[Code of Federal Regulations]
[Title 26, Volume 7]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.636-1]

[Page 545-548]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.636-1  Treatment of production payments as loans.

    (a) In general. (1)(i) For purposes of subtitle A of the Internal 
Revenue Code of 1954, a production payment (as defined in paragraph (a) 
of Sec. 1.636-3) to which this section applies shall be treated as a 
loan on the mineral property (or properties) burdened thereby and not as 
an economic interest in mineral in place, except to the extent that 
Sec. 1.636-2 or paragraph (b) of this section applies. See paragraph 
(b) of Sec. 1.611-1. A production payment carved out of mineral 
property which remains in the hands of the person carving out the 
production payment immediately after the transfer of such production 
payment shall be treated as a mortgage loan on the mineral property 
burdened thereby. A production payment created and retained upon the 
transfer of the mineral property burdened by such production payment 
shall be treated as a purchase money mortgage loan on the mineral 
property burdened thereby. Such production payments will be referred to 
hereinafter in the regulations under section 636 as carved-out 
production payments and retained production payments, respectively. 
Moreover, in the case of a transaction involving a production payment 
treated as a loan pursuant to this section, the production payment shall 
constitute an item of income (not subject to depletion), consideration 
for a sale or exchange, a contribution to capital, or a gift if in the 
transaction a debt obligation used in lieu of the production payment 
would constitute such an item of income, consideration, contribution to 
capital, or gift, as the case may be. For the definition of the term 
transfer see paragraph (c) of Sec. 1.636-3.
    (ii) The payer of a production payment treated as a loan pursuant to 
this section shall include the proceeds from (or, if paid in kind, the 
value of) the mineral produced and applied to the satisfaction of the 
production payment in his gross income and gross income from the 
property (see section 613(a)) for the taxable year so applied. The payee 
shall include in his gross income (but not gross income from the 
property) amounts received with respect to such production payment to 
the extent that such amounts would be includible in gross income if such 
production payment were a loan. The payer and payee shall determine 
their allowable deductions as if such production payment were a loan. 
See section 483, relating to interest on certain deferred payments in 
the case of a production payment created and retained upon the transfer 
of the mineral property burdened thereby, or in the case of a production 
payment transferred in exchange for property. See section 1232 in the 
case of a production payment which is originally transferred by a 
corporation at a discount and is a capital asset in the hands of the 
payee. In the case of a carved-out production payment treated as a 
mortgage loan pursuant to this section, the consideration received for 
such production payment by the taxpayer who created it is not included 
in either gross income or gross income from the property by such 
taxpayer.
    (2) If a production payment is treated as a loan pursuant to this 
section, no transfer of such production payment or any property burdened 
thereby (other than a transfer between the payer and payee of the 
production payment which, if the production payment were a loan, would 
extinguish the loan) shall cause it to cease to be so treated. For 
example, A sells operating mineral interest X to B for $100,000, subject 
to a

[[Page 546]]

$500,000 retained production payment payable out of X. Subsequently, A 
sells the production payment to C, and B sells X to D. C and D must 
treat the production payment as a purchase money mortgage loan.
    (3) The provisions of this paragraph may be illustrated by the 
following examples:

    Example 1. On December 22, 1972, A, a cash-basis calendar-year 
taxpayer who owns operating mineral interest X, carves out of X a 
production payment in favor of B for $300,000 plus interest, payable out 
of 50 percent of the first oil produced and sold from X. In 1972, A 
treats the $300,000 received from B for the production payment as the 
proceeds of a mortgage loan on X. In 1973, A produces and sells 125,000 
barrels of oil for $373,500. A pays B $186,750 with respect to the 
production payment, $168,750 being principal and $18,000 being interest. 
In computing his gross income and gross income from the property for the 
year 1973, A includes the $373,500 and takes as deductions the allowable 
expenses paid in production of such mineral. A also takes a deduction 
under section 163 for the $18,000 interest paid with respect to the 
production payment. For 1973, B would treat $18,000 as ordinary income 
not subject to the allowance for depletion under section 611.
    Example 2. Assume the same facts as in example 1 except that the 
principal amount of the production payment is to be increased by the 
amount of the ad valorem tax on the mineral attributable to the 
production payment which is paid by B. Under State law, the ad valorem 
tax with respect to the mineral attributable to the production payment 
is a liability of the owner of the production payment. For 1973, B 
inlcudes the amount received with respect to such taxes as income and 
takes a deduction under section 164 for the taxes paid by him. Since the 
ad valorem taxes paid by B are his liability under State law, A may not 
take a deduction under section 164 for such taxes.
    Example 3. On December 31, 1974, C, a calendar-year taxpayer and 
owner of the operating mineral interest Y, sells Y to D for $10,000 cash 
and retains a $40,000 production payment payable out of Y. At the time D 
acquires the property, it is estimated that 500,000 tons of mineral are 
recoverable from the property. In 1975, D produces a total of 50,000 
tons from the property. D's cost depletion for 1975 is $5,000 determined 
as follows:

Basis in property: $50,000
    Total recoverable units: 500,000
Rate of depletion per ton: $0.10 ($50,000/500,000)
Cost depletion for year: $5,000


 ($0.10 x50,000)

    (b) Exception. (1) A production payment carved out of a mineral 
property (or properties) for exploration or development of such property 
(or properties) shall not be treated as a mortgage loan under section 
636(a) and this section to the extent gross income from the property 
(for purposes of section 613) would not be realized by the taxpayer 
creating such production payment, under the law existing at the time of 
the creation of such production payment, in the absence of section 
636(a). See section 83 and the regulations thereunder, relating to 
property transferred in connection with the performance of services. For 
purposes of section 636(a) and this paragraph, an expenditure is for 
exploration or development to the extent that it is necessary for 
ascertaining the existence, location, extent, or quality of any deposit 
of mineral or is incident to and necessary for the preparation of a 
deposit for the production of mineral. However, an expenditure which 
relates primarily to the production of mineral (as, for example, in the 
case of a pilot water flood program with respect to the secondary 
recovery of oil) is not for exploration or development as those terms 
are used in section 636(a) and this paragraph. Whether or not a 
production payment is carved out for exploration or development shall be 
determined in light of all relevant facts and circumstances, including 
any prior production of mineral from the mineral deposit burdened by the 
production payment. However, a production payment shall not be treated 
as carved out for exploration or development to the extent that the 
consideration for the production payment:
    (i) Is not pledged for use in the future exploration or development 
of the mineral property (or properties) which is burdened by the 
production payment;
    (ii) May be used for the exploration or development of any other 
property, or for any other purpose than that described in subdivision 
(i) of this subparagraph;
    (iii) Does not consist of a binding obligation of the payee of the 
production payment to pay expenses of the exploration or development 
described in subdivision (i) of this subparagraph; or
    (iv) Does not consist of a binding obligation of the payee of the 
production

[[Page 547]]

payment to provide services, materials, supplies, or equipment for the 
exploration or development described in subdivision (i) of this 
subparagraph.
    (2) In the case of a carved-out production payment only a portion of 
which is subject to the exception provided in this paragraph, the rules 
contained in paragraph (a) of this section with respect to the treatment 
of income and deductions where a production payment is treated as a loan 
shall apply to the portion of the taxpayer's income or expenses 
attributable to the production payment which bears the same ratio to the 
total amount of such income or expenses, as the case may be, as the 
amount of the consideration for the production payment which would have 
been realized as income in the absence of section 636(a), by the 
taxpayer creating such production payment, bears to the total 
consideration to the taxpayer for the production payment. For example, 
A, owner of a mineral property, carves out a production payment in favor 
of B for $600,000 plus interest in return for $600,000 cash. A pledges 
to use $400,000 for the development of the burdened mineral property. In 
each of the payout years loan treatment applies to one-third of the 
income and expenses of A and B attributable to the production payment.
    (c) Treatment upon disposition or termination of mineral property 
burdened by production payment. (1)(i) In the case of a sale or other 
disposition of the mineral property burdened by a production payment 
treated as a loan pursuant to this section, there shall be included in 
determining the amount realized upon such disposition an amount equal to 
the outstanding principal balance of such production payment on the date 
of such disposition. However, if such a production payment is created in 
connection with the disposition, the amount to be so included shall be 
the fair market value of the production payment, rather than its 
principal amount, if the fair market value is established by clear and 
convincing evidence to be an amount which differs from the principal 
amount. See section 1001 and the regulations thereunder. In determining 
the cost of the transferred mineral property to the transferee for 
purposes of section 1012, the outstanding principal balance of the 
production payment shall be included in the cost.
    (ii) The provisions of this subparagraph may be illustrated by the 
following examples:

    Example 1. A, the owner of mineral property X which is burdened by a 
carved-out production payment to which section 636(a) applies having an 
outstanding principal balance of $10,000, sells property X to B, an 
individual, for $100,000 cash. The amount realized by A on the sale of 
property X is $110,000. B's basis in property X for cost depletion and 
other purposes is also $110,000.
    Example 2. Assume the same facts as in example 1 except that the 
production payment is retained by A in connection with the sale of 
property X to B, that section 636(b) applies to the production payment, 
that the production payment includes, in addition to the $10,000 
principal amount, an additional amount equivalent to interest at a rate 
which precludes application of section 483, and that the fair market 
value of the production payment is $9,000. The amount realized by A on 
the sale of property X is $109,000. B's basis in property X for cost 
depletion and other purposes is $110,000. A's basis in the retained 
production payment is $9,000. If the production payment is paid in full, 
A realizes income of $1,000 plus the amount equivalent to interest, 
which income is includible in A's gross income at the time when such 
amounts would be so includible if such production payment were a loan.
    Example 3. C, the owner of mineral property Y, sells the mineral 
property to D for $500,000 cash. Property Y is burdened by a carved-out 
production payment with an outstanding principal balance of $600,000, 40 
percent of the consideration for which was pledged for the development 
of property Y. The amount realized by C on the sale is $860,000 
($500,000 plus $600,000x.60). D's basis in property Y for cost depletion 
and other purposes is $860,000.

    (2) In the case of the expiration, termination, or abandonment of a 
mineral property burdened by a production payment treated as a loan 
pursuant to this section, for purposes of determining the amount of any 
loss under section 165 with respect to the burdened mineral property the 
adjusted basis of such property shall be reduced (but not below zero) by 
an amount equal to the outstanding principal balance of such production 
payment on the date of such expiration, termination, or abandonment. 
Thus, in example 2 in subparagraph (1)(ii) of this paragraph, if B 
abandons the mineral property at a

[[Page 548]]

time when $5,000 of the principal amount of the production payment 
remains unsatisfied, B's adjusted basis immediately before the 
abandonment would be reduced by $5,000 for determining his loss on 
abandonment under section 165.
    (3) In the case of a transfer of a portion of the mineral property 
burdened by a production payment treated as a loan pursuant to this 
section, such production payment shall be apportioned between the 
transferred portion and the retained portion by allocating to such 
transferred portion that part of the outstanding principal balance of 
the production payment which bears the same ratio to such balance as the 
value of such transferred portion (exclusive of any value not related to 
the burdened mineral) bears to the total value of the burdened mineral 
property (exclusive of any value not related to the burdened mineral).
    (4) In general, the entire amount of gain or loss realized pursuant 
to this paragraph shall be recognized in the taxable year of such 
realization. See section 1211 for limitation on capital losses. This 
subparagraph shall not affect the applicability of rules providing 
exceptions to the recognition of gain or loss which has been realized 
(e.g., a transfer to which section 351 or 1031 applies). However, see 
section 357(c) with respect to the assumption of liabilities in excess 
of basis in certain tax-free exchanges. Furthermore, in the case of a 
transaction which otherwise qualifies, gain realized on a transfer of a 
mineral property to which section 636(b) applies may be returned on the 
installment method under section 453.

[T.D. 7261, 38 FR 5463, Mar. 1, 1973]