Depletion

Depletion is a concept unique to extractive industries. It is based on the concept that

mineral resources are exhaustible as well as difficult to replace. Depletion is an additional
deduction available for tax calculations. Depletion must be calculated on a mine-by-mine
basis, i.e., a firm cannot consolidate its mines. There are two methods to calculate
depletion, cost, and percentage (also known as statutory). Depletion must be calculated
both ways, and the larger sum claimed. Generally the percentage method is larger, Cost
depletion is determined by the basis in the property applicable to the minerals. Thus, if a
firm acquires the mineral rights to an undeveloped property for $2 million, this is the cost
depletable basis, Exploration expenditures that are not expensed can be included in this
base. This amount can be written off as the minerals are mined on a unit-of-production
basis. For example, if the acquired reserves above are mined over ten years in equal
amounts, the annual cost depletion is $200,000. Once the basis has been exhausted or
reached zero, no further deductions are allowed. The cost depletable basis is also
reduced by any percentage depletion taken on the mine income. In contrast, percentage
depletion does not have a dollar limitation. It is calculated as a percentage of gross
income from the mine and varies by type of mineral. Percentage depletion is calculated
as the smaller of (I) the product of the set depletion rate for the mineral in question and
its gross income from mining (less royalty) and (2) 50% of the pretax income calculated
without the depletion allowance. No percentage depletion is allowed if income is negative.
The depletion calculation for coal varies slightly from this basis, but the idea is similar.
However, in this case cost depletion would be greater. Gross income from mining is the
revenue derived from the sale of concentrates. In general, royalties, treatment costs,
marketing fees, and transportation charges must be deducted. For example, if a company
sells refined copper, the percentage depletion is determined on the revenue less smelting,
refining, transportation charges, and royalties. The copper depletion rate is 15%. This
amount cannot exceed 50% of taxable income before depletion. The cash flow examples
in the Appendix further illustrates this concept. If a company is vertically integrated and
applies non-mining and mining procedures, it may be impossible to separate the mining
and non-mining component costs. A proportionate profits method is available that can be
calculated based on profits on return on capital. It should also be noted that the lessor of
a property who maintains a royalty interest is entitled to depletion. Taxable income, once
determined, is subject to a US tax rate of 46%. Although a firm is allowed percentage
depletion, it is known as a preference item for minimum tax calculations. Firms are liable
for a minimum tax on certain preference items. The minimum tax is in addition to the
regular tax and is designed to tax income sheltered from current taxation by accelerated
deductions. Other tax preference items affecting the mining industry are accelerated
depreciation on real property and amortization of certified pollution control equipment. For
further discussion of this, consult a tax reference guide (e.g., US Master Tax Guide,
Coopers and Lybrand). However, if a firm is taking percentage depletion and taxes are
reduced to zero or near-zero, the minimum tax will most likely apply.