Revenue Code 636: Tax Treatment of Mineral Payments

Internal Revenue Code Section 636 provides the tax treatment for transactions involving mineral production payments. These financial arrangements are used in industries like oil, gas, and mining to finance operations or transfer property interests. The code establishes a framework that treats these payments as loans, which has significant tax implications for all parties involved.

Defining a Mineral Production Payment

A mineral production payment is a right to a future share of income from a specific mineral property. As a non-operating interest, the holder does not participate in the work or management of the property. The payment is defined by its limitation, distinguishing it from a perpetual royalty interest. It terminates when a specific dollar amount, quantity of mineral, or time period is reached.

The payment’s expected economic life must be shorter than that of the mineral property it burdens. For example, an owner of a mineral property might grant a right to the first $1 million of revenue from production. Once that amount is paid, the right is extinguished, and the property owner receives all future production income.

This finite nature separates a production payment from a royalty interest, which continues for as long as the property produces minerals. A production payment, by contrast, is a temporary claim on the income stream.

Tax Treatment of Carved-Out Production Payments

A carved-out production payment occurs when the owner of a mineral property creates and sells a production payment while keeping the underlying working interest. This transaction is not treated as a sale of a mineral interest for tax purposes; instead, it is treated as if the property owner has taken out a mortgage loan from the buyer.

For the seller, the cash received is not immediately recognized as taxable income. As minerals are produced, the income used to satisfy the production payment must be included in the seller’s gross income. The seller is treated as the owner of the entire income stream and can claim associated deductions, such as depletion.

The buyer of the production payment is treated as a lender. The payments they receive are divided into a non-taxable return of principal and taxable interest income, which is reported as ordinary income. The buyer cannot claim a depletion deduction because they do not hold an economic interest in the mineral property.

Tax Treatment of Retained Production Payments

A retained production payment arises when an owner sells a mineral property but retains a production payment for themselves. This retained payment is treated as a purchase money mortgage loan from the seller to the buyer.

For the seller, the fair market value of the retained production payment is included in the total sale price, which impacts the calculation of any capital gain or loss. The payments the seller later receives are treated like mortgage payments, divided between a non-taxable return of principal and taxable interest income.

For the buyer, the value of the retained production payment is included in their acquisition cost and basis for the property. As minerals are produced, the income used to satisfy the payment is included in the buyer’s gross income. The buyer is considered the full owner of the economic interest and can claim depletion deductions on all income generated.

Exceptions and Special Rules

While loan treatment is the general rule, exceptions exist for certain transactions. These special rules apply when a production payment is used for exploration and development or is part of a leasing agreement. In these cases, the transaction is not characterized as a mortgage loan, resulting in different tax outcomes.

An exception applies to a production payment carved out for the exploration or development of a mineral property. If funds from the sale are pledged for developing that property, the transaction is not treated as a loan. The creator does not recognize income from the sale, and the developer does not include the payment in their income.

Another special rule applies when a production payment is retained by a lessor in a mineral leasing transaction. From the lessee’s perspective, this retained payment is treated as a bonus paid to the lessor in installments, which the lessee must capitalize and recover through depletion. For the lessor, the payment is treated as an economic interest, and the income received is considered ordinary income subject to depletion.