Smith and Hays, Circuit Judges and Bartels, District Judge.*fn*
This appeal concerns the proper allocation of the percentage depletion deduction between the lessor and the lessee of certain mining property. The Tax Court determined that an allocation of the depletion deduction to the lessor, appellant Callahan Mining Corporation, based upon the fifty percent share of net profits payments which it received under the terms of the lease represented an "equitable apportionment" satisfying the mandate of the relevant provision of the Internal Revenue Code of 1954, § 611(b) (1). Callahan contends that its depletion deduction should be based upon fifty percent of the total gross income from the property. We find no reason to disturb the determination of the Tax Court,*fn1 and accordingly, we affirm its decision that there are deficiencies due from appellant for the years 1959, 1960 and 1961 in the amounts of $112,585.06, $76,469.34 and $114,494.56, respectively.
The following summary of the facts as found by the Tax Court, 51 T.C. No. 1005 (March 24, 1969), is sufficient for an understanding of the issue involved in this case.
On January 15, 1947, appellant Callahan entered into a lease agreement with American Smelting and Refining Company (ASARCO) with respect to certain contiguous patented and unpatented lode claims in the Coeur d'Alene District in Northern Idaho. These claims, known as the Galena mining property, had been acquired by appellant in the early 1920's, and between 1922 and 1938 appellant had expended substantial sums on exploration and development of the property in an unsuccessful attempt to achieve commercial production. In 1946, after a period of inactivity at the mining property, independent engineers hired by appellant conducted an examination of the property's potential. Their report indicated that, in view of recently discovered valuable deep ore bodies in the vicinity of the Galena mining property, a deep exploration program was warranted, but that such a program would involve a substantial financial risk. Appellant, either unwilling or unable to undertake the risk itself, began negotiations with several major mining companies in an effort to secure outside financing. The lease agreement entered into with ASARCO was the result.*fn2
Under the terms of the lease agreement, ASARCO was granted the exclusive right to explore, develop and operate the Galena mining property for a term of 30 years with an option to renew for an additional 30 years. After completion of certain specified work on which ASARCO was required to expend no more than $600,000, ASARCO had the right to terminate the lease upon thirty days written notice. If it did not elect to terminate the lease, ASARCO was obligated to continue "with reasonable diligence" the exploration and development of the property; however, all exploratory, development and operational work was to be undertaken only as ASARCO "in its sole judgment" deemed advisable for the benefit of the enterprise. All moneys required for such work, including working capital, were to be advanced by ASARCO. ASARCO was also required to pay all taxes upon the property and to reimburse Callahan for any taxes paid by it.
Net profits*fn3 were to be applied first to reimburse ASARCO for its advances or expenditures in connection with the exploration, development and operation of the mining property and then to establish and maintain a working capital fund of $500,000. Article 14 of the lease agreement provided that any net profits in excess of those required to satisfy the foregoing requirements were to be divided "equally between the Lessor and the Lessee." Until such time as the lessor Callahan was entitled to share in the net profits of operations, ASARCO was require to pay royalties to Callahan on all ores and concentrates produced and sold in an amount equal to ten percent of the net smelter or mill returns.*fn4 However, these royalties were to be not less than fifty cents per ton of crude ore.
If, after the profit-sharing provision had become operative, Callahan's share of net profits during any calendar quarter fell below fifty cents per ton of crude ore produced, Article 17 required ASARCO to advance to Callahan the difference between Callahan's share of net profits for the quarter and the sum of fifty cents per ton of crude ore. These advances were chargeable against Callahan's share of net profits in any future calendar quarter to the extent that such share exceeded fifty cents per ton of crude ore, but Callahan was not otherwise liable for the repayment of the advances.
Finally, in Article 29, the lease agreement provided that upon termination of the lease ASARCO was required to surrender the property and to pay all bills and other obligations incurred in connection with its development and operation including all royalties and profits due to Callahan up to the date of termination. To the extent that ASARCO had not been fully reimbursed for expenditures made by it under the terms of the contract, including advances to Callahan under the provisions of Article 17, the working capital fund, including all equipment, material and supplies, was to be applied to satisfy ASARCO's claims. Any remaining amount in the working capital fund was to be divided equally between Callahan and ASARCO.
Since 1947, ASARCO has operated the Galena mining property under the terms of the lease agreement with its own employees and management team, expending substantial amounts in exploration, development and equipment. The operation began to show a profit in 1955, and by January 1959, sufficient net profits had been generated to reimburse ASARCO for its prior expenditures (totalling $3,641,079) and to establish the $500,000 working capital fund. Since that time and during the years 1959-1961 here in issue, appellant and ASARCO have divided net profits equally. During late 1959 and early 1960, because of a strike at the smelters, ASARCO advanced approximately $800,000 over and above the $500,000 working capital account in order to keep the mine in operation. These advances were subsequently recovered from net profits.
On its federal income tax returns for the years 1959, 1960 and 1961, appellant computed and claimed percentage depletion deductions based on fifty percent of the total gross income of the Galena mining property. The Commissioner ruled that appellant was entitled to depletion deductions based only on the amounts it actually received from ASARCO as its share of net profits.*fn5 Appellant filed a petition for redetermination in the Tax Court. The Tax Court held adversely to appellant, determining deficiencies due for the taxable years 1959, 1960 and 1961 in the amounts of $112,585.06, $76,460.34 and $114,494.56, respectively.*fn6
Section 611(a) of the Internal Revenue Code of 1954 authorizes, as a deduction in computing taxable income from mines and other natural deposits, a "reasonable allowance for depletion * * * according to the peculiar conditions in each case * * *." The allowable deduction in the case of metal mines is 15 percent of the "gross income from the property excluding from such gross income an amount equal to any rents or royalties paid or incurred by the taxpayer in respect of the property." Int. Rev. Code of 1954, § 613(a), (b)(3). ...