the quantity of oil or gas produced during the year for which the return

was made; the quantity produced during the year immediately preceding; 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 any other data which will be helpful in determining the reasonableness of the depletion deduction claimed in the return.

Statement by Lessee. 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, that is, depreciation due to use, wear and tear of physical property, the lessee not being entitled to any deduction for depletion or exhaustion of the oil or gas products, but being entitled to deduct annually as a rental payment, an aliquot part of any stipulated sum or 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 gas removed from such property, provided the entire proceeds from the oil or gas produced during the year are returned in the gross income of the operator.9

Rule Under 1913 Law. The 1913 Law made no express provision for an allowance for depletion of oil and gas wells and the Treasury Department made no rulings outlining any method of claiming such depletion.

Rule Under 1909 Law. Under the 1909 Law, which was silent on the subject of depletion, the Treasury Department permitted allowances for depreciation of oil wells. Owners were required to adopt an average value per barrel of the settled daily production as the guide

9 T. D. 2447.

in determining the value of the property at the time of the incidence of the tax or upon the date of commencement of production. With this basis per barrel the value of the property as a whole was to be determined by applying such unit value per barrel to the daily average production for the month of December, or other representative month in the year for which the return was made, the representative month chosen being the same in each year. The same unit value per barrel was to be retained in computing all future deductions for depreciation except where an additional production was secured by drilling, or acquired by purchase, in which case a new average rate per barrel based upon the actual cash invested might be adopted. The amount of the allowance each year was ascertained by multiplying the unit value by the difference between the daily average production in barrels during the representative month of each year. It was considered that by following this plan that the capital invested in the producing property would be automatically and wholly extinguished coincident with the complete exhaustion of the product, with the exception of such salvage as might remain after the exhaustion.10 In the case of gas wells the Treasury Department permitted a deduction for depreciation on a basis either of reduction of rock pressure or of reduction of volume. The cost of drilling gas wells was permitted to be charged to investment or to expense and the general custom of natural gas companies in the distribution of the cost of drilling wells was recognized.11

10 T. D. 1755. 11 T. D. 1754.

CHAPTER 34

DEDUCTION OF ALLOWANCE FOR DEPLETION OF MINES

The 1916 Law provides that individuals and corporations may deduct a reasonable allowance for the depletion of mines, 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.1 The allowance is to be made under rules and regulations to be prescribed by the Secretary of the Treasury. The purpose of permitting the allowance is to enable the taxpayer having capital invested in the mining deposit to receive back the capital originally invested, or in the case of purchase made prior to March 1st, 1913, the fair market value of the deposit, or his interest therein, as of that date, and when the aggregate of allowances reaches such sum no further allowance is permitted. Under this provision of the law, the Commissioner of Internal Revenue, with the approval of the Secretary of the Treasury, has made regulations which are discussed in the following paragraphs.

Depreciation Not Included in Depletion. It should be borne in mind that depletion is an allowance for the wasting of the natural resources and does not include any allowance for loss due to exhaustion, wear and tear of physical property used in the discovery or removal

1 Act of September 8, 1916, § 5 (a) and § 12 (a).