Commentary: Digging into valuable US tax incentives

Many Canadian miners operating in the U.S. are not aware of the extensive tax incentives that the U.S. government offers to individuals and companies exploring, developing and extracting minerals. These tax incentives can provide significant savings, especially for growing companies, since the tax benefits can increase over time based on the companies’ growing investment in U.S. mining operations.

That being said, the tax benefits that these incentives can provide may be materially reduced if taxpayers do not account for them in a way that maximizes the benefits. For example, we are aware of junior mining companies that have unknowingly significantly reduced these tax benefits and increased their U.S. tax liability by not accounting for them in a way that maximizes benefits.

These U.S. incentives for miners were developed to recognize the risks and capital outlay required in exploration and development for mining, but because the rules are complicated, many mining companies don’t always take full advantage of the potential tax savings.

Let’s describe how these incentives work so executives can understand what they can do to reduce their companies’ U.S. tax liability.

How do we optimize deductions for exploration and development expenses?

The U.S. tax system provides two incentives for the mining industry. One of these incentives allows the owners of a U.S. mineral property interest to claim depletion based on gross receipts generated by the mineral extracted and sold. Owners can keep claiming depletion even if their original cost in the mineral property interest has been fully cost depleted.

The second incentive is available when exploration and development costs are accounted for separately from the depletable basis of the mineral property interest. This separate accounting treatment indirectly allows optimization for cost recovery allowances compared to capitalizing all of these costs to the depletable basis of the mineral property interest. But because this approach of capitalizing all these costs together represents the standard financial accounting treatment the industry generally follows, companies that want to take advantage of this second tax incentive may need to change the detail captured by their accounting records.

For readers interested in the finer details of how this mechanism works, U.S. tax law requires exploration costs to be capitalized to the depletable tax basis of the mineral property.

However, taxpayers can deduct these costs as paid or incurred, subject to certain limitations. Exploration costs that are currently deducted are recaptured by reducing future depletion deductions taken against the mineral property interest or, at the election of the taxpayer, taken into income when the mine reaches the production stage, and added to the depletable tax basis of the property.

Development costs are accounted for separately and deducted separately from the basis of the mineral property interest. The development costs are deducted currently (subject to certain limitations) or, at the election of the taxpayer, treated as deferred expenses and amortized ratably over the units of minerals benefited by such costs.

Accordingly, the development costs give rise to a separate deduction that may not otherwise be identified if these costs were capitalized into the basis of the mineral property interest, which is often how these costs are treated for book accounting purposes. The taxpayer may also elect to capitalize any amount of its currently deductible exploration or development costs and amortize that amount ratably over a 10-year period.

Depletion computation

Now let’s look at how depletion of the capitalized cost in mineral properties works.

Depletion is essentially a separate computation that taxpayers who own mineral property interests must perform yearly on a property-by-property basis to determine two things: first, how much depletion is allowable as a deduction for tax purposes and second, how much the tax basis in their mineral property must be reduced.

The computation is fairly simple: for U.S. tax purposes, the depletion allowable represents the greater of cost or percentage depletion. Cost depletion is based on the amount of mineral mined sold during the year over the total reserves at the beginning of the year, multiplied by the tax basis of the mineral property. Percentage depletion is a statutory percentage of the taxpayer’s gross income from the mineral mined and sold, subject to a 50% taxable income from the property limitation. Taxpayers are not required to have tax basis in a mineral property to claim percentage depletion, and percentage depletion does not reduce a property’s tax basis below zero.

When difficulties arise, they are mostly in determining the various parameters, which include the definition of the “mineral property,” aggregated or not, the allocation of the tax basis between the properties, the allocation of income and expenses among the properties and the determination of the gross income subject to percentage depletion, among others. An elaboration on all these variables is outside the scope of this article, but we can focus on the variable that we consider the most important to illustrate: the percentage depletion tax incentive (i.e., in excess of tax cost basis), and also where taxpayers have commonly made mistakes.

Since miners receive the percentage depletion tax incentive when the tax cost of their mineral property is fully depleted, it is in their best interest to have the lowest possible cost allocated to their mineral properties. The U.S. tax law (the Internal Revenue Code) generally limits the amount capitalized to the depletable tax basis of the mineral property by allowing exploration and development costs to be either expensed or capitalized outside the depletable tax basis of the mineral property.

Sometimes miners mistakenly assume that the tax basis of the mineral property must be increased for all of the exploration and development costs, similar to what is often done for book purposes. Exploration and development may be capitalized for tax purposes but, as discussed below, the capitalization can be made in a separate pool distinct from the depletable tax basis of the mineral property.

Two deductions

If the tax basis of a mineral property has already been fully cost-depleted, a miner can claim two deductions: first, percentage depletion based on gross income and second, amortization expense on the pool of unamortized exploration and development costs. If miners combine exploration costs or erroneously combine development costs with the tax basis of the mineral property, only the depletion deduction is available, which can reduce the tax incentive the U.S. tax law provides for miners.

As such, mining companies may be missing tax savings because they’re not aware that exploration and development costs can be treated differently for tax purposes than they are treated for accounting purposes.

For book purposes, mining companies usually capitalize to the mineral property depletable basis all costs incurred that can provide future economic benefits, generally the development costs, whereas they expense the other costs with uncertain future economic benefit, generally the exploration costs.

For U.S. tax purposes, these exploration and development costs have their own definitions, classifications and tax treatment. Unlike for book purposes, the definitions and classification of exploration and development costs for tax purposes are not driven by a specific activity or future benefits, but instead by a specific point on a timeline of a mineral property. As a cut-off point on this timeline, the Internal Revenue Code uses the determination that a commercially marketable quantity of minerals exists on a property for the point when exploration ends and development begins.

As such, all costs incurred before discovering a commercially marketab
le quantity of minerals are classified as exploration, whereas the costs incurred thereafter are generally classified as development costs until production begins.

These exploration and development costs share some similarities — they can be either capitalized and amortized over a 10-year period or be expensed, subject to a 70% limitation rule for corporations (individuals are not subject to this 70% limitation rule).

The remaining 30% of the costs must be amortized ratably over a five-year period. The main difference between the tax treatment of these two types of costs is that exploration costs, when expensed, are subject to a recapture rule when the mine reaches production. This treatment generally has the effect of temporarily suspending the depletion deductions that can be claimed until all the expensed exploration costs related to that mine have been recaptured. Development costs are not subject to this rule.

Under most countries’ tax systems, misunderstanding the proper tax treatment of exploration and development costs would only create a timing difference that wouldn’t affect the company’s overall tax liability over its lifetime.

However, given the percentage depletion provisions in the U.S. tax system applying the proper tax treatment for exploration and development expenditures allows miners to accelerate deductibility of expenditures and generate additional tax deductions that they would not otherwise receive. Thus, taking advantage of the separate treatment of development expenses for U.S. tax purposes is important in order to maximize the allowable tax benefits offered by the U.S. tax system.

The U.S. tax system operates with a parallel tax system that requires taxpayers to compute their tax liability using different rules and pay the greater of the two tax liabilities computed. This Alternative Minimum Tax system (AMT) requires a minimum tax payment at a 20% tax rate, as opposed to the 35% regular income tax rate, and on a taxable income computed without taking in consideration various regular income tax incentives.

The AMT system generates a tax that is creditable indefinitely against regular tax as long as the regular tax doesn’t go below the AMT liability. Taxpayers need to be aware that the magnitude of their regular tax benefits may have them falling into the second tax system, reducing some of the economic benefit that they otherwise would have gained from the regular tax incentives provided.

If miners have not taken full advantage of the available tax incentives, it is possible to correct the situation so that they can claim these benefits for previous years and going forward. Unfortunately, making this change can be complicated. For instance, if a taxpayer erroneously capitalized development costs to its depletable mineral property basis, the U.S. tax authorities would not accept amended tax returns as a solution.

When a taxpayer has applied the same accounting method for two consecutive years, the U.S. tax law requires the taxpayer to continue applying the same method in the future, even if erroneous, unless the taxpayer makes a request to the Internal Revenue Service National Office to change its accounting method.

Although some changes in the accounting method can be automatic and fairly simple administratively, others may require permission from the Internal Revenue Service, which can be more complex and expensive. Correcting the erroneous capitalization of development costs to the depletable tax basis of the mineral property unfortunately requires a non-automatic change in tax accounting methods. However, the potential tax savings can make requesting this change worthwhile for many mining companies.

Though the U.S. tax incentives for miners may seem more complicated than those offered in other countries, they can also be more generous. Taking advantage of the separate provisions for treatment of exploration and development costs and the percentage depletion calculation may require time and effort, for example, to amend past tax filings and change accounting methods, but most mining companies will find that the tax savings outweigh the cost of taking the necessary steps to fully benefit from these incentives.

— Ronald Maiorano and Sebastien Tremblay focus on U.S. taxation of mining companies and are certified public accountants with KPMG’s U.S. corporate tax practice in the firm’s Toronto office. Please visit www.kpmg.com for more details.