1. Under the income and excess profits provisions of the Revenue
Act of 1916, as amended by Revenue Act of 1917, in determining the
existence and amount of profit realized from a sale of oil mining
properties -- land, leases, and equipment -- the cost of the
property sold is the original cost to the taxpayer (if purchased
after March 1, 1913, or its value on that date if acquired earlier
for less) diminished by deductions for depreciation and depletion
occurring between the dates of purchase (or March 1, 1913) and
sale. P.
274 U. S.
300.
2. The depreciation charge permitted as a deduction from the
gross income in determining the taxable income of a business for
any year represents the reduction, during the year, of the capital
assets through wear and tear of the plant used. P.
274 U. S.
300.
3. When a plant is disposed of after years of use, the thing
then sold is not the whole thing originally acquired. The amount of
the depreciation must be deducted from the original cost of the
whole in order to determine the cost of that disposed of in the
final sale of properties. P.
274 U. S.
301.
4. This rule applies to mining as well as to mercantile
business. P.
274 U. S.
301.
5. The depletion charge permitted as a deduction from the gross
income in determining the taxable income of mines for any year
represents the reduction in the mineral contents of the reserves
from which the product is taken. Because the quantity originally in
the reserve is not actually known, the percentage of the whole
withdrawn in any year, and hence the appropriate depletion charge,
is necessarily a rough estimate. P.
274 U. S.
302.
6. The amounts of depreciation and depletion to be deducted from
cost to ascertain gain on a sale of oil properties are equal to the
aggregates of depreciation and depletion which the taxpayer was
entitled to deduct from gross income in his income tax returns for
earlier years; but are not dependent on the amounts which he
actually so claimed. P.
274 U. S.
303.
61 Ct.Cls. 126 reversed.
Certiorari (271 U.S. 651) to a judgment of the Court of Claims
for an amount exacted as additional income and excess profits
taxes.
Page 274 U. S. 296
MR. JUSTICE BRANDEIS delivered the opinion of the Court.
Ludey brought this suit in the Court of Claims to recover an
amount exacted as additional taxes for 1917 under the income and
excess profits provisions of the Revenue Act of 1916, September 8,
1916, c. 463, Tit. I, 39 Stat. 756-759, as amended by the Revenue
Act of 1917, October 3, 1917, c. 63, 40 Stat. 300, 329. The tax was
assessed on the alleged gain from a sale in 1917 of oil mining
properties which had been owned and operated by him for several
years. The Commissioner of Internal Revenue determined that there
was a gain on the sale of $26,904.15. Ludey insists that there was
a loss of $14,777.33. The amount sued for is the tax assessed on
the difference. Whether there was the gain or the loss depends
primarily upon whether deductions for depletion and depreciation
are to be made from the original cost in determining gain or loss
on sale of oil mining properties. The question is one of statutory
construction or application. The Court of Claims entered judgment
for the plaintiff. 61 Ct.Cls. 126. This Court granted a writ of
certiorari. 271 U.S. 651.
The properties consisted, besides mining equipment, in part of
oil land held in fee, in part of oil mining leases. The aggregate
original cost of the properties was $95,977.33. [
Footnote 1] Of this amount, $30,977.33 was
the cost of the
Page 274 U. S. 297
equipment used in the business; $65,000 the cost of the oil
reserves. The 1917 sale price was $81,200. For the purpose of
determining the cost of the properties sold in 1917 the
Commissioner deducted from the original cost $10,465.16 on account
of depreciation of the equipment through wear and tear, and
$32,258.81 on account of depletion of the reserves through the
taking out of oil by the plaintiff, after March 1, 1913. There was
no dispute of fact concerning the correctness of the estimates upon
which these deductions were made. The finding of the depletion was
in accordance with the method of computation employed by the Bureau
of Internal Revenue, and there was no objection specifically to the
method of computation. But Ludey insisted that the amount of
depletion, if any, could not be found or stated as a fact, since,
in the nature of the case, it was impossible to determine how much
oil was recoverable, either when he acquired the properties or when
he disposed of them. The finding of the depreciation was, likewise,
in accordance with the method of computation employed by the
bureau, and there was no objection to the method of computation.
But Ludey insisted also in respect to depreciation that the
property was, as a matter of law, unchanged in character and
quantity throughout the period of operation.
Until 1924, none of the revenue acts provided in terms that, in
computing the gain from a sale of any property, a deduction shall
be made from the original cost on account of depreciation and
depletion during the period of operation. [
Footnote 2] But ever since March 1, 1913, the
revenue
Page 274 U. S. 298
acts have required that gains from sales made within the tax
year shall be included in the taxable income of the year, and that
losses on sales may be deducted from gross income. And each of the
acts has provided that, in computing the taxable income derived
from operating a mine, there may be made a deduction from the gross
income for the depreciation and that some deduction may be made for
depletion. The applicable provisions of § 5(a) of the Revenue
Act of 1916 concerning deductions to be allowed in computing net
income are these:
"Fourth. Losses actually sustained during the year, incurred in
his business or trade: . . .
Provided, that . . . the . .
. value of . . . property [acquired before March 1, 1913] as of
March 1, 1913, shall be the basis for determining the amount of
such loss. . . ."
"Seventh. A reasonable allowance for the exhaustion, wear and
tear of property arising out of its use or employment in the
business or trade. . . ."
"Eighth. (a) In the case of oil and gas wells, a reasonable
allowance for actual reduction in flow and production; . . . (b) in
the case of mines, a reasonable allowance for depletion thereof: .
. .
Provided, That when the allowances . . . shall equal
the capital originally invested . . . , no further allowance shall
be made."
Ludey does not deny that Congress has power to require that
deductions for depreciation and depletion shall be made from the
original cost when determining the cost of oil properties sold. His
contention is that, at the time of the sale in question, Congress
had not in terms required
Page 274 U. S. 299
the deductions in the case of any property, and that special
reasons exist why the acts should be construed as not requiring the
deductions in the case of oil wells. He urges that a corporation
organized for the purpose of utilizing a wasting property, like an
iron mine, is not deemed to have divided a part of its capital
merely because it has distributed the net proceeds of its mining
operations; that this is true even where the necessary result of
the operation is a reduction of the mineral reserve; that,
a
fortiori, the proceeds of oil mining are to be deemed income,
not a partial return of capital, since there is no ownership in oil
until it is actually reduced to possession; that a purchase of an
oil reserve cannot be likened to the purchase of a certain number
of barrels of oil; that an oil reserve is not a reservoir; that
Congress allowed the deduction from gross income for depreciation
and depletion probably as a reward in an extra-hazardous enterprise
in order to encourage new producing properties, and that to allow
the deductions would result, in the event of a sale of the
property, in taking back the rewards so offered.
The government contends that, in operating the properties, Ludey
disposed, in the form of oil, of part of his capital assets; that,
in the extraction of the oil, he consumed so much of the equipment
as was represented by the depreciation, and disposed of so much of
the oil reserves as was represented by the depletion; that the sale
of the properties made by him in 1917 was not a sale of all of the
property represented by the original cost of $95,977.33, since
physical equipment to the amount of the depreciation and oil
reserves to the amount of the depletion had been taken from it
during the preceding years, and that, for this reason, the cost to
plaintiff of the net property sold in 1917 was not $95,977.33, but
$53,258.36.
The Court of Claims did not consider whether, ordinarily,
deductions for depreciation and for depletion from the
Page 274 U. S. 300
original cost would be proper in determining whether there had
been a profit on a sale of property. It held that no deduction from
original cost should be made here, because of the nature of oil
mining properties. The deduction for depletion was, in its opinion,
wrong because oil properties are, in essence, merely the right to
extract from controlled land such oil as the owner of the right can
find and reduce to possession; because the existence of oil in any
parcel of land is dependent upon the movement which the oil makes
from time to time under the surface, and because whether there is
oil in place which can be reduced to possession, and if so, how
much, cannot be definitely determined. It held that, in the case at
bar, the right to explore for and take out oil may actually have
been more valuable at the time of the sale than at the time of the
purchase, and that, for this reason, the removal of the oil by
plaintiff during the years of operation cannot be said to have
depleted the capital. It held that the depreciation was not
deductible, because wear and tear of equipment was an expense or
incident of the business.
We are of opinion that the revenue acts should be construed as
requiring deductions for both depreciation and depletion when
determining the original cost of oil properties sold. Congress, in
providing that the basis for determining gain or loss should be the
cost or the 1913 value, was not attempting to provide an exclusive
formula for the computation. [
Footnote 3] The depreciation charge permitted as a
deduction from the gross income in determining the taxable income
of a business for any year represents the reduction, during the
year, of the capital assets through wear and tear of the plant
used. The amount of the allowance for depreciation is the sum which
should be
Page 274 U. S. 301
set aside for the taxable year, in order that, at the end of the
useful life of the plant in the business, the aggregate of the sums
set aside will (with the salvage value) suffice to provide an
amount equal to the original cost. The theory underlying this
allowance for depreciation is that, by using up the plant, a
gradual sale is made of it. The depreciation charged is the measure
of the cost of the part which has been sold. When the plant is
disposed of after years of use, the thing then sold is not the
whole thing originally acquired. The amount of the depreciation
must be deducted from the original cost of the whole in order to
determine the cost of that disposed of in the final sale of
properties. [
Footnote 4] Any
other construction would permit a double deduction for the loss of
the same capital assets.
Such being the rule applicable to manufacturing and mercantile
businesses, no good reason appears why the business of mining
should be treated differently. The reasons urged for refusing to
apply the rule specifically to oil mining properties seem to us
unsound. If the equipment had been used by its owner on the oil
properties owned by another, it would hardly be contended that the
depreciation through wear and tear resulting from its use should be
ignored in determining, on a sale of the equipment, whether its
owner had made a gain or a loss. The fact that the equipment sold
is owned by
Page 274 U. S. 302
the person who owned the mining rights, like the fact that it is
used in one class of mining, rather than in another, may have an
important bearing both upon the price realized on the sale and upon
the rate of depreciation which should be allowed, but these facts
cannot affect the question whether the part which has been
theretofore consumed by use shall be ignored in determining whether
a sale of what remains has resulted in a loss or a gain.
The depletion charge permitted as a deduction from the gross
income in determining the taxable income of mines for any year
represents the reduction in the mineral contents of the reserves
from which the product is taken. The reserves are recognized as
wasting assets. The depletion effected by operation is likened to
the using up of raw material in making the product of a
manufacturing establishment. As the cost of the raw material must
be deducted from the gross income before the net income can be
determined, so the estimated cost of the part of the reserve used
up is allowed. The fact that the reserve is hidden from sight
presents difficulties in making an estimate of the amount of the
deposits. The actual quantity can rarely be measured. It must be
approximated. And because the quantity originally the reserve is
not actually known, the percentage of the whole withdrawn in any
year, and hence the appropriate depletion charge, is necessarily a
rough estimate. But Congress concluded, in the light of experience,
that it was better to act upon a rough estimate than to ignore the
fact of depletion.
The Corporation Tax Law of 1909 had failed to provide for any
deduction on account of the depletion of mineral reserves.
Stratton's Independence v. Howbert, 231
U. S. 339;
Von Baumbach v. Sargent Land Co.,
242 U. S. 503;
United States v. Biwabik Mining Co., 247 U.
S. 116;
Goldfield Consolidated Mines
Co. v. Scott, 247 U.S.
Page 274 U. S. 303
126. The resulting hardship to operators of mines induced
Congress to make provision in the Revenue Law of 1913 and all later
acts for some deduction on account of depletion in determining the
amount of the taxable income from mines. [
Footnote 5] It is not lightly to be assumed that
Congress intended the fact to be ignored in determining whether
there was a loss or a gain on a sale of the mining properties. The
proviso limiting the amount of the deduction for depletion to the
amount of the capital invested shows that the deduction is to be
regarded as a return of capital, not as a special bonus for
enterprise and willingness to assume risks. It is argued that,
because oil is a fugacious mineral, it cannot be known that the
reserve has been diminished by the operation of wells. Perhaps some
land may be discovered which, like the widow's cruse, will afford
an inexhaustible supply of oil. But the common experience of man
has been that oil wells, and the territory in which they are sunk,
become exhausted in time. Congress, in providing for the deduction
for depletion of oil wells, acted on that experience.
Compare
Lynch v. Alworth-Stephens Co., 267 U.
S. 364. In essence, the deduction for depletion does not
differ from the deduction for depreciation.
The Court of Claims erred in holding that no deduction should be
made from the original cost on account of depreciation and
depletion, but it does not follow that the amount deducted by the
Commissioner was the correct one. The aggregate for depreciation
and depletion claimed by Ludey in the income tax returns for the
years 1913, 1914, 1915, and 1916, and allowed, was only $5,156.
Page 274 U. S. 304
He insists that more cannot be deducted from the original cost
in making the return for 1917. The contention is unsound. The
amount of the gain on the sale is not dependent on the amount
claimed in earlier years. If in any year he has failed to claim, or
has been denied, the amount to which he was entitled, rectification
of the error must be sought through a review of the action of the
bureau for that year. He cannot choose the year in which he will
take a reduction. On the other hand, we cannot accept the
government's contention that the full amount of depreciation and
depletion sustained, whether allowable by law as a deduction from
gross income in past years or not, must be deducted from cost in
ascertaining gain or loss. Congress doubtless intended that the
deduction to be made from the original cost should be the aggregate
amount which the taxpayer was entitled to deduct in the several
years.
The findings do not enable us to determine what that aggregate
is. The sale included several properties purchased at different
times. The deduction allowable in the several years for each of the
properties is not found. Under the Act of 1913, the full amount of
the depletion was not necessarily deductible. In order that the
amount of the gain in 1917 may be determined in the light of such
facts, the case is remanded for further proceedings in accordance
with this opinion.
Reversed.
[
Footnote 1]
Some of the properties were purchased before March 1, 1913. As
to these the term "cost" is used, throughout the opinion, as
meaning their value as of March 1, 1913, that value being higher
than the original cost.
[
Footnote 2]
The 1924 Act, June 2, 1924, § 202(b), 43 Stat. 253, 255,
provided that in computing gain or loss from sales, adjustment
should be made for items of exhaustion, wear and tear, and
depletion "previously allowed with respect to such property."
See Regulations 65, Arts. 1591-1603. The 1926 Act (Act.
Feb. 26, 1926, § 202(b), 44 Stat. 9, 11, 12) has a similar
provision with respect to deductions "allowable . . . under this
Act or prior income tax laws."
See Regulations 69, Art.
1561.
[
Footnote 3]
See Appeal of Even Realty Co., 1 B.T.A. 355.
Compare Appeal of Steiner Coal Co., 1 B.T.A. 821; Appeal
of W. W. Carter Co., 1 B.T.A. 849; Appeal of Keighley Mfg. Co., 2
B.T.A. 10.
[
Footnote 4]
Under regulations of the bureau the amount of the year's
depreciation is required to be fixed in accordance with a
reasonably consistent plan, and it must, in order to be allowed,
have been entered on the books of the business either as a
deduction from the book value of the plant or as a credit to a
depreciation reserve account.
See Regulations 33, revised,
Art. 159; Regulations 45, Art. 169; Regulations 62, Art. 169;
Regulations 65, Art. 169; Regulations 69, Art. 169. In either
event, it would be reflected in the annual balance sheet. After the
total of such credits equals the original cost, no further
deduction is allowed.
[
Footnote 5]
The bureau requires that taxpayers claiming depletion deductions
shall keep a ledger account in which deductions claimed are
credited against the cost of the property, or that a depletion
reserve account be set up.
See Regulations 33, revised
Art. 171, 172; Regulations 45, Art. 216; Regulations 62, Art. 216;
Regulations 65, Art. 217; Regulations 69, Art. 217.