United States Court of Appeals,
Fifth Circuit.
No. 97-60265
Summary Calendar.
Mary K. HERBEL and Stephen R. Herbel, Petitioners-Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
Carolyn M. WEBB and Jerry R. Webb, Petitioners-Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
Dec. 8, 1997.
Appeal from the Decision of the United States Tax Court.
Before DUHÉ, DeMOSS and DENNIS, Circuit Judges.
DUHÉ, Circuit Judge:
Taxpayers appeal the Tax Court's decision that payments
received in settlement of a "take or pay" contract dispute are not
"production payments" under 26 U.S.C. § 636(a). We affirm.
I
In February 1988, the Webbs and the Herbels
(collectively,"Appellants") formed Malibu Petroleum, Inc. to
explore for and produce oil and natural gas. The Webbs owned 90%
and the Herbels owned 10%. Appellants chose to treat Malibu as an
"S" corporation for federal tax purposes.1 Shortly after
1
An S Corporation is a corporation that elects to be treated
under Subchapter S of the Internal Revenue Code. The election
allows the corporation to pay no income tax. Instead, the income
or loss is passed to the shareholders who report their pro rata
shares on their individual tax returns. See I.R.C. § 1362 et seq.
1
incorporation, Malibu acquired an interest in gas wells covered by
a take-or-pay contract2 with Arkansas Louisiana Gas Co. ("Arkla").
Later Malibu claimed that Arkla owed Malibu over two million
dollars for failing to take or pay for a minimum quantity of gas.
Arkla disputed its liability. Arkla and Malibu settled their
dispute by an agreement which provided that Arkla would prepay
$1.85 million for natural gas. In return, fifty percent of the
natural gas thereafter delivered to Arkla would be considered
recoupment gas and received without further cost. Arkla would be
entitled to a cash refund of the remaining prepayment balance if
Malibu ended the contract or the contract wells substantially
depleted before recoupment of the prepayment. After receiving the
$1.85 million, Malibu lent $823,263 to Webb and $112,000 to Herbel.
Malibu treated the prepayment as a loan and did not include it as
gross income on its 1988 tax return. Upon audit, the Internal
Revenue Service ("IRS") concluded that the prepayment should have
been treated not as a loan but as an item of gross income.
Appellants separately petitioned the Tax Court for a
redetermination of tax liability, and the court consolidated the
cases. Appellants moved for summary judgment arguing that the
prepayment was a loan from Arkla. Alternatively, the prepayment
was a production payment under 26 U.S.C. § 636 and so must be
treated as a loan. The court denied Appellants' motion and held
2
Arkla agreed to pay for a specified amount of natural gas
even if it did not take delivery.
2
that prepayment was not a traditional loan or a production payment
within § 636. The court held that the Treasury Regulation § 1.636-
3(a)(1) required a production payment to be an economic interest,
and Arkla had no such interest. Appellants countered that the
regulation was invalid. The Tax Court rejected this argument after
examining the law preceding and the legislative history surrounding
§ 636. Thus, Malibu was required to include the prepayment as
income for the year it was received and appellants were required to
report as income their proportionate shares of the prepayment.
Appellants contend on appeal that the Tax Court erred as a
matter of law in holding that Treasury Regulation § 1.636-3(a)(1)
is valid and in holding that the prepayment was not a "production
payment" within 26 U.S.C. § 636(a).
II
A. STANDARD OF REVIEW
Whether a Treasury regulation is valid is a question of law
subject to de novo review. Tate & Lyle, Inc. v. Commissioner, 87
F.3d 99, 102 (3rd Cir.1996).
B. ANALYSIS
A production payment is:
"[A] right to a specified share or production from a mineral
property (or a sum of money in place of production) when that
production occurs. The production payment is secured by an
interest in the minerals, the right to the production is for
a period of time shorter than the expected life of the
property, and the production payment usually bears interest."
Carr Staley, Inc. v. U.S., 496 F.2d 1366, 1367 (5th Cir.1974)
(internal citations and quotation marks omitted).
There are two types of production payments: carved out and
retained. A carved out production payment is created when the
3
owner of mineral property sells a portion of his future production.
A retained production payment is created when the owner of a
mineral interest sells the working interest but reserves a
production payment for himself. The Appellants argue that the gas
allocated to Arkla in the settlement was a carved out production
payment because Arkla would receive 50% of all future gas
production. Thus, under § 636(a), the production payment should be
treated for tax purposes as if it were a mortgage loan on the
property. See 26 U.S.C. § 636(a) (1969).
The IRS argues that the recoupment cannot be a production
payment because the right to a specified share of production means
that there is an economic interest in the mineral in place. 26 CFR
§ 1.636-39(a)(1). The Supreme Court in Anderson v. Helvering, 310
U.S. 404, 60 S.Ct. 952, 84 L.Ed. 1277 (1940), held that for there
to be an economic interest, the money must derive solely from
mineral production. Id. at 412-13, 60 S.Ct. at 956-57. Thus,
where, as here, the payment is guaranteed by something in addition
to production (Arkla's right to cash reimbursement) the payment is
not a production payment and does not fall within § 636.
The Appellants respond that Congress did not intend to limit
§ 636(a) to cases where there were economic interests in the
minerals. Rather, § 636 treats all guaranteed mineral production
transactions as loans.
To resolve the issue, we must first examine briefly the law
before and the legislative history surrounding the adoption of §
636. The first important case involving the tax consequences of
4
production payments is Thomas v. Perkins, 301 U.S. 655, 57 S.Ct.
911, 81 L.Ed. 1324 (1937). There, an assignor transferred to
Perkins an oil and gas lease in exchange for which the assignor
received a sum of cash and reserved a payment of $395,000. The
latter sum was to be paid solely out of 25% of oil produced, and
Perkins was in no way personally obligated. At issue was whether
Perkins or the assignor had to report the $395,000 as income. The
Supreme Court held that the production payment should be taxed to
the assignor.
The Supreme Court later held, though, in Anderson v.
Helvering, 310 U.S. 404, 60 S.Ct. 952, 84 L.Ed. 1277 (1940) that
not all financing arrangements that called for payments to be made
out of mineral production were economic interests. Id. While the
facts were similar to those in Perkins, the Court found it
significant that the assignor's payment was guaranteed not only out
of oil production but also by a lien on the fee interest in the
property. Because the holder of the payment did not have to rely
solely on mineral production for payment, the holder did not have
an economic interest in the minerals. As a result, the assignee
would be taxed on the full amount of production including the
portion the assignor reserved.
Because these two cases treated payments differently based on
whether they qualified as economic interests, taxpayers began to
treat the sale or exchange of a production payment as the
equivalent of the sale or exchange of a capital asset. Taxpayers
saw that they could convert otherwise ordinary income into a
5
capital gain by selling a series of short term production payments.
The Supreme Court, in Commissioner v. P.G. Lake, 356 U.S. 260, 78
S.Ct. 691, 2 L.Ed.2d 743 (1958), however, held that ordinary income
could not be converted into a capital gain by selling a short term
production payment for a lump sum. According to the Court, "[t]he
lump sum consideration seem[ed] essentially a substitute for what
would otherwise be received at a future time as ordinary income[.]"
Id. at 265, 78 S.Ct. at 694.
While P.G. Lake closed one area of potential abuse, taxpayers
then developed two methods for exploiting the use of production
payments. First, with carved out production payments, taxpayers
began to manipulate the timing of the income by accelerating income
to avoid the 50% limitation on taxable income from property limit
for percentage depletion purposes, the foreign tax credit, the five
year net operation loss carryover limit, and the seven year
investment credit carryover. S. REP. NO. 91-552 at 182 (1969).
The second abuse was commonly known as the ABC transaction3 and
allowed a borrower in a retained production payment from the sale
of oil and gas property to pay off a loan with tax-free dollars
3
In a ABC transaction, A is the owner of the working interest
in the property. A then conveys the working interest to B for cash
and retains a production payment for most of the purchase price.
A sells the payment to C, a bank. Because the payment represents
A's entire interest in the property, he realizes a capital gain on
the sale. P.G. Lake does not apply because A did not transfer a
production payment carved out of a larger interest. The
transaction had the same economic result for A if B had borrowed
the purchase price for the entire property, but the transaction was
more beneficial to B than a traditional loan. B could repay a loan
with pre-tax dollars because the production payment C held was
treated as an economic interest in the minerals and not included in
B's gross income. S. REP. NO. 91-552 at 183-84 (1969).
6
while a borrower in any other industry had to satisfy the loan with
post-tax dollars. S. REP. NO. 91-552 at 184 (1969). Congress
added § 636 to the Internal Revenue Code through the Tax Reform Act
of 1969, Pub.L. 91-172, § 503(a), 83 Stat. 487, 630 to remedy this
situation. See generally S.REP. NO. 91-552 (1969), H.R. REP. NO.
91-413 (1969). Section 636 stated that carved out and retained
production payments would be treated as loans and would no longer
qualify as economic interest in mineral property.
Considering the legislative and previous case history, we hold
that Treasury Regulation § 1.636-3(a)(1) is valid and that Arkla's
prepayment does not fall within § 636. Appellants argue that the
Treasury Regulation is invalid because it limits production
payments to those payments that are derived solely from production.
They state that Congress intended any carve out to be treated as a
loan and cite the Senate Finance Committee's recommendation which
states that a carve out production payment which "is in any manner
guaranteed by the person who created it" should be treated as a
loan. Appellants argue that "any manner guaranteed" means that the
payment is not limited to economic interest but includes payments
guaranteed by liens, cash payments, etc.
In light of the previous history, however, we reject this
argument. The tax abuse that Congress sought to prevent occurred
only if the right to payment constituted an economic interest. If
the transaction did not involve an economic interest, then the
mineral property owner would continue to be taxed on the income
derived from the mineral property without regard to the
7
transaction. Christie v. United States, 436 F.2d 1216 (5th
Cir.1971). The tax court found (and Appellants do not challenge
this finding) that Arkla had no economic interest in the contract
wells; therefore, we affirm the tax court's holding that Treasury
Regulation § 1.636-3(a)(1) is valid and that Arkla's prepayment
does not fall within 26 U.S.C. § 636(a).
CONCLUSION
For the foregoing reasons, we AFFIRM.
8