Chapter 2.
4
TAXATION AND DEPLETION
J O H N W. W HITNEY
2.4.1 INTRODUCTION
Federal and state tax laws create a complex framework
within which the cash flow analysis of a mining project or opera-
tion is conducted. Two important components of federal tax
law are the capital recovery provisions of the depreciation and
depletion regulations. The other important elements of federal
taxes are the actual income tax provisions and the minimum tax
provisions. Anyone who works for profit needs to be aware of
tax concepts in order to determine how they will impact the
amount and timing of generated cash flows. The purpose of the
chapter is to emphasize the importance of tax planning and to
show the effects of taxes in investment evaluation. This chapter
describes the federal tax rules that apply to mining and different
kinds of state taxes that affect mining operations.
Tax planning requires the legitimate use of all current laws,
regulations, and court decisions to reduce taxable income. This
is referred to as tax avoidance and enables companies to reduce
their taxable income to the minimum allowed by the host coun-
try’s legal system. Thus careful tax planning permits the reten-
tion of a maximum amount of cash for the company to use in
its own endeavors.
It is necessary to include the effects of income tax in project
analysis. This allows one to evaluate projects in terms of the
net-after-tax return on total investment. There are several techni-
cal reasons for inclusion of the effects on income taxes, but the
most important is to ensure a realistic estimate of the expected
return on investment. For example, proposals that involve a mix
of foreign and domestic operations will be subject to different
tax rates and tax rules than either wholly foreign or wholly
domestic corporations. Also there may be alternatives that re-
quire choices between projects that are wholly foreign vs. proj-
ects that are wholly domestic. In either case, it is necessary to
analyze the project returns on an after-tax basis to avoid unrealis-
tic rate-of-return comparisons.
The two most important US tax elements for preliminary
financial analysis are depreciation and depletion. Although treat-
ment of these two elements is relatively straightforward, the
choice of the depreciation method will often depend on the
anticipated mine life, the discount rate, and expected profitabil-
ity. This is the reason that it is important to have a clear under-
standing of how depreciation and depletion are calculated and
how they interact to affect the net present value and the internal
rate of return.
Two categories of expenses, (1) exploration and (2) develop-
ment, incurred by mineral exploration companies are given spe-
cial tax treatment. Treatment of these two categories for tax
purposes is summarized in this chapter. It is also important to
emphasize here that oil and gas exploration expenditures are
treated somewhat differently from exploration expenditure for
other minerals. This chapter does not provide an analysis of the
treatment of expenditures incurred in exploration and develop-
ment of oil and gas.
Investment strategy and mine financing are discussed in
Chapter 2.5 and Section 6.
AND G ARTH H. S IBBALD
2.4.2 FEDERAL INCOME TAXATION
2.4.2.1 Exploration Expenditures
Exploration expenditures are defined as expenses incurred
by a mining organization in determining the location and quality
of mineral deposits that had not previously been commercially
exploited. As a general rule, exploration expenditures are capital-
ized and recoverable through depletion. Taxpayers do have the
option to deduct a significant percentage of the exploration ex-
penses in the year they are incurred and then recapture these
expenses when the production stage is reached or when the
property is transferred.
Two relatively separate stages in the exploration process
can be identified, (1) the pre-exploration and (2) subsequent
exploration activities. Pre-exploratory costs include the costs of
reconnaissance, that is, the cost of surveying wide areas to find
specific areas of interest. The Internal Revenue Service has ruled
that pre-exploratory costs incurred in a project are to be related
to the property ultimately acquired; these costs may be allocated
on an acreage-based formula. This allocation of costs serves to
establish part of the cost basis for the property.
Exploration expenditures are high-risk investments that are
essential for the growth and long-run existence of the mining
industry. For tax reporting purposes, exploration expenditures
are those expenditures, excluding cost of depreciating property,
that are paid or incurred by the taxpayer before the beginning
of the development stage for the deposit. The development stage
is deemed to begin when mineral deposits are determined to be of
sufficient quality and quantity to reasonably justify commercial
exploitation by the taxpayer.
Exploration costs include all expensable costs incurred prior
to entering the development stage. These costs include such
items as core drilling to ascertain the existence of commercially
marketable ore and underground shafts, drifts, and crosscuts for
the same purpose. Exploration costs also include the cost of
labor, administrative overhead, depreciation of equipment used
in exploration, and support facilities.
The taxpayer may elect to capitalize all exploration costs to
be recovered from depletion. Under this option, exploration costs
are capitalized and included with property costs to establish the
cost basis of the property. This cost basis is then used to deter-
mine the appropriate cost depletion rate for the mineral deposit.
Exploration costs also may be deducted currently instead of
capitalizing them. If this option is taken, the costs must be
recovered when the mineral deposit has reached the producing
stage. The amount of expenditures during the exploration stage
that is deductible depends upon when the expenditures were
incurred. Pursuant to the Tax Reform Act of 1986, expenditures
made after 1986 are subject to a 70% current deductibility limita-
tion. For expenditures incurred after 1984 but before 1987, de-
ductibility is limited to 80%; for taxable years subsequent to 1982
but before 1985, the corporation can deduct 85% of exploration
expenses. The remaining balance can be deducted ratably over
the 60-month period beginning with the month in which the
costs are paid or incurred.
There are two possible methods for recovering exploration
costs: (1) they may be recorded as income in the first year of
89
90 MINING ENGINEERING HANDBOOK
production, or (2) they may be recovered by disallowing the
depletion allowance until the cost is recaptured.
If the taxpayer elects to recapture exploration costs through
income, he/she should include in gross income for the taxable
year an amount equal to the adjusted exploration expenditures
applicable to the mineral property in the year that it reaches the
producing stage. The amount so recorded in gross income is then
capitalized as part of the cost basis of the mineral property and
will be recoverable through depletion.
If the exploration expenditures are not included in income
in the first producing year, they must be recaptured directly
through the allowance for depletion. The deduction for depletion
with respect to the property will be disallowed until recovery of
the total amount of depletion expenditures that has previously
been expensed.
2.4.2.2 Development Expenditures
Mine development expenditures include those necessary to
gain access to an ore body in the preproduction stage, but after
the existence of ores in commercially marketable quantities has
been disclosed. Development expenditures also include those
expenditures necessary to extend production in an existing ore
body.
Development expenditures may be either deducted currently
or deferred and amortized as ore is sold. Unlike exploration
expenditures, development expenditures are not subject to recap-
ture so that it is advantageous to classify expenditures as develop-
mental rather than exploratory.
For development expenditures incurred in taxable years be-
ginning after 1982, the amount currently deductible is limited to
85% of the expenditure. The remaining 15% must be capitalized
and recovered over a five-year period. For expenditures incurred
after 1984, the amount to be capitalized is increased to 20%.
The capitalized development costs, however, are not part of the
basis of the property for depletion purposes. For expenditures
incurred after 1986, the amount allowable as a deduction for
domestic mine development must be reduced by 30%. The
amount not allowable as a deduction for any taxable year after
1986 may be amortized over a 60-month period beginning with
the month in which the costs are paid or incurred.
2.4.2.3 Depreciation
Depreciation is the periodic write-off of the costs of items of
property and certain other long-lived tangible assets. It denotes
a periodic cost allocation against revenue of such tangible assets
as buildings, machinery, and equipment. Depreciation is also the
process by which the capitalized cost of a fixed asset is deducted
from taxable income.
The cash flow analysis is primarily concerned with the tax
savings that are a result of capital recovery provisions, and the
net present value of the tax savings. The method used to calculate
depreciation for tax purposes determines the value of the re-
sulting tax savings.
The modified accelerated cost recovery system (MACRS) is
mandatory for most tangible depreciable property placed in ser-
vice after Dec. 31, 1986. Under MACRS, the cost of eligible
property is recovered over a 3-, 5-, 7-, l0-, 15-, 20-, 27.5-, or
31.5-year period. The class-life of an asset determines its recovery
period, the method of depreciation used, and the applicable con-
vention.
The cost of property in the 3-, 5-, 7-, and l0-year classes is
recovered using the 200% declining-balance method over three,
five, seven, or ten years, respectively. The cost of 15- and 20-
year property is recovered using the 150% declining-balance
method over 15 and 20 years, respectively. Instead of the applica-
ble depreciation method, taxpayers may elect to claim straight-
line MACRS deductions over the regular recovery period.
In addition to the normal depreciation methods, mining
companies may also use the ore-reserve or units-of-production
method. This method of computing depreciation is similar to the
cost depletion computation, except that a different cost basis is
used in determining the depletion unit.
2.4.2.4 Depletion
Definition: Congress has recognized the unique risks and
special nature of the mining industry by granting it a percentage
depletion allowance that is not limited to the cost basis of the
property. In general, annual depletion deductions are allowed
only to owners of an economic interest in mineral deposits or
standing timber.
In the case of mineral resources, the allowance for depletion
may be calculated either upon the adjusted depletion basis of the
property (cost depletion) or upon a percentage of gross income
from the property (percentage depletion). The Internal Revenue
Code requires taxpayers to use the method that yields the largest
deduction for any taxable year. It is based on the concept that
mineral deposits are wasting assets that are difficult to replace.
Cost Depletion: Cost depletion is based upon the cost of
mineral property, the number of units of mineral or contained
metal sold during the year, and the number of units of mineral
or contained metal remaining in the deposit at the end of the
year. The basis that is established for cost depletion in any one
year is the undepleted cost basis of the mining property at the
beginning of the year.
The cost depletion allowance for any year is determined in
the following manner. First, the undepleted cost basis of the
property must be determined. Then subtract the accumulated
depletion to date from the original cost basis of the property.
This must be divided by the total number of units of mineral
remaining at the end of the year plus the number of units sold
during the year. The result is then multiplied by the number of
units sold during the year to determine the cost depletion allow-
ance for the taxable year. The applicable relationship is
(2.4.1)
where CDn is cost depletion allowance in year n, CB is the
original cost basis of the property, is accumulated deple-
tion taken in the preceding years (both cost and percentage), Un
is units of metal sold during year n, and Ur is units remaining at
year end (units of metal contained in ore reserves).
Each taxpayer who claims and makes a deduction for deple-
tion of mineral property must keep a record of the cost basis for
the mineral property and a record of the sum of depletion credits
previously taken. No further deductions for cost depletion will
be allowed when the sum of the depletion credit equals or exceeds
the cost basis of the property.
Percentage Depletion: Percentage depletion is an allowance
expressed as a percentage of the gross income from the mine and
varies in amount with the type of mineral (see Table 2.4.1). The
percentage depletion allowance is limited to 50% of the taxable
income from the property before the allowance is deducted. One
of the favorable aspects of the percentage depletion allowance is
that it is not limited by the cost basis of the property.
The percentage depletion for year n is calculated by multi-
plying the applicable percentage depletion allowance for the min-
 TAXATION AND DEPLETION 91
Table 2.4.1. Statutory Depletion Rates for Various Minerals
1. 22%
a. Sulfur and uranium; and
b. If from deposits in the United States, anorthosite, clay laterite, and nephelite syenite (to the extent that alumina and aluminum compounds
are extracted therefrom), asbestos, bauxite, celesite, chromite, corundum, fluorspar, graphite, ilmenite, kyanite, mica, olivine, quartz
crystals (radio grade), rutile, block steatite talc, and zircon, and ores of the following metals: Antimony, beryllium, bismuth, cadmium,
cobalt, columbium, lead, lithium, manganese, mercury, molybdenum, nickel, platinum and platinum group metals, tantalum, thorium, tin,
titanium, tungsten, vanadium, and zinc.
2. 15%–If from deposits in the United States
a. Gold, silver, and copper;
b. Oil shale (except shale described in paragraph 5); and
c. Domestic iron ore; for tax years beginning after 1983, the corporate statutory percentage depletion deduction for such minerals is to be
reduced by 15% of the excess of the percentage depletion deduction over the adjusted basis of the property as determined at the end
of the tax year and without regard to the depletion deduction for that year.
3. 14%
a. Metal mines [if paragraph (1)(b) or (2)(a) does not apply], rock asphalt, and vermiculite; and
b. If paragraph 1b, 5, or 6b does not apply, ball clay, bentonite, china clay, sagger clay, and clay used or sold for use for purposes dependent
on its refractory properties.
c. Foreign iron ore; for tax years beginning after 1983, the corporate statutory percentage depletion deduction for such minerals is to be
reduced by 15% of the excess of the percentage depletion deduction over the adjusted basis for the property as determined at the end
of the tax year and without regard to the depletion deduction for that year.
4. 10%
a. Asbestos (if paragraph 1 b does not apply), brucite, lignite, perlite, sodium chloride, and wollastonite. The depletion deduction for coal
(including lignite) is 10%, but for tax years beginning after 1983, the corporate statutory percentage depletion deduction for such minerals
is to be reduced by 15% of the excess of the percentage depletion deduction over the adjusted basis of the property as determined at
the end of the tax year and without regard to the depletion deduction for that year.
5. 7.5%
a. Clay and shale used or sold for use in the manufacture of sewer pipe or brick, and clay, shale, and slate used or sold for use as sintered
or burned lightweight aggregates.
6. 5%
a. Gravel, peat, pumice, sand, scoria, shale (except shale described in paragraph 2b or 5) and stone (except stone described in paragraph
7).
b. Clay used, or sold for use, in the manufacture of drainage and roofing tile, flower pots, and kindred products; and
c. If from brine wells, bromine, calcium chloride, and magnesium chloride.
7. 14%
All other minerals, including, but not limited to, aplite, barite, borax, calcium carbonates, diatomaceous earth, dolomite, feldspar, fullers
earth, garnet, gilsonite, granite, limestone, magnesite, magnesium carbonates, marble, mollusk shells (including clam shells and oyster
shells), phosphate rock, potash, quartzite, slate, soapstone, stone (used or sold for use by the mine owner or operator as dimension stone
or ornamental stone), thenardite, tripoli, trona, and (if paragraph 1 b does not apply) bauxite, flake graphite, fluorspar, lepidolite, mica,
spodumene, and talc (including pyrophyllite), except that, unless sold on bid in direct competition with a bona fide bid to sell a mineral listed
in paragraph 3, the percentage shall be 5% for any such other mineral (other than slate to which paragraph 5 applies) when used, or sold
for use, by the mine owner or operator as rip rap, ballast, road material, rubble, concrete aggregates, or for similar purposes. For purposes
of this paragraph, the term “all other minerals” does not include:
a. Soil, sod, dirt, turf, water, or mosses;
b. Minerals from seawater, the air, or similar inexhaustible sources; or
c. Oil and gas wells.
For purposes of this subsection, minerals (other than sodium chloride) extracted from brines pumped from a saline perennial lake within
the United States shall not be considered minerals from an inexhaustible source.
Source: Section 613(b) of the Internal Revenue Code.

era1 by the gross income from mining less royalty payments. The
amount of 0.5 times taxable income before depletion must be
calculated to determine whether this limits the allowable per-
centage depletion. This is illustrated by the following relations:
PDn = (MPDA) (GIMn – RPn) (2.4.2)
If
PDn > (0.5) (TIBD) (2.4.3)
then
PDn = (0.5) (TIBD)
where PDn is the allowable percentage depletion for the mineral
sold during the year, MPDA is the mineral’s percentage depletion
allowance (e.g., copper at 15%), GIMn is gross income from
mineral sales in year n, RPn is royalty payments, and TIBD is
taxable income before depletion.
2.4.2.5 Alternative Minimum Tax System
For taxable years beginning after Dec. 31, 1986, the Tax
Reform Act of 1986 replaces the old “add-on” corporate mini-
mum tax with a new alternative minimum tax. The new alterna-
tive minimum tax is based on a much broader income base than
the regular tax because the preferential treatment accorded many
items for regular tax purposes is not allowed in the alternative
minimum tax system. This system has separate but parallel rules
for several significant calculations, including depreciation, amor-
tization and depletion, net operating losses, and foreign tax
credits.
The corporation’s regular taxable income is the starting point
for the calculation of the alternative minimum tax. The amount
of taxable income is recomputed to reflect certain adjustments
required for determination of the alternative minimum tax. Some
of the major adjustments are to depreciation, mining exploration
92 MINING ENGINEERING HANDBOOK
and development costs, and depletion. Alternative minimum
taxable income is taxed at the corporate rate of 20%.
Depreciation: For purposes of calculating alternative mini-
mum taxable income, depreciation of most property is based
upon use of the 150% declining-balance method over the class
life of the property, switching to the straight-line method when
it results in a larger allowance. However, if the taxpayer uses
straight-line depreciation for regular tax, he must also use that
method for the alternative minimum tax.
Most assets used in the mining industry have class lives of
10 years. Equipment used in smelting and refining of metal
generally has a class life of 14 years. For regular tax purposes,
these assets would generally be depreciated using the 200%
declining-balance method or the straight-line method over a
17-year life. An election will allow the l0- and 14-year lives to be
used for regular tax purposes, thereby reducing the adjustment
necessary for computation of the alternative minimum tax. How-
ever, for the depreciation of buildings, the straight-line method
must be used for both alternative minimum tax and regular tax
purposes.
Exploration and Development Costs: Mining exploration
and development costs that are expensed must be computed
under 10-year straight-line amortization for purposes of the al-
ternative minimum tax.
Depletion: The excess of percentage depletion allowable for
regular tax over the adjusted basis of each piece of property at
the end of the taxable year (determined without regard to the
depletion deduction for the current taxable year) is treated as a
preference item for purposes of computing the alternative mini-
mum tax and must be added back in the calculation of alternative
minimum taxable income.
2.4.3 STATE TAXES
The major types of state taxes affecting mineral production
operations are property taxes, severance taxes, income taxes, and
sales and use taxes.
2.4.3.1 Property Taxes
A property tax is an ad valorem tax levied by the taxing
authority against the “value” of the property in question. Prop-
erty taxes can be levied by cities, counties, states, or other taxing
authorities such as school districts.
They can be levied against either real or personal property
or both. Many states do not have a general state property tax
authority and leave property taxation to the counties and local
divisions. Many states have a board of equalization, a body which
attempts to equalize taxes so that the tax burden is equitably
imposed in each of the counties or other divisions within the
state.
Real property is taxed in all states; however, some states do
not tax personal property, and intangible personal property is
exempt from taxation in most jurisdictions.
The amount of property tax to be paid depends on the tax
base and the tax rate. Valuation, usually carried out by local or
state assessors, determines the tax base. The tax rate, usually
expressed in “mills per dollar,” is applied to the assessed valu-
ation.
Property is generally assessed at its “fair market value.” The
fair market value is the value which a willing buyer would pay
to a willing seller in a “arm’s-length” transaction, that is, in a
situation in which neither is under any compulsion to buy or
sell, and each is reasonably well informed as to the facts having
a bearing on value. Other terms used to describe fair market
value are “market value” and “cash value.” All of these terms
mean virtually the same thing.
There are essentially three methods that property appraisers
(assessors) use to determine the fair market value of a piece
of property. They are the (1) comparable sales approach, (2)
replacement-cost method, and (3) capitalization of income
method. A variant of the capitalization of income method is the
net present value method. With the comparable sales approach,
the assessor uses recent sales of comparable property to deter-
mine what it would cost to replace the property with a new piece
of like property. Then the assessor subtracts depreciation based
on the age of the property in question. Under the capitalization
of income method, the present value of the annual net income
of the property is determined by using a rate of return acceptable
to a normal prudent investor. The figure is then capitalized to
produce the market value of the property. For example, if the
net income of the property is $12,000/year, and the acceptable
rate of return to a prudent investor is 12%, the capitalized value
of the property is $100,000.
The net present value method is similar to the capitalization
of income method, but is based upon projected future operating
income. There is a growing trend to use the net present value
method for mine property assessment. There can be problems
with this method because future mine income is based on metal
prices that fluctuate widely from year to year. Projected after-tax
cash flow over a mine’s life, based upon mineral reserves and
historical performance, is discounted using an appropriate capi-
talization or discount rate. The mine value is the sum of annual
discounted after-tax cash flows over the mine life. For example,
if the after-tax cash flow of a property is projected to be $12,000/
year, 10% is an acceptable rate of return, and reserves for 5
years remain, the net present value for the current tax year is
$10,908 + $9,912 + $9,012 + $8,196 + $7,452 = $45,480.
Although in many states, the state constitution and statutes
allow property to be assessed at 100% of fair market value, in
practice, property is often assessed at something less than 100%.
This lesser assessment rate usually varies from 25% to 50% of
market value. The assessment rate is referred to as the assessment
ratio. After the assessment ratio is applied to the property, the
tax is levied.
With mineral properties, the valuation of surface improve-
ments, machinery and equipment, and land poses few problems.
On the other hand, estimating the value of a mineral deposit
itself is not easy. Two main approaches have been used to value
ore bodies. One is to base the value of the ore body on its
annual proceeds. Production may be that of the year under
consideration or an average level over several preceding years.
The valuation basis of the ore deposit may be gross proceeds,
net proceeds, or some other criterion based on production. Gross
proceeds is generally the value of the ore as reflected by the sale
price if it is an arm’s-length transaction with no deductions for
costs of producing the ore. Net proceeds is the value as reflected
by the sales price less allowable costs of production. For example,
the costs of producing, transporting, refining, and selling the
ore are generally considered to be allowable deductions. The
property tax is then levied on the assessed value of the proceeds
at the prevailing rate for the locality in question. This approach
does not include in the valuation any mineral reserves to be
extracted in the future, but provides a “realized value” basis for
assessment.
An alternative approach is to use the present value of the
projected future earnings of the mining operation to represent
the value of the ore body. This application of the net present
value method requires assumptions regarding mine life, rates of
return, and future minerals prices. This type of tax is difficult to
administer due to the many poorly defined technical variables
 TAXATION AND DEPLETION
that must be included. The principal advantage to taxing authori-
ties of levying a property tax on the present value of mining
operations is that it provides a steady source of revenue. The
main disadvantage is that it discourages exploration for and
development of reserves ahead of actual mining operations. This
approach often results in “double taxation” on the equipment
and facilities used in the operation. States that have used this
method have experienced declines in their mining sectors over
the years because it does discourage ore reserve development.
A direct ore reserve tax represents a fixed cost to the property
owner. Ore reserve taxes clearly discourage ore reserve develop-
ment. A tax on the capitalized value of income has the same
negative implications although not to the same extent. In states
where this latter type of tax has been applied, mine operators
have tended to develop only the minimum amount of ore needed
to sustain ongoing operations. The lack of long-range ore devel-
opment due to the reduced ability of mine operators to adjust
their output can be inefficient and may lead to premature mine
closures during adverse economic periods. Often such mine clo-
sures are permanent because the lack of developed reserves
makes it difficult for the mining company to justify the financing
necessary to reopen the mine.
The net proceeds type of property tax was developed to
overcome some of the foregoing problems. This type of tax ap-
plies only to operations that are active and that are profitable on
a defined basis. The net proceeds property tax is beneficial be-
cause it encourages both ore reserve and mine development.
However, in states with a corporate income tax, it may result in
double taxation of the profits from mining unless there are spe-
cific exemptions.
Because taxes on real and personal property represent a fixed
cost regardless of profitability, some states permit exemptions
for certain classes of personal and/or real mine property. Such
exemptions may be justifiable because mining is capital intensive
and because the exemptions increase the amount of ore extract-
able from the mine by reducing fixed costs. Often the loss of
primary property tax revenues is more than compensated for by
secondary tax revenues and employment benefits.
2.4.3.2 Mineral Specific Taxes
A severance tax is a state tax imposed on the severing of
natural resources from the land and is based on the value or
quantity of production. In some states, this type of tax is given
a different name. Instead of being called a severance tax, it may
be called a mine license tax, an excise tax, a net proceeds tax, a
production tax, or a royalty tax, depending on the label chosen
by the legislators of the particular state. In all cases, however,
the tax is based on actual output or production.
These types of taxes are usually calculated either as a flat rate
per unit of production (sometimes called a “unit” or “specific”
severance tax), or as a percentage of the value of the resource
produced (sometimes called an “ad valorem” or “percentage”
severance tax). The tax base for an ad valorem severance tax is
generally either the gross or net value of resources produced or
sold.
With a unit severance tax, there may be an escalation clause
such that the tax increases with inflation. Ad valorem severance
taxes automatically vary with the value of the mineral. Severance
tax payments are altered by exemptions, credits, and exclusions
in many states. There may be exemptions for minimum levels of
production, credits for payments of ad valorem property taxes,
and exclusions for small producers.
States differ widely in the definitions of value they use for
calculating the base for an ad valorem severance tax. The tax
might be imposed on the value of the resource in the ground (net
93
proceeds), at the point of severance (gross proceeds), or after
processing and preparation for shipment. The value is greater at
each succeeding point. A severance tax based on gross sales
value, or value f.o.b. mill, corresponds to the case where the
resource is valued after processing and preparation for shipment.
A tax based on gross proceeds generally corresponds to the case
where the resource is valued at the point of severance. One
way to estimate this value would be to deduct processing costs,
transportation costs, certain production taxes, rentals, and royal-
ties from the value at the point of first sale. A tax based on net
proceeds corresponds to the case where the relevant value is the
value in the ground. To estimate value in the ground, all costs
of production, including mining costs, would be deducted.
The chief advantages of a tax of this type relative to many
property taxes on ore bodies are that it does not discourage
exploration for and development of additional ore reserves and it
does not require ‘valuation’ of the ore body with all the attendant
difficulties that entails. On the other hand, a severance tax does
not create a steady stream of revenue since it requires an op-
erating mine coupled with production or ore sales. Furthermore,
an output-related proceeds tax will raise the cutoff grade of ore
that will be mined, resulting in a waste of low-grade ore.
The net proceeds tax is preferable to other types of severance
taxes from a conservation point of view. If a progressive net
proceeds tax were imposed, mining operations might seek to
enter lower tax brackets by reducing their rates of recovery; but
a purely proportional net proceeds tax should have no effect on
the rate of recovery. Indeed, a proportional net proceeds tax
should have less effect on the production decisions of a mining
operation than a property tax or any other type of severance tax.
Severance taxes offer some advantages from the standpoint
of ability to pay. They are due only when a mining operation is
actually producing, so there is no penalty if there is a strike or
shutdown for market-related reasons. In contrast to property
taxes, severance taxes offer opportunities to achieve a more
nearly uniform distribution of revenues among areas of the state;
and a mine located in a district that lacks other business activity
is not so likely to be disadvantaged. A net proceeds tax is optional
if ability to pay is an important policy criterion because the tax
base most closely approximates profits. Only profitable opera-
tions will be required to pay taxes. The least satisfactory type of
severance tax from an ability to pay standpoint is a high unit tax.
With unit taxes, it often happens that an unprofitable operation
whose output has a relatively low unit value is taxed at a higher
percentage rate than a more profitable mine of comparable size
with higher valued output.
A unit severance tax simplifies administrative problems be-
cause the rate schedule depends only upon the amount produced.
A severance tax based on the value of output is easily determined
if there is a market sale, but in some cases there may be no
market transaction. Some barite mines, for example, are part of
a vertically integrated drilling-fluids service company. In such
cases, it is necessary to determine an accounting price for the
barite, causing tax administration to become more complex.
Revenue generation is much more unpredictable and volatile
with a severance tax of the net proceeds type than with other
severance taxes. During periods of low minerals prices, profits
and tax revenues also tend to be low. In addition, severance taxes
do not help cope with covering pre-operational costs as well as
property taxes do. If there is reliance on severance taxes, in the
early stages of mine development, tax revenues may be below the
levels needed to finance new services required by the community
where the mine is being built.
94 MINING ENGINEERING HANDBOOK
2.4.3.3 Corporate Income or Occupation Taxes
The income tax, like the net-proceeds-type severance tax, is
based on the profits of mines with certain statutory deductions
and adjustments. The income tax is advantageous from the min-
ing operator’s point of view because it is assessed only if the
operator makes a profit. The income tax has the least effect on
direct and indirect costs. Further, it does not affect the cutoff
grade of ore. Therefore, maximum ore recovery is promoted.
Both the federal and many state governments impose an income
tax.
The most significant income tax paid by mining companies
is the federal income tax. Several provisions of the Federal Tax
Code specifically relate to the minerals industry. These include
the depletion allowance and expensing privileges for exploration
and development costs. A percentage depletion allowance repre-
sents a deduction over the above recovery of actual costs equal
to a fixed percentage of gross receipt and is generally viewed as
an allowance for the reduction in asset value as mineral resources
are removed. The mineral industry is also provided special tax
treatment of costs associated with exploration and development.
Exploration and development costs may be expensed as incurred.
Most operations benefit from the expensing privilege for explora-
tion costs, but only economically profitable operations benefit
from expensing of development costs.
State corporate income taxes are applied to net income (in-
come less statutory deductions). Most states use the federal defi-
nition of net income, often with certain adjustments, but the tax
rate is much less than the federal rate. Items which are usually
deductible in computing net income include business expenses,
interest paid or accrued, uninsured losses, bad debts, a reasonable
allowance for depreciation, charitable deductions, and net loss
carryovers. Most states using the federal definition of net income
would also allow the federal depletion allowance. States using a
different tax base may or may not allow a deduction for deple-
tion. Rates vary from state to state.
Some states allow deduction of federal income tax liabilities.
If a mining operation is in the 34% tax bracket, this deduction
effectively reduces the company’s tax base by about that amount
for state income tax purposes. The actual amounts are deter-
mined by application of a simultaneous equation.
Corporations doing business and having income in more
than one state are generally taxed by the state in question on
both income allocated to the state and an apportioned part of
total US income under the unitary tax concept. Apportionment
is generally standardized among the various states that adopted
the “Uniform Division of Income for Tax Purposes Act” and is
based upon a formula relating in-state tangible assets, compensa-
tion paid, and sales receipts to total tangible assets, compensa-
tion, and sales. In general, nonbusiness income, such as rents and
royalties and capital gains from transactions in real or tangible
personal property, is allocated wholly to the state in which the
tangible property is located or from which it was sold. Interest
and dividend income is allocated to the state that is the taxpayer’s
commercial domicile. Normal business income is apportioned
among the states in which the taxpayer does business, irrespec-
tive of whether each such state imposes a corporate income tax.
The greatest disadvantage of the income tax from the state’s
point of view is that it does not provide the predictable, steady
stream of revenue that the property tax provides. On the other
hand, states can encourage mining development through the
use of tax incentives such as deductions for exploration and
development costs as well as liberal depletion deductions.
2.4.3.4 Sales and Use Taxes
The purpose of the use tax is to prevent users from purchas-
ing property from states having no sales tax or a lesser sales tax
and bringing it into a state with a higher sales tax. The use tax
eliminates this advantage. Items subject to use taxes are generally
not subject to sales taxes as well, because most states allow a
credit for sales or use taxes paid to the state in question or to
another state. For example, assume that a mining company is
located in state A, which has a retail sales tax of $0.05/dollar.
State B’s sales tax is only $0.03/dollar. If the mining company
purchases office equipment in state B for use in state A, state A
would charge a use tax for the difference, that is, in an amount
of $0.02/dollar.
Sales and use taxes produce revenues prior to production
start-up and so may help defray the costs of new services early
in the project life. Sales and use taxes raise the cost of mine
construction and equipment and raise the cost of mine operation.
To the extent that costs are increased, there will need to be
compensating increases in minable grade of the deposit, and the
ore reserves that are minable may be reduced. Such taxes also
increase the cost of exploration. In areas where mines are already
in operation, increases in sales and use taxes may cause a reduc-
tion in modernization and expansion and, to the extent that
operating costs are increased, may cause mines to close sooner
than they would in the absence of the tax.
Another disadvantage of a sales or use tax is relatively high
administrative costs. Revenues from this type of tax tend to
fluctuate through investment cycles, reaching their highest levels
in years when capital spending by the mining industry is strong.
Sales or use taxes will, however, generate a steadier and more
predictable revenue stream than income or net proceeds taxes.
Because tax payments are not necessarily directly tied to profits,
sales or use taxes do not satisfy most equity criteria as well as
income taxes do.
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