Opinion ID: 348408
Heading Depth: 2
Heading Rank: 3

Heading: The Cost Depletion Deduction

Text: 16 Section 611 authorizes a deduction for depletion in the case of mines, oil and gas wells, other natural deposits, and timber. The purpose of the deduction is to permit the owner of a capital interest in a natural resource in place to deduct the cost of that interest as the interest is exhausted. Otherwise expressed, depletion is predicated on allowing the owner of a capital interest of a mineral or other depletable natural resource to make a tax-free recovery of that depleting capital asset. See generally, Paragon Jewel Coal Co. v. Commissioner of Internal Revenue, 380 U.S. 624, 631, 85 S.Ct. 1207, 1211, 14 L.Ed.2d 116 (1965); Commissioner of Internal Revenue v. Brown, 380 U.S. 563, 575, 85 S.Ct. 1162, 1168, 14 L.Ed.2d 75 (1965); Parsons v. Smith, 359 U.S. 215, 79 S.Ct. 656, 3 L.Ed.2d 747 (1959). 17 The depletion deduction is totally dependent upon statute and has no independent significance in tax law as a legal or equitable principle. It is solely a matter of legislative grace. Commissioner of Internal Revenue v. Southwest Exploration Co., 350 U.S. 308, 311, 76 S.Ct. 395, 398, 100 L.Ed. 347 (1956); Anderson v. Helvering, 310 U.S. 404, 407, 60 S.Ct. 952, 954, 84 L.Ed. 1277 (1940). Unless we can find in the language of § 611, the applicable legislative history, or the relevant treasury regulations some recognition that a case of this general type merits a depletion allowance, the taxpayer must fail. Logical consistency alone does not govern in the land of legislative grace; there must be some evidence that Congress intended to include within the ambit of § 611 the kind of case presented here. In short we must decide whether the legislature has said grace over subsiding peat and muck. 18 The concept of depletion first found expression in Section II, G(b) of the Income Tax Act of 1913. The Act permitted corporations to deduct: 19 . . . in the case of mines, a reasonable allowance for depletion of ores and all other natural deposits, not to exceed 5 per centum of the gross value at the mine of the output for the year for which the computation is made . . . 20 Income Tax Act of 1913, ch. 16, 38 Stat. 114, 116, 172. Because that Act limited depletion to the case of mines, its authors obviously envisaged a severance requirement. 21 Unlike the 1913 Act, the Revenue Act of 1916 did not mention natural deposits. Nonetheless, it specifically provided for depletion deductions for oil and gas as well as mines. It also restricted the deduction regarding mining products to those that were sold. The 1916 Act provided corporate deductions of 22 . . . (a) 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; (b) in the case of mines a reasonable allowance for depletion thereof 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, such reasonable allowance to be made in the case of both (a) and (b) under rules and regulations to be prescribed by the Secretary of the Treasury . . . . 23 Revenue Act of 1916, ch. 463, 39 Stat. 756 § 12(a) Second. 24 The authors of the depletion provision still could not have envisioned allowing a depletion deduction in any case in which the taxpayer failed to sever or extract the natural resource. Both enumerated classes of depletable resources in the 1916 Act themselves entailed severance. 25 The Revenue Act of 1918 restored the term, natural deposits, to the depletion provision while clearly separating it from mining, which the 1913 Act had failed to do. The 1918 Act also eliminated the requirement that mining products be sold. Section 234(a)(9) of the 1918 Act allowed the following deductions to corporations: 26 In the case of mines, oil and gas wells, other natural deposits, and timber, a reasonable allowance for depletion and for depreciation of improvements, according to the peculiar conditions in each case, based upon cost including cost of development not otherwise deducted . . . 27 Revenue Act of 1918, ch. 18, 40 Stat. 1057, § 234 (a)(9). 28 To be sure, it is only with the 1918 Act that the question whether severance should be a condition precedent to the depletion deduction could independently have arisen. Nonetheless, the inclusion in the earliest versions of the depletion provision of only situations that entailed extraction or severance may weigh in favor of the government's position in this case. The changes made by the 1918 Act are entirely consistent with the notion that Congress still envisaged only severance situations, although the category of natural deposits does not logically entail that restriction. Certainly, nothing in the legislative history of the 1918 Act suggests that Congress intended to allow depletion deductions for other than extraction or severance situations. 29 One treasury regulation contemporaneously issued under the 1918 Act buttresses the notion that Congress envisaged depletion deductions only when the taxpayer had extracted the natural deposit. Article 201, Treasury Regulation 45 (1920 ed.), makes clear that in determining the taxpayer's basis in depletable assets, only value for purposes encompassed by the depletion provisions may be considered. Article 201 provides: 30 The essence of these (depletion) provisions of the statute is that the owner of mineral deposits, whether freehold or leasehold, shall within the limitations prescribed, secure through an aggregate of annual depletion and depreciation deductions the return of either (a) his capital invested in the property, or (b) the value of his property on the basic date, plus subsequent allowable capital additions . . . but not including land values for purposes other than the extraction of minerals (emphasis added). 6 31 Since Article 201 later defines minerals to include metals, coal, oil, gas, and such nonmetallic substances as . . . peat, the Regulation's emphasis on the extraction of minerals may be significant. To begin with, it seems clear that the Regulation was intended to cover the full range of depletion deductions. 7 Article 201's exclusion of land value based other than on its use for extraction purposes suggests that the Internal Revenue Service contemporaneously viewed the authors of the 1918 Act as concerned only with the extractive industries. 8 32 To be sure, this does not foreclose the possibility of depletion deductions absent extraction or severance. After all, depletion of a natural resource through means other than extraction was not a question that the Congress that passed the 1918 Act or the agency that promulgated the regulation specifically addressed. The most that can be said is that neither the drafters of the 1918 Act nor the authors of Article 201 considered the possibility of deductions in non-extractive situations. This factor, although not decisive, weighs in favor of the government's position in the case at bar. 33 The Internal Revenue Code of 1954 retains the basic structure of the 1918 Act's cost depletion provision: In the case of mines, oil and gas wells, other natural deposits, and timber, there shall be allowed . . . a reasonable allowance for depletion . . . . I.R.C. § 611. Nothing in the language of § 611 or related sections of the Code tells us whether extraction is a condition precedent to a depletion deduction. 34 Current Treasury regulations, however, cast some light on this matter. Treasury Reg. § 1.611-1(b)(1) (1960), which purports to define the nature of the economic interest requisite to claiming a deduction for depletion, 9 provides in part: 35 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. (emphasis added) 36 Again, of course, the regulation does not purport to limit the manner in which a depletable asset must be depleted in order for its owner to qualify for a § 611 deduction. On the other hand, Treas.Reg. § 1.611-1(b)(1) does seem to assume that the manner will always be extraction. The most that Duda can claim is that the words extraction and severance were used uncritically by the authors of a regulation devoted to other issues. Even on that view, however, the assumption that extraction was a suitable word weighs in favor of the government's position in the case at bar. 37 Other regulations suggest that the depletion allowance contemplated by the Congress and administered by the IRS extends only to a natural deposit or mineral property that has independent value and is exhausted by removal of the mineral itself. For example, Treas.Reg. § 1.611-2(a)(1) (1960) provides rules for computing cost depletion of mines, oil and gas wells, and other natural deposits. The regulation states that a taxpayer is to calculate cost depletion of natural deposits by multiplying the depletion unit . . . by the number of units of mineral sold. 10 Subsections (a)(3) and (c) refer to the number of units of mineral remaining . . . to be recovered from the property and to the total recoverable units. Subsection (e)(4) defines the expected gross income of a mineral deposit as the number of units of mineral recoverable in marketable form multiplied by the estimated market price per unit . . . . The picture that emerges of the kinds of depletion deductions encompassed by § 611 simply does not include the situation in which a natural asset wastes in place, but appears limited to cases in which the asset is recovered or extracted and then, in the vast majority of cases, sold. This is the same picture painted by the language of the Supreme Court. Once again, no case has directly addressed the issue presented by the case at bar, and it may be that the Court's language is ill-considered and not properly generalizable to cover the universe of depletion deductions. Nevertheless the Court has repeatedly used the term extraction in the context of synoptic statements that purport, at least, to address the general concept of depletion. For example, in Anderson v. Helvering, supra, 310 U.S. 404, 408, 60 S.Ct. 952, 954, 84 L.Ed. 1277 the Court observed: The deduction is therefore permitted as an act of grace and is intended as compensation for the capital assets consumed in the production of income through the severance of the minerals. In Commissioner of Internal Revenue v. Southwest Exploration Co., supra, 350 U.S. 308, 312, 76 S.Ct. 395, 397, 100 L.Ed. 347, the Court stated that the depletion deduction is based on the theory that the extraction of minerals gradually exhausts the capital investment in the mineral deposit. In Commissioner of Internal Revenue v. Brown, supra, 380 U.S. 563, 576, 85 S.Ct. 1162, 1169, 14 L.Ed.2d 75, the Court characterized depletion as a tax-free return of the capital consumed in the production of gross income through severance. 38 These statements, when taken together with the outline of depletion as delineated by the legislative history of the statute and the applicable treasury regulations, suggest that extraction or severance is bound up with the depletion deduction. The link seems certain to have been so self-evident to Congress and the Court that it has not heretofore been challenged or made explicit. Nevertheless our inquiry thus far, while instructive, cannot be said to have been conclusive. 39 It may be, for example, that the link between extraction and the depletion deduction is simply a happenstance, contingent on the manner in which industries depleted natural resources at the time the precursors to § 611 were taking shape. If this were the case, and extraction bore no functional relationship to the administration of the depletion provisions, there might be reason to cast off the requirement of extraction when confronted by a non-extraction case that was nonetheless functionally identical to those for which Congress clearly intended the deduction. 40 On the other hand, it might be the case that extraction serves some function in the administration of the depletion provisions. In that case, we should credit the references to extraction in the cases and legislative history as more than casual remarks. Extraction would then be not merely contingently but conceptually bound up with the depletion deduction. What functional relation might extraction bear to the concept of depletion? In other words, how can the case at bar, in which peat subsides in place, be differentiated from a case in which a deduction would be allowed, such as when a taxpayer digs up the peat, bags it, and sells it as fertilizer?