CHAPTER 4 A TAX TRAP FOR THE UNWARY: THE ACQUISITION|DISPOSITION OF MINERAL PROPERTIES
| Jurisdiction | United States |
(Mar-Apr 1977)
A TAX TRAP FOR THE UNWARY: THE ACQUISITION/DISPOSITION OF MINERAL PROPERTIES
Gorsuch, Kirgis, Campbell, Walker and Grover
Denver, Colorado
TABLE OF CONTENTS
INTRODUCTION
SALE VERSUS LEASE
Background
Significance of the Distinction
General Concepts
Economic Interest
Property Unit
General
Property Defined
Separate Interest
Mineral Property
Separate Tract or Parcel
Aggregations
Consequences of Aggregation
Classification of Conveyances
General
Sale (Exchange)
Lease (Sublease)
Non-Producing Properties
Producing Properties
Tax Planning
AN EXCEPTION: COAL AND IRON ORE
Significance of the Exception
Entitlement to Special Treatment
Ownership of Coal
Related Parties
Advance or Minimum Royalty
SURFACE RIGHTS
Significance of the Problem
Disposition of Surface Rights
Acquisition of Surface Rights
VARIABLE RATE ROYALTIES
CONCLUSION
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INTRODUCTION
Occasionally, hopefully not often, one hears the old adage that brings tears to the tax practitioner's eyes—"It's a good deal; don't let the tax tail wag the dog!" The aim of this paper is to demonstrate the fallacy of the premise behind that adage. That is, a good deal, if it is structured right, remains a good deal, but, one must not forget that a particular structure or conceptual arrangement may have attendant adverse tax consequences that can ruin the economics of even the "best" of deals. Furthermore, tax benefits may save what otherwise appears to be a disastrous or diseconomic deal.
This paper deals with four topics: (1) Sale versus lease; (2) the special treatment afforded coal and iron ore, (3) the acquisition or disposition of surface rights and (4) variable rate royalties. However, before discussion of each primary topic a background discussion relating to the consequences of certain transactional structures or concepts that have an effect on the tax result is provided. The background is hopefully sufficient and most important to an understanding of the subject matter. It should not be lightly regarded. Do so and you may find yourself or your client in a tax trap set for the unwary.
SALE VERSUS LEASE
Background
Significance of the Distinction. For tax purposes it is important to consider whether a particular arrangement regarding a mineral property will be treated as a lease or a sale. Depending on the individual circumstances of the taxpayer, either treatment may be appropriate, and each has its particular tax nuances. However, the real concern here is that the arrangement be treated for tax purposes as the parties intend.
Depending upon whether the arrangement is treated as a sale or as a lease, there are distinct tax consequences. If treated as a sale, the transaction may be entitled to
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capital gain treatment whereas a lease will result in ordinary income subject to a depletion allowance (cost or percentage). Another important aspect of the tax treatment is the treatment of the expenses of transfer which are different in each case.
If the arrangement is treated as a sale, then the transfer expenses (e.g. commissions and other fees) may be deducted from the selling price as part of the cost basis.1 If the transaction is treated as a lease, then the costs must be capitalized as part of the retained interest and recovered through the depletion allowance.2 In many cases, capitalization of such expenses would result in no real benefit, because the percentage depletion allowance will more often than not be greater than the cost depletion amount. Since the taxpayer is required to deduct the higher of the determined cost or percentage depletion,3 no attendant tax or economic benefit may result over time, because the cost basis of the mineral interest is reduced by tax deductible depletion.4 Selling costs are deductible in the case of a sale, and, therefore, at least some economic benefit is obtained. Capitalization may result in absolutely no economic benefit.
As the most significant difference between a sale and or lease is the prospect of capital gain treatment, it must be noted that even this important attribute is diminished to a certain extent by the so-called "minimum tax".5 The minimum tax can have the effect of increasing the overall effective rate of tax on the transaction. Furthermore, in the case of an individual, items of tax preference can reduce his ability to utilize the maximum tax (maxi-tax) on
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personal service income.6 Since, except for the first $50,000 of capital gain in the case of the alternative tax computation,7 the effective rate of tax on capital gains will be one-half of the effective rate of tax on the taxpayer's income, the loss of the maxi-tax increases the overall effective rate of tax on the taxpayer's income (including capital gain). Thus, depending on the economics of the deal, the fact that a transaction is structured as a sale or a lease may not be as important as in prior years. However, it will likely remain a very important consideration in most deals. Other attributes of the "sale versus lease" problem are discussed below.
General Concepts. It is clear that the tax characterization of a transaction does not depend on whether local law dictates that a transfer is a lease or a sale.8 Bankers Pocahontas Coal Co. 9 was the first case to apply this principle in the hard mineral area. The basic premise of this rule is
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that a distinction on the basis of when legal title to a mineral deposit passes under local law is not necessary if the economic consequences to the transferor are the same in all cases—i.e., the value of his interest is diminished by extraction.10 This policy is required so that there will be a uniform interpretative policy for the national scheme of taxation. Thus, the concern must be with the federal income tax attributes of an arrangement and not the legal status or characteristics under local property laws.
Since we are concerned with mineral taxation here, it should be understood what is meant by the term "minerals", because not only is a mineral a natural substance subject to extraction, but a mineral deposit encompasses a variety of distinguishable legal rights which can be variously conveyed and exploited.11 Not only can one parcel out surface and subsurface rights, but the various minerals encompassed within the subsurface rights can be segregated and individually transferred in whole or in part. Thus, a mineral is the bundle of rights pertaining to a mineral in place which carries with it the right to reduce such mineral to possession and remove it. Such right would also encompass the right to make reasonable use of the surface to develop the property for production.12 An interest in minerals in place (mineral interest) would then be an interest which gives the right to share in production (as contrasted with proceeds of production) even if the mineral is owned by another.13
The concept of a mineral interest can be refined further into its two major divisions—nonoperating and operating interests.14 The common nonoperating interests are the royalty, overriding royalty, net profits interest and certain production payments. These are called nonoperating interests, because they are free of the responsibility for development and operation of the mineral property.
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A royalty interest entitles its owner to a share, in kind or in value, of production, but it is free of development and operation expenses. It is generally called the landowner's royalty. It can be a minimum royalty, which is payable irrespective of production, or merely payable out of production. In the case of a minimum royalty, it will usually be recoverable out of future production, but such does not always necessarily follow. It can be created by assignment or reservation. In an assignment, the mineral owner conveys the royalty by reserving the operating rights and burdens. In the reservation, the operating rights and burdens are conveyed and the royalty is reserved. The overriding royalty interest is similar since it is also an entitlement to a non-cost bearing share of production. They are different in that the overriding royalty is carved out of the operating interest and is co-extensive in duration.
A net profits interest (NPI) is a share of gross production measured by the property's operating net profit which is calculated pursuant to the agreement of the parties. As in the case of the overriding royalty, it is also carved out of the operating interest and is of the same duration. However, unlike the overriding royalty, the NPI is required to bear specified development and operating costs, but such costs are covered by the attributable share of income. So, unlike the operating interest, an owner of a NPI is not required to advance or be liable for such costs. For this reason it is considered a nonoperating interest. The general danger inherent here is that the interest is measured by a formula (contractual agreement as to costs included or excluded) which may take on the aura of a mere contractual obligation rather than an interest in the mineral in place (i.e. an economic interest). However, a NPI has been recognized as an economic interest.15
Prior to the 1969 Tax Reform Act, a production payment was treated as an economic interest. Now only certain types of production payments are treated as economic interests, and the other types are treated as mortgages.16 A production payment is a right that entitles its owner to a limited share of production. The limitation may be imposed by a specific duration for the interest or it may be related to a specific dollar amount or a specified number of mineral
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units. It is like an overriding royalty, but it usually expires prior to the termination of the supporting operating interest. Certain types of "term" mineral interests or royalties may have the same effect as a production payment.17...
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