Opinion ID: 348408
Heading Depth: 1
Heading Rank: 1

Heading: Depletion

Text: 4 During the tax years contested in this case, taxpayer owned and operated the Belle Glade Farm and the Zellwood Farm in Florida. The topsoil on both farms consists of peat and muck soil composed of partially decomposed plant deposits. This organic soil is a uniquely rich and fertile medium in which to grow vegetables. Consequently it has a value greater than that of other soils. 5 Water covered the peat soils on both Duda farms prior to their cultivation. Cultivation requires lowering the water table, draining and compacting the soil, and applying various chemicals. The inevitable and irreversible result of cultivation is that the heavily carbonized soil oxidizes, releasing carbon dioxide gas and gradually subsides. One can halt or impede this process only by flooding the soil, which precludes cultivation of crops. In short, at the present state of our technology one can either maintain the level of peat soil or raise crops. One cannot do both. 6 Taxpayer, perhaps heeding Voltaire's sardonic dictum, chose to cultivate its garden. It then observed, more literally than did the good Dr. Pangloss, that the ground gradually gives way beneath one in this best of all possible worlds. Primarily through oxidation, the soil on its farms subsided at an average rate of 15 inches for the first year of cultivation and 1.1 inches per year thereafter. The peat soil on taxpayer's farms presently reaches a depth of about four or five feet. 7 Duda brought suit in district court to recover the federal income taxes attributable to the disallowed depletion or depreciation deductions for the subsiding peat. After denying the government's motion for judgment on the pleadings, the district court allowed Duda's evidence of depleting peat resources to go to the jury. As applied by the court, the jury's special verdicts meant that Duda was entitled to take cost depletion or depreciation deductions for the peat, calculating its cost as that portion of the farm purchase price allocable to the peat and muck. 8 Belle Glade Farm contains a layer of soft, partially decomposed limestone material called marl and some limestone rock underneath its peat soil deposit. Duda presented evidence that the limestone is not economically suitable for farming. The government's witnesses testified that the land could still be successfully farmed even when the peat was entirely gone. Zellwood Farm contains hardpan clay and sand underneath its peat. The sand and clay soil is suitable for farming. Duda claimed that once the peat soil on either farm was reduced to a depth of 12 to 15 inches, it could not be used for farming. 9 The jury could not determine a depth at which the peat deposit on either farm would no longer be useful in farming. The court did not ask the jury to find whether farming would be impossible on the Belle Glade Farm once the peat was gone. 10 The jury did find that taxpayer had paid one-half of the price per acre of the Belle Glade Farm for the peat soil alone and one-half for the underlying strata. With respect to the Zellwood Farm, the jury found that the entire purchase price per acre was allocable to the sand and clay substrata. 11 The only deductions at issue here involve the Belle Glade Farm. Duda's deposit of peat soil on this farm averaged 51/2 feet when purchased. It has been subsiding all the Duda day since taxpayer began cultivating it and is now 4 to 5 feet in depth. The jury found that it will disappear within 35 years.
12 The government concedes that peat soil is a natural deposit as that term appears in § 611 of the Code. 1 It does not dispute that as a result of cultivation the peat is subsiding at a rate of 1.1 inches per year nor that in 35 years Belle Glade Farm's peat soil will be exhausted. It does not dispute the jury's finding that half of the farm's purchase price per acre was allocable to the peat. 2 Its sole contention is that as a matter of law Duda is not entitled to depletion deductions for the peat because extraction or severance of a natural deposit is a necessary prerequisite to a § 611 deduction. The government urges that the cost depletion deduction is not available for a natural deposit that is wasting in place. 13 If the taxpayer exhausted the peat by digging it up and selling it to produce income, the government would grant the deduction. 3 Because the taxpayer exhausts the peat in the process of raising vegetables that are sold to produce income, the government would deny the deduction. The government does not argue that the distinction between the two cases is that in one the depletable asset itself is sold while in the other the taxpayer exhausts the asset on its own premises. 4 Instead, the government bases its entire argument on appeal on the notion that the difference between the two cases is that in one the taxpayer extracts the asset while in the other the taxpayer leaves the asset in place. 14 The government's position finds no support whatever in the language of § 611, nor do other provisions of the Code offer a clear answer. The Congress has never expressly required that a taxpayer prove extraction or severance as a prerequisite to a depletion deduction. In the applicable legislative history, Congress simply does not squarely address the question. The issue here is whether Congress's reticence regarding this question is attributable to the axiomatic nature of the answer. That is to say, Congress may have thought it obvious that extraction was bound up with the concept of depletion and never contemplated allowing depletion deductions in other than extraction situations. No court has allowed a depletion deduction when the taxpayer did not extract or sever the depletable asset from the ground. But, of course, no court has ever decided whether a taxpayer is entitled to depletion deductions for peat that is subsiding in place. 5 15 In short, we must decide this case outside the realm of the explicit, the black letter statement, or the certitude, but rather within the web of unarticulated assumptions and judicial inferences from those assumptions. The confluence of legislative history, semantics, and philology cannot write this opinion. We must search hard for a tax loom to solve our loam problem.
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?
41 A fundamental tenet of our federal income tax system is the principle that before gain or loss is recognized there must be a taxable event. Whether a transfer of appreciated property pursuant to a property settlement agreement, United States v. Davis, 370 U.S. 65, 82 S.Ct. 1190, 8 L.Ed.2d 335 (1962), or the seizure by a foreign power of a corporation's foreign assets, United States v. S.S. White Dental Mfg. Co., 274 U.S. 398, 47 S.Ct. 598, 71 L.Ed. 1120 (1927), the common question is whether a taxable event has occurred. Mere fluctuation in value of assets owned by a taxpayer is not sufficient to allow recognition of loss or force recognition of gain. The sale of property, its destruction or its abandonment as worthless constitute evidence of losses or gains which are fixed by identifiable events. United States v. S.S. White Dental Mfg. Co., supra, 274 U.S. at 401, 47 S.Ct. at 600. 42 No deduction is allowed in the former situations in part because there is no sufficiently observable, verifiable indicator that consistently provides sufficient information by which to recognize the value change for tax purposes. A deduction is allowed in the latter situations in part because the specified events provide such information. 43 In the case of the depletion deduction, extraction is precisely the kind of observable change accompanied by sufficient trustworthy information to make tax recognition appropriate. Unlike the case of depreciating an asset according to a fixed schedule, the depletion of a natural resource lends itself to false claims that a requirement of extraction helps prevent. This, then, is the function that Congress may have thought extraction would serve in the administration of the depletion deduction provisions. Given this functional relationship between extraction and the depletion deduction, the assumption apparently shared by Congress, the IRS, and the courts that depletion was designed for the extractive industries makes a good deal of sense. Without the frequent references in the legislative history and current regulations to extraction or severance, the existence of this functional relationship could not justify our holding. Without some functional relationship between extraction and depletion, one might be tempted to dismiss these references to extraction as careless remarks. Given both, however, the picture of the depletion deduction as bound up with extraction emerges with a rational aspect. 44 To be sure, in the case at bar the taxpayer presents us with a jury finding that its peat is subsiding at a determinate rate. But in many similar cases it will be difficult and will entail considerable administrative costs to the government to verify the rate by which an asset in place is being exhausted. Wind and water erosion cause irreplaceable soil losses in various parts of the country. In most cases, this is a consequence of cultivation like the depletion of Duda's peat soil. Moreover, the oxidation of organic matter occurs in all cultivated soils, albeit in different degrees and at different rates of subsidence, just as it occurs in Duda's peat. Finally, we might consider the case of a farmer who claims, justifiably, that if Duda is allowed a deduction for its peat, he ought to be allowed a depletion deduction for the exhaustion of the nutrients in his soil attributable to, say, cotton farming. There seems no reason why nutrients, which largely determine the fertility of a particular parcel of land, should not be considered natural deposits. Once the farmer crosses this threshold it will be an easy matter to show, in principle, that long term cultivation depletes the nutrients despite such short term devices as allowing the land to remain fallow. Although the farmer may purchase fertilizer to replace the nutrients, that is no different in principle from requiring Duda to replace its peat. The farmer may show all this in principle, but as a practical matter the administration of the depletion deduction in these sorts of cases raises whole new sets of difficulties. 11 45 It may be that Congress intends to grant deductions in these cases. If so we must insist that it address itself specifically to the case of a natural asset wasting in place. The Code abounds in specifics and delights in the particular; in light of the significant functional difference between the case of an asset wasting in place and an asset that is depleted by extraction, and in light of the legislative history of § 611 and the pertinent treasury regulations, we decline to extend the general depletion provisions to the particular situation with which Duda confronts us.