REVENUE RULE 94-48

1994-2 C.B. 3, 1994-29 I.R.B. 5.

Internal Revenue Service
Revenue Ruling

SECTION 29 CREDIT; PRODUCTION ATTRIBUTABLE TO NET PROFITS INTEREST

Published: July 18, 1994

Section 29. - Credit for Producing Fuel from a Nonconventional Source
(See Also Section 613A.)

Section 29 credit; production attributable to net profits interest. The production attributable to a net profits interest under section 29(d)(3) of the Code is the production required to be sold to produce that portion of the gross sales from the property that is equal to the amount of income received by the holder of the net profits interest.

ISSUE

If a taxpayer holds a net profits interest in a mineral property that produces a qualified fuel under s 29 of the Internal Revenue Code, what portion of the total production from the property is attributable to the net profits interest?

FACTS

X owns an operating interest in a mineral property. In 1990, X conveyed a 20 percent net profits interest to Y. X drilled wells that in 1991 produced 2,500x mcf of gas from coal seams. X incurred expenses of $2,000x and sold the gas to unrelated persons for $5,000x ($2 per mcf). Thus, the property generated net revenues of $3,000x ($5,000x - $2,000x). Pursuant to the net profits agreement, X paid Y $600x (20% of $3,000x) as proceeds from the sale of the production attributable to Y's net profits interest.

LAW AND ANALYSIS

Section 29(a) provides a credit for qualified fuel sold by the taxpayer to an unrelated person during the taxpayer year and the production of which is attributable to the taxpayer.

Section 29(c) defines the term "qualified fuels" to include gas produced from coal seams.

Section 29(d)(3) provides that in the case of a property in which more than one person has an interest, production from the property is allocated among the persons in proportion to their respective shares in the gross sales from the property or facility.

Section 29(f) provides that the credit is available for qualified fuels that are produced from a well drilled after December 31, 1979, and before January 1, 1993, and that are sold before January 1, 2003.

Rev. Rul. 93-46, 1993-2 C.B. 3, holds that the owner of a royalty interest is allowed an allocable share of the credit provided in s 29 if the mineral in which the royalty owner has an interest is a qualified fuel when extracted. 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. Thus, the holder of a net profits interest shares the allowable s 29 credit.

In the present situation, the gas produced from coal seams is a qualified fuel under s 29. Because Y's net profits interest is a royalty interest, Y may claim an allocable share of the s 29 credit on the production from the property operated by X. The amount of the credit available to Y is determined by the amount of production attributable to Y's net profits interest. Under s 29(d)(3), production is allocated to Y in proportion to Y's interest in the gross sales from the property. Therefore, it is necessary to determine Y's interest in the gross sales from the property.

Rev. Rul. 92-25, 1992-1 C.B. 196, considers what portion of the total production from a property is attributable to a net profits interest for purposes of determining percentage depletion under s 613A(c)(2). That ruling allocates production to the net profits interest based on the net profits interest holder's "gross income from the property." A net profits interest holder's gross income from the property is the amount the net profits interest holder actually receives. See Callahan Mining Corporation v. Commissioner, 428 F.2d 721 (2d Cir.1970), aff'g 51 T.C. 1005 (1969). Thus, the production attributable to a net profits interest for percentage depletion is the number of barrels required to produce that portion of the gross income from the property actually received by the holder of the net profits interest.

A net profits interest holder's share of percentage depletion is based on the share of the amount for which the fuel is sold (gross income from the property). Similarly, a net profit interest holder's share of the s 29 credit is based on the share of the amount for which the fuel is sold (gross sales). Because production is allocated based on a taxpayer's share of the amount for which the fuel is sold for purposes of both percentage depletion and the s 29 credit, it is appropriate to determine the production attributable to a net profits interest consistently for both. Accordingly, the production attributable to a net profits interest under s 29(d)(3) is the production required to be sold to produce that portion of the gross sales from the property that is equal to the amount of income actually received by the holder of the net profits interest.

The property in the present situation produced 2,500x mcf of gas in 1991, resulting in gross revenues of $5,000x and net revenues of $3,000x ($5,000x - $2,000x (expenses)). Y owns a 20 percent net profits interest in the property; therefore, Y's net profits interest generated $600x (20% of $3,000x). Accordingly, Y has a 12 percent ($600x/$5,000x) interest in the gross sales from the property. The production attributable to Y's net profits interest is 300x mcf of gas (12% of 2,500x mcf). Alternatively, the production attributable to the net profits interest may be determined by dividing the amount received by the price of gas per mcf ($600x/$2 per mcf).

HOLDING

If a taxpayer holds a net profits interest in a mineral property that produces a qualified fuel under s 29, the production attributable to the net profits interest is determined by multiplying the total production of the property by the taxpayer's interest in the gross sales from the property. The taxpayer's interest in the gross sales from the property is determined by dividing the amount of the taxpayer's net profits payment by the gross sales from the property.

DRAFTING INFORMATION

The principal author of this 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 Ms. Stewart on (202) 622-3120 (not a toll-free call).

Rev. Rul. 94-48, 1994-2 C.B. 3, 1994-29 I.R.B. 5.