Legal Advice Issued by Field Attorneys 20161401F
In a redacted Legal Advice Issued by Field Attorneys (LAFA), IRS has concluded that where a taxpayer that mined minerals and used some of its mined mineral to manufacture certain products, it had to perform two Code Sec. 613 percentage depletion allowance calculations: one for the mineral it sold to a large buyer and other smaller buyers, and one for the rest that it processed and manufactured before selling (which should be calculated based on the representative market or field price (RMFP)).
Background. Under Code Sec. 611, a taxpayer is allowed a deduction for depletion in the case of mines and other natural deposits. The percentage depletion rate allowed for the mineral at issue is 5% of gross income from the property. (Code Sec. 613(b)(6)) In the case of mineral property other than oil and gas, “gross income from the property” means gross income from mining and is the amount of income that is attributable to the extraction of minerals from the ground and the application of mining processes, including mining transportation. (Reg. § 1.613-4(a))
The regs provide three methods of determining gross income from the property for purposes of the percentage depletion allowance. Under the first method, gross income from the property is the amount for which the crude mineral product is sold as it emerges from the mine before application of any non-mining processing or transportation. (Reg. § 1.613-4(b))
Under the second method, if the taxpayer processes its mineral by application of a non-mining process or uses it in its operations, then the RMFP determines gross income. (Reg. § 1.613-4(c)(1)) The RFMP must be determined by reference to prices received from the actual sale of a mineral product of like kind and grade. (Reg. § 1.613-4(c)(2)) Weighted averages of competitive selling prices of minerals similar to the taxpayer’s, while not determinative, are an important factor in calculating the RMFP. (Reg. § 1.613-4(c)(3)) Exceptional, insignificant, unusual, tie-in, or accommodation sales are to be disregarded. (Reg. § 1.613-4(c)(3)) And discounts are to be subtracted from the sale price in computing RMFP under any method of computing the depletion allowance. (Reg. § 1.613-4(e)(1))
The third method, the proportionate profits method (PPM), applies if it is impossible to determine RMFP. Under the PPM, the taxpayer calculates gross income by multiplying gross sales of the first marketable product resulting from processing by a fraction that considers the costs and proportionate profits attributable to the processing. (Reg. § 1.613-4(d)(4)(i), Reg. § 1.613-4(d)(4)(ii))
If the above three methods can’t be used, the taxpayer is to use any method that clearly reflects income. (Reg. § 1.613-4(d))
In Gray Knox Marble Company v. U.S., (E.D. Tenn. 1966) 257 F. Supp. 632, the taxpayer was required to use the PPM because there was no RMFP. Other miners besides the taxpayer sold quarry block made by the taxpayer in such small quantities that their price could not be considered representative, and the taxpayer itself sold product in such small quantities that its sales could not be considered as being representative.
Facts. Taxpayer Corporation (Taxpayer) mined mineral and was entitled to a depletion allowance under Code Sec. 611, as computed under Reg. § 1.613-4. Taxpayer used some of its mined mineral to manufacture certain products (“manufactured mineral”), and sold the rest to a large buyer and to other smaller ones.
Taxpayer used the RMFP for a number of years, but decided it could not use it anymore and changed to the PPM. Taxpayer felt that certain of its sales of mineral were not a representative field price because of a volume (or other) discount, and other sales of mineral to others were too insignificant to be representative. Taxpayer manufactured products with most of its mined mineral, for which a “price” does not exist.
In calculating gross income for purposes of the percentage depletion deduction for minerals, Taxpayer used a price per pound based on the median of Taxpayer’s “published rate cards for mineral sales to third parties” in the two preceding years.
In its notice of proposed adjustment, the IRS examiner assumed that the Taxpayer was using the RMFP method of calculating gross income and redetermined the applicable price per pound under the RMFP based on an arithmetic weighted average of all third-party sales, including the price paid by paid by the large buyer and the price paid by all others.
Taxpayer disagreed with the examiner’s method of calculation on the ground that all sales to third parties were insignificant in comparison to the total amount of Taxpayer’s mined mineral, and thus couldn’t be indicative of true market price. In addition, Taxpayer insisted that certain of its mineral sales were “tied-in, exceptional and unusual,” and that as such those sales couldn’t be considered as evidence of market price under the RPFM. Taxpayer also argued that the PPM method of computing gross income demonstrated an alternative, close connection to the sales prices for third parties. Applying the PPM, Taxpayer now argues that a higher per-pound sale price was appropriate, resulting in an additional depletion deduction.
LAFA’s conclusion. In the LAFA, IRS rejected the suggestion that one percentage depletion-allowance calculation should be performed for the mineral used to manufacture products and the sold mineral. IRS determined that because an actual sale price exists for some but not all of the mineral, two calculations had to be performed.
IRS found that in Gray Knox Marble Company, the court agreed that under the first rule set out in the regs, the actual sale price of the material sold represented the gross income from that property. There, the court followed the rule in the regs that if the taxpayer sells the mineral product, gross income from the property means the amount for which it is sold. This established gross income and the percentage depletion deduction for the mineral sold to the large buyer and others.
IRS determined that the use of a weighted average of the two prices (i.e., the large buyer and the smaller buyers) demonstrated that calculating an RMFP wasn’t impossible. Gray Knox Marble Company did not support Taxpayer’s position for use of the PPM. Unlike there, Taxpayer did not sell a small quantity of mineral. And under the regs, the fact that a volume discount was applied didn’t prevent this from being a representative market or field price. (IRS also noted that the sales agreements did not actually show any evidence of an “unusual,” “tie-in,” or “accommodation” arrangement; these were only mentioned in Taxpayer’s response to an information request.)
Further, in Gray Knox Marble Company, the mineral sought to be compared to the mineral being mined wasn’t the same mineral, but was rather a mineral of a like kind or grade. In Taxpayer’s case, the subject mineral being evaluated for the RMFP was the very mineral Taxpayer was selling. This makes the argument that Taxpayer’s sale price was representative more compelling. IRS also characterized as illogical Taxpayer’s argument that the amounts of mineral sold were small in comparison to the amounts it used in its own manufacturing business. Just because Taxpayer used more mineral in its own business than it sold did not mean the amount sold was insignificant. The test was “market or field price”; amounts of mineral that did not enter the market and had no field price shouldn’t be considered as having any bearing on the RMFP, but if enough was sold on the open market to establish a field price, that should settle the matter.
Where Taxpayer did not sell the mineral, but rather used it in its own manufacturing business, IRS concluded that Taxpayer couldn’t use the first rule. Thus, the question was whether the RMFP, the second rule, applied. Under the regs, the criterion that a mineral (i.e., the mineral that is sold) is of like kind and grade as the taxpayer’s mineral (as actually processed by the taxpayer) is whether, in common commercial practice, that mineral is sufficiently similar in chemical, mineralogical or physical characteristics to the taxpayer’s ore or mineral that it used or is commercially suitable for use, for the same purposes as the uses to which the taxpayer’s mineral is put. The taxpayer’s own actual sales of minerals of like kind or grade are to be considered, if determined to be representative, in determining the RMFP. Accordingly, IRS considered Taxpayer’s actual mineral sales for its analysis. IRS noted that in examining the IRS agent’s use of an arithmetic weighted average for determining the market price, the weighted average the agent used was not of ores or minerals of like kind or grade, but was of the actual mineral in question, and of the ones Taxpayer itself actually sold. IRS concluded that while this perhaps didn’t make it determinative, it should give it some weight.
Because it is possible to arrive at a RMFP, Taxpayer was incorrect in saying that it could rely on the PPM either to support its original reporting position or to support an increased percentage depletion deduction.