Rev. Rul. 86-81

1986-1 C.B. 249, 1986-24 I.R.B. 12.

PERCENTAGE DEPLETION; GROSS INCOME FROM MINING

Published: June 16, 1986

26 CFR 1.613-4: Gross income from the property in the case of minerals other than oil and gas. (Also Sections 611, 631, 1.613-1, 1 .631-3).

  Percentage depletion; gross income from mining. If a lessor purchases extracted mineral from a lessee and applies section 614(c)(4)(A) of the Code processes to the mineral before reselling it at a profit, the proceeds are not considered gross income from mining and, therefore, are not subject to depletion.

ISSUE

  If (1) the owner of coal properties purports to lease those properties to an operator-lessee in exchange for royalties equal to a reasonable percentage of sales proceeds of the coal mined, (2) the operator-lessee agrees to follow the owner-lessor's engineering plans for the mining operation, and (3) the owner- lessor retains an option to purchase, at the then-prevailing fair market price, the unprocessed coal so mined, then what is the property tax treatment of the owner lessor's income from that transactions when the owner- lessor applies section 613(c)(4)(A) processes to that coal prior to its resale at a profit?

FACTS

  W, a lessor of coal properties located in the United States, leased a part of those coal properties to Z, a coal operator. Z, as lessee, has the exclusive right to mine coal for a specified period of years of until the designated coal reserves are exhausted. Under the terms of the lease, Z is required to follow plans, maps, and projections for the mining and operation of the coal properties as provided by W's engineer. Z's obligation to follow the plans, maps, and projections assures W that extraction will not be done in a manner that renders unextractable an unnecessarily large portion of the mineral in place. At the option of W, failure by Z to follow these plans, maps, and projections will result in either: (1) payment of the 'royalty' on any coal that was not mined because of this failure and that is deemed 'lost' by W, or

(2) cancellation of the lease.

  W will receive two 'royalty' payments that are dependent upon the extraction of the coal. These royalty payments are described as a production royalty of

10x percent of the amount Z receives for the coal, and an engineering royalty of x percent of the amount Z receives for the coal, which is to compensate W for the plans, maps, and projections provided by its engineer. Both royalties are reasonable in amount.

  Z agrees to sell all coal mined to W and will deliver the coal to W's tipple as directed by W. Z may sell coal to others on such days that W cannot accept coal mined. W purchases the coal from z at prevailing 'market ramp prices,' a fair market price for coal extracted as it comes for the mine. W will further process the coal by applying only the processes named in section 613(c)(4)(A) of the Internal Revenue Code. After application of these processes, W is able to sell the cleaned coal at a price greater than the 'market ramp price' received by Z.

LAW AND ANALYSIS

  Section 611(a) of the Code allows a reasonable deduction for depletion in computing taxable income. Section 611(b)(1) provides that in the case of a lease, the deduction must be equitably apportioned between the lessor and lessee.

  Section 1.611-1(b)(1) of the Income Tax Regulations provides that the depletion deduction shall be allowed only to the owner of an economic interest in mineral deposits.

  Section 613(b) of the Code provides a depletion allowance for coal mines of

10 percent of the gross income from the property, excluding from the gross income from the property, excluding from the gross income an amount equal to any returns or royalties paid or incurred by the taxpayer in respect of the property. With respect to coal, section 613(c)(1) defines gross income from the property as the gross income from mining. In the case of coal, section

613(c)(4) provides that cleaning, breaking, sizing, dust allaying, treatment to prevent freezing, and loading for shipment shall be considered as mining where

applied by the mine owner or operator to the ore or mineral in respect of which he is entitled to a deduction for depletion under section 611.

  Section 631(c) of the Code provides that in the case of the disposal of coal mined in the United States, held for more than 6 months before disposal, by the owner under any form of contract by which the owner retains an economic interest in the coal, the difference between the amount realized from the disposal of the coal and the adjusted depletion basis plus the deductions disallowed for the tax year under section 272 shall be considered as though it were a gain or loss, as the case may be, on the sale of the coal. The owner is not entitled to the allowance for percentage depletion provided in section 613 with respect to the coal. The term 'owner' means any person who owns an economic interest in coal in place, including a sublessor. However, this subsection specifies that it shall not apply to income realized by an owner as a co-adventurer, partner, or principal in the mining of the coal.

  Before the lease, W as owner of the coal had the right to all income from the extraction and sale of the coal and therefore had an economic interest. Through the lease, W granted to Z right to mine all the coal for a specified term or to exhaustion. Z is to dispose of the extracted but unprocessed coal by transferring it to W at a fair market price. Therefore, Z shares in income from the extraction of the coal and has acquired an economic interest in the coal in place. W has retained as its economic interest the right to receive royalties based upon production because the production royalty for the coal and the engineering royalty for the engineering services are payable only if coal is produced and the amount of such royalties is related to the value of the coal produced.

  Although the agreement provides that W is to receive from Z all the extracted coal and is to subject such coal to processes name in section 613(c)(4)(A) of the Code, these processes should not be treated as mining processes because W is not the 'mine owner or operator' when it processes the coal. The substance of the agreement must prevail over its form. See Rev. Rul. 74-568, 1974-2 C.B.

183. Here, in substance, W had not retained an interest in the coal other than W's royalty interests; rather, W through the lease has disposed of its entire interest in the coal in return for retained royalty interests, and has also agreed to purchase from Z the coal extracted under the lease.

  Helvering v. Bankline Oil Co., 303 U.S. 362 (1938), 1938-1 C.B. 306, established that a taxpayer who merely has the benefit of purchasing or processing minerals does not have an economic interest in the minerals. Since W

acquires no economic interest in the coal it purchases from Z, W is entitled to no depletion deduction with respect to income derived from its processing of the coal.

  Rev. Rul. 74-469, 1974-2 C.B. 177, is distinguishable. To be sure, that ruling involves a similar fact situation in that the party who grants to another the right to extract minerals also processes the extracted minerals. In that ruling, however, the taxpayer-grantor did not retain a royalty interest to compensate it for granting the right to extract the minerals. Rather, both the taxpayer that granted the right to extract minerals and the taxpayer who received such right directly shared in the ultimate sales price of the processed mineral. In contrast, here W and  and Z do not share in the sales price of the coal because Z sells the extracted coal to W for its fair market value. Except for W's royalty interests, only Z shares in the risks of fluctuations in the value of coal in place. In purchasing the extracted but unprocessed coal from Z, W is no different than any other purchases of extracted coal .

  The next question is whether income received by W is subject to treatment under section 631(c) of the Code as capital gain or loss. Clearly, W was the owner of the coal before entering into the agreement with Z, and it retained as its economic interest the right to production and engineering royalties. Accordingly, W should receive section 631(c) treatment unless it is deemed to be a co- adventurer, partner, or principal in the mining of the coal.

  The purpose of denying section 631(c) treatment to a co- adventurer, partner, or principal in the mining of coal is to distinguish between the passive interest of a lessor who retains an economic interest and the direct interest of a participant in the operation of a mine who shares in the risk and control of the venture. See Rev. Rul. 73-33, 1973-1 C.B. 307.

  Because W does not process the extracted coal as a mine owner or operator but is instead a purchaser of the coal who applies nominating processes, W's processing of the coal does not constitute a sharing in the risk and control of the mining operation. Therefore, W's processing of the coal does not affect its right to treat its royalty income under section 631(c). W's providing plans, maps, and projections, which Z is to follow in mining the coal, raises the question of whether W had such risk and control of the mining operation as to warrant treating it as a coadventurer, partner, or principal in the mining of coal.

  The engineering services here, in the form of plans, maps, and projections, are designed to afford W some safeguard that the property will be developed acccording to the plans; in this case they are merely incidental to the extraction of the coal and, as such, do not make w a direct participant as a co-adventurer, partner, or participant in the mining operation. Under the lease agreement. W is entitled to a production royalty of 10x percent of the amount Z receives for the coal and an engineering services royalty of x percent of the amount Z receives for the coal. The x percent is reasonable compensation for the incidental engineering services that are part and parcel of the lease itself. Therefore, considering the lease as a whole, amounts received under it as production royalties and engineering royalties should receive section 631(c) treatment.

HOLDING

  Because W is not a principal in the mining of coal, W is entitled to capital gains treatment under section 631(c) of the Code on both the production royalties and the engineering services royalties. The income derived by W from the resale of coal purchased from Z is not income from mining and consequently not subject to depletion.

Rev. Rul. 86-81, 1986-1 C.B. 249, 1986-24 I.R.B. 12.