Ninth Circuit Upholds Tax Court's Adjustments Cement Company's Depletion Deduction

(Parker Tax Publishing November 2020)

The Ninth Circuit affirmed the Tax Court's ruling 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 rather than the 15 percent rate used by the company, finding that the 15 percent depletion rate in Reg. Sec. 1.613-2(a)(3) is directly contradicted by the 14 percent rate provided in Code Sec. 613(b)(7) and the statute's language controlled. The Ninth Circuit also affirmed the Tax Court's holding that the purchased minerals were nonmining costs for purposes of calculating the company's gross income and held that the Tax Court properly rejected the taxpayer's proposed calculation of its gross sales. Mitsubishi Cement Corp. v. Comm'r, 2020 PTC 354 (9th Cir. 2020).

Background

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. During 2011 and 2012, the years at issue, most of Mitsubishi Cement's sales were to the subsidiaries of MCC Development Corp. (MCCD). Mitsubishi Cement and the MCCD subsidiaries were members of a controlled group for purposes of Reg. Sec. 1.613-4(j).

Mitsubishi Cement's direct mining costs for 2011 and 2012 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 as specified by 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.

The Tax Court held that the 14 percent depletion rate under Code Sec. 613(b)(7) 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 noted that Reg. Sec. 1.613-2(a)(3) was drafted in 1960, when the statutory rate was 15 percent, but Congress later amended Code Sec. 613 to reduce the rate to 14 percent, and therefore the lower 14 percent rate applied. The Tax Court also held that the cost of purchasing minerals from third parties was a nonmining cost. The Tax Court found that Reg. Sec. 1.613-4(f)(2)(iv), which addresses the calculation of mining gross income for percentage depletion purposes, specifically provides that mining does not include purchasing minerals from another. The Tax Court therefore concluded that the application of processes to purchased minerals does not constitute mining.

Addressing the calculation of Mitsubishi Cement's gross sales, the Tax Court held that Mitsubishi Cement could not increase the value of its constructive sales (meaning sales to entities that were controlled by the same corporate parent) to reflect the prices that it claimed it would have received for its products on the open market. Rather, the Tax Court held that Mitsubishi Cement was required to show that those sales were representative of the market under Reg. Sec. 1.613-4(c)(1). In addition, the Tax Court determined that even if Mitsubishi Cement had established that the prices it charged unrelated customers were representative of the market, Mitsubishi Cement also had to reduce those prices under Reg. Sec. 1.613-4(e) to reflect the reality that its purchasers would have been entitled to discounts under Reg. Sec. 1.613-4(e).

Mitsubishi Cement appealed the Tax Court's decision to the Ninth Circuit.

Ninth Circuit's Analysis

The Ninth Circuit affirmed the Tax Court's ruling and upheld the deficiencies. The Ninth Circuit found that the 15 percent depletion allowance in Reg. Sec. 1.613-2(a)(3) is directly contradicted by the language of Code Sec. 613(b)(7), and thus the statute's language controls. The court reasoned that an agency's interpretation of a statute cannot supersede the language chosen by Congress.

The Ninth Circuit also rejected Mitsubishi Cement's argument that the addition of purchased minerals to the calcium carbonate is a treatment process under Code Sec. 613(c)(4) and therefore the cost of purchasing those additives constitutes mining costs. The court found that it has rejected that argument on multiple occasions, including in Portland Cement v. U.S., 435 F.2d 504 (9th Cir. 1970), U.S. v. Cal. Portland Cement Co., 413 F.2d 161 (9th Cir. 1969), and Riddell v. Cal. Portland Cement Co., 330 F.2d. 16 (9th Cir. 1964). The court also noted, as did the Tax Court, that under Reg. Sec. 1.613-4(f)(2)(iv) the term "mining" does not include purchasing minerals from another.

The Ninth Circuit also rejected Mitsubishi Cement's arguments regarding its proposed calculation of its gross sales. The Ninth Circuit agreed with the Tax Court's holding that Mitsubishi Cement could not simply rely on its own sales to noncontrolled parties to establish a market price during this period; instead, it was also required to show that those sales were representative of the market under Reg. Sec. 1.613-4(c)(1). The Ninth Circuit also found no error in the Tax Court's holding that Mitsubishi Cement had to reduce the purported representative prices to reflect the reality that its purchasers would have been entitled to discounts under Reg. Sec. 1.613-4(e). The court noted that the Tax Court reviewed Mitsubishi Cement's sales data and found that the discounted prices Mitsubishi Cement charged members of its controlled group resembled discounts that unrelated purchasers of similarly large quantities of cement would have received in the market. In the view of the Ninth Circuit, Mitsubishi Cement failed to demonstrate that the Tax Court's finding on this point was clearly erroneous.

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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