ment of depreciation reserve funds in additions, betterments and improvements was not contemplated by the law.33 The present ruling holds that the words "charged off," in the statute, mean that the allowance for depreciation is to be credited to an appropriate reserve account and be carried as a liability against the assets, to the end that when the total of these credits equals the capital investment account no further deductions will be allowed. There is no requirement of law that the funds represented by these reserve liabilities shall be held intact or remain idle against the day when they may be used in making good the depreciation of the property with respect to which the deduction is claimed, or in restoring the capital investment in the depleted assets. The depreciation reserve may be invested in assets of any kind.34

Deduction by Lessees. Where a corporation issues all of its capital stock for cash and expends this capital in the erection of a building upon a plot of land which it holds under lease, the lease requiring the lessee to erect, operate and maintain a building and providing that at the end of the lease the building and improvements then on the land shall be surrendered to the lessor without compensation, the lessee may claim depreciation on the building through annual deductions based on the cost of the building and its estimated life, or the life of the lease, whichever is the shorter.35 This rule would hold true in the case of any tenant who invests capital in permanent improvements or buildings on the real estate of the landlord, unless it is expressly provided by

33 Reg. 33, Arts. 132 and 133, T. D. 2137.

34 T. D. 2481.

35 Letter from Treasury Department dated February 27, 1917; I. T. S. 1917, ¶ 2064.

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."1 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 dis

1 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.