REVENUE RULE 92-38

1992-1 C.B. 197, 1992-21 I.R.B. 6.

Internal Revenue Service
Revenue Ruling

PRODUCTION PAYMENT CARVED OUT FOR DEVELOPMENT

Published: May 26, 1992

Section 636  Income Tax Treatment of Mineral Production Payments, 26 CFR 1.636-1; Treatment of production payments as loans.

Production payment carved out for development. A production payment the consideration for which is used to purchase depreciable mining equipment to be used to develop a mineral property qualifies as a production payment carved out for development under section 636(a) of the Code. Rev. Rul. 74-549 modified. [Full text in this issue.]

ISSUE

Does a production payment the consideration for which is used to purchase depreciable mining equipment to be used to develop a mineral property qualify as a production payment carved out for development under section 636(a) of the Internal Revenue Code?

FACTS

Mining company A, the owner of a mine, created a production payment burdening the mine. The agreement between the grantor (A) and the grantee of the production payment provided that the consideration from the carved-out production payment was for development purposes and was to be used exclusively to purchase equipment to develop the mine.

In the same tax year, A used the consideration from the production payment to purchase certain equipment to be used in developing the mine. The expenditure for the equipment did not relate primarily to the production of minerals. This equipment was property of a character subject to the allowance for depreciation provided in section 167 of the Code.

LAW AND ANALYSIS

Section 636(a) of the Code provides that a production payment carved out of a mineral property is treated as a mortgage loan on the property and does not qualify as an economic interest in the mineral property. If, however, production payment is carved out for exploration or development, mortgage loan treatment applies only if and to the extent gross income from the property would be realized, in the absence of the preceding sentence, by the creator of the production payment.

Section 1.636-1(b) of the Income Tax Regulations provides that, for purposes of section 636(a) of the Code, an expenditure is for exploration and development to the extent it is necessary for ascertaining the existence, location, extent or quality of any deposit of mineral or is incident to and necessary for the preparation of a deposit for the production of mineral. An expenditure relating primarily to mineral production is not for exploration or development. Section 1.636-1(b) further provides that whether a production payment is carved out for exploration or development is to be determined in light of all relevant facts and circumstances, including any prior mineral production from the mineral deposit burdened by the production payment.

Situation 2 of Rev. Rul. 74-549, 1974-2 C.B. 186, holds that a carved-out production payment the consideration for which is used to purchase depreciable mining equipment to be used to remove overburden at an open-pit mine does not qualify as a production payment carved out for development under section 636(a) of the Code. This holding relies on section 616(a), which provides that the cost of acquiring depreciable property is not a development expenditure under section 616 (although depreciation allowances may be).

The reliance in Situation 2 on section 616(a) of the Code to exclude expenditures for depreciable equipment from the definition of development expenditures for purposes of section 636(a) was misplaced. Section 616(a) distinguishes between expenditures for the purchase of depreciable property and development expenditures so that the cost of depreciable property used in development is taken into account under that section over time as depreciation allowances are claimed, rather than up front in the year of purchase. Therefore, section 616(a) indicates that depreciable property may be used in development for purposes of that section and does not support a rule excluding all expenditures for depreciable property from the definition of development expenditures for purposes of section 636(a).

Moreover, the holding of Situation 2 of Rev. Rul. 74-549 is inconsistent with section 1.636-1(b) of the regulations. The holding excludes expenditures for the purchase of depreciable equipment from treatment as development expenditures for purposes of section 636(a), without regard to whether the expenditures satisfy the criteria of section 1.636-1(b). Under those criteria, expenditures for depreciable equipment may be development expenditures if, under all relevant facts and circumstances, the equipment is used in development.

HOLDING

A production payment the consideration for which is used to purchase depreciable mining equipment to be used to develop a mineral property qualifies as production payment carved out for development under section 636 of the Code.

EFFECT ON OTHER REVENUE RULINGS

This revenue ruling modifies Rev. Rul. 74-549 by revoking the holding in Situation 2.

DRAFTING INFORMATION

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

Rev. Rul. 92-38, 1992-1 C.B. 197, 1992-21 I.R.B. 6.