DEPLETION ALLOWANCE
Federal law allows the owners of mining operations, such as this copper mine in southeastern Arizona, to claim a tax deduction upon the depletion of the mine’s natural deposits.
A tax deduction authorized by federal law for the exhaustion of oil and gas wells, mines, timber, mineral deposits or reserves, and other natural deposits.
Frequently, the ownership of such resources is split so that the depletion deduction is allotted among the various owners. Rights to royalty payments, leases, and subleases are not the same
as ownership but the holders of such rights may be entitled to depletion deductions under the theory of “economic interest” formulated by the
courts to ascertain the right to depletion
allowances. Such economic interest,which signifies an investment interest in the minerals that furnish the sole resource for recouping the investment, is usually determined by the parties according to the provisions of their contract.
The cost method and the percentage, or statutory, method represent the two ways of calculating the DEPLETION ALLOWANCE.
Cost depletion, like depreciation, bases the allowance on the original cost of the income-
generating property. For example, a taxpayer who purchases rights to extricate oil for $2 million should be permitted to regain the capital tax-free when he or she extracts and markets the oil. The earnings from the depletable property should be viewed as encompassing a return of the taxpayer’s capital investment. A proportionate segment of such receipts each year should be exempt from taxation as income. When oil is
viewed as a “wasting asset,” cost depletion permits yearly deductions for the receipt of $2 million tax-free over the duration of the pumping operations. The tax law permits the taxpayer to divide the cost of the investment by the esti-
mated total of recoverable units in the natural
deposit. This cost per unit is subsequently mul-
tiplied by the number of units sold annually,
which results in the depletion deduction permit-
ted for that year.
The percentage, or statutory, method does not employ recovery of cost in the computation of the deduction. A percentage of annual income, rather than cost, is deductible each year, even if the owner has recovered all cost or dis-
covery value of the depletable asset. The federal
tax laws vary from year to year in regard to the
percentage depletion allowable for oil and some
other deposits, and the categories of producers
entitled to such allowances.
Percentage depletion, which applies to other
mineral deposits or energy sources such as geot-
hermal steam, provides an extremely profitable
allowance as an alternative to cost depletion.
The taxpayer calculates a fixed percentage of his
or her gross income and deducts that amount
from gross income annually for as long as the
property generates income, even after he or she
has completely recovered the actual cost. Some
taxpayers employ cost depletion at the outset of
operations, when a large number of units of the
deposit are extracted and sold, and then convert
to percentage depletion upon recoupment of
cost in other circumstances—when percentage
depletion yields a more sizable deduction.
Percentage depletion furnishes an additional
tax subsidy to detection, development, and dis-
sipation of qualified reserves. The subsidy
approach began during WORLD WAR I to induce
exploration for minerals. Cost depletion had
been expanded to permit discovery value rather
than cost to serve as the gauge of tax-exempt
recovery. A problem in estimating the quantity
of depletable units prior to extraction existed,
however, and percentage depletion was enacted
in 1924 as the solution. This method was subse-
quently extended to include additional minerals
and other deposits and to raise rates of depletion
in some instances. It was eventually diminished
due to excessive profits and tax benefits obtained
by some companies. Only depletion, rather than
percentage depletion,may be used for gas, water,
soil, timber, and oil.
For percentage depletion, gross income must
be restricted to income from extracting and sell-
ing the deposit, not from refining, processing, or
manufacturing it.
The option to deduct present exploration
and development expenditures rather than cap-
italizing them represents an additional tax
advantage for the industries entitled to deple-
tion allowances. A more substantial tax benefit
ensues if such expenses are deducted immedi-
ately, since they would never be recovered
through the application of percentage depletion,
which is based on gross income and not the cost
of the capital invested in the enterprise.
CROSS-REFERENCES
Income Tax; Mine and Mineral Law.
