What is the proper tax treatment if a manufacturer uses precious metals in a process where some or all of metal will be recovered by the manufacturer?  May the manufacturer claim depreciation on any of the cost of that metal?  That was the issue addressed by the IRS in Revenue Ruling 2015-11.

The IRS was updating and revoking the treatment outlined in two prior revenue rulings with this ruling (Revenue Rulings 75-491 and 90-65), and adopting a method the IRS believes complies with court decisions looking at the issue and that is also consistent with the IRS’s ruling in Revenue Ruling 97-54.

The ruling, in describing the state of the law, summarized the proper treatment as provided in the court cases as:

An asset is depreciable for federal income tax purposes to the extent that the taxpayer can show that the asset is subject to exhaustion, wear and tear, or obsolescence, and that the asset has a determinable estimated useful life.  See O’Shaughnessy v. Commissioner, 332 F.3d 1125 (8th Cir. 2003), aff’g in part, rev’g in part, 2002-1 U.S.T.C.¶ 50,235, 89 A.F.T.R. 2d 658 (D. Minn. 2001) (allowing depreciation for tin that declined in volume and purity as a result of glass manufacturing process); Arkla, Inc. v. United States, 765 F.2d 487 (5th Cir. 1985), cert. denied, 475 U.S. 1064 (1986) (allowing investment credit and depreciation for unrecoverable cushion gas but not for recoverable cushion gas); Rev. Rul. 97-54, 1997-2 C.B. 23 (adopting the reasoning of Arkla, supra).  In O’Shaughnessy, the Eighth Circuit allowed the taxpayer to depreciate the initial installation of molten tin used in the float manufacturing process of flat glass.  The Eighth Circuit concluded that whether an asset is depreciable for federal income tax purposes depends on the taxpayer’s showing that the asset is subject to exhaustion and wear and tear.  The Eighth Circuit reasoned that the tin’s decline in volume and purity as a result of its use in the glass manufacturing process constituted “exhaustion, wear and tear” within the meaning of § 167, and therefore, the taxpayer appropriately depreciated the tin under § 168.

The IRS describes the now revoked ruling’s treatment and the nature of the changes incorporated in this ruling as follows:

The analyses in Rev. Rul. 75-491 and Rev. Rul. 90-65 are inconsistent with Arkla, Inc. and Rev. Rul. 97-54,which require an analysis of the specific facts surrounding an asset’s use in a taxpayer’s trade or business when determining whether and the extent to which an asset is depreciable.  In addition, Rev. Rul. 75-491 and Rev. Rul. 90-65 have been supplanted by more recent authorities such as O’Shaughnessy.  Accordingly, this revenue ruling adopts the factual analysis approach as applied by those later authorities. Further, because the factual analysis approach permits depreciation of initial installations of certain precious metals, it is no longer relevant whether the cost of those initial installations is more than half the cost of the overall fabricated property.

The IRS summarizes the overall holding in one sentence in the ruling:

The capitalized cost of unrecoverable precious metals that are used in various manufacturing processes is depreciable under §§ 167 and 168 of the Code. The capitalized cost of any recoverable precious metal is not depreciable under §§ 167 and 168.

The IRS illustrates the agency’s view of the proper application of the principles outlined in Arkla and O’ Shaughnessy by giving three fact patterns and applying the principles to those facts.

The facts of the first case are outlined as follows:

Situation 1. A is a contract jeweler who fabricates jewelry to customers' specifications using gold supplied by the customers. A does not maintain an inventory of gold or completed jewelry, but to assist customers A fabricates and maintains gold sample jewelry showing currently available styles. A's samples are not held for sale. Every 3 years A melts down the sample jewelry, recovering 100 percent of the gold content of the jewelry. For A's purposes, the recovered gold is indistinguishable from gold that has not previously been used in sample jewelry and A reuses it in fabricating new sample jewelry. A capitalizes the cost of the gold into the basis of its sample jewelry.

The IRS determines that the taxpayer should treat these costs as follows:

In Situation 1, the gold used to manufacture sample jewelry can be recovered and reused by A in A's trade or business in a manner that is indistinguishable from other gold that has never been fabricated, used, and recovered. The utility of the gold does not diminish as a result of its having previously been fabricated into sample jewelry. Accordingly, the gold is not subject to exhaustion, wear and tear, or obsolescence and as a result, is not depreciable.

Or, to put it plainly, the taxpayer will need to keep the cost of the gold permanently on the books much like the taxpayer would treat the cost of land, with no deduction allowed until the property is either abandoned or disposed of.

The second situation the IRS poses goes as follows:

Situation 2. B is a petroleum refiner. As part of its refining process, B uses a catalyst called prills, fabricated from platinum and other chemicals. Based upon engineering studies performed by B, B determines that approximately 10 percent of the platinum initially utilized to fabricate prills is lost over the course of the platinum's reasonably expected useful life in the refining process. The remaining 90 percent of the platinum is recoverable and becomes available to B for other uses. B capitalizes the cost of the platinum.

In this case the IRS provides the following treatment the agency views as proper:

In Situation 2, approximately 10 percent of the platinum is lost over the course of its expected useful life and is not recoverable for reuse. Accordingly, approximately 10 percent of the platinum will undergo exhaustion, wear and tear, or obsolescence over a determinable useful life. To the extent that the platinum will be lost and is not recoverable for reuse (i.e., approximately 10 percent of the total amount), B may depreciate the capitalized cost of such platinum under §§ 167 and 168. To the extent that any of the platinum is recoverable for reuse (i.e., approximately 90 percent of the total amount), B may not depreciate the capitalized cost of such platinum.

Presumably if the taxpayer were to then use the recovered item in a second run at the process (which would presumably consume 10% of the recovered mineral), 10% of that 90% capitalized cost would then become depreciable.

The third fact pattern the IRS outlines is:

Situation 3. C manufactures flat glass using the float manufacturing process. This process involves the use of molten tin, which provides the ideal surface to manufacture high-quality, flat glass. During the manufacturing process, the tin declines in purity and volume due to chemical reactions and vaporization. Additional tin is added as needed to maintain the level required for the production of the glass. After approximately 7 years, all of the original tin is lost due to chemical reactions and vaporization. C capitalizes the cost of the initial tin installed in the tin bath.

The IRS gives the following treatment in this case:

In Situation 3, all of the original tin used in the glass manufacturing process is lost due to chemical reactions and evaporation after about 7 years. Thus, all of the original tin will undergo exhaustion, wear and tear, or obsolescence over a determinable useful life. Therefore, C may depreciate the capitalized cost of all the entire original tin under §§ 167 and 168.

The pattern here is fairly clear in theory, though practice may become more complicated.  Generally the IRS’s view is that you determine the portion of the item recoverable at the end of the process and that portion is not subject to depreciation.

Note that Situation 2 looks suspiciously like a “salvage value” calculation which, in theory, left the tax law decades ago (the Economic Recovery Tax Act of 1981 for those interested in historical analysis).  The IRS argument to differentiate this treatment is that a portion of the asset (the platinum in Situation 2) is actually unchanged over that period, and thus is not subjected to “exhaustion, wear and tear, or obsolescence” although the other 10% is completely consumed.