Rev. Rul. 74-67, 1974-1 C.B. 63

Research and experiments; mining exploration; core and noncore drill holes . Expenditures paid or incurred before January 1, 1970, by a domestic corporation under a mining lease agreement involving the drilling of core and noncore holes in connection with the production of minerals are mining exploration expenditures subject to the provisions of either section 615 or 617 of the Code. Additional expenditures required to use the drill holes for designing and testing a new mining method are research and experimental expenditures and are subject to the provisions of section 174.

Rev. Rul. 74-67

Advice has been requested regarding the treatment, for Federal income tax purposes, of expenditures for the drilling and subsequent use of drill holes under the circumstances described below.

A taxpayer, a domestic corporation, is engaged primarily in the business of exploring, developing, and producing minerals. Under an agreement with a State, the taxpayer entered into an option to lease mining rights in a mineral deposit on a large tract containing phosphate and other specified minerals that occurred at a moderate depth.

The taxpayer’s objective was to develop a profitable operation by (1) delineating the size and grade of the ore body by using conventional drilling methods, and (2) perfecting a new hydraulic mining method whereby the mineralized sediments could be extracted efficiently and profitably through drill holes.

The total project included the drilling of holes for three distinct purposes. First, core holes were drilled at widely scattered points over the leased area for maximum coverage of geologic information. Secondly, some of these core holes were also used, at additional cost, for testing the new hydraulic mining method. Finally, holes without the cores were drilled in closely-spaced clusters and used for optimum production with the new mining method.

This operation of the taxpayer resulted in its obtaining two patents. One covered a process whereby ore could be extracted as a slurry by inserting a water jet under pressure through a drill hole. The other patent covered an apparatus called an eductor, that draws out a mineral slurry from the drill hole by an airlift system. The use of the patented method and apparatus is feasible under appropriate geologic and economic conditions.

The expenditures for drilling the holes and testing the hydraulic method of extraction were paid or incurred during the years 1962-1966. The expenditures for developing the patented method and apparatus were paid or incurred during the years 1966-1968.

Sections 615 and 617 of the Internal Revenue Code of 1954 and the regulations thereunder prescribe rules for the treatment of expenditures for ascertaining the existence, location, extent, or quality of any deposit of ore or other mineral (other than oil and gas) paid or incurred by a taxpayer before the beginning of the development stage of the mine or other natural deposit.

Section 174(a)(1) of the Code provides:

* * * a taxpayer may treat research and experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account. The expenditures so treated shall be allowed as a deduction * * *.

Section 1.174-1 of the Income Tax Regulations provides, in part, that research or experimental expenditures may be deducted in the year paid or incurred, or they may be deferred and amortized.

Section 1.174-2 of the regulations provides, in part, that research and experimental expenditures are those expenditures incurred in a taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense. The term includes costs incident to the development of an experimental or pilot model, a plant process, a product, a formula, an invention or similar property, and the improvement of already existing property of the type above mentioned. The costs of obtaining a patent and perfecting a patent application are also includible as research or experimental expenditures.

Section 1.174-2(c) of the regulations provides that section 174 of the Code is not applicable to any expenditures paid or incurred for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore, oil, gas, or any other mineral.

Accordingly, in the instant case, it is held that the expenditures paid or incurred before January 1, 1970, for drilling the core and noncore holes are mining exploration expenditures that are subject to the provisions of section 615 or 617 of the Code; such expenditures paid or incurred after December 31, 1969, are subject to the provisions of section 617.

It is further held that, where the drill holes, either core or noncore, are also used for the purpose of designing and testing an apparatus, developing a new and innovative method of extracting ores or minerals, and similar purposes, the additional expenditures required for such use are for research and experimental purposes and are subject to the provisions of section 174 of the Code and the regulations thereunder.