Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 70-20

1970-1 C.B. 144

IRS Headnote

Advance minimum royalties paid by a lessee of mineral property that are subject to recoupment from royalties paid the lessor in subsequent years may, at the election of the lessee, be deducted in the year paid or accrued.

Full Text

Rev. Rul. 70-20

Advice has been requested whether, in the circumstances described below, a taxpayer may elect, under section 1.612-3(b)(3) of the Income Tax Regulations, to deduct advanced minimum royalties in the year paid or accrued where they are subject to being recouped in subsequent taxable years.

The taxpayer, an integrated miner-manufacturer, entered into an agreement under which it leased several tracts known to contain minerals, from a single owner in a single transaction. The taxpayer, as a lessee, is required to pay the lessor over the life of the lease a royalty of five percent of the total proceeds received from the sale of all the minerals produced based on a specified number of units.

In addition, the lessee is required to pay to the lessor advanced minimum royalty payments of $1,500 in the first lease year and $1,000 for each of eight successive years thereafter. These payments are required to be made at the beginning of each lease year. Under the agreement, the taxpayer (lessee) is not required to make any advanced royalty payments after the ninth year.

The agreement provides for the recoupment, of the advanced royalty paid at the beginning of each year, out of regular mineral royalties otherwise due and payable to the lessor during that particular year.

Under the provisions of the agreement, to the extent that the advanced minimum royalty is not recouped in the year paid, the amount not recouped in such year is subject to recoupment in a subsequent year when the regular royalty payable exceeds the amount of the advanced royalty recouped in that year. This recoupment of advanced royalties paid in prior years (beginning with the earliest prior year and then each respective preceding year) is limited to recoupment at the rate of ten percent of the excess of the regular royalty payable in the current year over the advanced minimum royalty paid at the beginning of that year.

In the instant case, in the first taxable year, an advanced royalty of $1,500 was paid to the lessor by the lessee and there was no production of minerals. In the second year, $1,000 was paid as an advanced royalty. Also, in that year production resulted in a mineral royalty due to the lessor in the amount of $6,000. The advanced royalty of $1,000 paid in the second year is recouped in full and $500 of the advanced royalty paid in the first year is also recouped ($6,000 - $1,000 = $5,000 x 10% = $500). The balance of the regular royalty, $4,500 ($5,000 - $500) is then paid to the lessor. At the beginning of the third year, the lessee paid the lessor an advanced royalty of $1,000. During that year production resulted in a mineral royalty to the lessee of $11,000. The advanced royalty for the third year, $1,000, is first recouped and then the balance of the unrecouped advanced royalty for the first year, $1,000, is recouped ($11,000 - $1,000 = $10,000 x 10% = $1,000), the advanced minimum royalty for the second year having been previously recouped.

Section 1.612-3(b) of the regulations provides, in part, as follows:

(1) If the owner of an operating interest in a mineral deposit * * * is required to pay royalties on a specified number of units of such mineral * * * annually whether or not extracted * * * within the year, and may apply any amounts paid on account of units not extracted * * *, within the year against the royalty on the mineral thereafter extracted * * *, the payee shall compute cost depletion on the number of units so paid for in advance of extraction * * * and shall treat the amount so determined as an allowable deduction for depletion from the gross income of the year in which such payment or payments are made. No deduction for depletion by such payee shall be claimed or allowed in any subsequent year on account of the extraction * * * in such year of any mineral * * * so paid for in advance and for which deduction has once been made.

* * * * *

(3) The payor, at his option, may treat the advanced royalties so paid or accrued in connection with mineral property as follows:

(i) As deductions from gross income for the year the advanced royalties are paid or accrued, or

(ii) As deductions from gross income for the year the mineral product, in respect of which the advanced royalties were paid, is sold.

* * * Every taxpayer must make an election as to the treatment of all such advanced royalties in his return for the first taxable year in which such amounts are paid or accrued. A taxpayer will be considered to have made an election in accordance with the manner in which such items are treated in the return. A failure to deduct any such items for the year paid or accrued will constitute an election to have all such items treated in accordance with subdivision (ii) of this subparagraph. An election made under this section is binding for the taxable year for which made and all subsequent years, and the taxpayer must treat all advanced royalties paid or accrued in all subsequent years in the same manner.

In this case the taxpayer elected to deduct the advanced royalties in the year paid or accrued.

Accordingly, under the circumstances described above, the advance or minimum royalties are deductible by the lessee under his election in the taxable year paid or accrued.