CHAPTER 1 TAX CONSEQUENCES OF MINERAL TRANSACTIONS AN OVERVIEW

• Jurisdiction: United States

Mineral Taxation
(Mar-Apr 1977)
CHAPTER 1
TAX CONSEQUENCES OF MINERAL TRANSACTIONS AN OVERVIEW
Terry T. Scamehorn
Arthur Andersen & Co.
Denver, Colorado

TABLE OF CONTENTS

SYNOPSIS

INTRODUCTION

I. SALES AND LEASES

A. Tax Consequences to Transferor

B. Tax Consequences to Transferee

C. Distinction Between Sale and Lease

1. Economic Interest

2. Nonoperating Interest

3. Continuing Interest

D. Planning for the Transferee—Rents and Royalties

1. Rents and Delay Rentals

2. Advance and Minimum Royalties

E. Mutuality of Interests—Coal and Iron Ore Leasing

II. PRODUCTION PAYMENTS AFTER 1969

A. Definition

B. Examples of Production Payments

1. Limited "Royalty"

2. Variable Royalty

3. Partnership Interest

4. Advance Payments for Minerals

C. Taxation of Retained Production Payments

D. Taxation of Carved-Out Production Payments

III. SHARING ARRANGEMENTS

A. Taxation to Transferor

B. Taxation to Transferee—Exploration and Development Expenditures

1. Defined and Distinguished

2. Capitalization as Acquisition Costs: "Carried Interests"

C. Tax Partnerships

D. Corporations

IV. SPECIAL PROBLEMS

A. Contingent Sales Price

1. Installment Sales

2. Deferred-Payment Method

3. Open Transaction

B. Transfer of Producing Mine

C. Compensation Aspects of Mineral Transactions: Receipt of Property and Partnership Interests

FOOTNOTES

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INTRODUCTION

The purpose of this paper is to outline in broad general terms the income tax consequences associated with the transfer of mineral properties. Although the income tax rules are often similar for the oil and gas industry, the emphasis is on the hard minerals industry.

Fundamentally, the mineral transactions discussed involve the reconciliation of the tax interests of two parties: the owner of reserves and the owner of the monetary resources necessary to develop and mine the reserves. The interaction of these competing interests is a basic premise which is interlaced throughout the explanation of the tax rules.

In the current industry climate, the user of the mineral and the possessor of mining knowledge and expertise also have crucial interests. The user's interest in the transactions discussed is considered to the extent it coincides with that of the supplier of monetary resources. A separate part of the last section of the paper is devoted to the party who supplies the knowledge and expertise.

The first section of the paper explains the income tax results to the transferor and transferee in the basic sale and lease transactions and various legal arrangements which have evolved in such transactions. In these transactions, the transferor will normally endeavor to recognize capital gains but the transferee's efforts should be directed to obtaining deductions which coincide with the timing of the payments which he makes or the liabilities he incurs. Coal and iron ore leasing is set forth as a separate topic in this section, since it is uniquely a transaction in which the tax considerations of the transferor and transferee can often be reconciled within the existing economic framework of the negotiations.

A separate section of the paper is devoted to production payments because of the frequency and often unexpected circumstances in which they occur. Often, the parties do not consciously intend to negotiate a transaction which will be taxed as a production payment. The uncertainty and risks involved in

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natural resources are such that the transferor frequently must agree that his profit from the transaction will be dependent upon the profitability of mining operations. The transferee, on the other hand, often desires that this share of profit be fixed at a predetermined maximum amount. The transferor's interest is often viewed as, and referred to in the agreement in terms such as royalties or working interests. Such interests may in fact be production payments for tax purposes, regardless of the wording used or the intent of the parties.

Production payments also deserve special attention because they are a means of attracting capital from financial institutions and other investors who are directly associated with the mining activity. In this context, a production payment can be viewed as a nonrecourse loan or advance in which the lender's sole security and source of repayment is production from the property. The tax rules relating to production payments thus have a broad and often unexpected application.

The first two sections of the paper are therefore directed to those situations where an owner of reserves or supplier of capital essentially severs himself from the actual control, risks, and rewards of mining operations, and assumes an essentially passive position through the ownership of a nonoperating interest. This is a meaningful posture for many transactions, particularly where unproven and speculative reserves are involved. Where proven reserves and significant initial capital obligations are anticipated, however, sharing arrangements often carry more favorable income tax consequences. In this context, the development and mining operations can be viewed as a joint commitment of reserves and capital in the manner which will result in the most financial resources being available and dedicated to the actual costs of development and operations. Financial resources which would otherwise be used for the payment of taxes, and reduced taxes resulting from current deductions, can then be devoted to the project. Accordingly, the third major section of this paper discusses sharing arrangements, including a discussion of the relevance and planning opportunities available through the use of corporations and tax partnerships.

The final section of the paper briefly outlines special problem areas which are encountered with some regularity. Three topics are discussed: (1) the sale of corporate stock and partnership interests on a contingent payment basis; (2) the transfer of producing mine and related equipment; and (3) the receipt of property interests as compensation for services rendered.

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I. SALES AND LEASES

A. Tax Consequences to Transferor

The transferor will usually prefer that the transfer of reserves be treated for income tax purposes as a sale rather than a lease. If the transaction is a lease, the transferor's proceeds will be taxed as ordinary income subject to depletion.¹ In minerals transactions, the allowable depletion deduction will be the greater of cost or percentage depletion. Normally, cost depletion will not be a significant factor since the tax basis of the transferor prior to the lease must be prorated over the total proceeds expected to be received by the lessor during the term of the lease.² The allowable depletion deduction is therefore usually computed on the percentage method. If, however, the lessee surrenders the lease before any production occurs, the percentage depletion previously deducted must be restored to income.³

If, on the other hand, the transaction is treated as a sale for income tax purposes, the transferor will be entitled to treat the proceeds as long-term capital gains, generally through the mechanism of Section 1231,⁴ provided he has held the reserves for the requisite holding period and did not acquire the reserves primarily for resale in the ordinary course of his trade or business. In this connection, at least one court has held that a taxpayer who is otherwise a dealer in properties may hold particular oil and gas leases for development, and therefore be entitled to Section 1231 treatment.⁵

The treatment as a sale is generally preferable for an individual taxpayer since the long-term capital gain deduction of 50 percent of the net gain is preferable to the statutory depletion rate which, at the maximum, will result in a 22 percent deduction. For a corporate taxpayer, its maximum rate of tax on capital gains is 30 percent, while the maximum regular tax rate for ordinary income subject to depletion is 37.44 percent (gross income reduced by 22 percent times 48 percent). An individual or corporate taxpayer will also be entitled to recover his costs against the proceeds if the transaction is treated as a sale, but must transfer his cost to the retained interest if the transaction is a lease. This principle can be as important as the capital gain — ordinary income dichotomy where the transferor has capitalized substantial acquisition costs in the property to be transferred.

In certain special situations, however, ordinary depletable income may be more desirable for the transferor. For instance, if a corporation has a net operating loss during the current year or from a carryover year, it will generally prefer to claim the depletion deduction. This deduction will increase its net operating losses while the special maximum rate on capital gains will be of no benefit. If either a corporate or individual taxpayer is a dealer in the property, capital gains will not be available and the

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percentage depletion deduction may, therefore, be more desirable, depending upon the tax basis in the transferred property. The minimum tax on preference items may also be a factor for the transferor; both the gain subject to capital gains taxation and percentage depletion in excess of the transferor's tax basis in the property are subject to a preference tax.⁶

B. Tax Consequences to Transferee

In the typical lease or sales transaction, the initial consideration paid by the transferee must be capitalized as a cost of acquiring the reserves.⁷ Costs which must be capitalized as costs of acquiring reserves are deductible for tax purposes only when the property is abandoned or as cost depletion when the minerals are produced and sold. In either case, the tax benefits to the transferee are deferred and, in the case of productive property where percentage depletion is otherwise available, of benefit only in reducing percentage depletion which would...