[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: 26CFR1.636-2]

[Page 548-549]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.636-2  Production payments retained in leasing transactions.

    (a) Treatment by lessee. In the case of a production payment (as 
defined in paragraph (a) of Sec. 1.636-3) which is retained by the 
lessor in a leasing transaction (including a sublease or the exercise of 
an option to acquire a lease or sublease), the lessee (or his successors 
in interest) shall treat the retained production payment for purposes of 
subtitle A of the Code as if it were a bonus granted by the lessee to 
the lessor payable in installments. Accordingly, the lessee 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 for the taxable year so applied. The lessee 
shall capitalize each payment (including any interest and any amounts 
added on to the production payment other than amounts for which the 
lessee would be liable in the absence of the production payment) paid or 
incurred with respect to such production payment. See paragraph 
(c)(5)(ii) of Sec. 1.613-2 for rules relating to computation of 
percentage depletion with respect to a mineral property burdened by a 
production payment treated as a bonus under section 636(c) and this 
section.
    (b) Treatment by lessor. The lessor who retains a production payment 
in a leasing transaction (or his successors in interest) shall treat the 
production payment without regard to the provisions of section 636 and 
Sec. 1.636-1. Thus, the production payment will be treated as an 
economic interest in the mineral in place in the hands of the lessor (or 
his successors in interest) and the receipts in discharge of the 
production payment will constitute ordinary income subject to depletion.
    (c) Example. The provisions of this section may be illustrated by 
the following example:

    Example. In 1971, A leases a mineral property to B reserving a one-
eighth royalty and a production payment (as defined in Sec. 1.636-3(a)) 
with a principal amount of $300,000 plus an amount equivalent to 
interest. In 1972, B pays to A $60,000 with respect to the principal 
amount of the production payment plus $16,350 equivalent to interest. 
The adjusted basis of the property in the hands of B for cost depletion 
and other purposes for 1972 and subsequent years will include (subject 
to proper adjustment under section 1016) the $76,350 paid to A. In 1973, 
B pays to A $60,000 with respect to the principal amount of the 
production payment plus $12,750 equivalent to interest. The adjusted 
basis of the property in the hands of B for cost depletion and other 
purposes for 1973 and subsequent years will include (subject to proper 
adjustment under section 1016) the $72,750 paid to A. The $76,350 
received by A in 1972, and the $72,750 received by A in 1973, will 
constitute ordinary income subject to depletion in the

[[Page 549]]

hands of A in the years of receipt of such amounts by A.

[T.D. 7261, 38 FR 5465, Mar. 1, 1973]