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Tax Court Upholds IRS's Adjustments to Cement Company's Depletion Deductions

(Parker Tax Publishing September 2017)

The Tax Court held that a cement producer that mined calcium carbonate and mixed it with minerals purchased from third parties was entitled to a 14 percent depletion rate for the calcium carbonate, not the 15 percent rate used by the company. The court also held that the purchased minerals were nonmining costs for purposes of calculating the company's gross income. Mitsubishi Cement Corp. v. Comm'r, T.C. Memo. 2017-160.

Mitsubishi Cement, a Delaware corporation that has its principal place of business in Nevada, mines calcium carbonates in the process of its primary business activity of producing finished cement. It also purchases from third parties other minerals needed for the production of cement. The purchased minerals are added to the mined calcium carbonates before the mixture is introduced into a preheating tower. Mitsubishi Cement's direct mining costs for 2011 and 2012, the years at issue, were around $9.4 million and $10 million, respectively. Mitsubishi Cement claimed depletion deductions under Code Sec. 611 of approximately $1.3 million for 2011 and $1.8 million for 2012 using the percentage depletion method in Code Sec. 613. The company calculated its gross income from mining using the proportionate profits method of Reg. Sec. 1.613-4(d)(4) and used a percentage depletion rate of 15 percent under Reg. Sec. 1.613-2(a)(3).

In 2015, the IRS sent a notice of deficiency disallowing a portion of the depletion deductions for 2011 and 2012. The IRS said that the correct percentage depletion rate was 14 percent under Code Sec. 613(b)(7). It also claimed that in determining the depletion deduction, Mitsubishi Cement had incorrectly computed its gross income from mining by including the costs of minerals purchased from third parties in calculating its mining costs.

The depletion deduction for mining is calculated under Code Sec. 613 as a percentage of the mine's gross income. The percentage depletion rates for specific minerals are listed in Code Sec. 613(b), and these rates are applied to the taxpayer's gross income from mining to determine the depletion allowance. Code Sec. 613(b)(7) provides that the rate for calcium carbonate is 14 percent. However, Reg. Sec. 1.613-2(a)(3) provides that 15 percent is the applicable rate for calcium carbonate. In calculating gross income, a mining company that also has nonmining activities (for example, the manufacture of finished products) must separate its income from the mining and nonmining activities and apply the depletion rate only to the mining gross income. Under the proportionate profits method, the taxpayer determines the ratio of its mining costs to its total costs incurred to produce its first marketable product, then applies this ratio to its total gross sales to determine the gross income from mining. The depletion percentage rate is then applied to the mining gross income amount to determine the depletion allowance.

In applying the 15 percent rate in the regulations instead of the 14 percent rate in Code Sec. 613(b), Mitsubishi Cement argued that the regulation is an agency pronouncement that should be deemed a concession or stipulation by the IRS. With respect to the calculation of its mining costs, the company argued that the costs of third party minerals should be included because they qualified as a treatment process applied to the calcium carbonate that the company mined. Mitsubishi Cement argued that, if the purchased minerals were not mining costs, they should be considered "nominating costs" under Reg. Sec. 1.613-4(d)(3)(ii) and excluded entirely from the proportionate profits formula.

The Tax Court rejected Mitsubishi Cement's arguments and held that the 14 percent depletion rate applied and that the cost of purchased minerals was a nonmining cost that should be included in Mitsubishi Cement's total costs. Regarding the depletion percentage rate, the Tax Court resolved the conflict between the regulations and the statute by noting that the regulation was drafted in 1960, when the statutory rate was 15 percent. In 1969, Congress amended Code Sec. 613 to reduce the applicable rate to 14 percent. According to the Tax Court, the regulation was effectively superseded and made obsolete by the statutory change and could not be regarded as an implementing regulation. The court further observed that in any event, an agency's interpretation of a statute cannot supersede the language chosen by Congress.

In determining that the cost of purchasing minerals from third parties was a nonmining cost, the Tax Court noted that under Reg. Sec. 1.611-1(b)(1), a depletion deduction is permitted only to the taxpayer who has an economic interest in the mineral in its unmined state. According to the court, a taxpayer that purchases a mineral mined or otherwise produced by another may gain some economic advantage in the mineral but has no depletable interest in it. Moreover, the regulations concerning the calculation of mining gross income for percentage depletion purposes specifically provide that mining does not include purchasing minerals from another, and that the application of processes to purchased minerals does not constitute mining. The fact that the third party minerals are added to the calcium carbonates early in the process of making cement ignored the fact that Mitsubishi Cement never had a depletable interest in the purchased minerals, according to the court. In any case, depletion allowances must be calculated separately for individual mineral properties combined in a mixture, in the court's view.

The Tax Court also rejected Mitsubishi Cement's argument that the purchased minerals qualified as "nominating costs" under Reg. Sec. 1.613-4(d)(3)(ii). The Tax Court determined that "nominating" is a typographical error, as it is not defined in the context of the depletion Code sections and appears nowhere else in Reg. Sec. 1.613-4, and is simply a misspelling of "nonmining." The costs of the purchased minerals were nonmining costs paid to produce Mitsubishi Cement's first marketable product. As such, these costs had to be included as part of the total costs in computing Mitsubishi Cement's gross income from mining under the proportionate profits method.

For a discussion of percentage depletion for mines and other natural deposits, see Parker Tax ¶95,335.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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