CHAPTER 7 TAX PROBLEMS OF OPERATING PROPERTIES

• Jurisdiction: United States

Mineral Taxation
(Mar-Apr 1977)
CHAPTER 7
TAX PROBLEMS OF OPERATING PROPERTIES
David T. Wright, Partner
Coopers and Lybrand
New York, New York

This paper will review some of the more significant and common tax problems confronting operators of mineral properties and hopefully will suggest planning ideas to deal with the problems. Further, some of the new tax developments that impact on mining operations will be discussed. The subjects that will be discussed are:

• Exploration

• Development

• Depreciation

• Investment Tax Credit

• Percentage Depletion

Exploration Expenditures

Exploration expenditures are those expenditures incurred "for the purpose of ascertaining the existence, location, extent or quality of any deposit of ore or other mineral" before the beginning of the development stage of the mine.¹ Expenditures for capital equipment used in exploration which would be depreciable are not considered exploration expenditures although the related depreciation would be so considered.² Exploration expenditures generally include costs for the following types of activities: operating and staffing general exploration departments, field trips, chemical, magnetic and air surveys, core drilling to ascertain mineralization, etc.

Exploration expenditures within the U.S. may be deducted as incurred or capitalized as depletable basis in the mineral interest. Capitalized exploration costs are deducted when and if the exploration project is abandoned. The election to currently deduct these expenditures is binding for all future years unless permission to change is obtained. However, it should be noted that affiliated corporations are eligible for separate exploration elections even if they are includible in a consolidated tax return and at the partnership level this election is made by the partners and not the partnership.³

If the mineral property ultimately attains commercial operation, previously deducted exploration costs incurred with respect to that property are recapturable.

[Page 7-2]

The taxpayer may elect to recapture exploration expenses in either of two tax ways: (1) include in gross income the entire amount of exploration expenditures previously deducted when the mine attains commercial production,⁴ or (2) forgo the amount of depletion otherwise deductible with respect to the mine until such amount equals the amount of previously deducted exploration expenditures.⁵ This election may be made annually,⁶ but if the first option is elected all mines reaching the production stage during the year must be included in that election.⁷

Exploration expenditures are also recapturable if the property to which such expenditures relate is sold or assigned. Thus, any gain arising from the sale or disposition of such mineral property which would otherwise be treated as capital gain is treated as ordinary income to the extent of the exploration expenditures previously deducted.⁸ Moreover, the recapturable nature of exploration expenditures remains with any property transferred pursuant to a tax-free exchange. Thus a recipient of property pursuant to a tax-free exchange could be responsible for repayment of exploration expenditures deducted by the transferor.⁹

Foreign exploration expenditures are with certain exceptions, capitablizable, when incurred.¹⁰ Such foreign expenditures are deductible if and when the specific foreign exploration effort is abandoned.

One of the obvious problems in accounting for exploration expenditures is to provide a mechanism to distinguish them from development expenditures since the tax treatment for these latter expenditures are more desirable. The considerations involved in distinguishing exploration and development expenditures and a discussion of the tax treatment of development expenditures is set forth in the following section.

Another tax problem in the exploration (and development) area is the structuring of cost-sharing arrangements where one party earns an interest in a mineral property by expending funds on the exploration (and development) of that property. Exploration and development expenditures incurred to acquire a fractional interest in mineral property are capitalizable by the carrying party as depletable basis to the extent these costs are attributable to the carried party's interest.¹¹ These capitalized costs are deemed to

[Page 7-3]

be cost of acquiring the fractional interest in the mineral property. The balance of these expenditures are deductible as exploration or development expenditures. However, if the carrying party had the right to recoup all the expenditures incurred with respect to the mineral property before the carried party could share in any of the possible revenue from the property all the expenditures would be currently deductible.¹²

If the carrying party is unable to negotiate the right of recoupment, the carrying party should consider utilizing the partnership format of reporting these activities for federal income tax purposes. In a partnership return a special partnership allocation for the exploration and development expenditures could be made to the partner venturer who financed these expenditures for the exploration and development expenditures.

The partnership form provides an additional tax benefit since the carrying party is not required to capitalize as depletable basis the carried party's interest in the depreciable assets when recoupment is achieved.

Development Expenditures

Development expenditures are those expenditures incurred for the development of a mine or other natural deposit (other than an oil or gas well) after the existence of ores or minerals in commercially marketable quantities has been disclosed.¹³ Development expenditures exclude any expenditures for the improvement or acquisition of property of a character subject to the allowance for depreciation. However, as is the case with exploration expenditures, depreciation is considered an expenditure for purposes of this definition.¹⁴

Development expenditures may be either: (1) deducted currently¹⁵ or (2) deferred and amortized as the ore benefited by such expenditures is sold.¹⁶ This election is made annually with respect to each separate mine or mineral interest. Unlike exploration expenditures, development expenditures are not subject to recapture. Moreover, development expenditures whether deducted currently or amortized, do not limit the taxpayer's right to claim a percentage depletion allowance. However, the deduction for development is included in the computation of the 50% of net income from the property limitation for percentage depletion purposes.

[Page 7-4]

Generally it is most beneficial to deduct currently development expenditures since it provides the greatest present value benefit from a use of cash viewpoint. Further, it may have the least deleterious affect on the cumulative amount of percentage depletion allowable over a period of years. However, companies sometimes defer development expenditures for other tax reasons — some of the principal tax motives are:

• Possible expiration of net operating loss, investment tax credit, and foreign tax credit carryovers.

• Avoidance of loss of percentage depletion allowances due to the 50% of taxable income limitation, which limitation will not apply, over the long term, if development expenditures are deferred and amortized.

The benefits from deferring development to achieve the above tax benefits frequently involves careful analysis of the relative cash flow benefits. For example, if the period over which development would be amortized is twenty years it may be economically more attractive to let an investment tax credit expire unused from a present value of cash viewpoint.

Because the amortization period for development expenditures tends to cover a substantial number of years particularly for a new mine, with the result that deferral of these expenses is unattractive, companies should consider utilizing a development carve out.

To aid in understanding a development carve out or production payment, it is helpful to review the nature of a production payment. It is an amount (carved out of a greater interest) of production (in kind or in money) realizable solely from the property. It is also a passive or nonoperating interest in property as long as the working owner fulfills certain agreed-upon conditions. The production payment is extinguished after the owner recoups his capital and profit from the mineral interest.

A development production payment or carve-out can be defined as a production payment whose proceeds are pledged and used by the mine owner to develop the mine. For tax purposes, the owner of the working interest is not required

[Page 7-5]

to recognize income at the time he assigns the development carve-out.¹⁸ For this purpose, the...