but not sold) plus the "number of units sold within the taxable year" as defined in this section. In determining the amount of the basis as adjusted applicable to the mineral deposit there shall be excluded (a) amounts representing the cost or value of the land for purposes other than mineral production, (b) the amount recoverable through depreciation and through deductions other than depletion, and (c) the residual value of other property at the end of operations, but there shall be included, in the case of oil and gas wells, those amounts of capitalized drilling and development costs which, as provided in § 9.23 (m)-16, are recoverable through depletion. In the case of a natural gas well where the annual production is not metered and is not capable of being estimated with reasonable accuracy, the taxpayer may compute the depletion allowance (without reference to percentage depletion) in respect of such property for the taxable year by multiplying the adjusted basis of the property by a fraction, the numerator of which is equal to the decline in closed or rock pressure during the taxable year and the denominator of which is equal to the expected total decline in closed or rock pressure from the taxable year to the economic limit of production. Taxpayers computing depletion by this method must keep accurate records of periodical pressure determinations.*+ With respect to any property for which discovery value is the taxpayer's basis for depletion, the depletion for any taxable year shall be computed by (1) adding to the discovery value of the mineral deposit in the property any subsequent allowable capital additions made by the taxpayer, (2) subtracting the aggregate of depletion deductions with respect to the property which would previously have been allowable to the taxpayer without the application of any net income limitation, (3) dividing the remainder by the number of units of mineral remaining as of the taxable year, and (4) multiplying the depletion unit, thus determined, by the number of units of mineral sold within the taxable year. The depletion allowance based on discovery value under this article shall not exceed 50 percent of the net income of the taxpayer (computed without allowance for depletion) from the property upon which the discovery was made, except that in no case shall the depletion be less than it would be if computed without reference to discovery value. For definition of "net income of the taxpayer (computed without allowance for depletion) from the property," see § 9.23 (m)-1 (h). This section does not apply to metal mines, coal mines, sulphur mines or deposits, or to oil or gas wells. units with respect to which depletion deductions were allowed or allowable prior to the taxable year. As used in this section the phrase, "number of units sold within the taxable year," in the case of a taxpayer re§ 9.23 (m)-3 Computation of deple- porting income on the cash receipts and tion of mines (other than metal, coal, disbursements basis, includes units for or sulphur mines) on the basis of dis- which payments were received within the covery value. The basis upon which de- taxable year although produced and sold pletion is to be computed in the case prior to the taxable year, and excludes of mines (other than metal, coal, or units sold but not paid for in the taxsulphur mines) discovered by the tax-able year. The phrase does not include payer after February 28, 1913, is the fair market value of the property at the date of discovery or within 30 days thereafter, if such mines were not acquired as the result of purchase of a proven tract or lease, and if the fair market value of the property is materially disproportionate to cost. The value must be equitably apportioned between the lessor and the lessee. For the method of determining whether a discovery has been made, see § 9.23 determining the fair market value, see § 9.23 (m)-7. (m)-14. For the method of "The number of units of mineral re maining as of the taxable year" is the number of units of mineral remaining at the end of the year to be recovered from the property (including units recovered but not sold) plus the "number of units sold within the taxable year" as defined in this section.*† § 9.23 (m)-4 Computation of depletion based on a percentage of income in the case of oil and gas wells. Under after December 31, 1937) for which he section 114 (b) (3), in the case of oil has any item of income or deduction and gas wells, a taxpayer may deduct with respect to such property. An elec. for depletion an amount equal to 271⁄2 tion once exercised under section 114 (b) percent of the gross income from the (4) and this section of the regulations property during the taxable year, but cannot thereafter be changed by the taxsuch deduction shall not exceed 50 per- payer, and the depletion allowance in recent of the net income of the taxpayer spect of each such property will for all (computed without allowance for deple- succeeding taxable years be computed in tion) from the property. (For defini- accordance with the election so made. tions of "gross income from the prop- If the taxpayer fails to make such stateerty" and "net income of the taxpayer ment in the return in which the election (computed without allowance for deple- should be so indicated, the depletion tion) from the property," see § 9.23 allowance for the year for which an (m)-1 (g) and (h).) In no case shall election must be first exercised and for the deduction computed under this arti- all succeeding taxable years will be comcle be less than it would be if computed puted without reference to percentage upon the cost or other basis of the prop- depletion. The method, determined erty provided in section 113.*† under section 114 (b) (4) and this section of the regulations, of computing the depletion allowance shall be applied in the case of the property for all taxable years in which it is in the hands of such taxpayer, or of any other person if the basis of the property (for determining gain) in his hands is, under section 113, determined by reference to the basis in the hands of such taxpayer, either directly or through one or more substituted bases, as defined in that section. The right of election specified in this paragraph is subject to the qualification that section 114 (b) (4) shall, for the purpose of determining whether the method of computing the depletion allowance follows the property, be considered a continuation of section 114 (b) (4) of the Revenue Act of 1934 and the Revenue Act of 1936, and as giving no new election in cases where either of such sections would, if applied, give no new election.*† § 9.23 (m)-5 Computation of depletion based on a percentage of income in the case of coal mines, metal mines, and sulphur mines or deposits. Under section 114 (b) (4) a taxpayer may deduct for depletion an amount equal to 5 percent of the gross income from the property during the taxable year in the case of coal mines, an amount equal to 15 percent of the gross income from the property during the taxable year in the case of metal mines, and an amount equal to 23 percent of the gross income from the property during the taxable year in the case of sulphur mines or deposits, but such deduction shall not in any case exceed 50 percent of the net income of the taxpayer (computed without allowance for depletion) from the property. (For definitions of "gross income from the property" and "net income of the taxpayer (computed without allowance for depletion) from the property," see § 9.23 (m)-1 (g) and (h).) Subject to the qualification specified in the last sentence of this paragraph, a taxpayer making his first return under Title I of the Act (for a taxable year beginning after December 31, 1937) in respect of a property must state as to each such property whether he elects to have the depletion allowance for each such property for the taxable year computed with or without reference to percentage depletion. For the purpose of this section the taxpayer's first return under Title I of the Act in respect of a property is the return made under that title for his first taxable year (beginning § 9.23 (m)-6 Determination of cost of deposits. In any case in which a depletion or depreciation deduction is computed on the basis of the cost or price at which any mine, mineral deposit, mineral right, or leasehold was acquired, the owner or lessee will be required to show that the cost or price at which the property was bought was fixed for the purpose of a bona fide purchase and sale by which the property passed in fact as well as in form to an owner other than the vendor. No fictitious or inflated cost or price will be permitted to form the basis of any calculation of a depletion or depreciation deduction, and in determining whether the price or cost at which any purchase or sale was made represented the actual market value of the property sold, due weight will be given to the relationship or connection existing between the person selling the property and the buyer thereof.*† If the fair market value must be ascertained as of a certain date, analytic appraisal methods will not be used if the fair market value can reasonably be determined by any other method. (b) To determine the fair market value of a mineral property by the present value method, the essential factors must be determined for each deposit included in the property. The factors essential in the case of all mineral deposits are (1) the total operating profit, (2) the rate at which this profit will be obtained, and (3) the rate of interest commensurate with the risk for the particular deposit. In case of oil and gas properties the additional factors are (i) the total quantity of oil and gas in terms of the principal or customary unit (or units) paid for in the product marketed, (ii) § 9.23 (m)-7 Determination of fair market value of mineral properties, including oil and gas properties. (a) If the fair market value of the property at a specified date is to be determined for the purpose of ascertaining the basis for depletion and depreciation deductions, such value must be determined, subject to approval or revision by the Commissioner, by the owner of the property in the light of the conditions and circumstances known at that date, regardless of later discoveries or developments in the property or subsequent improvements the quantity of oil and gas expected to in methods of extraction and treatment of the mineral product. The value sought should be that established assuming a transfer between a willing seller and a willing buyer as of that particular date. The Commissioner will give due weight and consideration to any and all factors and evidence having a bearing on the market value, such as cost, actual sales and transfers of similar properties, market value of stock or shares, royalties and rentals, value fixed by the owner for purpose of the capital stock tax, valuation for local or State taxation, partnership accountings, records of litigation in which the value of the property was in question, the amount at which the property may have been inventoried in probate court, and, in the absence of better evidence, disinterested appraisals by approved methods. Valuations by analytic appraisal methods, such as the present value method, are not entitled to great weight, (1) if the value of a mineral deposit can be determined upon the basis of cost or replacement value, (2) if the knowledge of the presence of the mineral has not greatly enhanced the value of the mineral property, (3) if the removal of the mineral does not materially reduce (c) If the deposit has been sufficiently the value of the property from which it developed the valuation factors specified is taken, or (4) if the profits arising from in paragraph (b) may be determined the exploitation of the mineral deposit from past operating experience. In the are wholly or in great part due to the application of factors derived from past manufacturing or marketing ability of experience full allowance should be made the taxpayer or to extrinsic causes other for probable future variations in the rate than the possession of the mineral itself. of exhaustion, quality or grade of the be recovered during each operating pe- mineral, percentage of recovery, cost of development, production, interest rate, and selling price of the product marketed during the expected operating life of the mineral deposit. Mineral deposits for which these factors may not be determined with reasonable accuracy from past operating experience may also, with the approval of the Commissioner, be valued by the present value method; but the factors must be deduced from concurrent evidence, such as the general type of the deposit, the characteristics of the district in which it occurs, the habit of the mineral deposits in the property itself, the intensity of mineralization, the oil-gas ratio, the rate at which additional mineral has been disclosed by exploitation, the stage of the operating life of the property, and any other evidence tending to establish a reasonable estimate of the required factors. oil and gas wells, see § 9.23 (m)-16. This cost of repairs is not to be confused with the depreciation deduction by which the cost or value of plant and equipment is returned to the taxpayer free from tax. In general, no estimates of these factors will be approved by the the operating experience of the property Commissioner which are not supported by or which are derived from different and arbitrarily selected periods. (e) The number of units of mineral recoverable in marketable form multiplied by the estimated operating profit per unit gives the total expected operating profit. The value of each mineral deposit is, then, the total expected operating profit from that deposit reduced to a present value as of the date as of which the valuation is made at the rate of interest commensurate with the risk for the operating life, and further reduced by the value at that date of the depreciable assets and of the capital ad (d) Mineral deposits of different grades, locations, and probable dates of extraction in a mineral property should be valued separately. The mineral conditions, if any, necessary to realize the tent of a deposit shall be determined in accordance with § 9.23 (m)-9. In lowest in cases where the factors of profits. The degree of risk is generally operating record of the mineral propvaluation are fully supported by the erty prior to the date as of which the attach to appraisals upon any other valuation is made; relatively higher risks basis. (f) For the purpose of the equitable apportionment of depletion between lessor and lessee provided by section 23 (m), when the value of any leased mineral property must be ascertained as of any specific date for the determination of the basis for depletion, the values of the equities of lessor and lessee may be determined separately, but, when determined as of the same date, shall together never exceed the value at that date of the mineral property in fee simple.* † estimating the average grade of the developed and prospective mineral, account should be taken of probable increases or decreases as indicated by the operating history. The rate of exhaustion of a mineral deposit should be determined with due regard to the limitations imposed by plant capacity, by the character of the deposit, by the ability to market the mineral product, by labor conditions, and by the operating program in force or reasonably to be expected for future operations. The operating life of a mineral deposit is that number of years necessary for the exhaustion of both the developed and prospective mineral content at the rate determined as above. The operating life of oil and gas wells is influenced by the natural decline in pres- § 9.23 (m)-8 Revaluation of mineral sure and flow, and also by voluntary or deposits not allowed. No revaluation of enforced curtailment of production. The a property whose value as of any specific operating cost includes all current ex- date has been determined and approved pense of producing, preparing, and mar-will be made or allowed during the conketing the mineral product sold (due con- tinuance of the ownership under which sideration being given to taxes) exclu- the value was so determined and apsive of allowable capital additions as de- proved, except in the case of a subsefined in §§ 9.23 (m)-15 and 9.23 (m)-16 quent discovery of nonmetallic minerand deductions for depreciation and de- als, other than coal, sulphur, oil, or gas, pletion, but including cost of repairs. as defined in § 9.23 (m)-14, or of For definitions of "development expenses" misrepresentation or fraud or gross and "operating expenses" in the case of error as to any facts known on the date The value should be redistributed (a) If a revision of the number of remaining recoverable units of mineral in the property has been made in accordance with section 23 (m) and § 9.23 (m)-9, and as to grade, only as accords with the best indications available as to richness. as of which the valuation was made. Revaluation on account of misrepresentation or fraud or such gross error will If the number of recoverable units of be made only with the written approval mineral in the property have been preof the Commissioner. The value should, viously estimated for the prior year or however, be corrected when a virtual years, and if there has been no known change of ownership of part of the prop-change in the facts upon which the prior erty results as the outcome of litigation. estimate was based, the number of recoverable units of mineral in the property as of the end of the taxable year will be the number remaining from the prior estimate, but when it is ascertained either by the taxpayer or the Commissioner as the result of operations or development work that the recoverable mineral units are materially greater or less than the prior estimate thereof, then such prior estimate shall be revised and the annual depletion allowance with respect to the property for subsequent taxable years will be based upon the revised estimate. Such revised estimate will not, however, affect the basis for depletion.*† (b) In case of the sale of a part of the property, between the part sold and the part retained.*† § 9.23 (m)-9 Determination of mineral contents of mines and of oil or gas wells. If it is necessary to estimate or determine with respect to any property as of any specific date the total recoverable units (tons, pounds, ounces, barrels, thousands of cubic feet, or other measure) of mineral products reasonably known, or on good evidence believed, to have existed in the ground as of that date, the estimate or determination must be made according to the method current in the industry and in the light of the most accurate and reliable information obtainable. In the selection of a unit of estimate preference shall be given to the principal unit (or units) paid for in the product marketed. The estimate of the recoverable units of the mineral products in the property for the purposes of valuation and depletion shall include as to both quantity and grade (a) The ores and minerals "in sight," "blocked out," "developed," or "assured," in the usual or conventional meaning of these terms with respect to the type of the deposit, and (b) "Probable" or "prospective" ores and minerals (in the corresponding sense), that is, ores and minerals that are believed to exist on the basis of good evidence although not actually known to occur on the basis of existing development; but "probable" or "prospective" ores and minerals may be estimated (1) as to quantity, only in case they are extensions of known deposits or are new bodies or masses whose existence is indicated by geological or other evidence to a high degree of probability, and (2) § 9.23 (m)-10 Depletion; adjustments of accounts based on bonus or advanced royalty. (a) If a lessor receives a bonus in addition to royalties, there shall be allowed as a depletion deduction in respect of the bonus an amount equal to that proportion of the basis for depletion as provided in section 114 (b) (1) or (2) which the amount of the bonus bears to the sum of the bonus and the royalties expected to be received. Such allowance shall be deducted from the lessor's basis for depletion, and the remainder is recoverable through depletion deductions on the basis of royalties thereafter received. (b) If the owner has leased a mineral property for a term of years with a requirement in the lease that the lessee shall extract and pay for, annually, a specified number of tons, or other agreed units of measurement, of such mineral, or shall pay, annually, a specified sum of money which shall be applied in payment of the purchase price or royalty per unit of such mineral whenever the same shall thereafter be extracted and removed from the leased premises, an amount equal to that part of the basis for depletion allocable to the number of units so paid for in advance of extraction will constitute an allowable deduction from the gross income of the year in which such payment or payments shall |be made; but no deduction for depletion |