What s News in Tax Analysis That Matters from Washington National Tax

Transcription

1 What s News in Tax Analysis That Matters from Washington National Tax Sale of Overriding Royalty Interest Treated as Anticipatory Assignment of Income. Really? The carve out and sale of an overriding royalty interest is commonplace in the mineral industry. Earlier this year, a court held, seemingly for the first time, that this type of transaction was an anticipatory assignment of income, not a sale of property. This article explains the transaction at issue, discusses the case, and considers what it might mean for the industry. Monday, October 13, 2014 by Christine R. Griffith and Robert A. Swiech, Washington National Tax Christine Griffith is a partner in the Federal Tax practice and Bob Swiech is a director in the Passthroughs group of WNT. Originally published and reproduced with permission from the Daily Tax Report, 180 DTR J-1, 9/17/14. Copyright 2014 by The Bureau of National Affairs, Inc. ( ) In Salty Brine I 1 the Fifth Circuit Court of Appeals held that the sale of overriding royalty interests ( ORIs ) carved out of oil and gas leases (i.e., operating mineral interests) located in the United States and sold to a related foreign entity was an anticipatory assignment of income. The carve out and sale of an ORI is a common transaction in the mineral industry; and this appears to be the first time the sale of an ORI has been treated as an anticipatory assignment of income, rather than as a sale of a property. The U.S. District Court of North Texas in a partnership TEFRA 2 proceeding had determined that: (1) the purchase of business protection policies ( BPPs ) was not true insurance; and (2) the BPPs and the sale of ORIs in oil and gas properties for an overstated, non-arm s-length price were estate planning devices. The court held that: (1) the payments for the BPPs were not deductible as business expenses, (2) the transfers of the ORIs should be disregarded, and (3) both the accuracy related and negligence or disregard penalties should be applied. The partnership appealed the ORI sale issue to the U.S. Court of Appeals for Fifth Circuit, which affirmed the district court s holding that the entire royalty interest transaction should be disregarded for tax purposes. 1 Salty Brine I, Ltd. v. U.S., No , 2014 WL (5th Cir. Jul. 31, 2014), aff g 2013 WL (N.D. Tex. May 16, 2013). 2 TEFRA is an acronym for the Tax Equity and Fiscal Responsibility Act of Pub. L. No , 402(a), 96 Stat. 648 (I.R.C ). In TEFRA, Congress enacted coordinated procedures for determining the proper treatment of partnership items in a single, unified audit and judicial proceeding. entity. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.

2 Anticipatory Assignment of Income. Really? page 2 The appeals court appears to have treated Salty Brine I as involving estate planning tax avoidance transactions and may have reached the same result without invoking the anticipatory assignment of income doctrine as it also relied heavily on the economic substance doctrine. If so, the anticipatory assignment of income discussion may be dicta. Some Definitions For mineral taxation a property is defined in section 614, depends, in part, on the economic interest doctrine established by the U.S. Supreme Court, 3 and also is now addressed in the regulations: An economic interest is possessed in every case in which the taxpayer has acquired by investment any interest in mineral in place and secures, by any form of legal relationship, income derived from the extraction of the mineral to which he must look for a return of his capital. For an exception in the case of certain mineral production payments, see section 636 and the regulations thereunder. 4 This definition intentionally does not include terms such as title or ownership of the minerals in the ground under state law and does not depend on varying state law legal theories for mineral lease transactions (e.g., fee simple determinable v. profit a prendre). The economic interest doctrine was an early form of economic substance tailored specifically for the mineral industry. 5 The regulations are taxpayer -specific and include overriding royalties in the definition of a mineral property: General rule. (1) For purposes of subtitle A of the Code, in the case of mines, wells, and other natural deposits, the term Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended (the Code ) or the applicable regulations promulgated pursuant to the Code (the regulations ). 3 Burnet v. Harmel, 287 U.S. 103 (1932); and Palmer v. Bender, 287 U.S. 551 (1933). 4 Section (b)(1). See also, KPMG LLP, Income Taxation of Natural Resources (2014) (hereinafter ITNR ). 5 According to the Supreme Court: Here we are concerned only with the meaning and application of a statute enacted by Congress, in the exercise of its plenary power under the Constitution, to tax income. The exertion of that power is not subject to state control. It is the will of Congress which controls, and the expression of its will in legislation, in the absence of language evidencing a different purpose, is to be interpreted so as to give a uniform application to a nation-wide scheme of taxation. State law may control only when the federal taxing act, by express language or necessary implication, makes its own operation dependent upon state law.

3 Anticipatory Assignment of Income. Really? page 3 property means each separate interest owned by the taxpayer in each mineral deposit in each separate tract or parcel of land. (2) The term interest means an economic interest in a mineral deposit. See paragraph (b) of The term includes working or operating interests, royalties, overriding royalties, 6 net profits interests, and, to the extent not treated as loans under section 636, production payments. 7 Operating and nonoperating interests are each defined, and special rules apply to each type of interest. 8 Background of Salty Brine I ORI Issue A partnership owning oil and gas producing leases carved out approximately 31 percent ORIs and sold them at a higher than arm slength price (about 26 percent higher) through related entities to foreign segregated insurance accounts that the government believed were owned by irrevocable trusts established for the benefit of the partner s children. The partners each selected family members as trustees for these irrevocable trusts, further the partners were apparently also a trustee of each other s irrevocable trust. The IRS examined the partnership tax returns and issued a Notice of Final Partnership Administrative Adjustment changing the partnership s income for the transferred ORIs based on the anticipatory assignment of income doctrine and economic substance grounds. The IRS issued statutory notices of deficiency to the individual partners and two related corporations. Harmel, 287 U.S. at 110 (1932) (cites omitted). The economic consequences to the lessor of the two types of lease [i.e., ownership and non-ownership] are the same. Id. at An overriding royalty interest is an economic interest in oil and gas in place, created from the working interest. It generally is coextensive with the term of the working interest from which it was created and entitles its owner to a specified fraction of gross production, free of operating and developing costs. See Rev. Rul , C.B ITNR, supra note 6, at Section (a). (Emphasis added). 8 Section 614(d) defines operating mineral interests as one that would bear costs of production for a mineral. Section 614(e)(2) defines a nonoperating mineral interest as one that is not an operating mineral interest (i.e., does not bear costs of production for a mineral). Section 614(b) provides special rules for operating oil and gas interests; section 614(c) provides special rules for operating mine interests; and section 614(e)(1) provides special rules for nonoperating mineral interests.

4 Anticipatory Assignment of Income. Really? page 4 The major partners and two corporations (taxpayers) paid the tax deficiencies 9 and filed refund suits with the district court, which consolidated all the related cases listing Salty Brine I as the lead case. The district court held that both the anticipatory assignment of income doctrine and the economic substance doctrine applied to the ORI transfer. With respect to the former, relying on the fact that the ORI transferor retained control over activities generating the royalty income, the court reasoned: [T]he operations of the properties did not change after the assignment of the royalty interests. the alleged transferees neither received the benefits of the income nor exercised control over its production. 10 The taxpayers appealed only with respect to the ORI issue to the U.S. Court of Appeals for the Fifth Circuit. It is noteworthy that the brief filed on behalf of the United States intentionally downplayed the anticipatory assignment of income doctrine. Although the court referenced the assignment-of-income doctrine its analysis ultimately focused on the principle that, where there is no real transfer of beneficial ownership of property, the property should be treated as never having been transferred. 11.The District Court discussed the assignment-of-income doctrine, but ultimately rested on [sic] its decision on the fact that there was no change in beneficial ownership of the income It is unclear if there was a deficiency on the ORI issue. If the partnership reported the ORI as a sale and received an above-market sales price, under section 613A(c)(7)(D), it would have allocated the high amount realized to its partners and the individual partners would calculate and report the gain or loss on the ORI. Because the ORIs were carved out of working interests the partners would need to split their tax bases in the working interests, property-by-property, between the ORIs and the working interests so burdened based on the relative fair market values of each on the date of sale. Section (a)(2). Further, under section 1254(a)(2)(A) the sale of a divided interest rule would likely require all prior depletion (not in excess of tax basis) and intangible drilling and development costs deducted on the working interests to be subject to ordinary recapture on the sale of the ORIs. Cf. Rev. Rul , C.B. 97. So it appears that the taxes owed on the non-depletable ordinary income and, if any, section 1231 gain from a sale would have been greater than one year of additional ordinary depletable income attributable to the ORIs WL , at * Brief for the Appellee, 2013 WL , at * Id. at *69

5 Anticipatory Assignment of Income. Really? page 5 Fifth Circuit Decision The Fifth Circuit did not follow the government s lead and downplay the anticipatory assignment of income doctrine. The court stated bluntly that: This case turns on the application of the assignment of income doctrine and the economic substance doctrine. 13 However, the two mineral tax cases cited by the court on this issue P.G. Lake 14 and C.M. Thibodaux Co. 15 do not support the result it reached. In P.G. Lake the taxpayer received $600,000 as consideration for an assignment of a production payment in the form of a limited 25 percent ORI that would terminate upon the transferee receiving $600,000 from future royalty production. The taxpayer-transferor of the production payment treated the $600,000 as proceeds from the sale of a capital asset. The IRS issued a statutory notice of deficiency to the taxpayer to increase the tax rate from the capital gains rate to the ordinary income tax rate. The taxpayer filed a petition in the U.S. Tax Court, which ruled in favor of the taxpayer. The IRS then appealed to the Fifth Circuit, which affirmed the Tax Court decision that the production payment owner had obtained an economic interest in the oil and gas in place. [T]he assignee and not the assignor of the mineral interest, under instruments like those here, is entitled to take depletion on it. 16 The IRS appealed to the U.S. Supreme Court, which granted certiorari and reversed the Fifth Circuit. The Court held that when payments were received as consideration for transfer of a mineral production payment, such consideration was a substitute for what would otherwise have been received at a future time as ordinary income. There were no conversions of a capital investment, but a mere conversion of future income into present income; and therefore, the consideration received for such payment rights was taxable to seller, as ordinary income subject to depletion, rather than as long-term capital gain. Note that it was the sales proceeds received by the transferor for the production payment that was ordinary depletable income. The transferor 13 Salty Brine I, 2014 WL , at *5. 14 Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958), rev g 241 F.2d 71 (5th Cir. 1957), aff g 24 T.C (1955). 15 C.M. Thibodaux Co. v. U.S., 915 F.2d 992 (5th Cir. 1990) F.2d at 77. The assignee had obtained a depletable mineral property interest.

6 Anticipatory Assignment of Income. Really? page 6 was not required to recognize as income the future production payable to the production payment owner. The production payment owner reported the future production proceeds it received and took depletion against that income. This distinction is important and made necessary because the production payment owner had obtained an economic interest in the minerals in place and a mineral property subject to depletion. 17 Although sales of carved-out production payments were no longer taxed at capital gains rates after P.G. Lake, taxpayers began to sell carved-out production payments to increase both depletable income and the taxable income from the property limitation under section 613(a), thereby increasing allowable percentage depletion. In 1969 section 636(a) was enacted to statutorily overrule P.G. Lake and to treat the proceeds from the sale of a carved-out production payment (not pledged for exploration or development) as a loan. Under this statute the seller of the production payment would not recognize income upon receipt of the production payment sales proceeds but would recognize depletable income on the minerals used to pay off the production payment. In sum, P.G. Lake provides no support for the anticipatory assignment of income holding in Salty Brine I and if it had been applicable, (which it is not because the ORI was not a limited interest, i.e., not a production payment, as it continued for the entire life of the mineral property) it would have required the partnership to record the sales proceeds as ordinary depletable income when received (limited to cost depletion by section 613A(d)(5)) and not record depletable income applicable to the ORI over its life. The section 636(a) statutory repeal of P.G. Lake, if applicable, would have required the partnership to record as ordinary depletable income the payments to the ORI holder over its life. However, section 636(a) is only applicable to certain production payments, not ORIs that extend for the full life of the mineral properties. The other mineral tax case relied on by the Fifth Circuit as support for its anticipatory assignment of income holding is C.M. Thibodaux Co., in which Thibodaux declared a dividend in kind to its shareholders of all outstanding 17 For a discussion of the use of so-called ABC and ACB production payments in mineral property purchases and sales prior to the enactment of section 636 see ITNR, supra note 4, at 7.20.

7 Anticipatory Assignment of Income. Really? page 7 and future mineral royalties on corporate-owned property. In a later year, Thibodaux amended the royalty deed to grant to its shareholders the right to receive all bonuses and delay rentals as well as royalties. What the Fifth Circuit does not mention in Salty Brine I is that the transferred rights to bonus payments and delay rentals in Thibodaux were held to be an anticipatory assignment of income, but not the transferred royalties. The IRS never challenged the taxability to the shareholders for the deeded royalties, presumably because they were economic interests and depletable mineral properties in the hands of its shareholders. 18 The non-mineral cases relied on for the anticipatory assignment of income holding in Salty Brine I are inapposite because they have very different sets of rules. To illustrate this difference, see for example, the General Counsel Memorandum addressing whether the transfer by a corporation of carved-out net profits interests in some of its oil properties to a royalty participation trust and the distribution of certificates of interest in the trust as a dividend was an anticipatory assignment of corporate income. On its face, the transaction in question appears to be a classic assignment of income. * * * retained the working interest in the oil properties and is solely responsible for the production and sale of oil from the properties. Its only obligation is to turn over to the trust 90 percent of the net proceeds from the sale of oil. In other words, * * * bears all costs of production and turns over 90 percent of the profit. If this transaction were to arise in other than the mineral extraction industry, there would be no doubt that the taxpayer retained the property and assigned the income which it produces. In the mineral extraction industry, however, what appears to be only a right to income from property may be recognized as an economic interest in a mineral in place, and a property interest. Thus, the answer to the assignment of income question in this case will turn upon whether a net profits interest is considered property or merely a right to income. 19 As previously noted in the regulations promulgated under section 614(a), one of the definitional items is each separate mineral interest owned by 18 Id. at 993 n.3 ( The IRS does not seek to tax Thibodaux on the royalty payments the shareholders received. ). 19 G.C.M (Aug. 28, 1981). (Emphasis added).

8 Anticipatory Assignment of Income. Really? page 8 the taxpayer. So two taxpayers, even if closely related, cannot own the same mineral property. 20 For example, two corporations in the same consolidated group each owning an economic interests in the same mine would still own separate property interests. 21 The Fifth Circuit in Houston Oil and Minerals Co. 22 treated a corporation and its shareholders as owning separate property interests in the same mineral leases. The corporation carved out ORIs in its oil and gas leases and conveyed those interests into a trust. The trust agreement divided beneficial interest in the trust among the corporation s shareholders on a pro rata basis according to the number of shares held by each shareholder. The court found that: Code 614 defines property as each separate interest owned by the taxpayer in each mineral deposit in each separate tract or parcel of land. The Treasury Regulation interpreting this provision states that the term interest includes, among other things, overriding royalties. See Treas. Reg (a). The overriding royalty interests at issue in this case fit comfortably within the definition of property in 614, thus meeting the first requirement of oil, gas, or geothermal property. 23 Conclusion The related-party control, economic reality, and operations control issues raised in Salty Brine I are not well suited for mineral property anticipatory assignment of income determinations, although they may be important in economic substance determinations. Perhaps the Fifth Circuit s decision was influenced by a perceived oleaginous nature of this taxpayer. Unless the anticipatory assignment of income determinations in Salty Brine I 20 In Helvering v. O Donnell, 303 U.S. 370 (1938), a parent corporation owned all the stock of a subsidiary corporation which owned an economic interest in a mineral property; however, the parent corporation s attempt to transfer an economic interest in that mineral property was ineffective because the parent corporation did not own an economic interest in its subsidiary s mineral property and therefore could not transfer one. 21 Rev. Rul , C.B Houston Oil & Minerals Corp. v. Commissioner, 922 F.2d 283 (5th Cir. 1991). 23 Id. at 285.

9 Anticipatory Assignment of Income. Really? page 9 become to be generally regarded as dicta, mineral tax planners will have yet another perplexing case 24 to ponder and distinguish. As previously noted, the economic interest doctrine was created by the U.S. Supreme Court and then adopted by the Treasury Department in regulations as a specialized form of economic substance for the mineral industry. If a lower court in a mineral tax case is going to trump the economic interest doctrine with general economic substance tests, it would be helpful if the court acknowledged that it is doing so and explained why it is not following the economic interest doctrine. 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. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP. KPMG s What's News in Tax is a publication from Washington National Tax that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. 24 For example, see the decision in Campbell v. Fasken, 267 F.2d 792 (5th Cir. 1959), which may be questionable, the case is interesting in that it illustrates the difficulties that frequently arise in classifying transactions involving oil and gas properties. The taxpayers, as fee owners of certain mineral properties, conveyed a 45 percent interest in each of the properties to an oil company for a specified amount of money, the deed being placed in escrow pending commencement of drilling operations. Simultaneously, the taxpayers agreed to pay to the oil company a slightly greater amount of money as their proportionate share (55 percent) of the cost of drilling and equipping the agreed wells, computed on a turnkey basis. The taxpayers treated the contracts as two separate transactions: (1) a sale of minerals the gain on which was reported as capital gain, and (2) paying their working interest share of development costs. The government apparently argued at the District Court that the exchange of checks should be ignored and that in substance the oil company pledged to drill a well for an interest in the property so the pool of capital doctrine should apply and therefore the taxpayer could not deduct the intangible drilling and development costs with money paid to it by the oil company. The District Court held that a sale had occurred and that the taxpayer could deduct the intangible drilling and development costs paid for with the sale proceeds. Fasken v. Campbell, No. 7191, 1957 WL (N.D. Tex. Dec. 13, 1957). Although the IRS had previously announced in G.C.M , C.B. 22, that it would not follow the Fifth Circuit s decision in West v. Commissioner, 150 F.2d 723 (5th Cir. 1945), which looked to the grantor s predominating purpose to secure development and operation of the property (rather than the retention of a royalty interest) to determine that a conveyance should be treated as a lease rather than a sale; the government presumably switched its argument on appeal and relied on West. The Fifth Circuit relying on West held first that instead of making a sale, the taxpayers executed a lease, receiving a lease bonus (i.e., ordinary income), and second that the taxpayers incurred and paid 55 percent of the development costs. Subsequently in Revenue Ruling , C.B. 34, the IRS once again determined that, [T]he ordinary income character of such a cash payment is not dependent on the presence or absence of any dominating purpose of the parties to secure development and operation of the property. the lump-sum payment received by the taxpayer-grantor of the mineral rights in conjunction with the retention by him of a royalty interest, is ordinary income and not proceeds from the sale of a capital asset.