Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 73-32

1973-1 C.B. 301

Sec. 611

IRS Headnote

A joint venture that mines coal deposits under a 16-year non-terminable lease from the parent of one of its participants and derives its income from the sale of the coal to the parent and others has a depletable economic interest in the coal deposit.

Full Text

Rev. Rul. 73-32

Advice has been requested whether, under the circumstances described below, a joint venture acquired an economic interest in a natural deposit of coal within the meaning of section 1.611-1(b)(1) of the Income Tax Regulations.

A wholly owned subsidiary company of a thermal-electric power company entered into an agreement with an unrelated coal mining company to form a joint venture. The joint venture filed a Form 1065, U.S. Partnership Return of Income, and it was determined on examination of the return that the joint venture is classifiable as a partnership for purposes of the Internal Revenue Code of 1954. The purpose of the joint venture was to mine coal for sale to the thermal-electric power company (the parent of the joint venture subsidiary) for use in one of its power plants. The subsidiary company supplied all of the mining equipment to the joint venture and retained title to the equipment. The unrelated coal mining company supplied management and conducted the actual mining operation. Each of the participants in the joint venture (the subsidiary and the unrelated coal mining company) contributed 200 x dollars in cash as working capital. A portion of the funds required by the subsidiary for its commitments under the joint venture were furnished to the subsidiary by its parent as a loan.

The joint venture agreement provided that the subsidiary company would receive a per ton fee for the use of the mining equipment and the coal mining member would receive a per ton fee for its management services. These fees were to be charged to the operating costs of the joint venture. The joint venture profit was to be shared equally by the two members of the joint venture.

The joint venture mined coal by the strip mining method from natural coal deposits leased from the power company. The coal was mined and transported to the power company's preparation plant. No processes other than physical extraction of the coal from the natural deposit and transportation to the power company's preparation plant were performed by the joint venture. Under the lease, the joint venture had the right to mine all of the coal from the leased lands. The lease required the joint venture to pay a royalty to the power company for each ton of coal mined and sold. Simultaneously with the coal lease the joint venture entered into a coal supply agreement with the power company. Under the coal supply agreement, the joint venture dedicated sufficient coal reserves to supply coal to a specified power plant for the duration of the supply agreement. If the joint venture was unable to supply sufficient coal to meet the needs of the power plant, the power company could make up the difference with purchases from others. From the dedicated reserves the joint venture was permitted to sell a specified amount of coal a year to others on the open market.

The lease and coal supply agreements were to continue for a term of sixteen years, were mutually dependent, and were terminable only for cause. The price paid by the power company for coal supplied by the joint venture was stated in the coal supply agreement.

The joint venture looked only to the proceeds from the sale of the coal for its income from mining. The coal, before sale, belonged to the joint venture under the lease from the power company.

Section 611(a) of the Internal Revenue Code of 1954 provides the general rule that there shall be allowed as a deduction in computing taxable income a reasonable allowance for depletion and section 611(b)(1) of the Code provides the special rule that in the case of a lease, the depletion deduction shall be equitably apportioned between the lessor and lessee.

Section 1.611-1(b)(1) of the regulations provides that an economic interest is possessed in every case in which the taxpayer has acquired by investment any interest in mineral in place and secures by any form of legal relationship income derived from the extraction of the mineral to which he must look for a return of his capital.

In general, the depletion deduction is denied to mining contractors where the lease owner could cancel the contract at will or upon nominal notice or where the contractor's compensation is not dependent upon the extraction and sale of the coal. See Emory W. Parsons v. Smith, 359 U.S. 215 (1959), Ct. D. 1836, 1959-1 C.B. 673, where the Supreme Court of the United States considered the economic interest question with regard to coal stripping contractors.

In Paragon Jewel Coal Co., Inc. v. Commissioner, 380 U.S. 624 (1965), Ct. D. 1896, 1965-2 C.B. 175, the Supreme Court of the United States held that the contractor had no depletable interest, because, "* * * the right to mine even to exhaustion, without more, does not constitute an economic interest under Parsons * * *" and the contractor looked to the personal covenant of the sublessee, not to the sale of the coal, for a return on its investment.

The Supreme Court in the Parsons and Paragon Jewel cases set forth two essential criteria of an economic interest for coal mining contractors: (1) the interest of the contractor must not be terminable at will or upon short or nominal notice and (2) the contractor must look for his compensation solely to the extraction and sale of the mineral.

Since in this case the joint venture leases the coal deposit under a nonterminable lease for 16 years and the joint venture looks for its compensation solely to the extraction and sale of the coal, the joint venture has met these two essential criteria for determining who has an economic interest in the coal.

Accordingly, in the instant case, the joint venture has an economic interest in the coal deposit, within the meaning of section 1.611-1(b)(1) of the regulations.