*1429 Depletion adjustments on the basis of a new estimate of ore reserves and a revaluation thereof denied. J. J. White Lumber Co.,24 B.T.A. 274">24 B.T.A. 274, followed.
*1080 The respondent has determined deficiencies as follows:
| Deficiency | ||
| Petitioner | 1929 | 1930 |
| James R. McCahill | $1,465.02 | $639.15 |
| Francis T. McCahill | 318.62 | 304.40 |
| Eugene P. McCahill | 2,655.56 | |
| Charles M. Denny, Jr | 812.84 | |
| Catherine M. Lane | 1,081.45 |
As their causes of action petitioners allege that for the years 1929 and 1930 the respondent has erroneously disallowed all depletion deductions from income derived from sales of ore produced from a certain iron mine. The several proceedings were consolidated for hearing and report.
*1081 FINDINGS OF FACT.
Petitioner James R. McCahill resides at Lake City, Minnesota; petitioners Francis T. MaCahill, Eugene P. McCahill, and Charles M. Denny, Jr., reside at Minneapolis, Minnesota; and petitioner Catherine M. Lane resides at Los Angeles, California. Charles M. Denny, Jr., and M. Eleanor*1430 McCahill Denny, his wife, filed joint returns of income and the issue in the case of Charles M. Denny, Jr., arises in respect of trust income of his wife.
Mary E. McCahill, late of Lake City, Minnesota, died testate on August 14, 1922. By her will substantially all of her property was devised and bequeathed to trustees for the benefit of her five surviving children, the petitioners, who are equal beneficiaries of the income of the trust so created.
Jennie I. Irwin, a sister of the decedent, and Eugene P. McCahill were executrix and the administrator with the will annexed of the estate of the decedent and have been the trustees of the trust at all times since it came into existence.
The property commonly known and hereinafter referred to as the Shenango Mine, to wit: East half of the southeast quarter of section 22, the northwest quarter of the southwest quarter of section 23, and the northeast quarter of the northeast quarter of section 27, in township 58 north, range 20 west, on the Mesaba Iron Range, in St. Louis County, Minnesota, constitutes a part of the corpus of the trust. This mine is subject to a mining lease dated May 26, 1900, which provides for royalties to be*1431 paid by the lessee to the lessor at the rate of 20 cents per ton for the iron ore mined and removed from the leased premises and for certain annual minimum payments for which ore may thereafter be mined.
In the years 1929 and 1930 the trustees received from the lessee the respective amounts of $111,480.58 and $87,052.03 as royalties on 557,402.9 and 435,260 tons of iron ore mined and shipped in such years. In their fiduciary returns they deducted from the respective gross incomes therein reported the amounts of $75,595.65 and $59,186.65 as depletion to which they considered the trust was entitled. Upon audit of the returns the respondent disallowed the depletion deductions so taken and increased the income for each year accordingly.
The rate or amount of depletion per ton fixed and allowed by the respondent for each of the years 1922 to 1927 and for a part of 1928, with respect to the income of the petitioners derived from the mine through the trust, was at the rate of 13.598 cents per ton.
In the administration proceedings upon Mary E. McCahill's estate in the Probate Court of Wabasha County, Minnesota, the inventory was appraised by George H. Crosby and D. L. Mills. The*1432 appraisal *1082 of the property here in question was adopted by the probate court and other state authorities without modification for purposes of the Minnesota inheritance taxes and was $206,662.24. This valuation was also adopted by the executors in making their Federal estate tax return, filed within one year after the death of the decedent, and in such estate tax return they fully stated the then known facts upon which and the manner in which the valuation had been determined.
The appraisal was made on information obtained from the records and publications of the Minnesota Tax Commission as specifically set forth in a letter from the secretary of that commission showing that the ore reserve in the Shenango Mine on May 1, 1922, was 1,669,751 tons. At the time the Federal estate tax return was filed neither the executrix nor the administrator had any knowledge as to the quantity of ore in the mine, nor any specific or general idea as to the value of the mine, nor any reason to believe that there was any greater tonnage than the Minnesota Tax Commission had reported.
The Federal estate tax return showed that from the estimates of 1,669,751 tons on May 1, 1922, there*1433 were deductible certain quantities shipped between May 1 and August 14, 1922. The value of the decedent's interest in the royalty, after deducting estimated expenses of inspection and accounting, was determined by the appraisers to be 19.4 cents per ton. The estate tax return showed the computations, together with the deduction for prepaid royalties at the date of death, and produced $206,662.24 as the net value of the decedent's interest in the mind at the date of her death.
Depletion had been allowed on the fiduciary returns from August 14, 1922, to and including part of 1928, on 1,517,008 tons of ore at the rate of 13.598 cents per ton, to the total amount of $206,282.75; and the respondent had also allowed depreciation on a tenement belonging to said trust and situated on the leased mining premises to the amount of $379.49; making a total of $206,662.24 so allowed for depletion and depreciation before the year 1929, which was the value of the mine at date of decedent's death as determined by appraisal under the direction of the Probate Court for Wabasha County, Minnesota. In 1928, 1929, 1930, and 1931 ore was recovered and shipped from the mines in the respective quantities*1434 of 340,255, 557,403, 435,260, and 420,655 tons, and royalties were received thereon upon which respondent has allowed no depletion deduction.
Some time in 1932 a competent mining engineer, long familiar with the gelogy of the Mesaba Range, using only such facts as were known in 1922, estimated that the ore reserve in the mine at August 14, 1922, was 4,802,041 tons, less prepaid ore of 78,932 tons, or a net reserve of 4,723,109 tons. Upon the basis of such estimated tonnage and by the formula used in determining the value of $206,662.24 by the executors, he computed a fair market value of the *1083 mine as of August 14, 1922, of $597,451.22. Based on this estimate and record of ore theretofore removed, the total unrecovered reserve at January 1929 was 2,942,737 tons, and at the same date the unexhausted value based on the new computation was $348,817.27.
William H. Crago, who made the revised estimate of tonnage in 1932, used the so-called "slump theory" in his computation of the ore reserve in question. In 1922 this theory was known to only four or five mining engineers in the service of the United States Steel Corporation. It became generally known several years later. *1435 In explanation of the theory he testified as follows:
The Mesaba iron formation is a very large area and volume of what might be called very low grade iron ore; that is, we call it an iron formation. It runs as it was originally laid down, about 25 per cent metallic iron, which, of course, is not a merchantable or mineable iron. It was laid down in its present position a very long time ago, even considered geologically, and covers a length of some 110 miles, a width ranging from one mile up to perhaps two miles, and an unknown depth. At a certain period in geological history, probably because of the presence of cracks, crevices and channels through which water could percolate, the surface waters at that time worked their way down through this iron formation, and leached out of the iron formation certain constituents, those constituents being largely silica, leaving behind the iron oxide; so that from an iron formation which originally ran say 25 per cent metallic iron, iron ore is produced which may run anywhere from 50 per cent up to 65 per cent, or 66 per cent iron, by the removal of the worthless material, or the silica. In so doing, however, a large amount of material was*1436 subtracted from the iron formation, creating pore space, or porosity, which later, because the rock was weakened, was crushed together; so the material occupied a lesser volume.
In other words, from perhaps 100 feet, for example, of iron formation, there would remain after the silica had been withdrawn, and the material crushed together, 35 or 40 feet only of iron ore. In the course of the exploration on the Mesaba Range, because of our ability to recognize certain definite strata in the iron formation, what we call horizon markers, we were able to follow those strata along for certain distances, and then we would find that they suddenly dropped off below their normal position. That was developed over the entire range, and in every case where this so-called slump took place, it indicated the presence of iron ore beneath, because when the drills went down through, we invariably found, and must of necessity have found, that there was iron ore beneath, and the slump was accounted for only by the presence of merchantable ore below that particular horizon. This idea of using a slump to indicate iron ore, was not a theory worked up. It was a fact, demonstrated first, and then we had*1437 to account for the slump by certain geological theories, the theory being, the leaching out of the silica, - although this leaching out of the silica is a well-recognized fact in the formation of iron ore bodies, not only on the Mesaba Range, but in various other places in the world. I think that covers it, in general.
OPINION.
LANSDON: The single issue here is whether the ore content of a mine, valued in 1922 for estate tax purposes at $206,662.24, may be revalued later as a basis for computing deductions from income on *1084 account of depletion. The Revenue Act of 1928 provides for a reasonable allowance for depletion and that the basis for the computation thereof, when the property is transmitted by death of a prior owner, shall be its fair market value at the time of death. In this proceeding the prior owner died on August 14, 1922, and by the terms of her will the property in controversy was later distributed to the trustees. In such circumstances the property is deemed to have been acquired by the trust on the date of death of the testator. *1438 ; ; affd., .
The facts disclose that after the death of the testator, appraisers duly appointed by a court of competent jurisdiction determined that on August 14, 1922, the property in controversy had a value of $206,662.24. This appraisal was based on data on file in the offices of the Minnesota State Tax Commission. Taking the estimated tonnage from such records and applying the royalty rate, less expense, the present worth thereof on the basis of a seven-year life of the mine was computed in the amount above set out. The estimated tonnage and computation of value were not made personally by the executors, who had no practical knowledge of such matters, but by other persons employed for such purposes. The value so computed was included in the inventory of decedent's estate attached to the Federal estate tax return duly filed by the executors. In so doing the executors acted in good faith. Upon audit of such return a deficiency was determined by the Commissioner, and on petition to the Board the controversy was finally settled and closed by order of*1439 the Board at Docket No. 31743, on December 30, 1930, about two years before the deficiency notices herein were mailed to the several petitioners, and the statute of limitations has now run against any additional estate tax. At no time during the pendency of such estate tax proceedings did the Commissioner question the correctness of the appraisal as of the date of the decedent's death.
The rate of depletion necessary to exhaust the value of the ore reserve determined by the appraisal was applied to the tonnage produced annually and deductions based thereon were allowed by the respondent until some time in 1928, when the entire original valuation was exhausted, and since then no depletion has been allowed. About 1925 it was discovered that the tonnage estimate of August 14, 1922, was very much too low, but no new estimate or valuation was made at that time. By the middle of 1928 such estimated tonnage had all been recovered. For the remainder of 1928 and the taxable years 1929 and 1930 ore in excess of the original estimate was mined and shipped in the respective quantities of 340,255, 557,403, and 435,260 tons.
*1085 In 1932, at the request of the petitioners, an experienced*1440 and competent engineer, long familiar with the geology of the Mesaba Range, made a new estimate of the tonnage recoverable from the mine as of August 14, 1922. This estimate was based only on information accessible in 1922, but its preparation involved the use of the so-called "slump theory", which was known to very few mining engineers in 1922, but was generally used in 1932. We are satisfied that such estimate is approximately correct and that at the basic date there were at least 4,723,109 tons of recoverable ore in the mine.
The petitioners contend that upon the basis of the facts they should be allowed depletion during the remaining life of the mine after January 1, 1929, sufficient to recover the amount of the 1922 value which they now claim. In support of this contention they rely on the statutory provision which entitles them to reasonable allowances on account of depletion, and Regulations 74, articles 228 and 229. 1 This Board and the courts have held that if an estimate of reserves at the basic date is erroneous, depletion allowance after discovery of error may be adjusted in accordance with facts not known at the date of the original estimate. *1441 In every instance, however, it was expressly set out that the sole purpose of the adjustment was to enable the taxpayer to recover the capital cost of the ore reserves without tax. ; ; . In none of these cases was there any controversy over the total amount of cost or value to be recovered, and our decision related only to the redetermination of the unit of depletion necessary to exhaust the remaining unrecovered capital cost during the life of the property. In passing upon a similar question in ; affd., ; certiorari denied, , the court said: "Under the language of this regulation it is perfectly plain that the new estimate is only to be applied to the capital remaining to be recovered", and further laid down the principle now recognized as governing the depletion of all natural resource reserves, except oil and gas, that "The taxpayer is entitled to recover the cost of the property by way of depletion. *1442 "
In our opinion the above cited authorities relied on by the petitioner have no bearing on the exact question here, which is the *1086 contention of the petitioner that it is entitled to revalue the ore reserve acquired in 1922, and then valued at $206,662.24, for the purpose of exhausting such new value by the application of an adjusted rate of depletion thereto. It is obvious, of course, that if the reserve in question had been acquired by purchase after*1443 March 1, 1913, this question would not be here and the only function of the Board would be to adjust the depletion rate to enable the petitioner to recover the unexhausted cost at the date to which the new estimate of recoverable tonnage is applicable. Here the petitioners have no cost, and their basis for depletion is an estimated value at date of acquisition.
In the Revenue Act of 1928 it is provided, that in the case of property transmitted by death the basis upon which depletion is to be allowed shall be the fair market value of the property at the time of the death of the decedent. Article 221(b) of Regulations 74 defines fair market value as that amount which would induce a willing seller to sell and a willing buyer to purchase. Article 226(a) provides that:
(a) * * * Where the fair market value of the property at a specified date is 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 in*1444 methods of extraction and treatment of the mineral product. * * *
At the basic date herein the fair market value of petitioners' ore reserve was estimated in exact conformity with the regulations. It was approved and has never been revised by the Commissioner, and depletion deductions completely exhausting such value have been allowed. Upon the evidence it is perfectly clear that the value of $206,662.24 was based on all the information known at that time. Article 228 states that no revaluation so determined and approved will be allowed during the continuation of the ownership under which such value was determined, except in case of subsequent discovery as defined in article 240 or of misrepresentation, fraud, or gross error as to any facts determinable on the basic date, and this only with the written permission of the Commissioner. The present question is not within the purview of article 240, which relates to discovery value. Neither misrepresentation nor fraud is alleged and it is clear that the executors acted in good faith. We are equally convinced that there was no gross error as to facts determinable at that time. The Commissioner has not granted written permission*1445 authorizing revaluation. It follows, therefore, that petitioners' claim must be denied, because the value determined in 1922 was the fair market value of the property at that time and such value is the *1087 amount which petitioners are entitled to exhaust by depletion allowances. ; .
Reviewed by the Board.
,Decision will be entered for the respondent.
TRAMMELL, dissenting: In my opinion, the question is, What was the value of the ore property at the basic date? My view is that the evidence shows that the original valuation was erroneous and should be corrected, not on any evidence subsequently developed or based on subsequent events, but on account of gross error in the original valuation.
Footnotes
1. ART. 228. * * * No revaluation of a property whose value as of the basic date has been determined and approved will be made or allowed during the continuance of the ownership under which the value was so determined and approved, except in the case of a subsequent discovery as defined in article 240, or of misrepresentation or fraud or gross error as to any facts determinable on the basic date. Revaluation on account of misrepresentation or fraud or such gross error will be made only with the written approval of the Commissioner. * * *
ART. 229 * * *
When information subsequently obtained clearly shows the estimate to have been materially erroneous, it may be revised with the approval of the Commissioner. ↩