CONSOLIDATED MINES, INC., COURT OF TAX APPEALS AND COMMISSIONER OF INTERNAL REVENUE, RESPONDENTS.

Consolidated Mines versus Court of Tax Appeals

The Case

This is a tax case in which Consolidated Mines, Incorporated, a domestic mining corporation, contested deficiency income tax assessments issued by the Commissioner of Internal Revenue for several taxable years. The dispute turns on two technical questions of income taxation: first, whether the Company may deduct, on the accrual basis, one half of its operator's share in uncollected accounts receivable as an expense; and second, how the rate of mine depletion should be computed. The case matters to the reviewee because it draws a clean line between the method of accounting a taxpayer uses for tax purposes and the method of computation the parties themselves agreed upon in their private contract — a distinction examiners love to test.

Procedural History

The Commissioner sent the Company a letter of demand and deficiency assessment notices for the years 1951 to 1954 and for 1956. The Company asked for reconsideration, the Commissioner refused, and the Company appealed to the Court of Tax Appeals. The assessments for 1951 to 1954 were contested in one case and the assessment for 1956 in another, and by agreement of the parties the two cases were heard and decided jointly.

On May 6, 1961 the Tax Court ordered the Company to pay deficiency income taxes for 1953, 1954 and 1956, and nullified the assessments for 1951 and 1952 because they were issued beyond the five-year period prescribed by Section 331 of the National Internal Revenue Code. Upon motion of the Company, the Tax Court reconsidered and, in an amended decision dated August 7, 1961, further reduced the liabilities, accepting the Company's theory that Benguet had no right to share in accounts receivable. Both the Company and the Commissioner then appealed to the Supreme Court.

Facts

The Company held mining claims in Masinloc, Zambales. On July 9, 1934 it entered into an agreement with Benguet Consolidated Mining Company, whereby Benguet undertook to explore, develop, mine, concentrate and market the ore, providing funds from its own resources. Under the agreement, while Benguet was being reimbursed for its expenditures, advances and disbursements, net profits were divided ninety percent to Benguet and ten percent to the Company; after full reimbursement, profits were divided share and share alike. By 1953 Benguet had completely recouped its advances, and the parties were dividing profits equally.

The Company kept its books and computed its income on the accrual method. In deducting Benguet's share as operator, however, the Company deducted one half of cash receipts less disbursements, but did not accrue one half of the accounts receivable; it deducted Benguet's share only when those receivables were actually paid. The Commissioner characterized this as a hybrid or mixed method and insisted that one half of the receivables be accrued as expense.

On depletion, the parties disagreed on the figures for mine cost and for pre-production development expenses. The Company claimed development expenses of 1,738,974.56 pesos, relying on a stockholders' report and a treasurer's sworn certification that the figure was taken from a pre-war balance sheet and was only an estimate.

Issues

• Whether or not the Company, using the accrual method, was correct in not accruing one half of Benguet's share in the accounts receivable as a deductible expense, and whether or not the Company employed a hybrid method of accounting.
• Whether or not the rate of mine depletion adopted by the Court of Tax Appeals was correct, and whether or not the Company discharged its burden of proving its claimed development expenses.

Applicable Provisions

Section 38 of the National Internal Revenue Code, on general rules of accounting, provides:

Section 38. General Rules. The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer but if no such method of accounting has been so employed or if the method employed does not clearly reflect the income the computation shall be made in accordance with such methods as in the opinion of the Commissioner of Internal Revenue does clearly reflect the income.

This fixes the starting point: the taxpayer's regular method governs, provided it clearly reflects income.

Section 39, on the period in which items of gross income are included, provides:

Section 39. Period in which items of gross income included. The amount of all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the methods of accounting permitted under Section 38, any such amounts are to be properly accounted for as of a different period.

This governs when receipts enter gross income under the accrual method.

Section 40, on the period for which deductions and credits are taken, provides:

Section 40. Period for which deductions and credits taken. The deductions provided for in this Title shall be taken for the taxable year in which paid or accrued or paid or incurred dependent upon the method of accounting upon the basis of which the net income is computed, unless in order to clearly reflect the income the deductions should be taken as of a different period.

This is the key provision: a deduction accrues only when the liability is actually incurred.

Section 30, paragraph g, subparagraph 1, subparagraph B, on depletion of mines, provides:

In the case of mines, a reasonable allowance for depletion thereof not to exceed the market value in the mine of the product thereof which has been mined and sold during the year for which the return is made.

This is the statutory basis for the depletion deduction the Company claimed.

Ruling

On the first issue, the Court held that the Company was not using a hybrid method and was correct in not accruing one half of the receivables. The Court distinguished the method of accounting used for tax purposes from the method of computation agreed upon between the Company and Benguet. The contract fixed the compensation on the basis of cash receipts and cash disbursements. The Court reasoned that a deduction cannot be accrued until an actual liability is incurred, even if payment has not been made. Since Benguet had no right to share in the receivables, the Company had no liability to accrue. To allow the deduction would give Benguet a right it did not have under the contract.

On the second issue, the Court held that depletion is wholly a creation of the statute, a matter of legislative grace, so the taxpayer bears the burden of justifying the deduction claimed. The Company failed to discharge that burden. Its treasurer's certification was not the entries contemplated by the rule on business entries, and a balance sheet is not itself a book of regular entries. The claimed development expenses were therefore disallowed.

Doctrine

A taxpayer's method of accounting for tax purposes is distinct from the method of computation the contracting parties stipulated for determining compensation. Where the contract computes the operator's share on cash receipts and cash disbursements, no liability accrues on uncollected receivables, and no deduction may be accrued for them under Section 40. Depletion is a matter of legislative grace; the burden of proving the correctness of the claimed allowance rests on the taxpayer.

Disposition

The Supreme Court upheld the disallowance of the accrued share in receivables and of the claimed development expenses, and sustained the deficiency assessments against the Company.

Remember This

Memorize this line: a deduction cannot be accrued until an actual liability is incurred, even if payment has not been made. Examiners use this case to test the accrual method, the distinction between accounting method and contractual computation, and the burden of proof on depletion deductions.