REVENUE RULE 92-25

1992-1 C.B. 196, 1992-14 I.R.B. 5.

Internal Revenue Service
Revenue Ruling

PERCENTAGE DEPLETION; NET PROFITS INTERESTS

Published: April 6, 1992

SECTION 613A. LIMITATIONS ON PERCENTAGE DEPLETION IN CASE OF OIL AND GAS WELLS, 26 CFR 1.613A-7: Definitions

(See Also Section 613; 1.613-1.)

Percentage depletion; net profits interests. For percentage depletion purposes, the production attributable to a net profits interest in an oil or gas property is determined by multiplying the total production of the property by the taxpayer's percentage participation in the revenues from the property. The taxpayer's percentage participation is determined by dividing the amount of the taxpayer's net profits by the gross income from the property.

ISSUE

If a taxpayer holds a net profits interest in an oil and gas property, what portion of the total production from the property is attributable to the net profits interest for purposes of determining the taxpayer's average daily production under section 613A(c)(2) of the Internal Revenue Code?

FACTS

X owns an operating interest in a mineral property. In 1989, X conveyed a 20 percent net profits interest in the mineral property to Y. During 1989, the property produced 10,000 barrels of oil. X sold the oil produced from the property in 1989 for $200,000 ($20 per barrel). X incurred expenses of $90,000. The property generated net revenues of $110,000 ($200,000 - $90,000). Pursuant to the net profits agreement, Y received $22,000 ($110.000 x .20).

LAW AND ANALYSIS

Section 613A(a) of the Code provides that, except as otherwise provided, the allowance for depletion under section 611 with respect to any oil or gas well shall be computed without regard to section 613, which relates to percentage depletion.

Section 613A(c)(1) of the Code provides that in the case of independent producers and royalty owners, the allowance for depletion under section 611 shall be computed in accordance with section 613 with respect to - (A) so much of the taxpayer's average daily production of domestic crude oil as does not exceed the taxpayer's depletable oil quantity; and (B) so much of the taxpayer's average daily production of domestic natural gas as does not exceed the taxpayer's depletable natural gas quantity; and IS percent shall be deemed to be specified in section 613(b) for purposes of section 613(a).

Section 613A(c)(2) of the Code provides that for purposes of section 613A(c)(1) - (A) the taxpayer's average daily production of domestic crude oil or natural gas for any taxable year, shall be determined by dividing the taxpayer's aggregate production of domestic crude oil or natural gas, as the case may be, during the taxable year by the number of days in such taxable year, and (B) in the case of a taxpayer holding a partial interest in the production from any property (including an interest held in a partnership), the taxpayer's production shall be considered to be that amount of the production determined by multiplying the total production of the property by the taxpayer's percentage participation in the revenues from the property.

Section 1.613A-7(f)(3) of the Income Tax Regulations provides, in part, that in the case of a taxpayer holding a partial interest in the production from any property (including an interest of a partner in property of a partnership or a net profits interest) the taxpayer's production is considered to be that amount of the production determined by multiplying the total production (which is produced after December 31, 1974, and to which gross income from the property is attributable during the taxable year) of the property by the taxpayer's percentage participation in the gross revenues from the property during the year.

In the case of independent producers and royalty owners, section 613A(c) of the Code allows percentage depletion on a limited quantity of the taxpayer's average daily production of domestic crude oil and natural gas. For purposes of determining the taxpayer's average daily production in the case of a taxpayer holding a partial interest in the production from a property, section 613A(c)(2)(B) and section 1.613A-7(f)(3) of the regulations provide that the production attributable to the taxpayer's interest is determined by multiplying the total production of the property by the taxpayer's percentage participation in the revenues from the property.

A taxpayer that owns a net profits interest in a mineral property holds a partial interest in the production from that property. Therefore, in determining the production attributable to a net profits interest, it is first necessary to determine the taxpayer's percentage participation in the revenues from the property for purposes of section 613A(c)(2)(B) of the Code.

A net profits interest is a "royalty paid by the lessees for the privilege of extraction." Kirby Petroleum Co. v. Commissioner, 326 U.S. 599, 605 (1946), 1946-1 C.B. 69. It is "[a] share of gross production measured by net profits from the operation of the property." United States v. Thomas, 329 F.2d 119, 130 n.2 (9th Cir. 1964). It follows, therefore, that the production attributable to a net profits interest should be the number of barrels required to be sold to produce that portion of the "gross income from the property" that is equal to the amount of income actually received by the holder of the net profits interest.

Under section 613A(c)(2)(B) of the Code and section 1.613A-7(f)(3) of the regulations, the production attributable to a net profits interest is to be determined by multiplying the total production of the property by the taxpayer's percentage participation (as measured by the net profits) in the gross revenues from the property. The taxpayer's percentage participation in the revenues from the property is determined by dividing the amount generated by the net profits interest by the gross revenues from the property.

In the present situation, the property generated gross revenues of $200,000 and net revenues of $110,000 ($200,000 - $90,000 (expenses)) in 1989. Y owns a 20 percent interest in the net profits from the property; therefore, Y's net profits interest generated $22,000 ($110,000 x .20). Y's percentage participation in the gross revenues from the property in 1989 is 11 percent ($22,000 divided by $200,000). The production attributable to Y's net profits interest is 1,100 barrels of oil (10,000 barrels x .11). The remaining production (8,900 barrels) is attributable to X's operating interest.

HOLDING

In the case of a taxpayer holding a net profits interest in an oil and gas property, for purposes of section 613A(c)(2) of the Code, the production attributable to the net profits interest is determined by multiplying the total production of the property by the taxpayer's percentage participation in the revenues from the property. The taxpayer's percentage participation is determined by dividing the amount of the taxpayer's net profits by the gross income from the property.

DRAFTING INFORMATION

The principle author of the proposed revenue ruling is Brenda M. Stewart of the Office of Assistant Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling contact Brenda M. Stewart on (202) 566-4919 (not a toll-free call).

Rev. Rul. 92-25, 1992-1 C.B. 196, 1992-14 I.R.B. 5.