Internal Revenue Service
Revenue Ruling
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smRev. Rul. 76-34
1976-1 C.B. 177
Section 636
IRS Headnote
Oil and gas royalties based on production. No part of the royalty payments received by the lessor of an undivided interest in oil and gas producing properties under a lease agreement providing that, from month to month, the royalty percentages could decrease or increase based on average daily gross production for the previous three consecutive month periods is a production payment within the meaning of section 636(c) of the Code and section 1.636-3 of the regulations.
Full Text
Rev. Rul. 76-34
Advice has been requested whether any part of royalty payments made to a lessor, A, by lessee, B, for an undivided interest in certain oil and gas producing properties is a production payment within the meaning of section 636(c) of the Internal Revenue Code of 1954 and section 1.636-3 of the Income Tax Regulations, under the circumstances described below.
A, the owner of an undivided interest in a lease from which oil and gas are being produced, leased its interest to B. The lease provides for a royalty of one-fourth of gross production for the first three months of the lease and for each month thereafter whenever the gross production of oil for the previous three consecutive months averaged more than 5,000 barrels per day.
The lease agreement further provides that whenever the gross production of oil for the previous three consecutive months averaged 5,000 barrels or less but more than 2,000 barrels per day, the royalty for the current month would be three-sixteenths of gross production. Finally, if, for the previous three consecutive months, the gross production averaged 2,000 barrels or less per day, the royalty for the current month would be one-eighth of gross production. From month to month the royalty percentages could decrease or increase as average gross production for the previous 3 consecutive month periods decreased or increased.
Section 636(c) of the Code provides, in part, that a production payment retained in a mineral property by the lessor in a leasing transaction shall be treated, for purposes of this subtitle, insofar as the lessee (or his successors in interest) is concerned, as if it were a bonus granted by the lessee to the lessor payable in installments.
Section 1.636-3(a)(1) of the regulations provides, in part, that the term "production payment" means, in general, a right to a specified share of the production from mineral in place (if, as, and when produced), or the proceeds from such production. Such right must be an economic interest in such mineral in place and such right must have an expected economic life (at the time of its creation) of shorter duration than the economic life of one or more of the mineral properties burdened thereby. A production payment may be limited by a dollar amount, a quantum of mineral, or a period of time. A right to mineral in place has an economic life of shorter duration than the economic life of a mineral property burdened thereby only if such right may not reasonably be expected to extend in substantial amounts over the entire productive life of such mineral property. Section 1.636-3(a)(2) of the regulations provides, in part, that a right which is in substance economically equivalent to a production payment shall be treated as a production payment for purposes of section 636 of the Code and the regulations thereunder, regardless of the language used to describe such right, the method of creation of such right, or the form in which such right is cast. Whether or not a right is in substance economically equivalent to a production payment shall be determined from all the facts and circumstances. An example of an interest which is to be treated as a production payment under this subparagraph is that portion of a "royalty" which is attributable to so much of the rate of the royalty which exceeds the lowest possible rate of the royalty at any subsequent time (disregarding any reductions in the rate of the royalty which are based solely upon changes in volume of production within a specified period of no more than 1 year). For example, assume that A creates a royalty with respect to a mineral property owned by A equal to 5 percent for 5 years and thereafter equal to 4 percent for the balance of the life of the property. An amount equal to 1 percent for 5 years shall be treated as a production payment. On the other hand, if A leases a coal mine to B in return for a royalty of 30 cents per ton on the first 500,000 tons of coal produced from the mine in each year and 20 cents per ton on all coal in excess of 500,000 tons produced from the mine in each year, the fact that the royalty may decline to 20 cents per ton on some of the coal in each year does not result in a production payment of 10 cents per ton of coal on the first 500,000 tons in any year.
In the instant case, the royalty provided for in the lease agreement between A, the lessor, and B, the lessee, will not have an expected economic life at the time of its creation of shorter duration than the economic life of the mineral properties burdened thereby. Therefore, it differs in this respect from a production payment, as defined in section 1.636-3(a)(1) of the regulations, which is limited by a dollar amount, a quantum of mineral, or a period of time.
While the rate of royalty is expected to vary during the life of the burdened properties, the variation will be based solely upon a change in volume of gross oil produced for a period of three consecutive months. Therefore, this royalty variation comes within the exception of section 1.636-3(a)(2) of the regulations that disregards any reductions in the rate of royalty which are based solely upon changes in volume of production within a specified period of no more than one year.
Accordingly, in the instant case no part of the royalty payments made to lessor A by lessee B for an undivided interest in certain oil and gas producing properties is a production payment within the meaning of section 636(c) of the Code and section 1.636-3 of the regulations.