                                T.C. Memo. 2017-160



                          UNITED STATES TAX COURT



 MITSUBISHI CEMENT CORPORATION & SUBSIDIARIES, A DELAWARE
                  CORPORATION, Petitioner v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 7161-16.                          Filed August 21, 2017.



      Paul W. Jones, for petitioner.

      Michael W. Tan and Aely K. Ullrich, for respondent.



                            MEMORANDUM OPINION


      COHEN, Judge: Respondent determined deficiencies of $76,580 and

$344,868 in petitioner’s Federal income tax for 2011 and 2012, respectively.

Unless otherwise indicated, all section references are to the Internal Revenue Code

(Code) in effect for the tax years in issue.
                                         -2-

[*2] The parties have reached agreements with respect to some of respondent’s

proposed adjustments to petitioner’s taxable income for the tax years in issue. The

sole adjustment still in dispute involves the correct calculation of petitioner’s

depletion deduction from the mining of calcium carbonates. The remaining issues

for consideration are: (1) whether the applicable depletion percentage rate for

petitioner’s mined calcium carbonates should be 15% per section 1.613-2(a)(3),

Income Tax Regs., or 14% per section 613(b)(7); (2) whether the costs of certain

materials purchased from third parties and mixed with petitioner’s calcium

carbonates in the process of making finished cement should be included in

“mining costs” for purposes of calculating petitioner’s “gross income from

mining” under the proportionate profits method, or alternatively, whether those

costs should be included in “total costs” for purposes of that calculation; and

(3) whether “gross sales”, as used to calculate “gross income from mining” under

the proportionate profits method, should include only actual sales or should

include additionally “constructive sales” resulting from applying the average price

per ton of finished cement sold to third parties to tons of finished cement sold to

related parties.
                                         -3-

[*3] By agreement of the parties, the first two issues have been submitted on

stipulated facts and are addressed in this opinion. The third issue is deferred

pending receipt of further evidence by stipulation or by trial.

                                    Background

      All facts are drawn from the parties’ stipulation. The stipulated facts and

exhibits are incorporated as our findings by this reference.

Petitioner’s Business Activity

      Petitioner is a Delaware corporation that has its principal place of business

in Henderson, Nevada. Petitioner’s largest shareholder is Mitsubishi Materials

Corp. (MMC) in Japan. MMC owns 67% of petitioner.

      Petitioner’s primary business activity centers around the production of

finished cement at its Cushenberry Cement Plant (Cushenberry) near Victorville,

California. Petitioner’s first marketable product is finished cement. Most of

petitioner’s sales are to MCC Development (MCCD) and MCCD subsidiaries.

MMC owns 70% of MCCD. MCCD mixes petitioner’s finished cement with

aggregates and other ingredients to produce ready-mix concrete for the end user.

      Calcium Carbonates and Additive Minerals

      In the process of producing finished cement, petitioner mines calcium

carbonates at Cushenberry. Petitioner purchases other minerals needed for the
                                        -4-

[*4] production of finished cement from third parties. Petitioner adds these

purchased minerals to its own mined calcium carbonates before introducing the

mixture into the preheating tower. The following table shows the costs of the

additive minerals that petitioner purchased from third parties during the tax years

in issue:

     Additive mineral                   2011                         2012

            Iron                      $971,834                   $1,113,640
            Red bauxite              2,578,713                    3,164,248
            Kaolin clay                562,674                      568,356
            Mill scale                 498,352                      680,824
             Total                   4,611,573                    5,527,068

      Total Costs, Mining Costs, and Depreciation

      For the tax years in issue petitioner incurred the following total costs in

connection with its production of finished cement:

              Costs                     2011                         2012

      Total direct costs            $57,817,477                 $63,561,773
      Direct cost variance             3,056,320                   4,766,089
      Overhead costs                   6,988,357                   8,449,084
                                          -5-

[*5] Out of petitioner’s total direct costs for the tax years in issue, it had direct

mining costs of $9,467,345 and $10,003,398, respectively.

      According to the parties’ agreed adjustments to depreciation, petitioner’s

depreciation expenses (in round numbers) associated with the production of

finished cement were:

            Depreciation                         2011                     2012

         Mining depreciation                 $1,302,997                $826,479
         Nonmining depreciation                 (960,855)              2,348,437
         Allocable general
          depreciation                           453,153                 380,373
            Total                                795,294               3,555,289

These agreed-upon depreciation expenses reflect adjustments made pursuant to

section 481.

Petitioner’s Depletion Deduction

      Petitioner filed Forms 1120, U.S. Corporation Income Tax Return, for the

tax years in issue. For each of the tax years in issue petitioner claimed a deduction

for depletion pursuant to section 611 in connection with its mining of calcium

carbonates at Cushenberry. For 2011 petitioner claimed a $1,310,242 depletion

deduction. For 2012 petitioner claimed a $1,839,662 depletion deduction.
                                        -6-

[*6] Petitioner determined its depletion deduction using percentage depletion

described in section 613 and the regulations thereunder. To determine percentage

depletion under section 613, petitioner calculated its gross income from mining

using the proportionate profits method of section 1.613-4(d)(4), Income Tax Regs.

For both tax years in issue, petitioner determined its depletion deduction using a

percentage depletion rate of 15% under section 1.613-2(a)(3), Income Tax Regs.

      On December 29, 2015, respondent sent petitioner a notice of deficiency for

tax years 2011 and 2012. In the notice respondent disallowed a portion of the

depletion deduction that petitioner claimed for each year. In adjusting petitioner’s

depletion deduction, respondent used a percentage depletion rate of 14% under

section 613(b)(7) rather than the 15% rate that petitioner had used. Respondent

also contends that in determining its depletion deduction petitioner incorrectly

computed its gross income from mining.

                                    Discussion

I.    Petitioner’s Depletion Percentage Rate

      Section 611(a) provides that in the case of mines there shall be allowed as a

deduction in computing taxable income a “reasonable allowance for depletion”.

Under section 613(a) this allowance is calculated as a specified percentage of “the

gross income from the property”. “Gross income from the property” in
                                        -7-

[*7] petitioner’s case is defined as “the gross income from mining”. Sec.

613(c)(1). Section 613(b) lists applicable percentage depletion rates for specific

classes of minerals, and these rates are applied to the taxpayer’s gross income from

mining to determine the depletion allowance. The amount of the depletion

deduction under section 613(a) can be expressed by the following formula:

           Gross Income From Mining × Percentage Depletion Rate =
                            Depletion Deduction

      Section 613(b)(7) provides that for “minerals * * * including * * * calcium

carbonates” 14% shall be the percentage applied to the gross income from mining

to determine the depletion deduction. Section 1.613-2(a)(3), Income Tax Regs.,

provides that 15% is the applicable percentage depletion rate for “minerals listed

in this subparagraph”, which includes calcium carbonates. Petitioner calculated its

depletion deductions for the tax years in issue using the 15% depletion rate

provided in the regulations.

      Petitioner contends that section 1.613-2(a)(3), Income Tax Regs., is “an

agency pronouncement that should be deemed a concession or stipulation” by

respondent. Petitioner cites Rev. Rul. 66-24, 1966-1 C.B. 157, as evidence that

respondent has “valid[ated]” the rate provided in section 1.613-2(a)(3), Income
                                        -8-

[*8] Tax Regs., although that ruling concerned the application of the regulation to

refractory and fire clay, not to calcium carbonates.

      Petitioner also makes an argument based on the legislative nature of

regulations adopted pursuant to section 611. Petitioner, however, ignores the

timing of the regulations in relation to the change in the controlling statute. The

final rule under section 1.613-2(a)(3), Income Tax Regs., was adopted in 1960,

when the statutory depletion percentage rate for the category of minerals including

calcium carbonates was 15%. See sec. 613(b)(6), I.R.C. 1954; T.D. 6446, 1960-1

C.B. 208, 231-232 (promulgating section 1.613-2, Income Tax Regs.). Before

1969 no mineral or category of minerals was subject to a depletion rate of 14%

under the Code. The Tax Reform Act of 1969, Pub. L. No. 91-172, sec. 501(a)(7),

83 Stat. at 629, lowered the statutory rate for the category of minerals including

calcium carbonates to 14%. Section 1.613-2(a)(3), Income Tax Regs., was, in

effect, superseded and made obsolete by the statutory change and cannot be

regarded as an implementing regulation.

      In any event, an agency’s “‘interpretation’ of the statute cannot supersede

the language chosen by Congress.” Pac. Gas. & Elec. Co. v. United States, 664

F.2d 1133, 1136 (9th Cir. 1981) (citing Mohasco Corp. v. Silver, 447 U.S. 807,

825 (1980)). We will not follow a regulation contrary to “the unambiguously
                                        -9-

[*9] expressed intent of Congress.” Chevron, U.S.A., Inc. v. Nat. Res. Def.

Council, Inc., 467 U.S. 837, 843 (1984). “If the intent of Congress is clear, that is

the end of the matter”. Id. at 842. The correct depletion percentage rate for

calcium carbonates is the rate specified under section 613(b)(7). We sustain

respondent’s determination to calculate petitioner’s depletion deduction by

applying the rate of 14% against petitioner’s gross income from mining.

II.   Petitioner’s Gross Income From Mining

      Generally, gross income from mining is “that amount of income which is

attributable to the extraction of the ores or minerals from the ground and the

application of mining processes”. Sec. 1.613-4(a), Income Tax Regs. Taxpayers

who, in addition to mining activities, conduct nonmining activities with respect to

a mineral property (as in the manufacture of finished products) must make an

allocation between gross income from the mining activity and gross income from

the nonmining activity so that the percentage depletion rate can be applied only to

the gross income from mining. Id. Under the general rule that applies in such a

situation, gross income from the mining activity is computed on the basis of the

representative market or field price of the particular mineral being processed. Id.

para. (c). Where a representative market or field price for a particular mineral

cannot be ascertained, the proportionate profits method of computing gross
                                        - 10 -

[*10] income from mining shall be used unless permission to use an alternative

method of computation is obtained from the Commissioner. Id. para. (d). The

parties agree that petitioner’s gross income from mining should be computed

under the proportionate profits method.

      A.     The Proportionate Profits Method

      The proportionate profits method is based on a determination of the total

mining and nonmining costs incurred by the taxpayer to produce its first

marketable product. Monsanto Co. & Subs. v. Commissioner, 86 T.C. 1232, 1243

(1986). Once determined, the ratio of mining costs to total mining and nonmining

costs is applied to the total gross income from the taxpayer’s combined mining and

nonmining activities with respect to the mineral that is the subject of depletion.

Sec. 1.613-4(d)(4)(ii), Income Tax Regs. The product therefrom is treated as the

gross income from mining against which the depletion percentage rate is applied.

Id. The proportionate profits method is premised upon the administratively

convenient principle that “each dollar of the total costs paid or incurred to

produce, sell, and transport the first marketable product * * * earns the same

percentage of profit.” Id. subdiv. (i); see N.C. Granite Corp. v. Commissioner, 56

T.C. 1281, 1289 (1971). Section 1.613-4(d)(4)(ii), Income Tax Regs., provides

the formula for the proportionate profits method as follows:
                                         - 11 -

[*11]                   [Mining Costs/Total Costs] × Gross Sales =
                            Gross Income From Mining

        The parties agree that for the purpose of computing petitioner’s gross

income from mining under the proportionate profits method petitioner’s total costs

shall be the sum of: total direct costs, direct cost variance, overhead costs, and

total depreciation associated with the production of finished cement. Furthermore,

the parties agree that total mining costs shall be the sum of: direct mining costs

and mining depreciation, plus those portions of direct cost variance, overhead

costs, and allocable depreciation that are properly attributable to mining activities.

The portions of direct cost variance, overhead costs, and allocable depreciation

attributable to mining activities will be determined in each case by multiplying

that total cost by a fraction, which is direct mining costs over total direct costs.

Petitioner’s direct mining costs, and therefore the correct amount of its total

mining costs, are at issue.

        B.    Petitioner’s Costs of Purchasing Additive Minerals

        The parties disagree over the proper treatment of petitioner’s costs of

purchasing minerals from third parties. Petitioner mixed these purchased minerals

with its own mined calcium carbonates in the production of finished cement before

introducing the mixture into the preheating tower. Petitioner contends that the
                                        - 12 -

[*12] costs of the purchased minerals should be included in its total mining costs

as direct mining costs for the tax years in issue. Respondent contends that the

costs of minerals purchased from third parties are nonmining costs and that they

should be included as part of petitioner’s total costs under the proportionate profits

method.

      Section 613(c)(2) provides that “‘mining’ includes not merely the extraction

of the ores or minerals from the ground but also the treatment processes

considered as mining described in paragraph (4)”. Section 613(c)(4) identifies

certain treatment processes for different classes of minerals, which “where applied

by the mine owner or operator shall be considered as mining”. The regulations

under section 613 refer to these treatment processes as “mining processes” and

contemplate that their costs to the taxpayer are includable as mining costs in the

calculation of gross income from mining under the proportionate profits method.

See sec. 1.613-4(d)(3), (4)(ii), Income Tax Regs. In the case of calcium

carbonates and other minerals when used in making cement, mining processes

include “all processes (other than preheating of the kiln feed) applied prior to the

introduction of the kiln feed into the kiln, but not including any subsequent

process”. Sec. 613(c)(4)(F). Section 613(c)(5) provides generally that a process
                                       - 13 -

[*13] of blending with other materials shall not be considered mining unless the

process is otherwise provided for in paragraph (4).

      In all cases, treatment processes “shall be considered as mining processes

only to the extent they are applied by a mine owner or operator to the ore or

mineral in respect of which he is entitled to a deduction”. Sec. 1.613-4(f)(2)(iv),

Income Tax Regs. A deduction for depletion with respect to a particular mineral is

allowed only to the taxpayer who has an “economic interest” in that mineral “in

place”, i.e., in its unmined state. Sec. 1.611-1(b)(1), Income Tax Regs.; see also

United States v. Swank, 451 U.S. 571, 579 (1981). A taxpayer who purchases a

mineral mined or otherwise produced by another may gain some “economic

advantage” in the mineral, but he or she has no depletable interest in it. See

Riddell v. Cal. Portland Cement Co., 330 F.2d 16, 18-19 (9th Cir. 1964). The

regulations concerning the calculation of gross income from mining for percentage

depletion specifically provide that “‘mining’ does not include purchasing minerals

from another” and the “application of * * * processes to purchased ores, minerals,

or materials does not constitute mining.” Sec. 1.613-4(f)(2)(iv), Income Tax Regs.

The costs of minerals for which the taxpayer is not entitled to a depletion

deduction and the costs of processes applied to such minerals “shall be considered

as nonmining costs in determining gross income from mining.” Id. para. (d)(3)(ii).
                                        - 14 -

[*14] When several minerals are mined separately and subsequently mixed

together, as in the making of finished cement, “gross income for percentage

depletion purposes must of course be computed separately with respect to each

component mineral, notwithstanding any such mixing.” Rev. Rul. 290, 1953-2

C.B. 41. This principle applies irrespective of the kiln-feed “cutoff point” set by

section 613(c)(4)(F) for treatment processes considered as mining in the case of

calcium carbonates and other minerals used in making cement. See Cal. Portland

Cement Co., 330 F.2d at 18.

      Petitioner contends that the minerals it purchases from third parties are

“applied” to its own mined calcium carbonates as a “treatment process”. Because

the third-party minerals are obtained and blended with the calcium carbonates

before the mixture is introduced into the kiln, petitioner argues they are a

treatment process that should be considered mining under section 613(c)(4)(F) and

their costs should be included in total mining costs under the proportionate profits

method. Petitioner contends that section 613(c)(5) does not preclude the costs of

the additive minerals from being treated as mining costs, because their purchase

and addition to the calcium carbonates is a treatment process “otherwise provided

for” in section 613(c)(4).
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[*15] The only mineral in respect of which petitioner is entitled to a depletion

deduction is calcium carbonates. We reject petitioner’s characterization of the

purchased minerals as a “treatment process” that is “applied” to the calcium

carbonates. The costs that petitioner seeks to include as direct mining costs are the

costs of the additive minerals themselves. Petitioner does not mine or otherwise

have an economic interest in these minerals. The regulations and applicable

caselaw hold consistently that the costs of minerals that are “nondepletable” with

respect to the taxpayer may not be included as mining costs in calculating the

taxpayer’s depletion allowance. Sec. 1.613-4(d)(3)(ii), Income Tax Regs.; see also

Whitehall Cement Mfg. Co. v. United States, 369 F.2d 468, 471 (3d Cir. 1966);

Cal. Portland Cement Co., 330 F.2d at 18.

      Petitioner’s focus on when the third-party minerals were added to the

calcium carbonates (i.e., before the kiln feed) ignores that it never had a depletable

interest in those minerals and that, in any case, depletion allowances must be

calculated separately for individual mineral properties combined in a mixture. On

brief petitioner acknowledges that the additive minerals themselves would have

been subject to a separate depletion allowance in the hands of another taxpayer.

Including the costs of these minerals in petitioner’s mining costs increases its own

deduction. Thus the effect of including such costs in petitioner’s mining costs
                                        - 16 -

[*16] would be to allow a “double depletion” on the additive minerals. See Cal.

Portland Cement Co., 330 F.2d at 18. We agree with other courts that have

considered the issue that double depletion “will not do.” Id.; see also United

States v. Cal. Portland Cement Co., 413 F.2d 161, 166 (9th Cir. 1969). Even if the

additive minerals were not the subject of a prior deduction, including their costs in

petitioner’s mining costs has the overall effect of depleting them as calcium

carbonates, which they are not. See Sw. Portland Cement Co. v. United States,

435 F.2d 504, 509 (9th Cir. 1970).

      Petitioner argues that if we should conclude that the costs of the additive

minerals may not be included in its mining costs, then we should conclude

alternatively that they are “nominating costs”, as that term appears in section

1.613-4(d)(3)(ii), Income Tax Regs., and on that basis exclude them from the

proportionate profits formula entirely. Petitioner has not provided and we have

not found any definition of “nominating” within the context of the Code sections

dealing with depletion. We agree with respondent that the word “nominating” as

it appears in section 1.613-4(d)(3)(ii), Income Tax Regs., is a typographical error.

The word “nominating” appears nowhere else in section 1.613-4, Income Tax

Regs., and petitioner does not cite any other Code section or regulation where that

term is used or defined. Section 1.613-4, Income Tax Regs., addresses at length
                                        - 17 -

[*17] the treatment of “mining” and “nonmining” costs, and from the context of

the relevant subparagraph we conclude that “nominating” is simply a misspelling

of “nonmining”. The word “nonmining” is, in fact, used in section 1.613-

4(d)(3)(ii), Income Tax Regs., as that regulation is reproduced in T.D. 7170, 1972-

1 C.B. 178, 183.

      The costs of the minerals that petitioner purchases from third parties are

nonmining costs in respect of petitioner’s mined calcium carbonates. The parties

have stipulated that these additive minerals are a necessary component of finished

cement. Their costs are “paid or incurred to produce * * * [petitioner’s] first

marketable product”. Sec. 1.613-4(d)(4)(ii), Income Tax Regs. The costs of the

additive minerals should be included as part of petitioner’s total costs in

computing its gross income from mining under the proportionate profits method.

      Application of the agreed formulas to determine petitioner’s gross income

from mining for 2011 and 2012 depends on resolution of the third issue in dispute

between the parties as identified above. In anticipation of that later resolution,


                                                 An appropriate order will be

                                           issued.
