Opinion ID: 381301
Heading Depth: 2
Heading Rank: 2

Heading: Application of 1968 Regulations

Text: 22 In July 1968, regulations were promulgated 9 which provide in pertinent part as follows: Reg. 1.613-3(b)(1) 23 For the purpose of this section, ordinary treatment processes (applicable to the taxable years beginning before January 1, 1961) and treatment processes considered as mining (applicable to the taxable years beginning after December 31, 1960) will be referred to as mining processes. Processes, including packaging and transportation, which do not qualify as mining will be referred to as nonmining processes. Reg. 1.613-3(d)(1)(iv) 24 As used in this section, the term first marketable product or group of products means the product (or group of essentially the same products) produced by the taxpayer as a result of the application of nonmining processes, in the form or condition in which such product or products are first marketed in significant quantities by the taxpayer or by others in the taxpayer's marketing area. For this purpose, bulk and packaged products are considered to be essentially the same product. . . . For example, if a cement manufacturer sells his own finished cement of various types in bulk and bags and also sells concrete blocks or dry ready-mix aggregates containing additives, the finished cement of various types, in bulk and bags, constitutes the first marketable product or group of products produced by him. 25 Reg. 1.613-3(d)(4)(i)Except as specifically provided elsewhere in this section, when determining gross income from the property by use of the proportionate profits method or any other approved method which is based on the taxpayer's costs, the costs attributable to mining transportation shall be treated as mining costs, and the costs attributable to nonmining transportation shall be treated as nonmining costs. Accordingly, except as specifically provided elsewhere in this section, all profits attributable to mining transportation shall be treated as mining profits, and all profits attributable to nonmining transportation shall be treated as nonmining profits. For this purpose, mining transportation means so much of the transportation of ores or minerals (whether or not by common carrier) from the point of extraction from the ground to plants or mills in which other mining processes are applied thereto as is not in excess of 50 miles. Reg. 1.613-3(d)(4)(iii) 26 In determining gross income from the property by use of the proportionate profits method (or any other approved method which is based on the taxpayer's costs) 27 (a) The costs attributable to containers, bags, packages, pallets, and similar items as well as the costs of materials and labor attributable to bagging, packaging, palletizing, or similar operations shall be considered as nonmining costs. 28 (b) The costs attributable to the bulk loading of manufactured products shall be considered as nonmining costs. 29 (c) The costs attributable to the operation of warehouses or distribution terminals for manufactured products shall be considered as nonmining costs. 30 Accordingly, all profits attributable thereto are treated as nonmining profits. Reg. 1.613-3(g)(3) 31 Transportation the primary purpose of which is marketing, distribution, or delivery for the application of only nonmining processes shall not be considered as mining. 32 The quoted regulations (hereinafter referred to as the 1968 Regulations) deal specifically with the issues relating to the bag premium, the cost of bagging, loading costs, and the costs of operating terminal facilities. In each case the regulations clearly dictate the result favored by the government, i. e., that bag cement, as well as bulk cement, be treated as the first marketable product and therefore that bag premiums be included in the proportionate profits as part of gross sales, and that bagging costs, loading costs, and the costs of operating terminal facilities be treated as nonmining costs. 33 The government urges that the 1968 Regulations, which purport to apply to all taxable years governed by the Internal Revenue Code of 1954, should be retroactively applied to all of the taxable years at issue here. Noting that the Ninth Circuit, in United States v. California Portland Cement Co., 413 F.2d 161 (1969), (hereinafter cited as California Portland ) did apply these regulations retroactively, the government argues that these regulations meet the test for retroactive application enunciated by this circuit in Anderson, Clayton and Co. v. United States, 562 F.2d 972 (5th Cir. 1977), rehearing en banc denied, 565 F.2d 1215 (1977), cert. denied, 436 U.S. 944, 98 S.Ct. 2845, 56 L.Ed.2d 785. Because we reach the same result considering only the pre-1968 Regulations and the applicable case law, we do not reach the question of the retroactive application of the 1968 Regulations. However, it is clear that the 1968 Regulations do govern the last taxable year here involved, the calendar year 1968. With respect to that year, we affirm the decision of the district court, with respect to the treatment of bag premiums, bagging costs, loading costs, and the costs of operating terminal facilities, on the authority of the 1968 Regulations. 34 Our consideration of the remaining taxable years, i. e., calendar years 1960-1967, will be based on the regulations 10 in effect before the 1968 Regulations, and the applicable case law.C. Primary Case Law and the Proportionate Profits Regulation 35 A review of the four cases which have considered the proper handling of the bag premium, the costs of bagging, and the costs of loading and other distribution costs will aid our resolution of the issues before us. Taxpayer places primary reliance upon United States v. Ideal Basic Industries, Inc., 404 F.2d 122 (10th Cir. 1968), cert. denied 395 U.S. 936, 89 S.Ct. 1997, 23 L.Ed.2d 451 (hereinafter cited as Ideal Basic ). 11 That case dealt with items identical to those at issue here-bag premium, cost of bagging, cost of loading bulk cement, and the costs of warehouses and distribution terminals-in the context of the proportionate profits method. The Tenth Circuit held that the bag premiums and all of the aforesaid cost items should be excluded from the proportionate profits formula. The reasoning employed by the court was: first, that bagging, loading, transportation to warehouses and distribution terminals, and warehousing are nonmining expenses which relate to the manufactured product (bulk cement) and not to the mining of the crude mineral (kiln feed); and second, that therefore these items must simply be excluded from the formula. We agree with the first step of this reasoning, 12 but not the second step. As authority for the second step, the Ideal Basic court simply cites Standard Lime and Cement Co. v. United States, 329 F.2d 939, 165 Ct.Cl. 180 (1964) (hereinafter cited as Standard Lime). 13 Our discussion below will demonstrate why we believe this reliance on Standard Lime was misplaced. 36 In California Portland, the Ninth Circuit considered the proper treatment of bag premiums and the cost of bags and bagging in applying the proportionate profits method. It held that the premium and the bagging costs must be included in the formula and that the bagging costs should be considered nonmining costs. 413 F.2d at 169. The court also reversed the district court's conclusion that bulk cement was the first marketable product, holding that the first marketable product was merely cement with no distinction as to the form of packaging. Although the Ninth Circuit held that the 1968 Regulations were retroactive and clearly required this result, it also held that the 1939 Regulations and the applicable case law lead to the same result. 14 The court relied on Whitehall Cement Manufacturing Co. v. United States, 369 F.2d 468 (3rd Cir. 1966) (hereinafter cited as Whitehall ), and expressly rejected Ideal Basic. 37 In Whitehall the Third Circuit considered the proper treatment, in the proportionate profits context, of the costs of loading bulk cement onto rail cars and trucks, and the proper treatment of bag premiums and costs. The court rejected the taxpayer's argument that bag premiums and the costs of bagging and loading should be excluded from the proportionate profits formula. The Whitehall court also considered finished cement, without distinction as to packaging, to be the first marketable product. 369 F.2d at 471. The court rejected taxpayer's erroneous assumption that its bagging costs produced only the premium revenue, finding instead that it was reasonable to infer that taxpayer's sale of bagged cement was an accommodation to customers, induced such sales, and at least partially contributed to substantial profits. 369 F.2d at 474. The court treated the loading and bagging costs as nonmining costs. 369 F.2d at 473, 474. 38 Both the taxpayer and the government rely on Standard Lime. Although the language used by the Court of Claims has undoubtedly and understandably misled the taxpayer, we conclude that the holding of the case supports the government's position here. Standard Lime did say that packing and loading costs are indirect costs which are not incurred for the benefit of the entire operation and as such cannot be included in taxpayer's computation of gross income from the property at kiln feed. 329 F.2d at 948. With regard to the cost of bags and the other costs incurred in the bagging operation, the court said: Thus, the entire amount of this expense must be eliminated from the computation for the same reason that packing and loading costs of bulk cement (and a percentage of the total profits attributable to them) must be excluded from the computation as an indirect cost which is not incurred for the benefit of the entire mining-manufacturing operation. 329 F.2d at 949. This is the language that has led the taxpayer astray. To understand this language, it is necessary to analyze carefully the particular proportionate profits formula which was being used by the Court of Claims and to understand how the formula used by the Court of Claims differs from the formula we apply. Gross income from mining was referred to as gross income from the property at kiln feed point and was computed by adding items (a), (b), and (c): 39 (a) Total direct cost up to kiln feed; 40 (b) Percentage of indirect cost allocable to process up to kiln feed, calculated as follows: 41 Direct cost up to kiln Indirect costs ----------------------- X Total processing direct which can be costs allocated 42 (c) Percentage of net profits allocable to kiln feed. 43 Item (c), the percentage of net profits allocable to kiln feed, is in turn calculated as follows: 44 (i) Gross income from end product (sales price X units sold) 45 (ii) Less Total costs in producing end product 46 (iii) Profit from entire operation 47 (iv) Less Profit attributable to indirect costs which 48 cannot be allocated 49 (v) Allocable net profit 50 (vi) Direct cost Net profit up to kiln X Allocable = allocable ------------------- Total net profit to kiln processing feed direct costs 51 Step (iv) in item (c) of the Standard Lime formula is the crucial step in the computation by which that court eliminated from the depletable base the profits attributable to the costs of loading and distribution and the costs of the bagging operation. The Standard Lime court labeled these costs as indirect costs which did not relate to the mining phase and which were not incurred for the benefit of the entire operation. Applying the formula, such costs are indirect costs which cannot be allocated and thus are not included in item (a) or in item (b), 15 and the proportionate profits attributable to these costs are excluded from the depletable base by step (iv). This exclusion properly results in a figure for the depletable base which includes only the cost up to the kiln feed, i. e., mining costs, and the profits attributable thereto, and which accordingly excludes loading and bagging costs and the profits attributable thereto. Thus, the exclusionary language is proper with respect to the particular Standard Lime formula. 52 Taxpayer's error arises when it transposes Standard Lime 's exclusionary language to the very different formula being used in this case. Both parties in this case use the following formula: 53 mining costs gross gross income ---------------------- X = total costs sales from mining (mining k nonmining) 54 Had the Standard Lime court used the above formula, it would have included the pertinent costs as part of the total costs in the denominator, because the court clearly held that the costs did not relate to the mining phase and were not allocable in any part of the mining phase. To accomplish that result one would have to include the costs at issue in the denominator of the fraction of the formula being used here, thus decreasing the fraction, and, when the smaller fraction is multiplied by gross sales, accomplishing the removal of such costs and their pro rata profits from gross income from mining. Thus, inclusion in the denominator of our formula accomplishes the same thing as exclusion from the Standard Lime formula. 16 55 On the basis of the above analysis, we conclude that the Tenth Circuit in Ideal Basic improperly relied upon Standard Lime. With respect, we believe that the Ideal Basic court was misled by the exclusionary language utilized by the Standard Lime court in applying its very different formula. We also believe that exclusion of the cost items at issue here, as Ideal Basic would require, would violate the purpose of the proportionate profits method. The effect of such exclusion would be to eliminate such costs from the denominator of our formula's fraction, thereby increasing the fraction. When the fraction is then multiplied by the gross sales 17 figure, the effect is to include in the depletable base the costs at issue and the profits attributable thereto. 18 Thus, although the Tenth Circuit properly classifies the cost items at issue as relating only to the manufacturing or nonmining phase, its treatment of the items fails to accomplish the purpose of the proportionate profits method, i. e., elimination of such nonmining costs and their proportionate profits from the depletable base. 19 56 The proportionate profits regulation in effect 20 during taxpayer's calendar years 1960 through 1967 was Treas.Reg. 118, § 39.23(m)-(1)(e)(3), which provides in part: 57 If there is no such representative market or field price (as of the date of sale), then there shall be used in lieu thereof the representative market or field price of the first marketable product resulting from any process or processes (or, if the product in its crude mineral state is merely transported, the price for which sold) minus the costs and proportionate profits attributable to the transportation (other than transportation treated, for the taxable year, as mining) and the processes beyond the ordinary treatment processes. If the taxpayer establishes to the satisfaction of the Commissioner that another method of computation, other than the computation, of profits proportionate to costs, clearly reflects the gross income from the property, then such gross income shall be computed by the use of such other method. 58 We will apply the principles derived from the above cases to, and analyze the import of the foregoing regulation on, the bagging operation in subpart D, and then the costs of loading and other distribution costs in subpart E. D. Bagging Operation 59 With respect to the bagging operation, taxpayer makes several arguments. First, taxpayer argues that its bagging operation produces no profit, and therefore the bag premium and bagging costs should be excluded from the proportionate profits formula. 21 The argument is that the proportionate profits formula assumes that each item of cost produces a pro rata share of the profits, that the evidence shows that the bag premium was designed simply to reimburse the costs of bagging and therefore shows that the bagging operation was a break-even operation, and that it would undermine the purpose of the proportionate profits method to include in the formula such a break-even operation. We reject taxpayer's argument. 60 We do not accept taxpayer's premise that the bagging operation produces no profit. Taxpayer's proof that the bag premium was designed simply to reimburse the costs of bagging does not constitute proof that the bagging operation produces no profit. The Third Circuit in Whitehall, 369 F.2d at 474, disposed of the same contention with these words: 61 There is implicit in the plaintiff's argument an erroneous assumption that the packaging costs produced only the additional revenue derived from the premiums . . . . The sale of cement in bags was presumably an accommodation to those customers whose particular requirements were such as to make the purchase of cement in bulk commercially unfeasible. The availability of packaged cement was undoubtedly a sales inducement to such customers. It seems reasonable to infer that the profits realized from the sale of packaged cement, and these were substantial, were attributable at least in part to the packaging costs. 62 Taxpayer concedes as much in its brief. Taxpayer notes that the bag premium was intended to recover the additional costs incurred in the bagging operation, as compared to bulk sales, in order to realize a profit on the bagged cement equal to the profit on bulk cement. 22 63 In any event, had taxpayer believed that the proportionate profits method created a distortion, it could have taken advantage of the provision in the regulations which permit application to the Commissioner to obtain permission to use some other formula in lieu of the proportionate profits formula. 23 There is no evidence that taxpayer made such application. To the contrary, taxpayer has proceeded, both in the filing of its tax returns and in the conduct of this case, on the assumption that the proportionate profits method applies. 64 The taxpayer's next argument turns on a determination of what is the first marketable product in the production of cement. Treas.Reg. 118, § 39.23(m)-1(e)(3) provides in pertinent part: 65 If there is no such representative market or field price (as of the date of sale), then there shall be used in lieu thereof the representative market or field price of the first marketable product resulting from any process or processes (or, if the product in its crude mineral state is merely transported, the price for which sold) minus the costs and proportionate profits attributable to the transportation (other than transportation treated, for the taxable year, as mining) and the processes beyond the ordinary treatment processes. 66 (emphasis added) Relying on the regulation, taxpayer argues that bulk cement is the first marketable product, and that the price of bulk cement should be the starting point. Since the bag premium would thereby be eliminated from the proportionate profits formula, taxpayer concludes that the costs of the bagging operation should likewise be excluded. 24 Taxpayer relies on the Tenth Circuit case, Ideal Basic. 67 On this issue, we are faced with a direct conflict among the circuits. As is apparent from our discussion in subpart C, Ideal Basic squarely supports taxpayer's position, both in labeling bulk cement as the first marketable product and in excluding the bag premium and bagging costs from the proportionate profits formula. The Ninth Circuit, in California Portland, rejected the taxpayer's position that bulk cement was the first marketable product, expressly rejected the Ideal Basic holding and rationale, and held that the bag premium and bagging costs should be included in the proportionate profits formula, and that bagging costs should be considered nonmining costs. In other words, California Portland squarely supports the government's position in this case. So also does the Third Circuit in Whitehall. As our discussion in subpart C demonstrates, the Court of Claims decision in Standard Lime also supports the government position here, although some of its language was understandably misleading. Having concluded in subpart C that Ideal Basic is not persuasive authority because of its misplaced reliance upon Standard Lime and because its solution does not comport, with the purpose of the proportionate profits method, we conclude that California Portland, Whitehall and Standard Lime set forth the correct law. 68 Before completing our discussion, we inquire whether some support for taxpayer's position can be found in several older cases 25 which, although they did not involve the proportionate profits method, did consider bagging costs in the context of determining the first marketable product and the depletion cutoff point under the pre-1960 law. Under that prior law, a taxpayer's percentage depletion was based upon its mining operations up to a cutoff point which was defined in the statute as including ordinary treatment processes to obtain the first marketable product. In several such cases, the courts determined that the first marketable product, i. e. the cutoff point, preceded the bagging operation, a determination that would seem to provide some support for taxpayer's position that bulk cement is the first marketable product. 26 The Ninth Circuit, in the California Portland case, however, distinguished such cases with the following language: 69 (T)he courts were not applying the proportionate profits method, as we are here, for there was a representative market price for the crude mineral product. Instead, the courts were concerned only with determining the cutoff point at which mining ceased and, faced with this question, they held that the taxpayers were not entitled to include the costs of bagging in their gross income, because bagging was not a cost of mining. If there were a representative market price for the ground calcium carbonate (i. e., kiln feed), we would not resort to the proportionate profits method in the present case, and would then exclude all nonmining costs from the computation. 70 413 F.2d at 169 (emphasis in original). To elaborate on the distinction made by California Portland, if there were a representative market price for the mineral at issue here at the cutoff point, i. e., kiln feed, then we would not be required to use the proportionate profits method. 27 However, the parties have agreed that there is no representative market price for kiln feed, and that the proportionate profits method is applicable. When the proportionate profits method is used, one cannot simply eliminate the cost items themselves; the proportionate profits attributable to those costs must also be eliminated. It is this step that taxpayer seeks to avoid. 71 We think the cutoff point cases are inapposite for another reason. Even if we assume, with those cases, that bulk cement is the first marketable product, it does not follow therefrom that bagged cement is a separate or different product. That is, it does not follow that bagged cement is the second marketable product. 28 Rather, bagging is simply a way of getting the same product, namely cement, to market. Some customers might want cement in rail cars, some in trucks, some in barges, some in piggy-back containers, and some in bags. The product, however, remains cement. 29 Bagging, then, does not create a different product. It is an expense very similar to the expense of transporting the product to market. Treas.Reg. 118, § 39.23(m)-1(e)(3), the regulation setting out the proportionate profits method, specifically provides that transportation costs and their proportionate profits shall reduce the depletable base. By analogy to the regulation's treatment of transportation costs, we believe that bagging costs and their proportionate profits should reduce the depletable base. The regulation, therefore, supports our conclusion that the cutoff point cases provide no authority with respect to the proper treatment of cost items in applying the proportionate profits method. 72 We therefore conclude that the persuasive authority is found in California Portland, Whitehall and Standard Lime. We hold that the bag premiums should be included in the gross sales figure of the formula, and that the full costs of bagging should be included in the denominator of the fraction as nonmining costs. 30 Our treatment rejects taxpayer's attempt to net the bag premium against an equal amount of bagging costs and exclude both from the formula, because the effect of taxpayer's attempt would be to fail to exclude from the depletable base the profits attributable to the bagging costs thus excluded, and because the purpose of the proportionate profits would be undermined to the extent of that failure. 31 Our treatment will remove from the depletable base all bagging costs and all profits attributable thereto, and thus will serve the purposes of the proportionate profits method, i. e., to remove from the depletable base all nonmining costs and all profits attributable thereto. 73 E. Costs of Loading Cement in Bulk and Other Distribution Costs 74 With respect to the costs of loading bulk cement and the costs of operating terminal facilities, taxpayer's primary argument is that these expenses benefit the entire operation and, therefore, should be allocated between the mining and nonmining phases of its operations. Alternatively, taxpayer argues, relying upon Ideal Basic, that such costs should simply be excluded from the proportionate profits formula. 75 We reject taxpayer's primary argument, and hold that these costs do not benefit the entire operation, but rather are related directly to the nonmining phase of taxpayer's operations. Section 613(c)(4)(F) provides that treatment processes shall be considered as part of the mining phase up to the cutoff point, but not including any subsequent process. The language implies that post-cutoff point processes are included in the nonmining phase. Taxpayer concedes as much. Taxpayer maintains, though, that these costs are distribution expenses, and not processes. Taxpayer's argument is that mining processes occur up to the cutoff point, that thereafter manufacturing or nonmining processes occur (e. g., the heating in the kiln, the cooling and grinding of the clinker into finished cement), but that these manufacturing processes cease when the manufactured product, i. e., cement, emerges. Thereafter, taxpayer argues, its expenses are distribution expenses which benefit the entire operation, and therefore should be allocated between the mining and nonmining phases. It is significant that taxpayer cites no cases to support this particular treatment of such cost items. 32 On the other hand, three cases oppose taxpayer's treatment. In Whitehall, the Third Circuit treated the cost of loading bulk cement into freight cars and trucks as a nonmining cost. In Standard Lime, the Court of Claims held that such loading costs and warehousing costs were distribution expenses which did not benefit the mining operations, which did not benefit the entire operation, and therefore no part of which could be allocated to the mining phase. In California Portland, the Ninth Circuit held that the cost of bagging cement was a nonmining cost. 33 76 In addition, the history of the relevant statute and regulations suggests that such costs are processes. Section 613(c)(4) provides that loading for shipment is an allowable treatment process for several named minerals and other ores or minerals which are not customarily sold in the form of a crude mineral product. This same language, suggesting that loading for shipment is a process, appeared in the predecessor statute. 34 Similar language appears not only in the current regulations 35 but also in the regulations issued under the Internal Revenue Code of 1939. 36 Also, Section 613(c)(2), both before and after the 1960 amendments, included within the definition of mining so much of the transportation of the mineral from the mine to the processing plant as is not in excess of 50 miles. The regulations have contained similar provisions. 37 Thus, we see that other portions of the same statute, and regulations thereunder, treat loading for shipment and transportation of the mineral as processes. This history of the statute and regulations persuades us that the loading and distribution costs at issue are processes, and do not cease to be processes, as taxpayer urges, simply because they occur after the manufactured product, cement, emerges. 77 More importantly, to allocate or exclude loading and distribution costs from the proportionate profits formula would be to treat these costs differently from similar costs which clearly must be attributed to nonmining phases. The regulation in effect for all taxable years at issue except 1968, Treas.Reg. 118, § 39.23(m)-1(e)(3), specifically provides that transportation costs and the proportionate profits attributable thereto shall reduce the depletable base. The regulation provides in pertinent part: 78 If there is no such representative market or field price (as of the date of sale), then there shall be used in lieu thereof the representative market or field price of the first marketable product resulting from any process or processes (or, if the product in its crude mineral state is merely transported, the price for which sold) minus the costs and proportionate profits attributable to the transportation (other than transportation treated, for the taxable year, as mining) and the processes beyond the ordinary treatment processes. 79 (emphasis added) We do not believe there should be a difference in treatment between the loading and distribution costs at issue-i. e., the cost of loading bulk cement onto a truck and the cost of operating terminal facilities to which the truck delivers the cement-on the one hand, and the sandwiched transportation costs-i. e., the costs of trucking the cement after the loading and before delivery to the terminal-on the other hand. If such transportation costs are to reduce the depletable base, as the proportionate profits regulation provides, then so also should the loading and terminal facility costs which occur, respectively, immediately before and after that transportation. 80 On the basis of the case law, the regulations, and the history of the statute and regulations, we reject taxpayer's primary argument and hold that the loading and distribution costs at issue here are post cutoff point processes, and are therefore nonmining costs. 81 Taxpayer's alternative argument, that the loading and other distribution costs should simply be excluded from the proportionate profits formula, relies upon the Tenth Circuit case, Ideal Basic. In subpart C we concluded that Ideal Basic's reliance on Standard Lime was misplaced and that its treatment of the cost items at issue violated the purpose of the proportionate profits method. We, therefore, reject taxpayer's attempt to exclude these cost items from the formula. We follow the holdings of California Portland, Whitehall and Standard Lime; we follow the implications in Reg. 39.23(m)-1(e)(3), and in the history of the statute and regulations as discussed above. We hold that the loading and distribution costs at issue are nonmining costs. This will accomplish the purpose of the proportionate profits method, i. e., the exclusion of these nonmining costs and their pro rata profits from the depletable base.