Rev. Rul. 80-70

1980-1 C.B. 104, 1980-11 I.R.B. 5.

                       Internal Revenue Service
                                 Revenue Ruling

       ADVANCED MINERAL ROYALTIES PAID OR INCURRED UNDER MINIMUM ROYALTY
                                   PROVISIONS

                           Published: March 17, 1980

Section 461.--General Rule for Taxable Year of Deduction, 26 CFR 1.461-1: General rule for taxable year of deduction.

(Also Section 612; 1.612-3.)

  Advanced mineral royalties paid or incurred under minimum royalty provisions. An advanced mineral royalty resulting from a minimum royalty provision and covering a 12-month period extending beyond the taxable year when paid or incurred is not fully deductible in the year when paid or incurred. Only the portion properly attributable to the current taxable year is deductible in the current taxable year. The cost of minerals extracted in subsequent years must be reduced by the advanced royalties deducted to date. Rev. Rul. 77-489 amplified.

ISSUE

  Is an advanced mineral royalty resulting from a minimum royalty provision and covering a 12 month period extending beyond the taxable year when the liability is paid or incurred deductible in full in the year when paid or incurred by a taxpayer using either the cash receipts and disbursements method or the accrual method of accounting?

FACTS

Situation 1

  X uses the cash receipts and disbursements method of accounting and files its federal income tax returns on a calendar year basis.  On December 1, 1977, X and Y entered into a lease agreement under which X obtained the operating mineral interest in a mineral property from Y. The agreement requires X to pay Y a production royalty of 5 percent of the proceeds received from the sale of minerals extracted during each lease year over the 10 year lease term. Regardless of production, X is required to make a nonrefundable payment to Y of 60x dollars on the first day (December 1) of each annual leasing period. Production royalties otherwise due each lease year are to be reduced by the 60x dollars paid on December 1 of each year.  In any year in which the minimum royalty exceeds the production royalties, the excess is to be applied to reduce the production royalties due for any subsequent year.

  The mineral reserves committed to the lease are substantially in excess of those sufficient for complete pay-out of the total minimum royalty and it is practical to extract a quantity of the mineral over the term of the agreement in excess of that necessary for complete payout of the total minimum royalty.

  On December 1, 1977, X paid 60x dollars to Y for the lease period December 1, 1977, through November 30, 1978.  X extracted no minerals from the leased property during December 1977.  In accordance with section 1.612-3(b)(3) of the Income Tax Regulations, X elected to treat the advanced royalties as deductions from gross income for the year in which the advanced royalties are paid or accrued.

Situation 2

  The facts are the same as in Situation 1 except that X uses the accrual method of accounting and executes a negotiable promissory note on December 1 of each lease year payable on demand to Y as payment for the 60x dollars.

LAW AND ANALYSIS

  Section 461(a) of the Internal Revenue Code provides that the amount of any deduction shall be taken for the taxable year that is the proper taxable year under the method of accounting used in computing taxable income.

  Section 1.461-1(a)(1) of the regulations provides that, under the cash receipts and disbursements method of accounting, amounts representing allowable deductions shall, as a general rule, be taken into account for the taxable year in which paid.

  Section 1.461-1(a)(2) of the regulations provides that, under the accrual method of accounting, an expense is deductible for the taxable year in which all the events have occurred that determine the fact of the liability and the amount thereof can be determined with reasonable accuracy.

  Section 1.612-3(b)(3) of the regulations provides that the payor shall treat the advanced royalties paid or accrued in connection with mineral property as deductions from gross income for the year the mineral product, in respect of which the advanced royalties were paid or accrued, is sold. However, in the case of advanced mineral royalties paid or accrued in connection with mineral property as a result of a minimum royalty provision, the payor, at its option, may instead treat the advanced royalties as deductions from gross income for the year in which the advanced royalties are paid or accrued. This subparagraph further provides that no deduction is allowed under this provision that is disallowed under other provisions of the Code such as section 461.

  Rev. Rul. 77-489, 1977-2 C.B. 177, addresses the deductibility of cumulative advanced minimum royalties due over the term of a ten year lease. Rev. Rul. 77- 489 provides two situations in which a taxpayer using the cash receipts and disbursements method of accounting and a taxpayer using the accrual method of accounting attempt to accelerate the deduction for the payment of the cumulative advanced minimum royalties either by paying the full amount of these royalties due over the ten year lease term in cash or by executing a negotiable promissory note payable on demand for these royalties.  In both situations in Rev. Rul. 77-489, payment of the cumulative advanced minimum royalties due over the ten year lease was made on the first day of the taxable year.  Rev. Rul. 77-489 concludes that, for both the taxpayers, only that portion of the advanced minimum royalties that is properly attributable to the initial year of the lease is deductible in that year. The present situation differs from Rev. Rul. 77-489 in that it involves only a 12 month portion of the cumulative advanced minimum royalty due over the ten year lease and the period used for fixing liability under the lease is not coextensive with the taxable year of payment or accrual.

  In Zaninovich v. Commissioner, 69 T.C. 605 (1978), a taxpayer deducted in the year of payment a full 12 months' rent that was attributable to 2 taxable years.  In disallowing the deduction, the court stated the general rule for rental deductions as provided in University Properties, Inc. v. Commissioner, 45 T.C. 416, 421 (1966), aff'd, 378 F.2d 83 (9th Cir. 1967):

    Rentals may be deducted as such only for the year or years to which they are applied.  If they are paid for the continued use of the property beyond the years in which paid they are not deductible in full in the year paid but must be deducted ratably over the years during which the property is so used.

  In both situations 1 and 2, X has elected pursuant to section 1.612-3(b)(3) of the regulations to treat the advanced royalties as deductions from gross income for the year in which the advanced royalties are paid or accrued.  This election is in lieu of deducting the advanced royalties in the year the mineral product in respect of which the advanced royalties were paid or accrued is sold.

  In Burnet v. Hutchinson Coal Co., 64 F.2d 275 (4th Cir. 1933), and Commissioner v. Jamison Coal and Coke Co., 67 F.2d 342 (3rd Cir. 1933), the courts indicated that minimum royalty payments are like rent.  In accordance with Zaninovich, the portion of the payment made by cash or negotiable promissory note for the advanced royalties applicable to the months in the lease period occurring in 1978 is not deductible in 1977.  This result is the same for both the taxpayer using the cash receipts and disbursements method of accounting and the taxpayer using the accrual method of accounting.  See Smith v. Commissioner, 51 T.C. 429 (1968).

  In both Situation 1 and Situation 2, X may deduct only 5x dollars of the advanced royalty resulting for the minimum royalty provision for the taxable year 1977.  For subsequent taxable years remaining on the lease X may deduct 60x dollars of advanced royalties, consisting of 55x dollars from the lease year beginning in the prior taxable year and 5x dollars from the lease year beginning in the current taxable year. However, if production occurs in subsequent taxable years, the taxpayer must reduce the cost of minerals extracted by the amount of the advanced royalties that have been deducted to date.

HOLDING

  An advanced mineral royalty resulting from a minimum royalty provision and covering a 12 month period extending beyond the taxable year when paid or the liability is incurred is not deductible in full in the year when paid or the liability is incurred by either a taxpayer using the cash method of accounting or a taxpayer using the accrual method of accounting.  Only that portion of an advanced minimum royalty paid or incurred that is properly attributable to the current taxable year is deductible by either of these taxpayers.  Furthermore, if production occurs in subsequent taxable years, the taxpayer must reduce the cost of minerals extracted by the amount of the advanced royalties that have been deducted to date.

EFFECT ON OTHER RULINGS

  Rev. Rul. 77-489 is amplified.

Rev. Rul. 80-70, 1980-1 C.B. 104, 1980-11 I.R.B. 5.