Rev. Rul. 87-60

1987-2 C.B. 154, 1987-28 I.R.B. 9.

PERCENTAGE DEPLETION

Published: July 13, 1987

Section 613.-Percentage Depletion, 26 CFR 1.614-4: Gross income from the property in the case of minerals other than oil and gas

(Also Section 1502; 1.1502-13.)

  Percentage depletion. If the payor-lessee of a mineral property pays a royalty and uses all of the mined mineral in the manufacture of depreciable property, and the payor-lessee and the payor-lessor of the royalty file a consolidated income tax return, the payee-lessor's depletion deduction is taken when the royalty income is reportable in its separate taxable income. Rev. Rul. 74-10 clarified and distinguished.

ISSUE

  If the payor-lessee of a mineral property (X) pays a royalty, the payor- lessee uses all of the mined mineral in the manufacture of depreciable property, and the payor-lessee and the lessor-payee of the royalty (Y) file a consolidated income tax return, then is the lessor- payee's depletion deduction with respect to the royalty allowable when the royalty is received or is it allowable as the payor-lessee depreciates the property manufactured from the mineral?

FACTS

  X is a regulated public utility engaged in the production and sale of nuclear

generated electricity and Y is a corporation owning properties that contain deposits of uranium minerals.

  X and Y are affiliated companies that file consolidated income tax returns using the accrual method of accounting. X and Y operate as separate entities.

  Under an arm's-length agreement having a valid business purpose, Y conveyed to X the operating mineral rights in a producing mine and other properties considered to have mineral reserves. In return, X agreed to pay Y a royalty of a specific percentage of the fair market value of the minerals produced from the mines. The royalty payment from X to Y is payable (and was paid) in the year the minerals were produced. Under this agreement X and Y each have an economic interest in the mineral properties.

  The uranium minerals produced under the royalty agreement are manufactured into uranium pellets by X for use as nuclear fuel elements in X's nuclear reactors for generating electricity. Payment by X of the royalty is charged to a capital account that becomes part of the depreciable basis in the manufactured nuclear fuel elements used by X.

LAW AND ANALYSIS

  Section 613(a) of the Internal Revenue Code provides an allowance for depletion based on a percentage of gross income from mining. This allowance shall not exceed 50 percent of the taxpayer's taxable income from the property computed without allowance for depletion.

  Section 1.613-2(c)(5)(i) of the Income Tax Regulations provides that any rents or royalties representing depletable income to the payee that are paid or incurred by the taxpayer in respect of the property shall be excluded in determining the 'gross income from the property.'

  Rev. Rul. 68-565, 1968-2 C.B. 263, states the general rule that the time for taking the deduction for depletion by a lessor of mineral property is the taxable year in which the lessor reports income from the leased property. See also Rev. Rul. 76-533, 1976-2 C.B. 189; Rev. Rul. 67-303, 1967-2 C.B. 221. Thus, Y may claim the depletion deduction for the taxable year in which the income from the royalty is property reported.

  Section 1.1502-13(a)(l)(i) of the regulations provides that, with certain exceptions not here relevant, the term 'intercompany transaction' means a transaction during a consolidated return year between corporations that are members of the same group immediately after such transaction.

  Section 1.1502-13(a)(2) of the regulations provides that the term 'deferred intercompany transaction' means (i) the sale or exchange of property, (ii) the performance of services in a case where the amount of the expenditure for such services is capitalized, or (iii) any other expenditure in a case where the amount of the expenditure is capitalized, in an intercompany transaction.

  Section 1.1502-13(c)(1)(i) of the regulations provides that, to the extent gain or loss on a deferred intercompany transaction is recognized under the Code for a consolidated return year, such gain or loss shall be deferred by the selling member (hereinafter referred to as 'deferred gain or loss').

  Section 1.1502-13(c)(1)(ii)(b) of the regulations provides that, with respect to the deferral of gain or loss on a deferred intercompany transaction, a selling member shall take into account the gain or loss on a deferred intercompany transaction in accordance with the provisions of sections 1.1502- 13(d), (e), and (f), notwithstanding that such selling member, under its method of accounting, would not otherwise recognize such gain or loss until a later taxable year.

  Section 1.1502-13(d)(l)(i) of the regulations provides, as a general rule, that if property (including a capitalized expenditure for services or any other capitalized expenditure) acquired in a deferred intercompany transaction is, in the hands of any member of the group, subject to depreciation, amortization, or depletion, then, for each taxable year (whether consolidated or separate) for which a depreciation, amortization, or depletion deduction is allowed to any member of the group with respect to such property, a portion (as determined under section 1.1502-13(d)(1)(ii)) of the deferred gain or loss attributable to such property shall be taken into account by the selling member.

  Rev. Rul. 74-10, 1974-1 C.B. 251, considered the issue of whether the payment of a coal royalty by one member of an affiliated group which filed a consolidated return to another member of that group was a deferred intercompany transaction. Under the facts of the ruling, 'the royalties paid by [the lessee were] a reduction of [the lessee's] gross income from mining and [were] not capitalized. . . .' 1974-1 C.B. at 252. The ruling held that the transaction was not a deferred intercompany transaction because the royalties paid by the lessee were not capitalized.

  Rev. Rul. 72-507, 1972-2 C.B. 198, clarified by Rev. Rul. 74-237, 1974-1 C.B. 70, states that expenditures for nuclear fuel assemblies (that is, the composite of fabricated nuclear fuel and container) are capital expenditures subject to an allowance for depreciation under section 167 of the Code.

  The royalty agreement between X and Y is within the meaning of an  'intercompany transaction' since a consolidated return was filed and X and Y were members of the same group immediately after the transaction. See Rev. Rul. 74-10, which held that such a transaction and payment is an intercompany transaction within the meaning of section 1.1502-13(a)(1) of the regulations.

  The expenditures by X are for the manufacture of nuclear fuel elements, and those expenditures were properly capitalized. See Rev. Ruls. 72-507 and 74-237. Therefore, the transactions are 'deferred intercompany transactions' under section 1.1502-13(a)(2) of the regulations. Rev. Rul. 74-10 is distinguishable because in that case the royalty payment was not capitalized by the payor.

  In a deferred intercompany transaction, any gain or loss on the transaction is deferred from the time it would otherwise be reported by the selling member under its method of accounting. The deferred gain or loss is taken into account ('restored') in accordance with the provisions of sections 1.1502- 13(d), (e), or (f) of the regulations, which describe various 'restoration events.' Under section 1.1502-13(d)(1), if in any taxable year a member of the group is allowed depreciation with respect to property acquired in a deferred intercompany transaction, then a portion of the deferred gain or loss is taken into account in that year by the selling member.

  In the present case, Y (the 'selling member') has recognized royalty income when the income is received or the right to payment arises. However, because the transaction that gives rise to the royalty is a deferred intercompany transaction, the income is deferred under section 1.1502-13(c) of the regulations. Under section 1.1502- 13(d)(1), the royalty is taken into income by Y when depreciation is taken by X (the 'purchasing member') on the

manufactured mineral product. Therefore, Y is entitled to take depletion with respect to that royalty only when the royalty income is taken into income. See Rev. Rul. 68-565.

HOLDING

  Y cannot deduct the depletion allowance at the time X pays the royalty. The depletion deduction is to be taken at the time the royalty income is reportable in Y's separate taxable income.

EFFECT ON OTHER REVENUE RULINGS

  Rev. Rul. 74-10 is clarified and distinguished.

Rev. Rul. 87-60, 1987-2 C.B. 154, 1987-28 I.R.B. 9