mines) to John Locke for a payment of $20,000 down and 75¢ per ton royalty for all the ore extracted from the properties. Up to this time the properties had not been operated. The ore content on December 1, 1916, was still estimated to be 50,000 tons. The lease contained appropriate clauses providing for the continuous operation of the properties, etc. Beginning with 1917, John Locke extracted 5,000 tons of ore each year. QUESTION: To what depletion deductions would Mr. Bush and Mr. Locke, respectively, be entitled in 1921? ANSWER: The bonus received by Mr. Bush is regarded as reducing the capital sum to be recovered by him through depletion. The remaining capital sum is therefore $40,000, on the basis of which the depletion unit is 80¢ per ton. 5,000 tons of ore having been removed in 1921, the depletion deduction to which Mr. Bush is entitled is 5,000 times 80¢, or $4,000. The bonus paid by Mr. Locke is in his case the basis for the depletion to which he is entitled. Having paid a bonus of $20,000, and the ore content at the date of acquisition of the lease by Mr. Locke being 50,000 tons, the depletion unit is 40¢ per ton, while the depletion deductible in 1921 is $2,000. REFERENCES: Art. 215 (a), Regulations 62: "Where a lessor receives a bonus or other sum in addition to royalties, such bonus or other sum shall be regarded as a return of capital to the lessor, but only to the extent of the amount remaining to be recovered through depletion by the lessor at the date of lease. If the bonus exceeds the amount remaining to be recovered, the excess and all the royalties thereafter received will be income and not depletable. If the bonus is less than the amount remaining to be recovered by the lessor through depletion, the difference may be recovered through depletion deductions based on the royalties thereafter received to the extent that such deductions are legally allowable. The bonus or other sum paid by the lessee for a lease made on or after March 1, 1913, will be his value for depletion as of date of acquisition." PROBLEM 130 Illustrating Determination of March 1, 1913, Value of FACTS: Anticipated Profits The Cornwall Copper Company, which paid $500,000, for copper properties in 1910, determines from its records and from other sources the following information as of March 1, 1913: That the company was able to estimate the ore in sight at 1,500,000 tons; that the mine could reasonably be expected to earn a net profit of $200,000 annually ($1% per ton mined); that the ore would be exhausted in ten years; and that the company was entitled to receive a return of 10% on the investment. Amounts set aside to amortize capital investment earn interest at the rate of 4%. QUESTION: What is the March 1, 1913, value of the properties, assuming that the so-called "present value" method is the only method available in arriving at this value? ANSWER: The present value of the properties as of March 1, 1913, would be $1,090,000. That is, of the annual profit of $200,000, there could be set aside annually into a sinking fund an amount which at 4 per cent compound interest would, by the time of the exhaustion of the mine, equal the March 1, 1913, value, or $1,090,000, and the remainder of the $200,000 would permit an annual dividend of 10% upon such sum of $1,090,000. REFERENCE: Art. 206 (b), Regulations 62: "To determine the fair market value of a mineral property by the present value method, the essential factors must be determined for each deposit included in the property. The factors are (1) the total quantity of mineral in terms of the principal or customary unit (or units) paid for in the mineral product marketed, (2) the average quality or grade of the mineral reserves, (3) the expected percentage of extraction or recovery in each process or operation necessary for the preparation of the crude mineral for market, (4) the probable operating life of the deposit in years, (5) the unit operating cost, i.e., cost of production exclusive of depreciation and depletion, and (6) the rate of interest commensurate with the risk for the particular deposit. When the deposit has been sufficiently developed these factors may be determined from past operating experience. In the application of factors derived from past experience full allowance should be made for probable future variations in the rate of exhaustion, quality or grade of the mineral, percentage of recovery, cost of production, and selling price of the product marketed during the expected operating life of the mineral deposit." PROBLEM 131 Illustrating Basis for Depletion of an Oil Well in Case of Discovery by Taxpayer after March 1, 1913 FACTS: Henry Muldoon, an employee of a certain oil producing company in California, purchased in 1910, out of savings accumulated by him, a certain tract of farm land in the vicinity of a well-known oil well. He paid $2,000 for this tract. This tract was not known to contain oil but Henry Muldoon had a "hunch" that this purchase would bring him wealth. In 1918, Mr. Muldoon inherited $50,000 from an uncle. Mr. Muldoon resigned from the employ of the company for whom he had been working and forthwith commenced drilling operations on the farm which he purchased as mentioned above. On September 24, 1918 he struck oil, as a result of which the properties for which he paid $2,000 in 1910, had a fair market value on Octtober 15, 1918 of $275,000. He operated the property from this date on through 1921. The depletion for 1921, based upon the fair market value of the property on October 15, 1918, was $47,000. The net income for 1921 from this property, without allowance for depletion, was $62,000. QUESTION: In computing the depletion for 1921, to which Mr. Muldoon is entitled as a deduction from gross income, what value is to be used as the basis? ANSWER: As the oil wells were not acquired by Mr. Muldoon through the purchase of a proven tract or lease, but were discovered by him after March 1, 1913, as a result of which discovery the fair market value of the property within thirty days after such discovery was materially disproportionate to the cost, such fair market value is the basis for the depletion allowance. REFERENCE: Sec. 214 (a) (10) [also Sec. 234 (a) (9)]: 66 . . . That in the case of mines, oil and gas wells, discovered by the taxpayer on or after March 1, 1913, and not acquired as the result of purchase of a proven tract or lease, where the fair market value of the property is materially disproportionate to the cost, the depletion allowance shall be based upon the fair market value of the property at the date of the discovery, or within thirty days thereafter: And provided further, That such depletion allowance based on discovery value shall not exceed the net income, computed without allowance for depletion, from the property upon which the discovery is made, except where such net income so computed is less than the depletion allowance based on cost or fair market value as of March 1, 1913; . . ." PROBLEM 132 Illustrating Deductions from Gross Income-Depletion Deductible in Case Depletion Based on Cost (or March 1, 1913 Value) Lower than, and Depletion Based on Discovery Value Higher than, Net Income FACTS: Before Deducting Depletion H. M. Dune on March 1, 1913, purchased a certain piece of mining property, the ore content of which at that time was valued at $10,000. Subsequent discoveries on the property proved the ore content to be worth $300,000, which was the value within thirty days after discovery. During 1921 (the first year of the operation of the property) one-twentieth of the total ore content was removed and used in operations, so that the depletion based on cost (March 1, 1913, value) was $500, and the depletion based on discovery value was $15,000. The net income from that particular piece of property, before deducting depletion, was $10,000. QUESTION: What amount of depletion on the above property is deductible in Mr. Dune's 1921 income-tax return? ANSWER: A literal interpretation of the statute would indicate that Mr. Dune is entitled to deduct $15,000. This interpretation, however, is seemingly contrary to the intent of Congress. The author's interpretation of this particular feature of the statute is that depletion based upon discovery value may not exceed the depletion based upon cost (or March 1, 1913, value) unless the depletion based upon cost (or March 1, 1913, value) is less than the net income from the property subject to depletion (computed without the benefit of a depletion deduction), in which case the depletion based upon discovery value may not exceed such net income. Under the circumstances assumed as facts in this problem, since the net income (computed without allowance for depletion) is higher than depletion based on cost (or March 1, 1913, value) and lower than the depletion based on discovery value, the amount of depletion deductible is equal to such net income, or $10,000. REFERENCES: Sec. 214 (a) (10) [also Sec. 234 (a) (9)]: (Quoted under Problem 131). Art. 201 (h), Reg. 62: "Depletion allowance in case of discovery: The deduction for depletion in case of a discovery can not exceed the net income computed without allowance for depletion, from the property upon which the discovery is made, except where and to the extent that such net income so computed is less than the depletion allowance based on cost or fair market value as of March 1, 1913." See Problem 36 (under Sec. 204). |