What is percentage depletion?

Percentage depletion is a tax deduction placed in order to reflect the depletion of mineral resources, fossil fuels and other sources of non-renewable energy over time. It is only applicable to independent producers and royalty owners of the said non-renewable resources.

Percentage depletion works by allocating a fixed percentage of depletion to the gross income, which is derived from the extraction of exhaustible resources.

Why is percentage depletion important?

Percentage-depletion deduction has been part of the US tax code since 1926, and is meant to support the development of the US oil and gas industry, along with various other mineral resources. 

It also allows for the production of key commodities such as oil, natural gas and mineral resources without making the process uneconomic. The deduction allows businesses to retain revenue that can be used to further their operations and investments.

According to the Internal Revenue Service (IRS), percentage depletion allows mine owners, oil and natural gas producers, and those with mineral interests to recover in minerals in the same manner that manufacturers may retrieve the cost of equipment and other key assets.

Some of the key sections to note are IRS section 611, which establishes the depletion allowance. Internal Revenue Code (IRC) section 612 defines the basis of the mineral property concerned; section 613 defines the rates of percentage depletion, the gross income from mining and taxable income from mining; and section 614 defines property and other associated rules.

Percentage-depletion deduction can be up to 50% of the net income generated from the property, minus the exploration costs. It may continue to be claimed by taxpayers on the basis of income from the property, after the basis in the property has been completely retrieved.

Calculating percentage depletion

Calculating the percentage depletion depends on the type of resource being considered. The IRS lays down the percentage-depletion rates for several types of resources, and a fixed percentage is considered based on the income generated from the property from which the resource is being extracted.

The rates are different for different mineral deposits such as sulphur, uranium and lead, and key metals such as gold, silver and copper. The percentage-depletion rates are also different for minerals such as granite, limestone and marble.

An example of percentage depletion would be if the percentage depletion rate set by the IRS for oil and gas is 15%, the gross income from the oil and gas property will be multiplied by 15%. Therefore, if the said property produces and generates a sale of $1m per annum, the percentage depletion would be $150,000.