UNITED STATES v. HILL ET UX.
Legal provision: Internal Revenue Code
Argument of Kent L. Jones
Chief Justice Rehnquist: We'll hear argument now in No. 91-1421, United States against William F. Hill.
Mr. Jones: Mr. Chief Justice, and may it please the Court:
The question in this case which affects billions of dollars of revenues under the minimum tax is ultimately a quite narrow one: what costs are properly included in the adjusted basis of a depletable mineral deposit?
While the question is a narrow one, its background is somewhat complex.
Since 1926 the tax treatment of mineral deposits has created a sizable incentive or tax preference for mining activities.
The mineral depletion allowance for mineral deposits differs dramatically from the ordinary depreciation of other types of wasting assets.
Percentage depletion exempts from tax a portion of the total income derived from the mineral deposit.
The allowance continues so long as production continues, even long after the total costs of the mineral deposit have been fully recovered.
By 1969 the percentage depletion allowance and other tax preferences had been abused to such an extent that many wealthy taxpayers were able to shield their entire incomes from Federal tax.
Congress enacted the minimum tax to avoid this inequity and to improve the fairness of the tax system as a whole.
Unknown Speaker: When did Congress enact the minimum tax?
Mr. Jones: The first version of the minimum tax was enacted in 1969.
Unknown Speaker: Thank you.
Mr. Jones, Congress has recently enacted another change?
Mr. Jones: Yes.
Unknown Speaker: And by virtue of the most recent change, I guess no minimum tax will be applied to this.
Mr. Jones: Under section 1915 of the Energy Policy Act of 1992, which was enacted 2 weeks ago, Congress has exempted the restricted minimum... I'm sorry... percentage depletion allowance for independent oil producers from the coverage of the minimum tax.
Congress left in place the application of the minimum tax to all other types of percentage depletion allowances.
Unknown Speaker: Well, that certainly indicates that at least the present Congress isn't viewing the situation quite like you do.
Mr. Jones: Actually what we think and what I believe the statute reflects is that there are two ways to attack abusive tax preferences.
One is to tax them, which is the way the minimum tax works.
The other is to restrict the availability of the preference.
What Congress has done since 1969 for oil and gas depletion alone is to create a statute, 613(a), which very narrowly restricts the availability of the depletion allowance for that one industry.
Since 1969 Congress has cut the depletion rate applicable to oil production in half, from 27 to 15 percent.
They have removed the availability of oil and gas depletion for all integrated refining and marketing companies, which are the major producers of oil in this country.
They have also restricted, even for independent producers, the amount of depletion from an unlimited quantity, first to 2,000 barrels a day and now to 1,000 barrels a day.
And perhaps most importantly, in section 613(a)(D), Congress has provided that the oil and gas depletion allowance cannot be used to exempt more than 65 percent of the total income of the taxpayer, and so in that manner, Congress has avoided the spectacle of the depletion allowance being used to exempt all of the taxpayer's income, which is the function of the minimum tax.
Unknown Speaker: Well, Mr. Jones, since I have you interrupted, may I ask one other question?
I thought that the regulation, 1.571(h), was particularly relevant in this case, and yet your brief doesn't really address it or discuss it.
Mr. Jones: Well, we address it in the sense that all that regulation does is refer the reader to section 1016 of the code for adjustments to basis.
Every one of the depletion regulations has the same cross-reference, and the significance of that--
Unknown Speaker: Well, but this regulation 1.57 at least can be read to mean that the special rule referred to in the regulation 1.612 doesn't apply.
Mr. Jones: --Well, there's--
Unknown Speaker: And so, I just wondered why you didn't even talk about it.
Mr. Jones: --There's at least two reasons why that regulation has no relevance to the Court's decision in this case.
The first is that the reference to 1016... if you look at 1016(a)(2), it says you shall make downward adjustments to basis for depletion allowances.
That is the reason that 57 and the regs under 61, 612 itself, all refer to 1016.
These... under 1016(a)(2), the adjusted basis of a mineral deposit is adjusted downward each year.
The other and perhaps more important reason why 1016 has no ultimate relevance to this case is because the court simply misunderstood what the... how that statute works, and if you like, I can address it now or I can come to it in the course of the discussion.
Unknown Speaker: As you wish.
Mr. Jones: Well, I think it might be helpful if I put it into the context of the overall discussion in this case.
Section 57 recognizes that the percentage depletion allowance is a tax preference only to the extent that the allowance exceeds the adjusted basis of the mineral deposit.
The question presented in this case is the apparently elementary one of how the adjusted basis of a mineral deposit is determined.
Does it, as we contend, include only the intangible costs of acquiring and developing the deposit, or as the courts below concluded, does it also include the costs of depreciable physical property used in connection with production?
In our view, which all of the commentators have agreed with, the answer is clearly set forth in the statute and the regulations and in the decisions of this Court, as well as in the history of the minimum tax.
Under section 611 of the code, the costs of the mineral deposit are to be recovered by depletion, and the costs of physical improvements are to be recovered by depreciation.
Since separate-methods are employed to recover these different types of costs, the regulations specifically require that the basis of the depletable minerals be maintained separately from the basis of the depreciable improvements.
The regulations state that the basis of the mineral deposit does not include amounts recoverable through depreciation deductions.
This is what Justice O'Connor was referring to as perhaps the special rule.
But if you look at section 1.611-2(b)(2) of the regulations, you'll see that it is not a special rule that applies only to cost depletion because the regulation says in no event shall percentage depletion in excess of the basis of the mineral deposit be credited to the depreciable improvements account.
Congress did not... I'm sorry.
The Service... and these, by the way, are substantive rules authorized by section 611.
The Service quite clearly did not intend to allow these bases to be commingled.
In 1937, they issued a ruling which states... and I quote... the basis of depletable property must be set up as an item separate from the basis of depreciable property.
So, the question in this case is ultimately and directly answered by the regulations.
The agency's longstanding requirement that a separate basis be maintained reflects a fundamental principle of tax accounting.
As Judge Friendly said in Commissioner v. Ferrar, the bases of even closely related assets must be maintained separately when one is subject to one kind of tax treatment and the other is subject to a different kind.
It was for this very reason that in the United States v. Dakota-Montana case in 1933 this Court rejected the taxpayer's claim that depletable property could be recovered through depreciation.
The Court said that those different types of costs must be recovered through the separate mechanisms that Congress provided, and the basis of the two types of property, therefore, can't be commingled.
The Court said essentially the same thing in Parsons v. Smith when they said... and I quote... depreciable equipment is not an investment in the minerals in place.
The legislative history of the '86 amendments to the minimum tax confirms this same distinction, for the conference report to the bill stated that the depletion preference under section 57 is... and I quote again... the excess of the depletion allowance over the adjusted basis of the depletable property.
It is, after all, excess depletion, not excess depreciation that the depletion tax preference in section 57 addresses.
Well, what the court below concluded, notwithstanding all of this evidence, was that the costs of depreciable equipment should be included in the adjusted basis of the depletable property because the court concluded that this kind of physical property represents an improvement to the mineral deposit, and the court thought that under section 1016 of the code all improvements are necessarily to be merged into the basis of the assets that they improve.
That in turn--
Unknown Speaker: In that event, I suppose the improvements or the tangible assets that you think are depreciable wouldn't be... there wouldn't be a depreciation allowance.
Mr. Jones: --Well, that's right.
If... they either are depreciable or they're not.
If they are depreciable, they have to be maintained separately.
Unknown Speaker: Yes.
Mr. Jones: And if they're merged--
Unknown Speaker: But under the court of appeals' view, the depreciable assets would be included in the depletion base.
Mr. Jones: --That's correct.
Unknown Speaker: But then they wouldn't be depreciated also, would they?
Mr. Jones: Well, that's... that doesn't follow.
I mean, that follows logically, but that's not what the court seemed to think.
Unknown Speaker: Well, is that what... the company is both depleting... both including the basis of the... these tangible assets in their depletion base and also depreciating them?
Mr. Jones: --Yes.
They are including... they are depreciating them, and they're saying that they should be included in the basis for purposes of the... in determining the basis of the depletable property.
Unknown Speaker: So, you're recovering the cost of them twice.
Mr. Jones: That's... that would be their ultimate position.
I don't think they've been pressed to describe it that way.
Unknown Speaker: But you wouldn't care even if they weren't depleting them.
Even if they weren't depreciating them, you would say that they still... I mean, that's how they have to be treated.
Mr. Jones: Yes.
Unknown Speaker: Depreciated rather than depleted.
Mr. Jones: The regulations require that they be depreciated.
The taxpayer doesn't have an election here.
They have to be set up as a depreciable asset.
Unknown Speaker: Where are all these sections set forth?
I've been looking through your briefs.
Mr. Jones: Which sections because there's--
Unknown Speaker: The ones you're relying on.
Mr. Jones: --Well--
Unknown Speaker: They're in the United States Code.
Mr. Jones: --Yes, 26 U.S.C. Was that your question?
Unknown Speaker: It would have been nice if they were in the briefs somewhere.
Your statute involved... you don't even set out 1016.
Mr. Jones: Oh, you mean if I had set them out in the... I noticed that myself, Justice Scalia, after we filed the brief.
I think it would have been helpful if we had had additional materials, and I apologize for that.
Unknown Speaker: Can you tell me why it is that the regulations under section 57 direct you to go to IRSC 1016 and its regulations to determine the adjusted basis?
I would have thought they would have told you to go to IRSC 612 and the special rule.
Mr. Jones: Well, they... if you will notice, under the regs under 612 and 611, they also refer the reader to the regs under section 1016.
And as I was trying to say earlier, that is because 1016(a)(2) requires that the basis be adjusted downward each year as depletion is taken.
But there's a... there's a larger philosophical and practical point here that I haven't had a chance to explain.
Under section 1016, the costs of improvements... under 1016(a)(1), the costs of improvements are not always added to the basis of the asset they improve.
They are to be merged only with that asset when, as the statute says, it is proper to do so.
If we take the simple example of a commercial structure built on a tract of land, the land is not a depreciable asset.
The costs of the land are, therefore, to be maintained in a basis separate from the costs of the commercial structure which is depreciable.
The regulations under section 167(a)(5) require that result.
So, even though the commercial structure can be said to be an improvement to the land, the costs of that improvement have to be maintained in a separate basis.
This Court recognized in the Dakota-Montana case that that simple example applies directly to mineral enterprises.
A mineral deposit, like other types of interests in land, is not depreciable.
It can sit there for a billion years and never be depreciated.
Its costs are to be recovered by depletion only as production occurs.
By contrast, the depreciable property that is installed on the location can be depreciated from the day of its installation without regard to whether production occurs, without regard to the quantity of production, and without regard to whether production ceases.
Unknown Speaker: Mr. Jones, can I ask you a question about the statutory text?
57(a) refers to the adjusted basis of the property.
Mr. Jones: Yes, sir.
Unknown Speaker: And when you stated the case, you described it as adjusted basis of the mineral deposit.
You were very careful to focus on mineral deposit.
What is it that makes the word property mean mineral deposit within the statute?
Mr. Jones: The reference in 57(a)(8), as it existed at the time this case arose, is to the property as defined in section 614.
Under 614, the word property is defined as mineral deposit.
Unknown Speaker: I see.
Mr. Jones: The regulations under 614 make that express.
And at page 8 of the briefs of the amicus and the respondent, they concede that the question in this case is what is the adjusted basis of the mineral deposit.
That's why I compressed that issue since it wasn't--
Unknown Speaker: It's... section 614 is the one that--
Mr. Jones: --Yes, sir.
That's the short answer.
Unknown Speaker: --Thank you.
Of course, your reply brief refers to them as improvements to a mineral enterprise.
Mr. Jones: That's correct.
Unknown Speaker: Why did you shift terminology?
Mr. Jones: I don't think I shifted.
Mineral enterprise is a different regulatory term.
Mineral enterprise is defined in the regulations under 611 as the mineral deposit and improvements.
Now, we point out in our brief that that term, mineral enterprise, has been known to Congress a long time, and so if Congress wanted to reach the result that the courts reached in this case, the wording in the statute would have referred not to the adjusted basis of the mineral deposit, but to the unrecovered costs of the mineral enterprise.
That is the result that the courts reached here, which went well beyond what Congress wrote.
Unknown Speaker: Well, how do the definitions of mineral enterprise and mineral deposit differ?
Mr. Jones: The term mineral deposit is defined by the regulations as minerals in place.
The term mineral enterprise is defined by the regulations as mineral deposit plus improvements.
Section 611 has in its text a separate provision for depletion and for depreciation of improvements.
And so on occasion it is relevant to group the entire property at issue, the deposit plus the improvements, and when the regulations group those separate constructs, they group it under the term mineral enterprise.
And that is one of the points we made in our brief, that if Congress had meant to group these two separate concepts, they would have used the term mineral enterprise in doing so.
Unknown Speaker: Mr. Jones, you did make that point in your reply brief, but the reason I said it seemed to me you shifted is, as you framed the question presented, whether the unrecovered costs of depreciable tangible improvements to a mineral deposit may properly be included in the adjustable basis.
That's not what you're saying now.
These are not improvements to the mineral deposit.
Mr. Jones: These are what section 611 refers to as improvements.
They are improvements to the mineral enterprise.
Unknown Speaker: To the enterprise.
So, the question presented, were we to follow that, would mislead us.
Mr. Jones: Well, I wouldn't say mislead you.
I think that this is to a large degree a semantical question about what is being improved.
Unknown Speaker: You raised it.
I mean, it's--
Mr. Jones: Well, I didn't mean to raise it.
Unknown Speaker: --You make a big point of it in your reply brief.
All I'm saying is I wish you had made the same point in your question presented.
Mr. Jones: Well, again, I have no recourse but to apologize if we should have done it differently, but it appears to me that this... the purely semantical question is what does this improve.
It doesn't matter what it improves because the regulations say that improve... the basis of improvements are to be kept separately from the basis of the mineral deposit.
I think that it is more logical to apply the terminology that the regulations apply, that what is improved is the mineral enterprise; in the same way, as we point out in our brief, a manufacturing enterprise may be improved by adding a machine to a plant, but you would keep the basis of those assets separately and account for them separately.
I want to stress just for a moment the import... that this issue remains vitally important even for years after this recent amendment to the minimum tax.
Of course, as we've told you, it involves a good deal of money before and after the enactment, but there's another important way in which the application of this tax to other types of minerals production is of extreme importance.
These other types of minerals production are not subject to the restrictions that are applicable to oil and gas depletion allowance, and so they are... they have more opportunity to obtain this depletion allowance, more--
Unknown Speaker: I take it that with hard minerals, the tangible costs for replacing equipment are very, very high.
Mr. Jones: --Yes, and would be recovered over a long time.
And that perhaps focuses the greatest illogical feature of this Court's... of the lower court's decision because it allows the unrecovered depreciable cost to be set off against the depletion allowance each year even if prior depletion allowances have fully recovered all of the costs of the mineral enterprise.
As several of the commentators have pointed out, this utterly eviscerates the minimum tax as applied to these types of minerals producers with large amounts of depreciable equipment, and as the amicus brief for the coal and hard minerals industry in this case has pointed out... and we agree with it... their coverage under the minimum tax will be decided by this Court's decision in this case.
Unknown Speaker: Could... is it your position that the provision of the regulations, 612-1(b)(1)(i), which says that the basis for cost depletion of mineral property does not include amounts recoverable through depreciation deductions... that's superfluous really.
Mr. Jones: No.
That's... that is--
Unknown Speaker: What does that achieve?
Mr. Jones: --That... that notes the marked distinction that the regulations require between the basis for depreciable and depletable property.
They're to be kept separately.
Unknown Speaker: But that would be the case even if that regulation didn't exist.
You mean that regulation is simply observing what the... what the effect of the law is.
Mr. Jones: I agree with that.
The regulation states what... what proper tax accounting requires.
Unknown Speaker: What it would have... would have produced anyway.
Mr. Jones: Yes, sir.
Unknown Speaker: Why didn't the percentage... a percentage depletion reg say the same thing then?
Why the lack of parallelism?
Mr. Jones: Well, these regs are rather complicated.
The percent... in 611-2(b)(2), the regs say that the percentage depletion allowance shall in excess of... maybe I had better quote it.
I don't want to--
Unknown Speaker: You have the advantage over us.
You have the text right there.
Mr. Jones: --Well, Justice Scalia, in somewhat self-defense, there's an awful lot of text here, but I suppose we could have put it all in a... in an appendix.
The 611-2(b)(2) reg says in no event shall percentage depletion in excess of the basis of the mineral deposit be credited to the depreciable improvements account.
So that observes for percentage depletion the same distinction between depletion account and improvements account.
It runs throughout the regs and it appears in many places.
That is the clearest expression that the Service, who is the authoritative interpreter of this substantive regulation and whose interpretation is entitled to deference... but it is the clearest expression of the Service's views that percentage depletion should be kept... that the account of the mineral deposit for percentage depletion purposes must be kept separately from the account of depreciable property.
Unknown Speaker: Mr. Jones, it may not be your fault, but I think it's a reflection on the Government in this case that all the statutory and regulatory material that you wish to have us consider was not included in your brief.
Mr. Jones: Well, I note that and I... as I mentioned to Justice Scalia, in reviewing the materials in preparation for argument, I felt the same deficiency.
I'd reserve the balance of my time for rebuttal.
Unknown Speaker: Very well.
We'll hear now from you, Mr. Robinson.
Argument of Richard B. Robinson
Mr. Robinson: Mr. Chief Justice, and may it please the Court:
This case involves the operation of a formula that was created by Congress for determining how much of a taxpayer's depletion deduction would be subject to the minimum tax.
In section 57(a)(8), Congress stated that taxpayers would be subject to a minimum tax for their depletion only to the extent that their depletion deduction for each mineral deposit exceeds the adjusted basis they have in that property.
The specific question at issue here is whether certain depreciable improvements to the taxpayer's mineral deposit can be included in the calculation of adjusted basis.
Now, the tax law recognizes two kinds of improvements to an oil and gas property, and that is the specific issue that is involved in this case, whether or not the improvements to an oil and gas property can be included in adjusted basis.
These are intangible improvements and tangible improvements.
Both kind of improvements improve the mineral deposit itself, the oil and gas, because they allow it to be produced.
Intangible improvements are the costs incurred in drilling the well and preparing the well for production.
A taxpayer has the election for these improvements to either capitalize them or to expense them.
If they elect to capitalize them, then those intangible costs that are associated with physical property are recoverable through the depreciation deduction, but those intangible costs that are not represented by physical property are recovered through the depletion deduction.
The Government would agree that those intangible improvements which are recoverable through depreciation would be included in the adjusted basis for this calculation.
The second kind of improvements are tangible improvements, and those are the improvements that are at issue in our case.
The tangible improvements are those physical improvements that are connected to the oil and gas deposit in order to produce it.
Those are the improvements that are used to lift the oil and gas out of the ground and bring it to the surface.
Unknown Speaker: As distinguished from the cost of drilling the well in the first place?
Mr. Robinson: Your Honor, I think they both help in terms of producing them, but yes, they are distinguished from drilling the well in the first place.
Unknown Speaker: And drilling the well is in your view an intangible.
Mr. Robinson: Drilling the well is an intangible cost.
That's exactly right.
Without the cost of these tangible improvements, there could be no production, and if there is no production from the well, there can be no depletion deduction.
So these tangibles are a cost associated with obtaining the depletion deduction itself.
Now, the Government contends in this case that the code draws a clear barrier between the depreciation deduction and the depletion deduction.
And I might add in response to an earlier question that the taxpayer is not claiming both depletion and depreciation with respect to these costs.
The tangible improvements are only being recovered through depreciation.
Unknown Speaker: Well, are you depreciating any tangible property in connection with this mineral enterprise?
Mr. Robinson: Your Honor, we are depreciating the tangible improvements to the mineral deposit.
I might add--
Unknown Speaker: You're taking a depreciation deduction.
Mr. Robinson: --A depreciation deduction for the tangible improvements.
Unknown Speaker: And not including that for purposes of figuring your depletion.
Mr. Robinson: We are not including it for purposes of figuring our depletion.
Unknown Speaker: So what kind of... what kind of property are you depreciating?
Mr. Robinson: We're depreciating the casing that goes down into the well, the pump that brings the oil and gas to the surface.
Unknown Speaker: And you're not including that in your... figuring your depletion.
Mr. Robinson: No, we're not.
Unknown Speaker: Well, without those properties, you wouldn't have much of an oil well either.
Mr. Robinson: We couldn't.
That was my point, Your Honor, is that those are... we couldn't be able to pull the oil up from the ground.
And if you recall, there is no depletion deduction that can be obtained unless there is production from the property.
So these are a cost you must incur in order to obtain the depletion deduction.
Unknown Speaker: Well, I thought you said that you were... the casing... are you including that in your... your basis for the depletion?
Mr. Robinson: Not for depletion, Your Honor.
Unknown Speaker: Even though it's absolutely essential for... to get the oil out of the ground.
Mr. Robinson: Any costs that are represented by physical property have to be recovered through depreciation.
You can't recover those costs of physical property through depletion.
Unknown Speaker: Well, now, tell me again.
What properties then are at issue in this case?
Mr. Robinson: It is the casing, the pipes, and the pumps that are lifting the oil and gas out of the ground.
We were including those costs in the calculation of our adjusted basis.
Unknown Speaker: May I just--
Mr. Robinson: Yes.
Unknown Speaker: --It's those costs to the extent they have not been depreciated.
Mr. Robinson: That's exactly right.
Unknown Speaker: So the amount changes every year.
Mr. Robinson: The amount goes down each year as we claim a depreciation deduction on those items.
Unknown Speaker: Which means that the minimum tax, or whatever they call the tax, goes up every year.
Mr. Robinson: Once we've... yes.
Unknown Speaker: Until you go down to zero on your basis.
Mr. Robinson: Once we've recovered all the costs of these depreciable improvements, then each year, as we're claiming depreciation, the amount of the minimum tax... subject to the minimum tax goes up.
Unknown Speaker: So, what are the expenses that you're claiming the depletion on?
That is just the cost of drilling the well?
Mr. Robinson: No, not the cost of drilling the well, Your Honor.
In the record, if you look in the record at... that was filed with the Federal Circuit at page 850 and 868, we listed through a stipulation with the Government what those expenses were, and they are the pipes, the pumps, and the equipment that is used to lift it.
When you're drilling an oil and gas well, the costs of drilling, the wages, the fuel, those are intangible costs.
That's the costs of actually putting the hole in the ground that are not represented by physical property.
Unknown Speaker: And how do you treat those for tax purposes?
Mr. Robinson: Those are treated as intangible costs as compared to tangible, and you have the option of either--
Unknown Speaker: Of capitalizing.
Mr. Robinson: --of capitalizing or expensing them.
Unknown Speaker: But now, are you suggesting that you treat your pipes and so forth different from the casing to your well?
Mr. Robinson: No.
I'm treating that the same.
Anything represented by physical property falls within the category of tangibles.
Unknown Speaker: Now, what is the basis for the distinction between tangibles and intangibles?
Mr. Robinson: There's two bases, Your Honor.
Number one is the intangibles have to do with drilling the well.
Unknown Speaker: No.
I understand what they have to do with... what text justifies depreciating only tangibles and not depreciating, as you say--
Mr. Robinson: In the regulations under section 612, which in our brief, Your Honor, they're described for you over on page 18, and they were cited in the discussion of the opinion of the lower courts over on the appendix to the Government's petition for their writ of certiorari on the appendix on page 5a.
Unknown Speaker: --What's the regulation number?
I have my own--
Mr. Robinson: It's section 612-4(a), (b), and (c), which goes through the discussion of what is tangible and what is a non... intangible expense.
Unknown Speaker: --Well, I'm not worried about identifying them.
I'm worried about what entitles them to disparate treatment.
Mr. Robinson: The regulations describe the disparate treatment for them, and it's based... it is based on--
Unknown Speaker: What regulation in particular?
Mr. Robinson: --Section 612-4.
Unknown Speaker: Dash 4.
Mr. Robinson: Yes, and that is derived, Your Honor, from code section 263(c) which authorizes the Secretary of the Treasury to issue regulations describing the election to expense or capitalize intangible costs.
Unknown Speaker: Where in your brief will we find the text of 612.4?
Mr. Robinson: In our brief, Your Honor--
Unknown Speaker: Well, where in the briefs if you haven't a better way--
Mr. Robinson: --Yes.
In the petition for the writ of certiorari, appendix 5a, the opinion discusses section 612 and--
Unknown Speaker: --And does it set it out?
Mr. Robinson: --No, it doesn't, Your Honor.
Unknown Speaker: Then where in your brief is it if you're relying on it?
Mr. Robinson: I have set out portions, but I did not set out the text, Your Honor.
Unknown Speaker: Well, that reflects on you, Mr. Robinson--
Mr. Robinson: Yes.
Unknown Speaker: --the same way the Government's failure... if you want us to consider something, it ought to be fully set out in the text of your brief.
Mr. Robinson: I apologize, Your Honor.
The Government's principal objection to the lower court's opinion... or criticism of the lower court's opinion is that the code draws separate treatment... draws a line between the treatment of the depletion deduction and the treatment of the depreciation deduction, and that the lower court's opinion improperly crosses that line.
And I would suggest that the Government is not accurately reflecting the lower court's opinion.
The lower courts recognized the difference between the depletion deduction and the depreciation deduction, but the lower courts said that the issue in this case does not involve the calculation of the depletion deduction.
This case involves the calculation under a formula of how much depletion is subject to the minimum tax, and code section 57(a)(8) tells us that we make that determination by reference to the adjusted basis of the property.
Unknown Speaker: If the regulations under section 57 had directed you to 612 instead of to 1016, would you have been able to make the same argument that you're making here?
Mr. Robinson: Your Honor, I think that there is a difference in the statutory language between section 57(a)(8) and section 612 in that section 57(a)(8) does not contain any possibility of an exception or a special meaning for the rule of adjusted basis, whereas section 612 talks about except as otherwise provided.
In the section 612 regs, Your Honor... and they are reprinted on page 14 of our brief... those regulations make it clear that there are two separate rules at issue here and that the Government is focusing on the rules for calculating the depletion deduction; whereas section 57 and the regulations focus on the rules for calculating adjusted basis.
The title of these regulations is Basis for Cost Depletion, and if you look at section 612-1(a) of those regulations, they tell you that the basis upon which the cost depletion deduction is to be calculated is the adjusted basis of the property as provided in section 1011 for purposes of determining gain or loss except as otherwise provided.
So they tell you that there is a rule for calculating the adjusted basis of the property for determining gain or loss.
And then there is this special rule provided in calculating the adjusted basis for calculating cost depletion, and that special rule is set forth under paragraph (b).
Paragraph (b) says that the basis for cost depletion excludes the cost of depreciable improvements to the property, amounts recoverable through the depreciation deduction.
As the lower courts recognized, the difference in the language between the section 57 regulations and the section 612 regulations is very significant.
The fact that the section 612 regulations had to have what is labeled a special rule to exclude the cost of depreciable improvements from the calculation evidences that absent that special rule, the normal rules of calculating adjusted basis would apply.
And the lower courts felt that if Congress or the Treasury had wanted that special rule to apply, because that special rule under the regulations had been outstanding for at least 10 years at the time that section 57(a)(8) was adopted and the 57 regulations drafted, then there was a way for them to achieve that result, but that they didn't adopt that special rule.
And what the Government is asking this Court to do is to, in effect, redraft the section 57 regulations so that they would read the same as under the section 612 regulations.
Unknown Speaker: Mr. Robinson, you say... to be sure it is entitled special rule, special rule, but I think what the issue comes down to is whether it is a disposition that would not occur but for the fact that it's recited in the regulation, or whether it is, as Mr. Jones suggests, simply an acknowledgement of what the law would otherwise provide.
And that... the regulation you're referring... you're referring to, 612-1(b), in addition to saying that, what you have just discussed, also says, for example, in the case of any mineral property, the basis for cost depletion does not include amounts representing the cost or value of land for purposes other than mineral production.
I tend to think that would have been the case even if it weren't set forth there, don't you?
Mr. Robinson: In terms of calculating the depletion deduction, you're right, Your Honor, and that is the point that I'm trying to make.
Unknown Speaker: Well, the point that I'm trying to make is that... is that (b)... is that 612-1(b) includes some dispositions that are just a recitation of what the law would be even without any specification.
If you acknowledge that that sentence is simply reciting what is obvious from other provisions of the code, why can't I say that (b)(i) is meant to do the same thing?
Mr. Robinson: Because, Your Honor, I believe there's a difference between the rules for calculating adjusted basis for property on the sale of the property and the rules for calculating the depletion deduction.
Adjusted basis is an aggregate concept.
If you would turn back to our discussion on page 2 of the regulations under section 1016, section 1016-2(a) of the regulations, which discuss the rules for calculating the adjusted basis of property, it makes it clear that this is an aggregate concept.
What we're trying to identify in the calculation of adjusted basis is all the capital outlays that are associated with the property that are taken into account in connection with computing the gain or loss on the sale of that property.
And these regulations very specifically tell us that adjusted basis includes the cost of improvements or betterments made to the property.
There's no qualification on the kind of improvements or betterments that are added to adjusted basis.
They use the word including without any qualification.
So, for example--
Unknown Speaker: But it depends on what you mean by the property.
I mean, that's the essential dispute between you and the Government.
Mr. Robinson: --No, I don't believe that's true, Your Honor.
We agree that the property is the taxpayer's interest in the mineral deposit that's identified in section 614, but the issue is not what the cost of that property is, because section 57(a)(8) tells us that we have to compute the adjusted basis of that property in order to determine the tax preference item for depletion.
And in computing adjusted basis, we have to take into account a variety of costs associated with the property.
For example, if we had a building and we installed a new furnace into that building, that new furnace would be an improvement to the building.
And when we went to sell the building, we would include the unrecovered cost of that furnace in our calculation of adjusted basis in computing the gain or loss.
Now, that furnace might be subject to... we may have already depreciated down the building.
It might be subject to another cost recovery method.
Or, for example, if we had a parcel of land and we installed a fence on that land, that fence would be an improvement to the land.
And we went to sell it, we would include the cost of that fence even though in that case the land would not be subject to depreciation, but the fence would be.
So, by focusing under the section 57 regulations on the adjusted basis of the property, I believe that this is a fundamentally different concept, and that explains why there has to be a special rule under the section 612 regulations because a variety of items that may not be subject to the depletion deduction, such as tangibles whose costs are recovered through depreciation, have to be withdrawn from the calculation in order to compute the amount of cost depletion since those amounts aren't... those costs are not recoverable through the depreciation... the depletion deduction.
Now, as was pointed out earlier in the discussion, the section 57 regulations are very significant on this point because these regulations do not contain any reference to a special rule.
Their cross-reference is directly to the general rule for calculating adjusted basis under this regulation at 1016-2(a), and as a consequence, we should be entitled to take those improvements into the calculation in computing adjusted basis.
I have nothing else, Your Honor, unless you have any further questions.
Unknown Speaker: Very well.
Thank you, Mr. Robinson.
Mr. Jones, you have 6 minutes remaining.
Rebuttal of Kent L. Jones
Mr. Jones: Thank you.
I did want to clear up what seemed to me to have been a confusion in the discussion that I just heard.
The respondents claim a right to depreciate the physical property.
They also claim a right to add the costs of that property into the basis of the mineral deposit for purposes of determining the amount of the tax preference.
So, in that respect, as Justice White discussed at the beginning, I think it's quite clear they're trying to merge these... merge the adjustments and the deductions in a way that's just logically inconsistent, as well as inconsistent with the regulations.
And as far as the question about why is it that some kinds of intangible drilling costs are added to the basis of the mineral deposit, but tangible improvements are not, well, there's the fact that that's the way the regulations require them to be treated, but this Court dealt with that issue at length in 1933 in the Dakota-Montana case.
And the Court's explanation of the different treatment was that the costs of drilling a hole in the ground don't depreciate over time and have a salvage value, the way that a machine or a pump does.
So, it's not depreciable over time in the way depreciable property is.
What the Court said in Dakota-Montana is that the hole simply adds to the value of the mineral deposit, the minerals in the ground, and that that is the logical reason for joining the intangible drilling costs with the mineral deposit.
Unknown Speaker: Of course, that case didn't deal with the tax on the depletion allowance.
I mean, that's just distinguishing depreciation from depletion.
It doesn't involve the second step that we have here.
Mr. Jones: Well, it certainly doesn't involve the minimum tax.
Unknown Speaker: Right.
Mr. Jones: But it certainly does explain the rather stark line that the Court has recognized for 60 years between the separate bases of depletable and depreciable property, and that's the primary relevance of it for this case.
Unknown Speaker: But the taxpayer here is not including the value of these depreciable properties in figuring the depletion allowance.
Mr. Jones: Not in figuring the allowance per se.
Unknown Speaker: Exactly.
They're just... it's just for figuring the tax, the... this extra tax.
Mr. Jones: Yes, only for the purpose of reducing their tax preference from depletion.
They're saying that in determining the amount of the excess depletion they've recovered, they should be able to set off the unrecovered depreciable costs.
But the only way they can reach that result is by showing that these unrecovered depreciable costs form part of the basis of the mineral deposit, and that's where their argument breaks down because the regulations and this Court's decisions and the Service's rulings specifically require that those accounts be kept separately.
And the logic of the minimum tax requires that they be kept separately too because, as I mentioned earlier, as commentators have pointed out, if you're allowed to each year set off these unrecovered depreciable costs against the depletion allowance, the result is to create a gaping hole in the coverage of the act and to allow large amounts of excess depletion wholly to escape taxation, which is precisely contrary to the objectives of the minimum tax.
Unknown Speaker: I must say you describe the minimum tax and the adjustments as much more rational creatures than it seems to me they are.
I mean, if you were going to say there's a hole, you would just say, well, so there's a hole.
Congress left a hole.
Mr. Jones: Well, I--
Unknown Speaker: You can regard the whole depletion allowance as a hole.
It's a great big hole, and Congress wanted the hole.
Mr. Jones: --I don't think it's really quite that simple, Justice Scalia.
When the minimum tax was enacted, what Congress said was... and in the legislative reports... what they said was that they were concerned that these tax preferences were destroying taxpayer morale, and by that what they meant was that our tax system is based upon each individual's obligation to report and pay their taxes.
And Congress was concerned that if certain taxpayers were allowed to escape utterly from Federal tax, it would have a devastating impact on the long-range morale of the taxpayers and the ability of the system to work as a whole.
And so, it does serve that very important function.
Unknown Speaker: They did not eliminate the depletion allowance.
Mr. Jones: No.
Unknown Speaker: The only question is how much of the depletion allowance they chose to leave in effect.
That's all we're arguing about.
Mr. Jones: Well, I certainly agree with that, but our point is that the analysis of the courts below would result in a large amount each year that would be exempt from the effect of the tax in--
Unknown Speaker: Don't they just achieve that exemption by investing more and more on their properties?
Isn't there sometimes an incentive to do that?
Basically you're talking about unrecovered investment in these properties that presumably will produce more oil and gas over the long run.
Mr. Jones: --Well, the amount of investment required for production... I mean, you don't necessarily get more production by more investment, but those kinds of economic issues are really outside the scope of the statute because what the statute says, what Congress said, was that in deciding the amount of the preference, it's simply the amount of the depletion above the basis of the deposit.
That was their economic judgment.
Unknown Speaker: I'm not sure that the basic reason for giving it a depletion allowance in the first place is inconsistent with the taxpayer's position in this case.
Mr. Jones: Well, the basic reason is to provide an incentive, and the flip side of that incentive is the abuse.
And to the extent there's an abuse, the tax applies, but the abuse is defined by Congress as simply the amount of the depletion in excess of the adjusted basis.
Chief Justice Rehnquist: Thank you, Mr. Jones.
The case is submitted.