CHAPTER 12 PROBLEMS INCIDENTAL TO THE RIGHT TO TAKE PRODUCTION OR PRODUCTION ROYALTY "IN KIND"

• Jurisdiction: United States

Mining Agreements II
(May 1981)
CHAPTER 12
PROBLEMS INCIDENTAL TO THE RIGHT TO TAKE PRODUCTION OR PRODUCTION ROYALTY "IN KIND"


Douglas V. Johnson
Atlantic Richfield Company
Denver, Colorado

Introduction

The elective right or affirmative obligation to take ores or mineral products¹ in kind is an almost universal provision found in joint operating, joint venture and similar joint development or sharing arrangements for mineral properties.² Although there may be other reasons for a participant to take production in kind, the routine inclusion of such a provision in sharing arrangements usually is based upon interpretations of Federal income tax laws. These interpretations appear to make taking in kind a "safe harbor," eliminating the possibility of classification of the joint operation as an "association" which would be taxable as a corporation under the Internal Revenue Code (the "Code"). In some instances, taking in kind may also provide the participants the flexibility of electing whether or not the joint operating entity should be treated as a reporting partnership for tax purposes. Taking product in kind is also believed to be one of a number of positive factors which will reduce the possibility of an attack upon a joint operating entity under the antitrust laws.

Historically, production royalty was often taken in kind, although this form of "payment" is now unusual and royalty obligations are usually satisfied by payment in money. In recent years, nowever, more owners of mineral properties, and other holders of royalty interests,³ have requested that production royalty obligations be satisfied in kind, rather than by payment in money. Such requests are particularly likely if a property is believed to have value as a precious metals mine, or if the property owner has its own use for the likely products. Some royalty interest holders wish to take in kind because of their belief that by holding the product taken in kind from year to year they may delay the recognition of "income" for Federal income tax purposes until the time that such production is actually sold.

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Conceptually, taking production or production royalty in kind sounds relatively simple to the uninitiated, and seems eminently fair and equitable as it provides the Owner or Non-Operator with possession of an actual share of either the ores produced by the Operator,⁴ or some subsequent mineral product produced from that ore, such as concentrates or refined metal. Some years ago, after discussing the potential problems and disputes created in computing production royalty by the "pricing" of uranium by reference to a "market" or "published" price, one speaker at a Foundation Institute noted:

In one highly unusual situation there is a very simple solution which completely eliminates all the problems...created by changes in market price. Where crude ore is the final product in the lessee's operation, this solution will also do away with questions of acceptable sampling and assaying procedures. The situation I refer to is one in which the lessor himself has a need for uranium and therefore wishes to take his royalty in kind. Of course a take-in-kind royalty provision is possible only in the unusual circumstance that the lessor has a use for uranium. Precious few such situations will ever arise.⁵

However, in the past few years it appears that some Owners have requested provision for a production royalty taken in kind even when they do not have any use for the product to be taken.

While taking royalty in kind will effectively resolve any disputes as to the correct computation and payment of a monetary production royalty, it may create many unforseen problems for both the Operator and the Owner. Taking in kind may work well with respect to mineral products that the Owner has some use for, and with readily salable products (such as placer gold) that can also be divided relatively easily between the parties without the possibility of significant disputes. The problem is that many mineral ores and products are bulky; most products do not lend themselves to a simple division free of potential disputes between the parties; and, once taken, such products may not be readily salable, or are only salable on less than advantageous terms from the seller's perspective.

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Most taking in kind arrangements will pose special concerns for the Operator, and for the Owner or Non-Operator. Not the least of the problems posed for the Operator is the uncertainty which may exist as to whether or not, in fact, product will be taken in kind. This uncertainty can significantly affect the development of the Operator's mine plan, plans for the construction of handling, storage, processing and related facilities, and the design and scale of such facilities. The Operator must also be concerned with what specific products will be taken in kind; when and where that taking will occur; the procedures which will be used to divide the product taken, and to resolve any disputes between the parties concerning that division; how extra costs incurred as a result of taking in kind will be allocated and paid; now severance, ad valorem and similar taxes will be computed and paid; and the manner in which any advance royalties or development expenditures or other amounts previously advanced in cash will be recouped.

Similarly, the person or entity taking in kind will share some (but not all) of these concerns, and will raise other problems. From this perspective the most important question will be what the person taking in kind intends to do with the product taken. Any agreement providing for taking in kind should include provisions that facilitate the Owner's or Non-Operator's plans for sale, further processing or use of the product, addressing such matters as minimum and maximum quantities to be taken, the ore grade or elemental composition of that product, its amenability to further processing, and how it will be handled and packaged. Also important will be plans for transportation and storage and, particularly for valuable products, clear provisions concerning insurance and the passing of both title and the risk of loss or damage. The person taking in kind will often have specific plans for the further processing or sale of the product taken, often requiring entry into the specialized markets which exist for particular products. For this reason many taking in kind provisions will necessarily include elements of ore purchase, smelting, refining or custom milling contracts in order to facilitate the eventual sale of the product taken, or other specific plans for its use.

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Much has been written about the often competing needs for a well-drafted royalty provision to anticipate and prevent future disputes as to computation and payment of royalty, and to provide flexibility for the Operator to change its mining or processing operations in the future (including the utilization of technological changes or improvements), without the necessity of renegotiating the royalty arrangement.⁶ As one commentator has noted: "A good royalty clause springs as much from a thorough understanding of the technology and economics of possible mining operations as from any sort of legal wizardry."⁷ This is particularly true with any royalty provision which contemplates the taking of mineral products in kind. A thorough understanding of the future exploration and development of the ore deposit involved, the Operator's mining plans and the Owner's plans for selling, further processing or consuming the product to be taken will be of great significance in structuring and drafting any such provision. Additionally, the Owner's right to take in kind can affect many of the other relatively "standard" provisions contained in mining leases and other agreements providing for a royalty on production, and those provisions will need to be reviewed with reference to the possibility of taking royalty in kind.

Joint operating agreements and similar sharing arrangements usually provide few detailed provisions regarding the actual taking of products in kind.⁸ This probably results from the fact that such agreements are often entered into prior to substantial exploration of a mineral property, and little information is then available concerning what products might eventually be produced by joint operations. Additionally, such agreements generally include detailed provisions for a management, operating or similar committee, and for regular "work plans," meetings, reports and similar mechanisms to allow the Operator and Non-Operator to have some degree of joint control over the development of and production from a particular mineral property.⁹ If necessary, such procedures may be used to facilitate further agreement regarding taking in kind.

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Where it is not certain what minerals and ores will be produced from a property, or whether it will be economic to further process those ores before a taking in kind, it may be difficult to provide much more than simply that each party will take its share of "production" in kind. However, even in these cases it is helpful to analyze the taking in kind process as it might apply to a particular mineral property or area, and to include carefully drafted statements as to the parties' intent to reduce the possibility for future conflict between the participants.¹⁰ Further, although lawyers generally dislike "agreements to agree" in the future, it may be possible to deal with obvious areas of uncertainty by providing mechanisms facilitating future agreement on necessary points.¹¹

This paper will discuss the reasons that currently make taking in kind attractive to Non-Operators and Owners, with consideration of some of the pitfalls that may affect such arrangements under the Federal tax laws; and then discuss some (but certainly not all) of the potential problems to be considered in the negotiation and drafting of any mining agreement...