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Demystifying the Tax Aspects of Development and Depletion

John C. Siegesmund III, John R. Maxfield, Proceedings of 31st Annual Rocky Mountain Mineral Law Institute (1985)

Few sections of the Internal Revenue Code2 (Code) are as intimidating as those provisions governing the taxation of natural resources. To the uninitiated the area appears to be little more than a morass of complex rules, exceptions, defined terms, and cross references having little, if any, unifying principles and even less logical basis. That perception is not without some validity. Nevertheless, understanding the taxation of natural resources and placing the rules in a more or less rational framework is not so hopeless a task as it may at first appear. This paper is an effort to provide that framework and demystify the rules relating to the development of mineral properties and the allowance for depletion.

A useful starting point is the concept of a capital expenditure. Generally speaking, expenses incurred in the production of income are deductible as they are incurred.3 Capital expenditures are the major exception to this rule. A capital expenditure can roughly be defined as one which creates, results in the acquisition of, or improves an asset which will have value significantly beyond the year in which the expenditure is incurred.4 Because capital expenditures have long-range benefits, the Code requires that they be added to the basis of the asset created, acquired, or improved, and deducted over the life of that asset. This is accomplished through the allowance