Editor: Mary Van Leuven, J.D., LL.M.
The law known as the Tax Cuts and Jobs Act, P.L. 115-97, revised Sec. 451(c), changing the timing of taxation for certain advance payments, including advance payments for future mineral production and delivery. A taxpayer using the accrual method of accounting that receives any advance payment during the year generally includes the advance payment in gross income for the tax year of receipt. Receipt for purposes of new Sec. 451(c) means actual or constructive receipt and encompasses situations in which an item is due and payable to the taxpayer. Now, certain advance payments for future mineral deliveries that previously could be deferred to subsequent tax years under the old law are no longer eligible for deferral treatment.
This item examines four types of advance mineral payments for federal income tax purposes; new Sec. 451(c) does not affect the first two, but it may change when income related to an advance sale of minerals to be delivered in the future or an advance sale of inventoriable goods is included in taxable income. These variations on advance payments for future mineral delivery are discussed below.
Sale of a royalty interest
The owner of a mineral operating interest may carve out a royalty interest (a nonoperating interest) and sell it. When the royalty interest is carved out, the owner will treat the royalty conveyance as a sale and will split its adjusted tax basis in the mineral property between the retained operating rights and the conveyed royalty. The adjusted tax basis in the mineral property under Sec. 1016 is apportioned based on the fair market values of the two interests on the sale date. The proceeds received less the adjusted tax basis of the royalty interest determines the gain or loss for the seller. The seller would likely have either Sec. 1231 loss, or gain subject to Sec. 1254(a)(2)(A) ordinary income recapture. Alternatively, the buyer could purchase a mineral lessor's retained royalty interest, and the seller would likely have either Sec. 1221 loss, or gain subject to Sec. 1254(a)(2)(B) ordinary income recapture.
The royalty interest buyer will receive a fractional interest share of any future production from the mineral property, either in cash or in kind. When the buyer receives royalty income, it is subject to depletion under Sec. 611, 613, or 613A.
A mineral operating interest owner or a royalty interest owner may carve out a volumetric (i.e., a volume of minerals to be delivered in the future) production payment burdening one or more mineral properties and sell it to a buyer. A carved-out production payment must be an economic interest in the minerals in place and have a shorter life than the life of the mineral property it burdens.
Rev. Proc. 97-55 provides a safe harbor if it is reasonably expected, at the time the production payment right is created, that (1) the right will terminate upon the production of not more than 90% of the reserves then known to exist, and (2) the present value of the production expected to remain after the right terminates is 5% or more of the present value of the entire burdened mineral property. The safe harbor treats carved-out production payments (not pledged for exploration or development of the burdened property under Sec. 636(a)) as a purchase money mortgage loan generating interest expense and a repayment of principal by the burdened mineral property owner and interest income and a repayment of principal to the production payment buyer.
However, if the production payment proceeds are pledged for exploration or development of the burdened mineral property, then the burdened mineral property owner is treated as conveying an economic interest in the mineral property to the buyer in a "pool of capital" transaction (General Counsel Memorandum 22730, 1941-1 C.B. 214). The pledged production payment seller does not have any income from the sales proceeds for the pledged production payment and does not receive any deductions for the expenditure of the pledged funds. The pledged production payment buyer receives income from the property that qualifies for depletion.
Advance sale of minerals to be produced and delivered in the future
The owner of an operating or royalty interest in mineral property may receive advance proceeds for a volume of mineral production that is expected from the mineral property and will be delivered to a buyer if and when produced. New Sec. 451(c) may change when the proceeds received are subject to tax.
Old rules: Prior to Jan. 1, 2018, the general rule was that under the accrual method of accounting, income was includible in gross income when all the events occurred that fix the right to receive the income and the amount thereof can be determined with reasonable accuracy (Regs. Sec. 1.451-1(a)). Thus, when a taxpayer received a payment for goods prior to providing those goods, the advance payment would, as a default matter, be included in income upon receipt. However, Regs. Sec. 1.451-5 allowed advance payments for goods to be reported in the tax year in which the payments were properly accruable for tax purposes (i.e., when the goods are shipped, delivered, or accepted), but no later than the tax year in which those amounts were taken into account for financial reporting purposes, unless an inventoriable goods exception applied (the general deferral method).
Regs. Sec. 1.451-5(c) limited deferral of payments under the general deferral method. Recognition of advance payments could be deferred until the end of the second tax year following the year the taxpayer received the payment (i.e., a maximum two-year deferral) if the payment has not already been included in income under the taxpayer's accrual accounting method and:
- The taxpayer was deferring prepayments on the sale of goods under Regs. Sec. 1.451-5;
- The taxpayer had received "substantial advance payments" (the total of the advance payments received on the future sales of inventoriable goods equaled or exceeded the total estimated cost of goods to be sold under the sale agreement); and
- The taxpayer had goods of a substantially similar kind on hand (or available during the year through the normal source of supply) in sufficient quantity to satisfy the sale agreement.
In an advance sale of minerals to be produced in the future, the third requirement was usually not met because the mineral reserves had not been produced. As a result, the advance payments were not considered to be substantial advance payments, and this inventoriable-goods exception did not apply. The law changed, and the IRS proposed removing Regs. Sec. 1.451-5(c) as obsolete because it was supplanted by Sec. 451(c) (Preamble, REG-104872-18, 83 Fed. Reg. 51904 (Oct. 15, 2018)).
New rules: For periods after 2017, new Sec. 451(c) requires an accrual-method taxpayer that receives any advance payment during the tax year to include the advance payment in gross income for that tax year, unless the taxpayer elects to include in gross income the amount included in its financial statements and include the remaining portion of the advance payment in gross income in the succeeding tax year.
Other considerations: Percentage depletion under Sec. 613 for minerals other than oil and gas should be claimed when the depletable income is accrued (Malloy & Co., 33 B.T.A. 1130 (1936), acq. in result, 1964-2 C.B. 3 (lump-sum consideration received by the taxpayer for the sale of its entire gas production over the life of the field constituted depletable "gross income from the property" for the tax year of receipt)). For tax years after 1986, percentage depletion on oil and gas may be claimed only when produced. In Freede, 864 F.2d 671 (10th Cir. 1988), the court noted that a buyer had "no legal title or leasehold interest in the gas or the gas-producing property." In fact, the contracts stated specifically that title to the gas passed from seller to buyer at the point of delivery, "which occurs at the wellhead or at the outlet of the well separator, if any" (id. at 673; see also Coleman, 388 F.2d 337 (Ct. Cl. 1967) (gas sales agreement for the entire life of the reserves did not convey an economic interest to the gas purchaser)).
The advance sales of inventoriable goods in connection with streaming agreements will generally follow the new Sec. 451(c) rules. A streaming agreement is generally an advance sale of minerals that are produced and refined. The sales proceeds received are typically required to be used for exploration and development of a specified mineral property.
The agreement may give the buyer the right to receive refined minerals, the volume of which is determined by a percentage of the mineral volume extracted from the specified mineral property. However, there is generally no requirement for the refined minerals delivered to the buyer to have been extracted from the specified mineral property. The purchase of refined mineral volumes is a derivative covenant, which does not purport to grant the buyer any interest in the specified mineral property. The delivery for the refined mineral is often by London Metal Exchange (LME) or Commodity Exchange Inc. (COMEX) warrants.
In light of the changes to when advance payments for future mineral production are subject to tax, taxpayers should review their agreements to determine if there is a change to the accrual timing under new Sec. 451(c).
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com..
Contributors are members of or associated with KPMG LLP. These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.