Mining operations: the receding-face doctrine.

Minerals are extracted from the ground through surface and underground mining methods. A mine goes through three principal operational stages during its life--exploration, development and production. At the production stage, a mine will produce a consistent level of ground minerals each year. Over time, a recession of the mine's working face will occur, necessitating that support services be extended up the mine's face to maintain a normal production output.

Under Regs. Sec. 1.612-2(a), taxpayers can claim certain capital additions at mines as ordinary and necessary business expenses instead of capitalizing them as depreciable assets, if the expenditures are necessary to maintain normal output of a mine. These regulations specifically state:

... (a) In general. Expenditures for improvements and for replacements, not including expenditures for ordinary and necessary maintenance and repairs, shall ordinarily be charged to capital account recoverable through depreciation deductions. Expenditures for equipment (including its installation and housing) and for replacements thereof, which are necessary to maintain the normal output solely because of the recession of the working faces of the mines and which--

(1) Do not increase the value of the mine, or

(2) Do not decrease the cost of production of mineral units, or

(3) Do not represent an amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made shall be deducted as ordinary and necessary business expenses.

Background

The facts of a particular situation determine if an expenditure qualifies for receding-face treatment. Currently, no Code section exists that covers this area of tax law. Not until after Marsh Fork Coal Co., 11 BTA 685 (1928), rev'd, 42 F2d 83 (4th Cir. 1930)), did Treasury issue regulations covering the receding-face issue. The language contained in Regs. Sec. 1.612-2(a) is virtually identical to the language of T.R. 111, Section 29.23(m)-15, issued in 1939.

The concept of an ordinary and necessary business expense versus a capital expenditure dates back to the Revenue Act of 1918 and early mining-industry accounting practices. During this time period, most discussion focused on the need to have different tax treatments for expenditures made to maintain the normal output of a mine from a recession of the working face versus expenditures made to increase mine production.

In the event that expenditures made by a taxpayer to maintain a normal production level would have been theoretically capitalized, such costs would be "pyramided" against the mineral farther back in a mine. This action would have resulted in the closest mineral in the mine being extracted at an abnormally high profit level, while the mineral further back in the mine would be extracted at a loss. Such a practice would have presented many accounting problems and challenges for the mining industry.

Based on a review of tax law, the courts have dealt extensively with the receding-face doctrine over the years 1920-1969. The vast majority of receding-face issues have involved underground mining operations. The principal focus in each of these cases has been on what the proper tax treatment should be for conveyor belts, power, ventilation, rail transportation and mine rail-car systems. Today, the receding-face issue has been occurring more and more in surface-mining situations.

Current State of Affairs

Some of the most prevalent expenditures seen by IRS engineers being Claimed in recent months as receding-face deductions include:

* A percentage of mine haul truck purchased;

* Installation of new conveyor-belt systems, extension of existing conveyor-belt systems and replacement of worn-out conveyor-belt components;

* Change over from a track-hauling system to a truck-hauling system;

* Change over from a truck-hauling system to a conveyor-belt hauling system;

* Construction of a second fuel station for trucks hauling between a mine pit and a processing/load-out facility;

* Relocation of power lines; and

* Extension of haul roads into a new mining area.

From an underground mining perspective, receding-face expenditures have included:

* Upgrade of mainline conveyor-belt systems (from a 48-inch width to a 60-inch width);

* Replacement of mainline and section conveyor-belt components due to age and wear;

* Construction of a new mine portal facility to serve new areas of a mine;

* Conversion of a track-hauling system to a belt-hauling system;

* Construction of an airshaft to serve a new mining area;

* Purchase of conveyor-belt components not actually placed in service during the year;

* Upgrade of power center facilities;

* Construction of new rock-dust bins (required by law for fire prevention purposes);

* Construction of a new borehole power substation (to supply more power); and

* Drill of degasification wells in coal deposits to release methane prior to mining.

The question of whether each of these expenditures qualified as a deduction in total, in part or not at all under the receding-face doctrine was determined by the IRS Engineer conducting a complete analysis of the facts of the situation in relation to the applicable tax law.

Cases and Rulings

A receding face issue is a very fact-sensitive matter. IRS Engineers must review the circumstances that surround a particular situation to determine the specific reason(s) for expenditures. Such information is of vital importance in determining the applicability of the receding-face doctrine to a particular transaction.

The regulations require that a direct and exclusive causal relationship exist between the particular expenditure and the recession of a mine's working face to qualify as a deduction; see Letter Ruling 9935061, Kennecott Copper Corp., 171 Ct. Cl. 580 (1965), and U.S. Gypsum Co., DC IL, 3/1/62. Under the receding-face doctrine, expenditures that increase mine production do not qualify for receding-face treatment, as the action has no relationship to maintaining production.

Receding-face deductions do not apply to expenditures for replacing equipment that wears out over time (Alsted Coal Company v. Yoke, 4th Cir., 12/22/52, and Clear Fork Coal Company, 22 TC 1075 (1954)).

Expenditures that a taxpayer makes for mine equipment due to a shortage of manpower or a change in the seam thickness of a mineral deposit do not qualify for receding-face treatment. In addition, the acquisition of larger and more efficient mining equipment does not qualify for receding-face treatment if it (1) decreases the mine's overall production costs, (2) increases the mine's production level and (3) increases the mine's value (H.E. Harman Coal Corp., 4th Cir., 9/17/52).

Equipment associated with a receding-face deduction must be placed in service during the year the deduction is claimed (Amherst Coal Company, DC WVA, 2/26/65).

Driving a new rock slope into a mine that cannot be used currently for production, escape or ventilation purl poses is not a receding-face expenditure, because it has no relationship to the maintenance of the mine production level. However, if a taxpayer about to deplete an ore zone were to incur additional expenditures in driving a vertical shaft into a lower level of a mine to maintain normal output, such expenditures would qualify for deduction under the receding-face doctrine; see Roundup Coal Co., 20 TC 388 (1953), and U.S. Gypsum Co.

For receding-face purposes, an expenditure cannot increase a mine's overall value. A higher production level is a measure of an increase in value (Repplier Coal Co., 3rd Cir., 2/19/44).

Deductibility of expenditures under the receding-face doctrine rests on the character or classification of a particular cost actually incurred, as opposed to the character or classification of a cost that might have been occurred if another method had been employed (Letter Ruling 66031551360A).

Equipment expenditures made to satisfy state or Federal safety requirements do not qualify as receding-face expenditures, because they do not relate solely to recession of a working face (Letter Ruling 9935061, Kennecott Copper Corp. and U.S. Gypsum Co).

Upgrading the size of certain equipment does not automatically preclude a taxpayer from claiming a receding-face deduction. The facts that surround a particular upgrade are important in determining the applicability of the receding-face doctrine. Two examples of upgrading include:

* Enlarging a mainline conveyor belt from a 48-inch width to a 60-inch width to handle increased production capacity; and

* Enlarging a mine-water discharge pumping system from 4-inch to 6-inch pipes to handle increased drainage generated at the face area of a mine that does not increase production capacity (Roden Coal Corp., 39 F2d 425 (5th Cir. 1930)).

In the first situation, a production increase occurs through the taxpayer's action, which disqualifies the expenditure for receding-face treatment. However, in the second example, the taxpayer's actions are deemed necessary to maintain production and are eligible for receding-face treatment.

Expenditures under the receding-face doctrine must involve recurring acquisition costs of depreciable equipment used in a mining operation as a face recedes (Letter Ruling 6603159360A and Kennecott Copper Corp.).

Under the receding-face doctrine, taxpayers cannot deduct equipment purchased to (1) comply with face-area height limits imposed by state law, (2) change the upward floor slope of a mineral deposit and (3) change mining methods made in the interest of economy and efficiency, because none of these expenditures have any relationship to the recession of a working face (U.S. Gypsum Co.).

Conclusion

In summary, this item has attempted to explore some of the many issues that exist in the receding-face doctrine. As seen in the discussion, the facts that surround a particular situation are the key components that determine the applicability of this concept. It is expected that this area of tax law will see much more usage in the near future, as a result of the growing awareness among taxpayers and its broadening use in tax planning applications. On Oct. 22, 2001, the IRS released the Mining Technical Advisor's "Receding Face Coordinated Issue Paper" This document provides some guidance for understanding and applying the receding-face doctrine to four mine conveyor-belt scenarios.

Author's note: The views and perspectives presented are those of the author and do not represent any official position of Treasury, the IRS or both. The author wishes to extend sincere thanks to the various IRS Engineers, Revenue Agents, Mining Technical Advisors, Disclosure Officers and Counsel Attorneys who provided input and review assistance.

FROM W.W. WATTS JR., MINING ENGINEER, U.S. DEPARTMENT OF THE TREASURY, IRS, TERRITORY 1855, DENVER, CO