Opinion ID: 390279
Heading Depth: 1
Heading Rank: 4

Heading: Timber Subject to Depletion

Text: 22 Georgia-Pacific next argues that the ordinary income provisions of Treas.Reg. § 1.1502-13(c)(4) do not apply because the purchasers did not have an economic interest in the timber and consequently were not entitled to claim depletion as the timber was cut. We do not agree. 23 Because several parties may be involved in the growing, cutting, and marketing of timber, the IRS has promulgated regulations governing who may claim depletion. 24 Annual depletion deductions are allowed only to the owner of an economic interest in mineral deposits or standing timber. An economic interest is possessed in every case in which the taxpayer has acquired by investment any interest in mineral in place or standing timber and secures, by any form of legal relationship, income derived from the extraction of the mineral or severance of the timber, to which he must look for a return of his capital. But a person who has no capital investment in the mineral deposit or standing timber does not possess an economic interest merely because through a contractual relation he possesses a mere economic or pecuniary advantage derived from production. For example, an agreement between the owner of an economic interest and another entitling the latter to purchase or process the product upon production or entitling the latter to compensation for extraction or cutting does not convey a depletable economic interest Treas.Reg. § 1.611-1(b)(1) (1973). 8 25 Although the distinction between economic interest and pecuniary advantage in the quoted regulation is vague, judicial decisions have clarified the distinction. The Supreme Court has held that a mineral lessee has an economic interest in the minerals and is entitled to claim depletion if the lessee looks to the sale of the minerals in the open market for its return. See Commissioner v. Southwest Exploration Co., 350 U.S. 308, 76 S.Ct. 395, 100 L.Ed. 347 (1956); Palmer v. Bender, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489 (1933). Where the lessee is required to sell the minerals removed to the lessor at a predetermined price and does not look to the sale in the open market for its return, however, the lessee does not have an economic interest and may not claim depletion. See Paragon Jewel Coal Co. v. Commissioner, 380 U.S. 624, 85 S.Ct. 1207, 14 L.Ed.2d 116 (1965); Parsons v. Smith, 359 U.S. 215, 79 S.Ct. 656, 3 L.Ed.2d 747 (1959). 26 This court applied principles very similar to those employed by the Supreme Court in the above-cited cases in determining the nature of the purchaser's interest under a timber-cutting contract. United States v. Giustina, 313 F.2d at 712-13. There a taxpayer agreed to purchase standing timber under an agreement that called for the taxpayer to cut and remove a specific quantity of timber within a specific time period. The taxpayer was to pay a fixed price per board foot as the timber was cut, but would be liable for the entire amount due whether the trees were actually cut and removed or not. The purchaser's power to assign the contract and risk of loss in case of fire was limited. The taxpayer later sold its rights in the timber and claimed capital gains treatment under the predecessor of Int.Rev.Code § 631. The IRS contended that because the taxpayer was not the owner of the timber, it could not claim the benefits of the statute. The court held that the taxpayer was the owner because it had the right to sell the timber for its own account in the open market and thus possessed the investment opportunity and risk of ownership. 27 We conclude that the present case is controlled by Giustina. 9 As in Giustina, the contracts at issue here provide for the purchase of a specified amount of timber at a predetermined price. The purchasers are thus able to sell the timber in the open market and possess the investment opportunity and risk of ownership. Although the Rex/Georgia-Pacific contract provides for periodic readjustment of the contract price to reflect changes in market value, Georgia-Pacific still has the ultimate opportunity and risk of selling the timber at above or below market value. Even a minor opportunity to sell in the market is enough to give a timber cutter an economic interest in the timber. See Thornberry Const. Co., Inc. v. United States, 576 F.2d 346 (Ct.Cl.1978). 28 The contract at issue in Giustina, like those in the present case, also limited the ability of the purchaser to assign its contract rights and provided that the risk of loss remained with the seller until the timber was cut. The court expressly rejected the proposition that those provisions did not make the purchaser the owner. 313 F.2d at 712-13 & n.6. The court also rejected the argument made by Georgia-Pacific here that the purchasers made no investment within the meaning of Treas.Reg. § 1.611-1(b)(1) because the timber was to be paid for only as removed. The court reasoned that a contract that calls for a specific amount to be purchased at a specific price within a specific time creates a liability that is itself an investment. Id. at 712. 29 The fact that Giustina held that the purchaser was an owner, while the present case concerns whether the purchaser has an economic interest in the timber, is not a material distinction. The test used by the Supreme Court in determining if a purchaser has an economic interest whether the purchaser looks primarily to sale in the open market for its return is the functional equivalent of the investment opportunity and risk test of Giustina. 10 We also note that the court suggested in Giustina that the purchaser had an economic interest sufficient to claim depletion. Id. at 714-15 n.11. 11