Rev. Rul. 80-73

1980-1 C.B. 128, 1980-11 I.R.B. 10.

                       Internal Revenue Service
                                 Revenue Ruling

                 ADVANCED ROYALTIES; CASH AND NONRECOURSE NOTES

                           Published: March 17, 1980

26 CFR 1.612-3: Depletion; treatment of bonus and advanced royalty.

  Advanced royalties; cash and nonrecourse notes. Under section 1.612-3(b) of the regualtions, neither a cash nor an accrual basis taxpayer may deduct as advanced mineral royalties the amount of nonrecourse notes that are payable only to the extent of the proceeds received from the sale of the minerals. Cash paid as advanced royalties is a deferred expense to be taken into account

when the mineral are sold.

ISSUE

  In what year and to what extent may a taxpayer using the cash receipts and disbursements method of accounting deduct cash and notes given as advanced royalties; and similarly, in what year and to what extent may a taxpayer using the accrual method of accounting deduct notes given as advance royalties?

FACTS

  On February 1, 1977, A, an individual, and Y entered into a lease agreement under which A obtained an operating mineral interest in mineral property owned by Y.  The agreement provides that a minimum advanced royalty is due Y each lease year over the 10-year lease term in the amount of 600x dollars, payable at the beginning of each lease year.  The lease further provides that, for the first year, payment of the royalty is to be made in cash and a promissory note, and for all subsequent years payments may be made entirely with notes.  The amount of the minimum annual royalty reasonably reflects the value of the leasehold interest.  A is a cash method, calendar year taxpayer.

  On January 1, 1977, B, an individual, also entered into the same type of agreement with Y except that the advanced mineral royalties payable at the beginning of each lease year may be made entirely with promissory notes. B is an accrual method, calendar year taxpayer.

  In both cases the notes are unsecured, nonrecourse, non-interest bearing, have no maturity date, and are payable only to the extent of the proceeds received from the sale of the minerals.

  On January 1, 1977, A gave Y 150x dollars in cash and a note for 450x dollars.  B gave Y a note for 600x dollars.

LAW AND ANALYSIS

  Section 1.612-3(b)(1) of the Income Tax Regulations provides that advanced royalties exist when the owner of an operating interest in a mineral deposit or standing timber is required to pay royalties on a specified number of units of such mineral or timber annually whether or not extracted or cut within the year, and the owner may apply any amounts paid on account of units not extracted or cut within the year against the royalty on the mineral or timber thereafter extracted or cut.

  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, if advanced mineral royalties are 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 royalties as deductions from gross income for the years in which the advanced royalties are paid or accrued.  A minimum royalty provision requires that a substantially uniform amount of royalties be paid at least annually either over the life of the lease or for a period of 20 years.

  Under section 1.612-3(b) of the regulations advanced royalties may only be deducted when payment is not contingent upon the extraction of the mineral. Here, payments of the notes are contingent upon extraction and sale of the minerals.  Consequently, except for the cash payment, all royalties both as to A and B are not advanced royalties paid or accused within the meaning of section 1.612-3(b) of the regulations because there is no fixed liability to pay any royalty until the minerals are produced and sold.  The cash payment is an advanced royalty, but does not result from a minimum royalty provision because substantially uniform royalties are not required to be paid each year over the life of the lease.

  Moreover, the giving of the note by A does not constitute payment. For a payment to be deductible by a cash method taxpayer there must be a depletion of assets and, therefore, the payment must be in cash or its equivalent.  If the note is never paid, the cash method maker has not parted with anything other than a promise to pay.  A promise to pay is not cash or its equivalent.  See Eckert v. Burnet, 283 U.S. 140 (1931), X-1 C.B. 241; Page v. Rhode Island Hospital Trust Co. Executor, 88 F.2d 192 (1st Cir. 1937).

HOLDING

  A deduction is not allowable to A or B for the amount of the notes because under section 1.612-3(b) of the regulations an advanced royalty must be payable whether or not the minerals are extracted and sold.  Here the notes are payable only out of the proceeds received from the sale of the minerals.  While the 150x dollars actually paid in cash by A is an advanced royalty under section 1.612-3(b), it is deductible only for the year the mineral product, in respect of which the advance royalties were paid, is sold because it does not result from a minimum royalty provision.

  For years after December 31, 1978, see also section 465 as amended by the Revenue Act of 1978.

Rev. Rul. 80-73, 1980-1 C.B. 128, 1980-11 I.R.B. 10.