Memorandum. Honigman Miller Schwartz and Cohn LLP. Unrelated Business Taxable Income: Income from Royalty Interests

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1 Memorandum To: From: Re: Noble Royalties, Inc. Honigman Miller Schwartz and Cohn LLP Unrelated Business Taxable Income: Income from Royalty Interests Date: February 23, 2009 This memorandum addresses the federal tax treatment of income from an ownership interest in royalty and overriding royalty interests (collectively referred to as royalty interests and the income therefrom referred to as royalty income ) received by: 1) certain tax-exempt organizations described under Section 501(c) of the Internal Revenue Code of 1986, as amended (the Code ), 1 and certain retirement plans, including qualified trusts granted tax-exempt status under Section 401(a) (referred to herein as tax-exempt organizations ), and 2) by individual retirement accounts (IRA s) described in Section 408. I. Royalty Income: Unrelated Business Taxable Income A. General Definition of Unrelated Business Taxable Income Sections impose a tax (at the corporate rates set forth in Section 11) on the unrelated business taxable income ( UBTI ) of tax-exempt organizations and individual retirement accounts. 2 UBTI is any gross income derived from any unrelated trade or business regularly carried on by the organization, less any allowable deductions and subject to the modifications described in Section 512(b). An unrelated trade or business is any trade or business the conduct of which is not substantially related (aside from the need of such organization for funds) to the exercise or performance of the organization s charitable, educational or other exempt purpose. 3 1 Unless otherwise stated, all references to section are to sections of the Code. 2 Individual retirement accounts are not organizations exempt from federal income tax under Sections 401(a) and 501(a) but are instead exempt from federal income tax under Section 408(e)(1). Like organizations exempt from federal income tax under Sections 401(a) and 501(a), individual retirement accounts are subject to the unrelated business tax. Section 408(e)(1). 3 Section 513(a). The definition of unrelated trade or business is modified for any trusts described in Sections 401(a) and 501(c)(17). For such trusts, the term unrelated trade or business means any trade or business regularly carried on by such trust. Section 513(b)(2).

2 Page 2 B. Non-Working Interest Royalty Income -- Exclusion From Unrelated Business Taxable Income Internal Revenue Code Section 512(b) excludes certain passive income from UBTI (such as dividends, interest, real property rents and royalties). The organization receiving the royalties may not actively participate in the arrangement producing the royalties; otherwise, the income is not considered passive income and is treated as UBTI. 4 Specifically, Section 512(b)(2) excludes from UBTI all royalties (including overriding royalties) whether measured by production or by gross or net income from the property. IRS Revenue Ruling provides that non-working interest mineral royalties are excluded from UBTI. This ruling notes that an exempt royalty interest is a right to a mineral in place that entitles the owner (IRA or exempt organization) to a specified fraction of the total production from the property free of expense of development and operation. 5 This exclusion for oil and gas royalties 6 has two exceptions described in more detail below. 1. Income from a Controlled Entity The first exception is that interest, rent, royalties and annuities received from a controlled entity 7 are included in UBTI under Section 512(b)(13) to the extent that payment of the same reduces the controlled entity s net unrelated income (or increases its net unrelated loss ). 8 This exception includes payments of oil and gas royalty income received from a controlled entity. 9 4 See, e.g., Oregon State University Alumni Association, Inc., v. Comm r, 99-2 U.S.T.C. 50,879 (9 th Cir. 1999); Fraternal Order of Police, Illinois State Troopers, Lodge No. 41, 87 T.C. 747 (1986), aff d, 833 F.2d 717 (7 th Cir. 1987); National Collegiate Athletic Ass n, 92 T.C. 456 (1989), rev d on other issue, 914 F.2d 1417 (10 th Cir. 1990). 5 Treasury Regulation Section 1.512(b)(-1(b) provides: Royalties, including overriding royalties, shall be excluded in computing unrelated business income tax. Mineral royalties shall be excluded whether measured by production or by gross or taxable income from the mineral property. However where an organization owns a working interest in mineral property such an interest shall NOT be excluded from UBTI. 6 See also Treas. Reg (a)-1(b); IRS Revenue Ruling , C.B. 158; Welch Foundation v. United States, 228 F. Supp. 881 (S.D. Tex. 1963). 7 A tax-exempt organization controls an entity if it owns more than 50% of the corporation's stock (or, in the case of other entities, more than 50% of the beneficial/ownership interests of the entity). Section 512(b)(13)(D)(i). 8 For purposes of Section 512(b)(13), net unrelated income means the UBTI of a tax-exempt controlled entity, or, in the case of a controlled entity that is not a tax-exempt organization, that portion of the entity s income that would be UBTI if the organization were tax-exempt and had the same tax-exempt purpose as the controlling organization. Section 512(b)(13)(B). Net unrelated loss means a net operating loss adjusted in the same manner as net unrelated income. Id.

3 Page 3 The Pension Protection Act of 2006 (the Pension Protection Act ) narrowed this exception for payments received or accrued after December 31, 2005 and before January 1, As modified by the Pension Protection Act, Section 512(b)(13) applies only to the portion of a payment of interest, rents, royalties and annuities that exceeds the amount that would have been paid or accrued if such payment had been determined under Section Income from Certain Working Interests The second exception is that Section 512(b)(2) does not apply if the tax-exempt organization or individual retirement account owns a working interest in a mineral property and is not relieved of its share of the development and operating costs under the terms of its agreement with the operator of the property. 10 In IRS Revenue Ruling , a tax-exempt organization owned a working interest in oil and gas producing property. Under the terms of an agreement with an independent operator, it was relieved of any liability for the development costs associated with the interest but remained liable for operating expenses. The Internal Revenue Service held that the income from the mineral interest was not a passive royalty and therefore not excluded from unrelated business taxable income under the Section 512(b)(2) exclusion for passive royalty income. II. Royalty Income: Unrelated Debt-Financed Income A. Definition of Unrelated Debt-Financed Income In addition to the taxation of unrelated business taxable income, tax-exempt organizations and individual retirement accounts are also subject to taxation on any unrelated debt-financed income. With respect to royalty income, Section 512(b)(4) provides that if the royalty interest constitutes debt-financed property, then any income derived from the royalty interest is taxable as unrelated business taxable income, notwithstanding the Section 512(b)(2) general exemption from UBTI for passive royalty income. 11 Debt-financed property is property held by an exempt organization to produce income with respect to which there is acquisition indebtedness at any time during the taxable year See, for instance, J.E. & L.E. Mabee Foundation, Inc., 389 F. Supp. 673 (N.D. Okla. 1971), in which overriding royalties were deemed to be unrelated business taxable income when received by a tax-exempt organization from a wholly owned subsidiary owning the working interest.. 10 See Treas. Reg (b)-1(b); IRS Revenue Ruling Section 512(b)(4) states in pertinent part, that notwithstanding [Section 512(b)(2)], in the case of debtfinanced property (as defined in section 514) there shall be included, as an item of gross income derived from an unrelated trade or business, [the amount of otherwise excludable passive royalty income]. 12 Section 514(b)(1)(A).

4 Page 4 The term acquisition indebtedness means, with respect to any debt-financed property, the unpaid amount of the indebtedness incurred to acquire or improve the property, including any indebtedness incurred before or after the acquisition or improvement of the property, if such indebtedness would not otherwise be incurred. 13 The amount treated as unrelated taxable income and subject to tax under Section 514 is equal to the total gross income derived from the property for the year multiplied by a fraction, the numerator of which is the average acquisition indebtedness 14 and denominator of which is the average adjusted basis of the property during the period the property is held by the tax-exempt organization during the taxable year. B. Exception for Real Property Acquired by Qualified Organizations Section 514(c)(9) excludes from the term acquisition indebtedness any indebtedness incurred by certain qualified organizations 15 to acquire or improve any real property, provided the following requirements are met: 1) the price to acquire or improve the real property is a fixed amount determined as of the date of the acquisition or the completion of the improvement; 16 2) neither the amount nor the due date of any indebtedness or any other amount payable with respect to any such indebtedness is dependent, in whole or in part, upon any revenue, income or profits derived from the real property; 17 3) the real property may not be at any time leased to the seller or any person related to the seller (as determined under Sections 267(b) or 707(b)); Section 514(c)(1). 14 Section 514(c)(7) provides that, for any taxable year, the term average acquisition indebtedness means the average amount, determined under regulations prescribed by the Secretary, of the acquisition indebtedness during the period the property is held by the organization during the taxable year. 15 The following organizations are qualified organizations : (i) schools, colleges and universities described in Section 170(b)(1)(A)(ii) and their affiliated support organizations described in Section 509(a)(3); (ii) qualified trusts under Section 401(a); (iii) title holding organizations described in Section 501(c)(25); and (iv) retirement income accounts described in Section 403(b)(9). Section 514(c)(9)(C) Section 514(c)(9)(B)(i). Section 514(c)(9)(B)(ii). Section 514(c)(9)(B)(iii).

5 Page 5 4) a qualified trust may not acquire the real property from or lease the real property to the employer of any of the employees covered by the trust or certain parties related to the employer; 19 5) financing may not be provided by the seller, any person related to the seller (as determined under Sections 267(b) or 707(b), and, in the case of qualified trusts, from employer of any of the employees covered by the trust or certain parties related to the employer; 20 6) generally, the qualified organization must own the real property directly and not through a partnership or other pass-through entity, unless the requirements set forth in Section 514(c)(9)(vi)(I) (III) are met. 21 If indebtedness incurred by a qualified organization to acquire or improve real property meets all of these requirements, then it is not treated as acquisition indebtedness and no part of any income derived from such real property is subject to taxation as unrelated debt-financed income. Individual retirement accounts are not among the organizations listed in the definition of a qualified organization under Section 514(c)(9)(C) and therefore do not qualify for this exception from unrelated debt-financed income. III. Conclusions (1) Unless the tax-exempt organization or individual retirement account owns a working interest in the mineral property and remains liable for the costs of developing or operating the mineral interests, royalty income received from non-working royalty interests is generally excluded from unrelated business taxable income under Section 512(b)(2). (2) To the extent that the royalty interests are subject to any unpaid acquisition indebtedness, some portion or all of the income from the royalty interests in any tax year may be unrelated debt-financed income subject to tax under Section 514. (3) Indebtedness incurred by certain qualified organizations (including qualified trusts under Section 401(a)) to acquire or improve real property that meets the requirements set forth in Section 514(c)(9) is not acquisition indebtedness; no part of any income derived from Section 514(c)(9)(B)(iv). Section 514(c)(9)(B)(v). 21 Section 514(c)(9)(B)(vi). The requirements set forth in Section 514(c)(9)(vi)(I) (III) are as follows: (I) all the partners of the partnership must be qualified organizations; (II) all allocation to the partners of the partnership must be qualified allocations (within the meaning of Section 168(h)(6); and (III) the partnership meets the requirements set forth in Section 514(c)(9)(E).

6 Page 6 such real property is subject to taxation as unrelated debt-financed income. Individual retirement accounts, however, do not qualify for this exception. =================== IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, by any person for the purpose of (i) avoiding tax-related penalties or (ii) promoting, marketing or recommending to another person any transaction or matter addressed in this communication. ==================== DETROIT