Rev. Rul. 71-140

Advice has been requested whether, under the circumstances described below, a lessor qualifies under section 631(c) of the Internal Revenue Code of 1954 for the treatment provided by section 1231 of the Code on iron ore royalties paid to the lessor with respect to natural deposits of iron ore held for more than six months.

A so-called "captive mine" or "cost company," described in Revenue Ruling 56-542, C.B. 1956-2, 327, as amplified by Revenue Ruling 68-28, C.B. 1968-1, 5, was organized as a domestic corporation, with three equal stockholder-participants, to mine certain natural iron ore deposits in the United States. The cost company and its three stockholders, X, Y, and Z, all of which are unrelated parties, executed a contract. The contract provides among other things, that the stockholder-participants, each in proportion to its stock ownership, shall advance all funds, both capital and operative, necessary for the cost company to operate and shall share the iron ore produced in the same proportion.

X, owned in fee certain natural deposits of iron ore in the United States and held certain other natural deposits of iron ore (also in the United States) under a lease from A, who is not related to X, Y, or Z. Under a mining lease, X leased the deposits it owned in fee and subleased those it had leased from A to the cost company for a stated royalty amount per ton of ore mined.

All the tests described and set forth under Revenue Ruling 56-542 have been met and, therefore, each of the stockholder-participants (X, Y, and Z) has an economic interest in the iron ore in place.

During 1968, the cost company paid 30x dollars to X as royalties on the iron ore produced from the deposits during that year; 27x dollars were royalties on the deposits that X owned in fee and 3x dollars were royalties on the deposits that X had leased from A. X paid 2x dollars royalty to A; thus, X retained an overriding royalty of 1x dollar on the deposits leased from A.

Section 631(c) of the Code sets forth the conditions under which certain net amounts realized from disposal of iron ore with a retained economic interest shall be considered as though such amounts were gain or loss, as the case may be, on the sale of such iron ore. However, that provision does not apply to income realized by an owner as a co-adventurer, partner, or principal in the mining of such iron ore, or to any disposal of iron ore to a person controlled directly or indirectly by the same interests that own or control the owner. An "owner" is defined as any person who owns an economic interest in iron ore in place, including a sublessor.

Section 1231(a) of the Code provides that if, during the taxable year, the recognized gains on sales or exchanges of property used in the trade or business, plus the recognized gains from compulsory or involuntary conversions of property used in the trade or business and capital assets held for more than six months into other property or money, exceed the recognized losses from such sales, exchanges, and conversions, such gains shall be considered as gains and losses from sales or exchanges of capital assets held for more than six months. If such gains do not exceed such losses, such gains and losses shall not be considered as gains and losses from sales or exchanges of capital assets.

Section 1231(b) of the Code defines the term "property used in the trade or business," for purposes of section 1231 of the Code, to include timber, coal, and iron ore with respect to which section 631 of the Code applies.

Section 1.611-1(b)(2) of the Income Tax Regulations provides that no depletion deduction shall be allowed the owner with respect to any domestic iron ore that the owner has disposed of under any form of contract by virtue of which he retains an economic interest in such domestic iron ore, if such disposal is considered a sale under section 631(c) of the Code.

Section 1.631-3(a) of the regulations provides, in part, that the provisions of section 631(c) of the Code apply to an owner who disposes of iron ore mined in the United States, held for more than six months before such disposal under any form or type of contract whereby he retains an economic interest in such iron ore. In the case of such disposal, the provisions of section 1231 of the Code apply, and the iron ore shall be considered to be property used in the trade or business for the taxable year in which it is considered to have been sold regardless of whether the iron ore is property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.

Section 1.631-3(b)(3)(i) of the regulations provides, in part, that the amounts of rents and royalties paid or incurred by a lessee with respect to iron ore shall be excluded from the lessee's gross income from the property for the purpose of determining his percentage depletion without regard to the treatment of such rents or royalties in the hands of the recipient under this section.

Revenue Ruling 56-542, as amplified by Revenue Ruling 68-28, provides, in part, that in the case of a so-called captive mine or cost company arrangement, the cost 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. 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 of the cost company shall be included by the participants in proportion to their respective shares in the mining operations.

(b) In computing their gross and net income, the participants, in proportion to their shares, shall deduct all operating costs including depreciation that are of a character allowable as deductions in computing gross and net income.

(c) The participants will be allowed deductions for percentage depletion in accordance with section 613 of the Code.

(d) Any funds or credits transferred or furnished to the cost company by the participants shall not be regarded as indebtedness incurred by the cost company.

In the instant case, the economic interest in the iron ore deposits and the right to receive the iron ore mined are not in the cost company, but in the stockholder-participants and, under Revenue Ruling 56-542, as amplified, and the contractual agreements of the parties in this case, the iron ore mined and the deductions allowable with respect to the mining of such ore deposits are allocable to such stockholders in proportion to their respective stockholder participation. (In the instant case X, Y, and Z participate equally.) It follows that X, Y, and Z, as equally sharing stockholder-participants, must carry their pro rata share (10x dollars each) of the cost of the royalties that the cost company paid to X (30x dollars) during the year referred to in the instant case. Also, in the instant case, qualification under section 631(c) of the Code by the lessor (and sublessor), X, for the treatment provided by section 1231 of the Code is limited to those royalties paid to X on behalf of the other two participating stockholders, Y and Z.

The lessor (X) in the instant case does not control the participating stockholders (Y and Z) which are the lessees with respect to their proportionate shares of the iron ore properties.

Therefore, the lessor (X) qualifies, under section 631(c) of the Code for the treatment provided by section 1231 of the Code, on that portion of the iron ore royalties paid to X by the cost company on behalf of Y and Z that represents the shares of the other stockholder-participants (Y and Z) with respect to the iron ore deposits X owned in fee. However, X does not qualify for such treatment on the portion of the royalties that represents X's own share of the payment by the cost company of such iron ore royalties.

Furthermore, X qualifies, under section 631(c) of the Code for the treatment provided by section 1231 of the Code, on that portion of the iron ore royalties paid to X by the cost company on behalf of Y and Z that represents the shares of the other stockholder-participants (Y and Z) with respect to the iron ore deposits X leased from A and subleased to the cost company. However, X does not qualify for such treatment on that portion of the royalties that represent X's own share of the payment by the cost company of such iron ore royalties that the cost company collects from X as his participating share of the cost of the royalties that are paid to X as sublessor, which represent overriding royalties.

Of the 30x dollars received by X from the cost company in 1968, 27x dollars were with respect to the iron ore deposits X owned in fee, and 3x dollars were with respect to the deposits X leased from A. The 27x dollars represents 9x dollars paid to X, as lessor, out of funds provided by X as his share of the cost of the royalties, and 18x dollars paid to X by the cost company on behalf of Y and Z. The 3x dollars represents 1x dollar paid to X, as sublessor, out of funds provided by X as his share of the cost of the royalties, and 2x dollars paid to X by the cost company on behalf of Y and Z. The 18x dollars and the 2x dollars represent amounts paid as royalties on behalf of Y and Z, and qualify under section 631(c) of the Code for the treatment provided by section 1231 of the Code. However, the 9x dollars and the 1x dollar represent payments to X out of funds provided by X, as his share of the cost of the royalties, and do not qualify under section 631(c) of the Code for the treatment provided by section 1231 of the Code.

Revenue Ruling 56-542, as amplified by Revenue Ruling 68-28, is further amplified.