Rev. Rul. 56-542

Advice has been requested whether, in the case of a so-called "captive mine," the right to the deduction for depletion extends to the stockholders of the captive mining company, by virtue of rights acquired under a contract entitling them to the ore produced and obligating them as joint venturers to furnish the funds needed by the mining company to develop and operate the mine.

An illustration of this pattern of operation containing the pertinent provisions is generally as follows: Certain manufacturing corporations, which require for their normal operations several grades and several kinds of ore, unite and join with other manufacturers in an arrangement for the acquisition, by fee or lease, of mining property and for the exploration, development and operation of such property. The manufacturers organize a corporation to own and operate the property, subscribe to the corporation's capital stock, and advance all funds needed both for capital and operative purposes. The mining company, referred to as a "cost company," executes a contract with its stockholding manufacturing corporations. The contract provides essentially that the participants, each in proportion to its stock ownership, shall advance all funds, both capital and operative, necessary for the mining company to operate and shall share in the same proportion in the ore produced. Under an agreement signed with its stockholding manufacturing corporations, the mining company will not sell any ore and will have no net income. Its operations, as well as the disposition of the products mined, will at all times be under the control of the participants.

Thus, the basic issue for consideration is whether the economic interest in the ore thus being produced, with the resultant right to claim depletion, is in the captive mining company or its stockholding corporations.

Section 611 of the Internal Revenue Code of 1954 provides that "in the case of mines, oil and gas wells, other natural deposits, and timber, there shall be allowed as a deduction in computing taxable income a reasonable allowance for depletion and for depreciation of improvements, according to the particular conditions in each case * * *."

Early decisions involving the right to depletion turned upon the ownership and title of the ore in place. Abandonment of legal title as the criterion for depletion was firmly established in the case of E. G. Palmer v. Bender 287 U. S. 551, Ct. D. 641 C. B. XII-1, 265 (1933), which also established the principle that depletion is allowable to one having an "economic interest" in the property. See also W. A. Thomas v. J. J. Perkins et al. 301 U. S. 655, Ct. D. 1237, C. B. 1937-1, 162.

In G. C. M. 22730, C B 1941-1, 214, the Internal Revenue Service defined an "economic interest" as the right to share in the production, or the gross proceeds therefrom, and as not depending upon the legal title to the oil and gas or mineral deposits. Thus, it was stated that assurances of a share upon production mark ownership of an economic interest in oil and gas in place.

The Code provisions with respect to depletion refer to the income from mining property rather than to the income of the taxpayer. Sections 611 and 613 of the Internal Revenue Code of 1954. Section 23(m)-1 of Regulations 118, made applicable herein by virtue of Treasury Decision 6091, C. B. 1954-2, 47, provides in part that "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 severance and sale of the mineral or timber, to which he must look for a return of his capital * * *."

The decision with respect to who has the economic interest in the depletable property depends more on the practical consequences of the contract provisions as to disposition of the ore than on the form of contract. As pointed out in G. C. M. 22730, supra, cited with approval by the court in the case of Easter Coal Corp. v. Yoke, 67 Fed. Supp. 166, the form of contract dividing the product or the gross income therefrom, or the legal phraseology or devices utilized to accomplish the division, are immaterial.

The tests or criteria for determining whether an economic interest exists may be stated to be the result of numerous court decisions and may be summed up as follows:

First, there must be a right to receive and share in the ore or mineral itself and that right must be a binding right, not terminable at the will of another. G. C. M. 26290, C. B. 1950-1, 42.

Second, the right must stem from an investment. Investment means the acquisition of a direct equity in the ore, not acquisition by stock ownership which is indirect (Helvering v. Thomas A. O'Donnell, 303 U. S. 370, C. B. 1938-1, 337), nor acquisition of a "creditor's interest." Commissioner v. Caldwell Oil Corp., 141 Fed (2d) 559.

Third, recovery of the investment must be dependent solely upon the extraction of the ore. Kirby Petroleum Co. v. Commissioner, 325 U. S. 599; Ct. D. 1664, C. B. 1946-1, 69; Thomas v. Perkins, supra; Burton-Sutton Oil Co. Inc. v. Commissioner, 328 U. S. 25, Ct. D. 1674, C. B. 1946-1, 237.

Whether the depletable interest is in the manufacturing corporations rather than the mining company rests upon the substance of the contractual agreement entered into between the parties. Applying the three tests set out above to the case under consideration, the manufacturing corporations must, in order to establish their economic interests in the ore bodies operated by the mining company, show that:

(1) they, and they alone, each have the right to take their individual share of the ore produced (or the proceeds from the severance and sale thereof);

(2) they have no source other than their respective shares of the ore produced (or the proceeds therefrom) from which they may recoup any capital investment or advance of money they have made or may be required to make under their agreement to furnish funds required for development and operation of the mine;

(3) they, as joint owners of the economic interest, under the contractual arrangement on whose behalf the mine is being operated, have the ultimate power to manage the mine; and

(4) the contributed capital (amounts paid in for stock) of the mining company is nominal in relation to the working capital required for the mining operation.

In view of the above, it is held that in the case of a so-called "captive mine," where the above described tests are met, the stockholders of the captive mining company, by virtue of rights acquired under a contract entitling them to the ore produced and obligating them as joint venturers to furnish the funds needed by the mining company to develop and operate the mine, are entitled to the depletion deduction.

APPLICATION OF THIS RULING

An example of a contractual arrangement between a group of participants, which is held to meet the requirements of the above-mentioned criteria, may be shown, as follows:

(1) A mining company is organized with a capitalization of $5,000.

(2) The stockholders agree to participate jointly, through the mining company, in all operations required to produce merchantable ore.

(3) The participants agree that all expenditures, both capital and noncapital, and all merchantable ore produced will be shared in proportion to their stockholdings.

(4) The mining company carries on mining activities under the control of, and with funds furnished by, the participants and delivers to them their respective shares of the total production.

(5) The cost of production is divided among the participants so that each shall bear its proportionate share.

(6) The mining company accounts for all of the funds furnished to it, it being understood that all such funds, including funds paid in for capital stock, and any assets acquired by the use of such funds, shall be used for the purpose of carrying out the provisions of the agreement and for no other purposes. The mining company has no obligation to repay to the participants any funds advanced to it, it being understood that such advanced funds are not loans or capital contributions, but are funds furnished by the participants for use on their behalf and are recoverable solely from merchantable ore, or returnable if not used in the mining operations.

(7) No participant shall sell or otherwise dispose of all or any part of its contractual economic interest in the mining properties except in conjunction with a sale of all or part of its stock in the mining company to a party who shall in writing assume all, or a corresponding proportion, of its obligations under the contractual arrangement.

Under such an arrangement, the Federal income tax consequences are:

(1) The mining company will file a corporate return showing no income and no deductions on its face, but containing schedules showing the gross income and deductions allocable to the participants.

(2) The participants will be deemed to share the economic interest in the mineral in place and so long as the agreement continues in effect and unchanged (and in the absence of other material circumstances) they shall make their accounting for Federal income taxes in accordance with the following terms and conditions:

(a) All income, less exclusions therefrom allowable under the Internal Revenue Code of 1954, from operations of the mining company shall be included by the participants in computing their gross incomes, in proportion to their respective shares in the mining operations.

(b) In computing their gross and net incomes, the participants, in proportion to their shares, shall deduct or shall include in their respective inventories and cost of goods sold, as the case may be, all operating costs including interest charges, depreciation, depletion, and amortization of emergency facilities, which, under the Internal Revenue Code of 1954 are of the character allowable as deductions in computing gross and net income; provided, however, that the participants shall include in their respective inventories or cost of goods sold only those items which may be properly included therein under the provisions of the Code, the regulations, and rulings thereunder.

(c) For the purposes of the preceding subparagraph, the participants will be allowed deductions for percentage depletion in accordance with section 613 of the Code. For the purpose of computing such percentage depletion, gross income is and will be computed by accounting for the produced merchantable ore at the market price.

(d) Any funds or credits transferred or furnished to the mining company by the participants shall not be regarded as indebtedness incurred by the mining company, and the participants shall not be entitled to any Federal tax credits arising from such transactions.

(e) It is to be understood that any election, affecting the computation of taxable income derived from the mining property, whether exercisable by the participants jointly or by each participant separately, will be considered by the Internal Revenue Service to have been made only upon giving notice in writing, or notice by other appropriate action, to the Commissioner by the mining company; and, when so made, it shall be binding on all the participants if a joint election is provided, or on the individual participants making elections which may be made individually.