The Supreme Court/The Supreme Court.iso/pc/ascii/1991/91_1421/91_1421.zo

Text File | 1993-01-25 | 25.5 KB | 488 lines

NOTICE: This opinion is subject to formal revision before publication in the
preliminary print of the United States Reports.  Readers are requested to
notify the Reporter of Decisions, Supreme Court of the United States, Wash-
ington, D.C. 20543, of any typographical or other formal errors, in order that
corrections may be made before the preliminary print goes to press.
SUPREME COURT OF THE UNITED STATES
--------
No. 91-1421
--------
UNITED STATES, PETITIONER v. WILLIAM F.
HILL et ux.
on writ of certiorari to the united states court
of appeals for the federal circuit
[January 25, 1993]

  Justice Souter delivered the opinion of the Court.
  Under 56 and 57(a)(8) of the Internal Revenue Code
of 1954, 26 U. S. C. 56, 57(a)(8) (1976 ed.), a taxpayer
must pay a -minimum tax- on the excess of the allowable
depletion deduction for an interest in a mineral deposit
over the taxpayer's adjusted basis for that interest.  The
question presented here is whether the term -adjusted
basis,- as used in 57(a)(8), includes certain depreciable
drilling and development costs identified in 1.612-4(c)(1)
of the Treasury Department regulations.  We hold that
the term does not cover such costs.

                             I
  In 1981 and 1982, respondents William F. and Lola E.
Hill were in the oil and gas exploration and production
business, and, on their federal income tax returns for
those respective years, they deducted $439,884 and
$371,636 for depletion with respect to their interests in
oil and gas deposits.  Under 26 U. S. C. 57(a)(8) (1976
ed.), the excess of the allowable depletion deduction for
each of the deposit interests over the interest's -adjusted
basis- is an -ite[m] of tax preference- on which a taxpayer
must pay a -minimum tax- for the tax year in question.
See 56(a).  In determining the adjusted bases of their
deposit interests, the Hills included not only the unrecov-
ered portions of the amounts they originally paid to
purchase the interests, but the unrecovered costs of
depreciable tangible items (machinery, tools, pipes, and so
forth) used to exploit the deposits.  Having thus reduced
the amount of each item of tax preference under 57(a)(8),
they calculated and paid minimum taxes on those items
of $29,812 for 1981 and $26,736 for 1982.
  The Commissioner of Internal Revenue disputed the
inclusion of the tangible costs in the deposits' adjusted
bases, and assessed a larger minimum tax based on their
exclusion.  The Hills paid the resulting respective deficien-
cies of $30,963 and $18,733, and filed a refund claim,
which the Commissioner denied.  The taxpayers then sued
the United States, petitioner here, for a refund in the
Claims Court, which granted summary judgment in their
favor.  21 Cl. Ct. 713 (1990).  The Court of Appeals for
the Federal Circuit affirmed.  945 F. 2d 1529 (1991).
Because of the importance of the issue to the federal fisc,
we granted certiorari, 503 U. S. ___ (1992).  We now
reverse.

                            II
  An oil and gas producer cannot ordinarily depreciate or
otherwise recover (before disposition) his investment in
land on which he drills wells because the process of
producing his taxable income does not wear out or use up
the land.  See, e.g., Treas. Reg. 1.167(a)-2 (disallowing
a depreciation deduction for -land apart from the improve-
ments or physical development added to it-).  Part of the
purchase price of a fee simple interest in the land,
however, represents investment in the right to extract any
oil and gas from subsurface deposits, which (unlike the
land) are -wasting assets,- gradually depleted as the
minerals are removed.  An owner of such wasting assets,
according to basic income tax theory, should accordingly
be allowed a -reasonable allowance for depletion,- 26
U. S. C. 611(a) (1976 ed.), -to compensate [him] for the
part exhausted in production, so that when the minerals
are gone, the owner's capital and his capital assets remain
unimpaired.-  Paragon Jewel Coal Co. v. Commissioner,
380 U. S. 624, 631 (1965).
  To a degree, however, practice and theory have drifted
apart.  The Code and associated Treasury Department
regulations require taxpayers to calculate depletion
allowances by whichever of two methods produces the
larger deduction for the current taxable year.  Treas. Reg.
1.611-1(a)(1); see also 26 U. S. C. 613(a) (1976 ed.) (-In
no case shall the allowance for depletion under section
611 be less than it would be if computed without refer-
ence to this section [concerning percentage depletion]-).
The first method, -cost depletion,- remains firmly moored
to the rationale articulated in Paragon Jewel.  Under that
method, the taxpayer estimates the number of recoverable
units in his mineral deposit, and deducts an appropriate
portion of the deposit's adjusted basis for each unit
extracted and sold.  See Treas. Reg. 1.611-2; Treas. Reg.
1.612-1.  When the sum of prior deductions equals the
cost or other basis of the deposit, plus allowable capital
additions, -[n]o further deductions for cost depletion shall
be allowed.-  Treas. Reg. 1.611-2(b)(2).  The second
method, -percentage depletion,- has no such ties.  It
generously allows the taxpayer extracting minerals from
a deposit to deduct a specified percentage of his gross
income, even when his prior depletion deductions have
exceeded his investment in the deposit.  See 26 U. S. C.
613 (1976 ed. and Supp. V); Treas. Reg. 1.613-1.  For
the tax years at issue, percentage depletion produced the
larger deduction for the Hills, and they accordingly
calculated their depletion allowance according to that
method.
  For those tax years, however, percentage depletion's
gleam is dimmed by the minimum tax.  Section 57(a)(8)
of the Code requires a taxpayer to calculate as a -tax
preference- -[w]ith respect to each [interest in a mineral
deposit], the excess of the deduction for depletion allow-
able under section 611 for the taxable year over the
adjusted basis of the [mineral deposit interest] at the end
of the taxable year (determined without regard to the
depletion deduction for the taxable year).-  In turn, 56
of the Code requires a taxpayer to pay an extra minimum
tax of 15% on the amount by which the sum of the
enumerated tax-preference items in 57(a) exceeds the
specific deductions permitted by 56.  Because the amount
subject to the extra tax is reduced dollar-for-dollar by
every outlay that can be added to the adjusted basis of
the mineral deposit interest, a taxpayer would like as long
a list of eligible outlays as possible.
  In this case the dispute is about the inclusion in
adjusted basis of certain tangible drilling and development
costs, as defined by the Treasury Regulations implement-
ing 263(c) and 612 of the Code.  Section 263(c) grants
taxpayers an option to deduct against current income
certain -intangible drilling and development costs.-  The
regulations limit the costs recoverable under that option
by distinguishing -intangible costs- from costs for -capital
items,- which the parties refer to as -tangible costs-:
-The option with respect to intangible drilling and
development costs does not apply to expenditures by
which the taxpayer acquires tangible property ordi-
narily considered as having a salvage value.  Exam-
ples of such items are the costs of the actual materi-
als in those structures which are constructed in the
wells and on the property, and the cost of drilling
tools, pipe, casing, tubing, tanks, engines, boilers,
machines, etc. . . . These are capital items and are
returnable through depreciation.-  Treas. Reg.
1.612-4(c)(1).
It is the cost of such capital items as these, to the extent
that they have not already been recovered through depre-
ciation, that the Hills would like to add to the bases of
their mineral deposit interests for purposes of calculating
the amount of their percentage depletion deductions
subject to the minimum tax.

                            III
  The taxpayers enter the race with a handicap.  As we
have noted, see n. 4, supra, 57(a)(8) defines the -prop-
erty- with which it is concerned by reference to 614,
which speaks in terms of the adjusted basis of -each
separate interest owned by the taxpayer in each mineral
deposit.-  26 U. S. C. 614(a) (1976 ed).  A regulation
defines -mineral deposit- as -minerals in place,-  Treas.
Reg. 1.611-1(d)(4), while a neighboring regulation defines
another term, -mineral enterprise,- to include -the mineral
deposit or deposits and improvements, if any, used in
mining or in the production of oil and gas.-  Treas. Reg.
1.611-1(d)(3) (emphasis added).  Because these regulatory
definitions were well-established at the time Congress
passed 57(a)(8), see 25 Fed. Reg. 11796 (1960); Pub. L.
91-172 301, 83 Stat. 580, 582, we think it reasonable to
assume that Congress relied on the accepted distinction
between them in its reference to -mineral deposit- as
contained in 614.  Thus the definitional scheme suggests
strongly that the -property- we are concerned with in
57(a)(8) excludes just those improvements that the Hills
wish to treat as part of the property's adjusted basis.
  They assert, however, (and petitioner does not dispute)
that the term -mineral enterprise- occurs in only that one
operative provision in the regulations, Treas. Reg.
1.611-1(d)(4), which concerns the allocation of a portion
of the cost of a mineral enterprise to a mineral deposit or
deposits.  On that basis, the Hills argue that the term
has the limited function of -assist[ing] in identifying
depletable and depreciable costs when an operating
mineral property is acquired as a unit.-  Brief for Respon-
dents 18, n. 21.  Consistently with that view, they note,
a regulation implementing 57(a)(8) directs us to -see
section 1016 and the regulations thereunder . . . [f]or the
determination of the adjusted basis of the property.-
Treas. Reg. 1.57-1(h)(3).  The computation of adjusted
basis under 26 U. S. C. 1016 (1976 ed. and Supp. V),
they argue, is independent of the definition and function
of -mineral enterprise- in the 611 regulations; thus, the
implications of this term's definition do not extend to the
calculation at issue in this case.
  We agree that 1016 is the proper place to look for the
rules concerning adjustment of basis; but we conclude that
the computation of adjusted basis under 1016 is wholly
predicated on, rather than independent of, an understand-
ing of -mineral deposit- as distinct from -improvements-
within the meaning of the regulations under 611.
  Section 1016 is one of a number of general provisions
that together determine the amount of gain or loss a
taxpayer must recognize when he sells or otherwise
disposes of any type of property.  Section 1001(a) provides
the basic rule: gain or loss is determined by subtracting
-adjusted basis- from -amount realized.-  Section 1011(a)
defines -adjusted basis- as -basis (determined under
section 1012 [or other parts of the Code]), adjusted as
provided in section 1016.-  Section 1016 provides the rules
for making -[a]djustments to basis.-
  The taxpayers, acknowledging the centrality of 1016,
seize on the last phrase of a regulation addressing that
section:
      -The cost or other basis shall be properly adjusted
for any expenditure . . . or other item, properly
chargeable to capital account, including the cost of
improvements and betterments made to the property.-
Treas. Reg. 1.1016-2(a).
The ordinary meanings of the terms -improvements- and
-betterments,- the Hills say, include all valuable additions
to property that are more than mere repairs; the tangible
costs that they have incurred to exploit their mineral
deposits increase the value of those deposits, and in any
case are specifically referred to in the regulations imple-
menting 611 as -improvements,- see Treas. Reg.
1.611-5; therefore, those costs should be included in the
adjusted basis of the mineral deposit for purposes of
1016.
  The Hills' chosen passage, however, cannot carry the
weight they ask it to bear.  The purpose of the phrase
-including the cost of improvements and betterments made
to the property- in Treas. Reg. 1.1016-2(a) is not to
provide guidance in particular cases as to whether, for tax
accounting purposes, an expense should be added to the
basis of an existing -property,- or treated as a separate
-property- of its own.  Rather, it is to ensure coordination
of 1016 with 263, the Code section from which the term
-improvements and betterments- (which should probably
be read as a unit) is borrowed.  Section 263(a)(1) provides
that an expenditure may not currently be deducted from
income if it is -paid out for new buildings or for perma-
nent improvements or betterments made to increase the
value of any property or estate.-   26 U. S. C. 263(a)(1)
(1976 ed. and Supp. V).  We have said that -[t]he purpose
of 263 is to reflect the basic principle that a capital
expenditure may not be deducted from current income.
It serves to prevent a taxpayer from utilizing currently a
deduction properly attributable, through amortization, to
later tax years when the capital asset becomes income
producing.-  Commissioner v. Idaho Power Co., 418 U. S.
1, 16 (1974).  In turn, inclusion of the term -improve-
ments and betterments- in Treas. Reg. 1.1016-2(a)
ensures the fulfillment of 263's implicit promise: If a
taxpayer cannot deduct an expenditure from current
income because it has been deemed an -improvement or
betterment- to property, he will be able to recover it later,
either through a form of cost recovery such as depreciation
or depletion, or upon sale as a deduction from the amount
realized.
  Thus it is not by deciphering particular terms in the
regulations accompanying 1016 that the question in this
case is answered, but by relying on the basic principles
embodied in 1016's directives.  For our purposes, the
most important mandate is found in 1016(a)(2), which
requires a taxpayer to subtract from his original basis in
the property sold or exchanged -not less than the amount
allowable [for exhaustion, wear and tear, obsolescence,
amortization, and depletion] under this subtitle or prior
income tax laws.-  In other words, whether or not the
taxpayer ever took a depreciation, amortization, or deple-
tion deduction with respect to the item he is selling, he
must, for purposes of 1016, determine whether such
deductions were allowable with respect to that item, and
reduce his basis by at least that allowable amount.
  To follow this directive, the taxpayer must determine
whether parts of the item sold are subject to different tax
treatments, and must treat those parts as different
properties for purposes of 1016.  Thus, a taxpayer who
bought an apartment building and the land it sits on for
a single price must determine how much of that price
went to pay for each, and must treat each cost as a
separate asset for purposes of 1016.  This is so because
the depreciation deduction allowable for the building (if
the building is used to produce income) must, upon the
sale or exchange of the property, be subtracted from the
taxpayer's basis in the building whether the deduction was
taken or not; but there is no subtraction from the land's
basis since no such deduction is allowable for the land.
See, e.g., Treas. Reg. 1.167(a)-5 (requiring an apportion-
ment of basis when a taxpayer has acquired -a combina-
tion of depreciable and nondepreciable property for a lump
sum, as for example, buildings and land-).
  Although the Code and regulations allow some flexibility
within such major categories of tax treatment, the
boundaries between the major categories are almost
completely impassable.  When a taxpayer is dealing with
associated items falling into two different major categories,
he cannot, as a general matter, choose to treat those
items as a single property falling into one category or the
other; a taxpayer may not, for example, decide to treat
some or all of his apartment building as more land.  Nor
may a taxpayer choose to add -improvement- costs to the
basis of whichever item he pleases: some costs, say of a
new roof, must be treated as adding to the value of the
depreciable building (or as separate depreciable assets),
whereas other costs, like that of grading a building site,
must be treated as additions to the value of the nondepre-
ciable land.  See, e.g., Rev. Rul. 74-265, 1974-1 Cum.
Bull. 56 (distinguishing between depreciable and nondepre-
ciable improvements to land).
  Depletion and depreciation are two of these major
categories of tax treatment.  As this Court said almost a
half-century ago, -[t]h[e] distinction between depletion and
depreciation runs through the basis provisions of the
[Internal Revenue Code].-  Choate v. Commissioner, 324
U. S. 1, 3 (1945).  Thus, the Code's depreciation allowance
-does not apply to natural resources which are subject to
the allowance for depletion provided in section 611.-
Treas. Reg. 1.167(a)-2.  Accordingly, 611 itself carefully
appends, to its provision for -a reasonable allowance for
depletion- in the case of natural deposits and timber, the
qualification -and for depreciation of improvements,
according to the peculiar conditions in each case.-  26
U. S. C. 611(a) (1976 ed.); see Treas. Reg. 1.611-5(a).
To implement this distinction, the regulations under 611,
mentioned above, separately define -mineral deposit- as
-minerals in place,- Treas. Reg. 1.611-1(d)(4), and
-mineral enterprise- as including -the mineral deposit or
deposits and improvements.-  Treas. Reg. 1.611-1(d)(3).
The section defining -mineral deposit- then further pro-
vides that -[w]hen a mineral enterprise is acquired as a
unit, the cost of any interest in the mineral deposit or
deposits is that proportion of the total cost of the mineral
enterprise which the value of the interest in the deposit
or deposits bears to the value of the entire enterprise at
the time of its acquisition.-  Treas. Reg. 1.611-1(d)(4);
see also 1.611-2(g)(2)(vii) (requiring a statement to be
attached to the taxpayer's return showing -[a]n allocation
of the cost or value among the mineral property, improve-
ments and the surface of the land for purposes other than
mineral production-).  These provisions are designed to
isolate those portions of the cost of a -mineral enterprise-
that are subject to recovery through depletion.
  Thus, just as one generally cannot calculate an adjusted
basis under 1016 by treating an apartment building as
-more land,- one generally cannot treat tangible tools and
equipment as -more mineral deposit.-  If a mineral deposit
and associated equipment are sold together, 1016 re-
quires the seller to separate them for the purpose of
determining his gain or loss on the sale, just as 167
and 611 required him to keep them separate for the
purpose of calculating his depreciation and depletion
deductions.  Since, as the Hills point out, a regulation
incorporates the 1016 rule into 57(a)(8), and since the
Hills have identified no exception to this rule, we infer
that the Hills' tangible costs may not be included in the
basis of depletable mineral deposits for purposes of
calculating the amount of percentage depletion subject to
the minimum tax.
                            IV
  Our conclusion is confirmed by the astonishing, circu-
itously achieved results of reading 57(a)(8) as the taxpay-
ers urge.  A regulation that the Hills do not challenge
provides that -[i]n no event shall percentage depletion in
excess of cost or other basis of the property be credited
to the improvements account or the depreciation reserve
account.-  Treas. Reg. 1.611-2(b)(2).  The tangible costs
at issue here are recorded in these accounts.  Thus, under
this regulation, a tangible cost is not itself adjusted for
the amount of percentage depletion that on the Hills'
theory it would shelter from the minimum tax each year.
As a result, the tangible cost would shelter, over the years
the taxpayer owned the capital item it represented, an
amount of percentage depletion many times that of the
cost itself.  For example, a $21,000 capital item, subject
to straight-line depreciation over 20 years with a salvage
value of $1000, would add $20,000 to the basis of the
mineral deposit the first year, $19,000 the second year,
and so on for 20 years.  At the end of the 20th year, the
item would be fully depreciated, and the taxpayer's basis
in the item would then remain at $1000, the salvage
value, for as many more years as he continued to own it.
Thus, over the first 20 years, the capital item would
shelter $210,000, or 10 times its cost, from the minimum
tax; beginning in the 21st year, it would shelter $1000 per
year for as long as it remained in the taxpayer's hands.
At a minimum tax rate of 15%, a taxpayer would realize
a tax benefit, from his $21,000 investment, of $31,500
over the first 20 years from 57(a)(8) alone, without
regard to the additional tax benefit from ordinary depreci-
ation of the item.  It is hard to believe that Congress
would enact a minimum tax to limit the benefit that
taxpayers could realize from -items of tax preference,- only
to define one of those items in a way that would create
an even greater proportional tax benefit from investing in
tangible items, and to do so in an oblique fashion that,
as far as we know, has no precedent in the history of the
federal income tax.
                             V
  The Hills contend that two Treasury Department
regulations we have not yet discussed foreclose our
conclusion.  They point first to one of the cost depletion
regulations under 612, which, but for its title and one
adjective, would independently reinforce our conclusion:
-The basis for cost depletion of mineral or timber
property does not include:
      -(i) Amounts recoverable through depreciation deduc-
tions, through deferred expenses, and through deduc-
tions other than depletion, and
      -(ii) The residual value of land and improvements
at the end of operations.-  Treas. Reg. 1.612-1(b)(1).
This, of course, is exactly the conclusion in the case of
percentage depletion that we have reached after a long
detour through 1016.  Section 1.612-1(b)(1) applies by its
terms, however, only to the determination of mineral
deposit basis for the purpose of calculating cost depletion;
and the title of 1.612-1(b) is -Special rules.-  Therefore,
reason the Hills, the -general rule- for determining
mineral deposit basis under 1016 must include the items,
such as -[a]mounts recoverable through depreciation
deductions,- excluded in the -special rule.-  But this
argument proves too much.  If the Hills stuck to their
logic, they would have to claim that they could also add
-[t]he residual value of land and improvements at the end
of operations- to their bases in their mineral deposit
interests, an absurdity that they cannot, and do not try
to, support.  The simple answer is that when an arguable
suggestion of the title of one subsection of a regulation is
pitted against the entire Code framework for determining
basis, the Code wins, and the title is at most an infelicity.
  The infelicity is understandable here.  The calculation
of percentage depletion is unconnected to the concept of
basis; the annual percentage depletion deduction is not
measured in relation to basis, nor are the cumulative
deductions limited by basis.  See 26 U. S. C. 613 (1976
ed. and Supp. V).  The concepts of basis and percentage
depletion meet only in the minimum tax provisions, for
the purpose of calculating the item of tax preference in
57(a)(8).  Since 1.612-1(b)(1) was issued long before the
minimum tax was enacted, see 25 Fed. Reg. 11801 (1960);
Pub. L. 91-172, 301, 83 Stat. 580, that regulation's
reference to a -special rule- for -cost- depletion cannot
have been intended to indicate that some other rule
applied to the calculation of basis for percentage depletion.
After the minimum tax was enacted, the Treasury Depart-
ment inserted a regulation about basis for percentage
depletion where one would expect it: among the regula-
tions implementing the minimum tax.  That regulation,
1.57-1(h)(3), directs us to 1016, but unfortunately
contains no correlative reference to the regulations under
612.
  Second, the Hills argue that excluding tangible costs
from the adjusted basis of their mineral deposit interests
would run counter to regulations specifying the inclusion
of certain intangible costs.  As we have already noted, 26
U. S. C. 263(c) (1976 ed., Supp. V) grants taxpayers an
option to deduct as expenses certain -intangible drilling
and development costs.-  If a taxpayer chooses instead to
capitalize those costs, the regulations require the taxpayer
to sort the costs into two bins.  Costs -represented by
physical property- are recoverable through depreciation,
either through adjustments to the bases of pre-existing
items to which the costs relate, or through an initial entry
in a new depreciation account.  Treas. Reg. 1.612-4(b)(2).
Costs -not represented by physical property- are recover-
able through depletion, as adjustments to the bases of the
mineral deposit interests to which they relate.
1.612-4(b)(1); see 1.612-4(d) (if a taxpayer fails to elect
to expense intangible costs correctly, -he shall be deemed
to have elected to recover such costs through depletion to
the extent that they are not represented by physical
property, and through depreciation to the extent that they
are represented by physical property-).  Since these latter
costs are added to depletable basis, the taxpayers argue,
so should the tangible costs that are excluded altogether
from the 263(c) option.  We fail to see the logic of this
argument.  To the extent that the regulation allowing
intangible costs -not represented by physical property- to
be added to a mineral deposit's basis deviates from
general principles of basis allocation, we see no reason
why one deviation should force the Government, or this
Court, to create another.  Nor have the Hills explained
why this regulation in fact represents a deviation.

  The judgment of the Court of Appeals is
                                                 Reversed.