[Code of Federal Regulations]
[Title 26, Volume 7]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.612-3]

[Page 405-407]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.612-3  Depletion; treatment of bonus and advanced royalty.

    (a) Bonus. (1) If a bonus in addition to royalties is received upon 
the grant of an economic interest in a mineral deposit, or standing 
timber, there shall be allowed to the payee as a cost depletion 
deduction in respect of the bonus an amount equal to that proportion of 
his basis for depletion as provided in section 612 and Sec. 1.612-1 
which the amount of the bonus bears to the sum of the bonus and the 
royalties expected to be received. Such allowance shall be deducted from 
the payee's basis for depletion and the remainder of the basis is 
recoverable through depletion deductions as the royalties are thereafter 
received. (But see paragraph (e) of this section.) For example, a 
taxpayer leases mineral property to another reserving a one-eighth 
royalty and in addition receives a bonus of $10,000. Assuming that the 
taxpayer's basis with respect to the mineral property is $21,000 and 
that the royalties expected to be received are estimated to total 
$20,000, the depletion on the bonus would be $7,000:

[$21,000 (basis)x$10,000 (bonus)]/$30,000 (bonus plus estimated 
    royalties).


The remaining $14,000 of basis will be recovered through depletion as 
the royalties are received.
    (2) If the grant of an economic interest in a mineral deposit or 
standing timber with respect to which a bonus was received expires, 
terminates, or is abandoned before there has been any income derived 
from the extraction of mineral or cutting of timber, the payee shall 
adjust his capital account by restoring thereto the depletion deduction 
taken on the bonus and a corresponding amount must be returned as income 
in the year of such expiration, termination, or abandonment.
    (3) In the case of the payor, payment of the bonus constitutes a 
capital investment made for the acquisition of an economic interest in a 
mineral deposit or standing timber recoverable through the depletion 
allowance. See paragraph (c)(5)(ii) of Sec. 1.613-2 in cases in which 
percentage depletion is used.
    (b) Advanced royalties. (1) If the owner of an operating interest in 
a mineral deposit or standing timber is required to pay royalties on a 
specified number of units of such mineral or timber annually whether or 
not extracted or cut within the year, and may apply any amounts paid on 
account of units not extracted or cut within the year against the 
royalty on the mineral or timber thereafter extracted or cut, the payee 
shall compute cost depletion on the number of units so paid for in 
advance of extraction or cutting and shall treat the amount so 
determined as an allowable deduction for depletion from the gross income 
of the year in which such payment or payments are made. No deduction for 
depletion by such payee shall be claimed or allowed in any subsequent 
year on account of the extraction or cutting in such year of any mineral 
or timber so paid for in

[[Page 406]]

advance and for which deduction has once been made. (But see paragraph 
(e) of this section.)
    (2) If the right to extract minerals or to cut timber against which 
the advanced royalties may be applied expires, terminates, or is 
abandoned before all such minerals or timber have been extracted or cut, 
the payee shall adjust his capital account by restoring thereto the 
depletion deductions made in prior years on account of any units of 
mineral or timber paid for in advance but not extracted or cut, and a 
corresponding amount must be returned as income for the year of such 
expiration, termination or abandonment. (But see paragraph (e) of this 
section.)
    (3) The payor shall treat the advanced royalties paid or accrued in 
connection with mineral property as deductions from gross income for the 
year the mineral product, in respect of which the advanced royalties 
were paid or accrued, is sold. For purposes of the preceding sentence, 
in the case of mineral sold before production the mineral product is 
considered to be sold when the mineral is produced (i.e., when a mineral 
product first exists). However, in the case of advanced mineral 
royalties paid or accrued in connection with mineral property as a 
result of a minimum royalty provision, the payor, at his option, may 
instead treat the advanced royalties as deductions from gross income for 
the year in which the advanced royalties are paid or accrued. See 
section 446 (relating to general rule for methods of accounting) and the 
regulations thereunder. For purposes of this paragraph, a minimum 
royalty provision requires that a substantially uniform amount of 
royalties be paid at least annually either over the life of the lease or 
for a period of at least 20 years, in the absence of mineral production 
requiring payment of aggregate royalties in a greater amount. For 
purposes of the preceding sentence, in the case of a lease which is 
subject to renewal or extension, the period for which it can be renewed 
or extended shall be treated as part of the term of the original lease. 
For special rules applicable when the payor is a sublessor of coal or 
domestic iron ore, see paragraph (b)(3) of Sec. 1.631-3. Every taxpayer 
who pays or accrues advanced royalties resulting from a minimum royalty 
provision must make an election as to the treatment of all such advanced 
royalties in his return for the first taxable year ending after December 
31, 1939, in which the advanced royalties are paid or accrued. The 
taxpayer's treatment of the advanced royalties for the first year shall 
be deemed to be the exercise of the election. Accordingly, a failure to 
deduct the advanced royalties for that year will constitute an election 
to have all the advanced royalties treated as deductions for the year of 
the sale of the mineral product in respect of which the advanced 
royalties are paid or accrued. See section 7807(b)(2). For additional 
rules relating to elections in the case of partners and partnerships, 
see section 703(b) and the regulations thereunder. the provisions of 
this subparagraph do not allow as deductions from gross income amounts 
disallowed as deductions under other provisions of the Code, such as 
section 461 (relating to general rule for taxable year of deduction), 
section 465 (relating to deductions limited to amount at risk in case of 
certain activities), or section 704(d) (relating to limitation on 
allowance to partners of partnership losses).
    (4) The application of subparagraphs (2) and (3) of this paragraph 
may be illustrated by the following examples:

    Example 1. B leased certain mineral lands from A under a lease in 
which A reserved a royalty of 10 cents a ton on minerals mined and sold 
by B. The lease also provided that B had to pay an annual minimum 
royalty of $10,000 representing the amount due on 100,000 tons of the 
particular mineral whether or not B mined and sold that amount. It was 
further provided that, if B did not mine and sell 100,000 tons in any 
year, he could mine and sell in any subsequent year the amount of 
mineral on which he had paid the royalty without the payment of any 
additional royalty. However, this right of recoupment was limited to 
minerals mined and sold in any later year in excess of the 100,000 tons 
represented by the $10,000 minimum royalty required to be paid for that 
later year. Assume that in 1956 B paid A the minimum royalty of $10,000, 
but mined and sold only 60,000 tons of the mineral and that in 1957 he 
abandoned the lease without any further production. Since the $10,000 
represents royalties on 100,000 tons of mineral and only 60,000 tons 
were mined and sold, A must restore in 1957 to his capital account the 
depletion deductions taken in 1956 on

[[Page 407]]

$4,000 on account of the 40,000 tons paid for in advance but not mined 
and sold, and must also return the corresponding amount as income in 
1957.
    Example 2. Assume that B, under the lease in example 1, paid the 
$10,000 minimum royalty and mined no minerals in 1956 but that in 1957 B 
mined and sold 200,000 tons of mineral. If this is B's first such 
expenditure, B has an option, for the purpose of computing taxable 
income under section 63, to deduct in 1956 the $10,000 paid in that year 
although no mineral was mined, or to take the deduction in 1957 when the 
mineral, for which the $10,000 was paid in 1956, was mined and sold. 
(For treatment under percentage depletion, see example in paragraph 
(c)(5)(iii) of Sec. 1.613-2.)

    (c) Delay rental. (1) A delay rental is an amount paid for the 
privilege of deferring development of the property and which could have 
been avoided by abandonment of the lease, or by commencement of 
development operations, or by obtaining production.
    (2) Since a delay rental is in the nature of rent it is ordinary 
income to the payee and not subject to depletion. The payor may at his 
election deduct such amount as an expense, or under section 266 and the 
regulations thereunder, charge it to depletable capital account.
    (d) Percentage depletion deduction with respect to bonus and 
advanced royalty. In lieu of the allowance based on cost depletion 
computed under paragraphs (a) and (b) of this section, the payees 
referred to therein may be allowed a depletion deduction in respect of 
any bonus or advanced royalty for the taxable year in an amount computed 
on the basis of the percentage of gross income from the property as 
provided in section 613 and the regulations thereunder. However, for 
special rules applicable to certain bonuses and advanced royalties 
received in connection with oil or gas properties, see paragraph (j) of 
Sec. 1.613A-3.
    (e) Cross reference. In the case of bonuses and advanced royalties 
received in connection with a contract of disposal of timber covered by 
section 631(b) or coal or iron ore covered by section 631(c), see that 
section and the regulations thereunder.

[T.D. 6500, 25 FR 11737, Nov. 26, 1960, as amended by T.D. 6841, 30 FR 
9305, July 27, 1965; T.D. 7523, 42 FR 63641, Dec. 19, 1977; T.D. 8348, 
56 FR 21938, May 13, 1991]