Retained production royalty makes mineral transfer a lease

Plain-English summary

An international mining company transferred its interest in a mine for cash while retaining a one-time bonus royalty and a production royalty. The bonus royalty was triggered by adding reserves, whether or not minerals were produced, so it was not an economic interest in minerals in place. The production royalty depended on mineral extraction, even though payments began only after a production threshold and varied with commodity prices. The IRS therefore advised that the company retained an economic interest and that the transaction was a mineral lease, not a sale.

Ruling snapshot

• Question: Was a mine-interest transfer with retained bonus and production royalties a lease or a sale for federal tax purposes?
• Outcome: Advice given: the transfer was a lease because the production royalty was a retained economic interest
• Key authorities: IRC §§ 611, 612, 613, and 614; Treas. Reg. §§ 1.611-1(b) and 1.614-1(a)(2); Ridley v. Commissioner, 58 T.C. 439 (1972)

Full text (IRS public release)

                     INTERNAL REVENUE SERVICE
           NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                                June 3, 2014

                                                Third Party Communication: None
                                                Date of Communication: Not Applicable

Number: 201448020
Release Date: 11/28/2014

Index (UIL) No.: 611.00-00, 611.02-04
CASE-MIS No.: TAM-149207-13

CC:LB&I:CTM:PNX

   Taxpayer’s Name:                             ------------------------------------------
   Taxpayer’s Address:                          --------------------------------
                                                ----------------------------------------
   Taxpayer’s Identification No                 ----------------
   Year(s) Involved:                            ------
   Date of Conference:                          ----------------

LEGEND:

Taxpayer = ----------------------------------------
Company A = --------------------------------------------------
Company B = ---------------------------------
Date 1 = ----------------
a% = ------
Mine A = ----------------------
b% = ---
Date 2 = -------------------
Commodity = ------
Audit Period = ----------------
$c = ------------------------------------------------------------------------------------------
d% = --
$e = -----------
g = -----------------------
TAM-149207-13 2

$h = --------------
i = ---
j = ------------------------------------------------------

ISSUE:

Should the transfer of Taxpayer’s b% interest in Mine A, when Taxpayer retained a
bonus royalty and a production royalty, be treated for tax purposes as a lease or a sale
of minerals?

CONCLUSION:

The transfer of Taxpayer’s b% interest in Mine A, when Taxpayer retained a bonus
royalty and a production royalty is treated for tax purposes as a lease of minerals.

FACTS:

Taxpayer, an international mining company, acquired Company A as part of a stock
acquisition on Date 1. Prior to its acquisition by Taxpayer, Company A purchased an
a% interest in Mine A. Company A subsequently, purchased additional interests in
Mine A, and owned a b% interest during the Audit Period. The owners of Mine A
treated this as a joint venture, and elected out of being treated as a partnership under
Subchapter K. Therefore, each owner includes on its own return the operating income
and expenses with respect to its ownership interest.

On Date 2, Company A transferred its b% interest in Mine A to Company B for $c and
retained two interests, a production royalty and a bonus royalty. The production royalty,
which burdened the b% interest transferred by Taxpayer, is payable on a sliding scale
topping out at d% for Commodity prices above $e, beginning after g reserves have been
produced. The bonus royalty, a single lump sum of $h, is payable to Taxpayer within i
days after cumulative reserves of j are added to the existing reserves.

LAW AND ANALYSIS:

Section 611(a) of the Internal Revenue Code (Code) provides, in part, that in the case
of mines, oil and gas wells, other than natural deposits and timber, there shall be
allowed as a deduction in computing taxable income a reasonable allowance for
depletion and for depreciation of improvements, according to the peculiar conditions in
each case; such reasonable allowance in all cases to be made under regulations
prescribed by the Secretary. The Code provides for two basic types of depletion
allowance. Cost depletion is provided for in § 612 and percentage depletion in § 613.
TAM-149207-13 3

Section 1.611-1(b) of the Income Tax Regulations provides that the annual depletion
deductions are allowed only to the owner of an “economic interest.” Section 1.611-
1(b)(1) further provides that the term “economic interest” is defined as follows:

   An economic interest is possessed in every case in
   Which the taxpayer has acquired by investment any
   interest in mineral in place … and secures, by any
   form of legal relationship, income derived from the
   extraction of the mineral … to which he must look for
   a return of this capital.

Section 1.614-1(a)(2) provides that the term “economic interest” includes working or
operating interests, royalties, overriding royalties, net profits interests, and, to the extent
not treated as loans under § 636, production payments.

Whether the conveyance of an interest in a mineral property is classified as a lease or
as a sale or exchange depends upon whether the transferor retains an interest in the
mineral property and the nature of the interest, if any, retained by the transferor. When
the transferor assigns all of his or her interest in a mineral property or a fractional
interest that is identical to the interest retained, or when a transferor assigns a
continuing nonoperating interest and retains a working interest, the conveyance is
classified as a sale. On the other hand, when the transferor assigns the operating rights
and retains a continuing nonoperating interest the conveyance is classified as a lease or
sublease. See, e.g., Burnet v. Harmel, 287 U.S. 103 (1932); Palmer v. Bender, 287
U.S. 551 (1933)

In Ridley v. Commissioner, 58 T.C. 439 (1972), the taxpayer received an upfront
payment at closing and no further payments until about 42% of the ore body had been
extracted. If thereafter extraction exceeded that threshold the taxpayer would receive a
royalty for the balance of the deal. The Tax Court held that no sale had occurred,
stating that the advance payment was a bonus or advance royalty even though the
taxpayer argued that it had no remaining interest in the first 42% of minerals extracted
from the premises because the taxpayer had already been paid.

In the instant case, Taxpayer transferred its b% interest in Mine A for an upfront cash
payment, and retained a bonus royalty and a production royalty. The transfer
constitutes a lease if Taxpayer retained an economic interest. The only relevant legal
issue, then, is whether either the bonus royalty or the production royalty is in fact an
economic interest in minerals in place. If either is an economic interest, then
Taxpayer’s retention of the interest is inconsistent with sale treatment, and lease
treatment must apply to the instant transaction. Sale treatment is applicable only where
there is a complete and total alienation of the Taxpayer’s entire economic interest.
TAM-149207-13 4

The bonus royalty is payable to Taxpayer within i days after cumulative reserves of j are
added to the existing reserves, without regard to whether any minerals are produced
and sold. Under § 1.611-1(b)(1) in order for an interest to qualify as an economic
interest the owner of that interest must derive income from the extraction of mineral to
which the owner looks for a return of capital. The bonus royalty is payable without
regard to production. Therefore, Taxpayer’s income from the bonus royalty is not
derived from the extraction of mineral. Consequently, the bonus royalty does not qualify
as a retained economic interest.

The remaining question is whether the production royalty qualifies as a retained
economic interest. The production royalty is payable on a sliding scale topping out at
d% for Commodity prices above $e, beginning after g reserves have been produced.
Because Taxpayer’s income is derived from the extraction of minerals and can only be
satisfied from the extraction of mineral, the production royalty qualifies as an economic
interest for purposes of § 1.611-1(b)(1). The fact that Taxpayer’s production royalty is
preceded by a production holiday and is subject to a sliding scale regarding certain
Commodity prices does not prevent the production royalty from being treated as a
retained economic interest in minerals in place

CONCLUSION

Therefore, we conclude that Taxpayer has retained an economic interest in minerals in
place through the retention of the production royalty regardless of the contingencies
related to that production royalty.

CAVEAT(S):

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section
6110(k)(3) provides that it may not be used or cited as precedent.