Internal Revenue Service
Revenue Ruling

TaxLinks.com   sm

 Rev. Rul. 77-57

1977-1 C.B. 166

Section 613

IRS Headnote

Depletion; breach of contract settlement. Amounts received in settlement of a breach of contract suit by a mineowner from a purchaser who refused to accept delivery of the mineral extracted from the mine, thereby forcing the mine-owner to sell the mineral at a lower price, are not includible in gross income from mining for purposes of computing the percentage depletion under section 613 of the Code.

Full Text

Rev. Rul. 77-57

Advice has been requested whether, under the circumstances described below, the amount received in settlement of a breach of contract suit is includible in the taxpayer's gross income from mining for the purpose of computing percentage depletion pursuant to section 613 of the Internal Revenue Code of 1954.

In 1972, X entered into a contract with Y, an unrelated purchaser of mineral mined from X's mines. The contract provided for the purchase and delivery to Y of a specified percentage of X's production for 3 years. Y accepted delivery of the mineral for the first 18 months of the contract. After that, Y refused to accept any further delivery of the mineral from X. Consequently, during the balance of the contract term the mineral refused by Y was sold by X after the application of only mining processes. These latter sales to other unrelated purchasers were at arm's-length negotiated prices but were lower than the price specified in the contract with Y.

As a result of the lower prices received on the sales to others, X sued Y for breach of contract and was awarded damages. By compromise X agreed to accept 15x dollars in settlement of its claim against Y. The amount received from the sale of the mineral, 75x dollars, plus 15x dollars settlement was 90x dollars, which was 10x dollars less than the price originally specified in the contract with Y. X reported the total amount, 90x dollars, as gross income from mining in its Federal income tax returns.

Section 611(a) of the Code provides that in the case of mines there shall be allowed as a deduction in computing taxable income a reasonable allowance for depletion according to the peculiar circumstances in each case, made under regulations prescribed by the Secretary or the Secretary's delegate.

Section 613(a) of the Code provides, in part, that in the case of mines, the depletion allowance shall be based upon a percentage, specified in section 613(b), of the gross income from the property, excluding any rents or royalties paid or incurred with respect to such property. Such allowance shall not exceed 50 percent of the taxable income from the property (computed without allowance for depletion).

Section 613(c)(1) of the Code defines the term "gross income from the property," in the case of a property other than an oil or gas well, as the gross income from mining.

Section 1.613-4(a) of the Income Tax Regulations defines the term "gross income from mining" as that amount of income attributable to the extraction of ores or minerals from the ground and the application of mining processes, including mining transportation. This statement is amplified in subdivisions (i) and (ii) of section 1.613-4(b)(1), which provide that gross income from mining is the actual amount for which the ore or mineral is sold prior to the application of nonmining processes with the exception of nonmining transportation as provided in section 1.613-4(g)(2).

In Guthrie v. United States, 323 F. 2d 143 (6th Cir. 1963), the United States Court of Appeals for the Sixth Circuit held that proceeds received from business interruption insurance could not be included in gross income from mining and only the amount actually received from the sale of coal could be included. There the court refused to classify insurance proceeds received in lieu of coal sales proceeds as sales proceeds and therefore held that they were not includible in gross income from mining. The actual proceeds from the sale of coal were lower because a fire had destroyed facilities that could have increased the value of the coal by application of additional mining processes.

In contrast, Amherst Coal Co. v. United States, 295 F. Supp. 421 (S.D. W.Va. 1969), aff'd per curiam, Nos. 14,257-14,260 (4th Cir. 1971), held that an amount received in settlement of a suit for damages resulting from a breach of contract to purchase coal was to be included in gross income from mining.

The Supreme Court of the United States, in interpreting the predecessor to section 613 of the Code, defined narrowly the term "gross income from the property". In Helvering v. Mountain Producers Corp., 303 U.S. 376, 382 (1938), 1938-1 C.B. 343, it was held that the courts cannot fashion a "theoretical gross income" for depletion purposes, but are limited to a consideration of the actual sale price.

Where the asset which is the subject of the sales contract has not been transferred, settlement proceeds are not sales proceeds. The Tax Court of the United States in Gerald Melone, 45 T.C. 501, 507 (1966), held that damages received by a seller from an action for breach of a land sale contract are not sales proceeds since no exchange takes place. See also Harold S. Smith, 50 T.C. 273, 279-80 (1968), aff'd per curiam, 418 F.2d 573 (9th Cir. 1969); Binns v. United States, 254 F. Supp. 889, 891 (M.D. Tenn. 1966), aff'd per curiam, 385 F.2d 159 (6th Cir. 1967).

In the instant case, the income received by X was the result of the settlement of a breach of contract suit against Y and, not income received with respect to a sale of minerals.

Accordingly, in the instant case, the amount received in settlement of the breach of contract suit by X is not includible in gross income from mining for the purposes of computing percentage depletion. Gross income from mining in the instant case is limited to 75x dollars, the amount of the actual sale price of the mineral.