OIL & GAS OVERVIEW SPELLINGS SPRING 2016
Oil & Gas Overview
Overview
Oil & Gas Leasing
Fundamental Questions in Analyzing the Taxation of an Oil & Gas Transaction:
Two primary categories:
Timing
Inclusion in income, or
Allowance of deductions
Characterization
Ordinary (income/loss), or
Capital (gain/loss)
Special rules? (allowing a current deduction for an otherwise capital expenditure)
Issues for each party:
Lessor’s Considerations:
When to include payments received into gross income?
Whether the income is ordinary or capital gain?
Whether the income is depletable?
Lessee’s Considerations:
Whether a payment is currently deductible (or, in the case of royalty payments, excludible from gross income) or a capital expenditure?
Whether the deduction, if any, is ordinary or a capital loss?
State Law/Fed Tax
Two basic state law theories of mineral ownership:
Ownership-in-place (TX, et al.)
Rights in a corporeal estate in realty includes ownership of the minerals in place beneath the surface of the land
Mineral interest can be severed, creating a distinct estate
Non-ownership (OK, et al.)
Migratory or fugacious theory
Rule of Capture applies
Owner of the surface land merely has a right to search for and reduce the minerals to possession
Effect of state natural resource law on federal taxation of natural resources
Burnet v. Harmel (SCOTUS, 1932) – taxpayer recorded bonus payment as a capital gain because Texas law regards an oil and gas lease as a present sale of the oil and gas in place.
RULE: Bonus & Royalty payments to lessor = income NOT capital gain
RULE: Federal law trumps state law.
The Oil & Gas Lease
Two keys to understanding (Nutshell)
First, identify the two fundamental goals of a lessee:
The lessee seeks the right to develop the leased land for an agreed term without any obligation to develop
If production is obtained, the lessee wants the right to maintain the lease for as long as production is economically profitable
Second, bear in mind the nature of the transaction
At bottom, an O&G lease is between
A mineral owner (who lacks capital and expertise to explore & develop), and
An oil company (who impliedly or expressly represents that it has both the money and talent to develop the property)
What do they share? The same motivation—of profit from the land
Why important? Because courts often look to the expectations of the parties in settling disputes over lease terms
Four points on the nature of an O&G lease (Nutshell)
Both a conveyance and a contract
Most states treat as both
Conveyance: b/c lessor transfers her rights to the minerals
Contract: b/c lessee accepts certain conditions and obligations
: Louisiana, by statute (mineral leases are solely contracts granting the right to explore for and produce minerals, not subject to prescription for non-use; however, statutory limitation on leases of 10 yrs w/o drilling, operations, or production)
More a deed than a lease
Deed: of an easement, or a mineral deed
Why? 3 primary differences from ordinary real property leases:
Lessee has the right to take substances of value from the land (not mere use)
Lessee’s rights not limited to a term of years
Lessee’s rights to use the land are not exclusive (must be shared w/surface owner)
Legal classification of lessee’s interest varies among states
, in fee simple determinable in the O&G in place (TX)
Profit a prendre (OK, CA, MT, WY)
License (KS)
Inchoate right, that becomes a vested tenancy only after production (some Appalachian states)
Essential provisions are necessary to make a valid transfer or rights and accomplish the lessee’s fundamental goals
Granting clause
Habendum clause
Drilling-delay rental clause
The Granting Clause
Overview
Size of the Interest Granted
Accurate determination of the land boundaries can be an issue
Relevant clauses (6 in book, only 1 & 2 mentioned in class)
Proportionate reduction clause
“Mother Hubbard” clause
will not terminate “if Lessee commences additional drilling or reworking operations within 60 days.”
Clifton v. Koontz
Two factors:
No production, and
Lessee isn’t holding onto the lease merely for speculative purposes
Force-Majeure Clause
Other Savings Clauses
Economic INterest – Chapter Two
Overview
DEFINITION
Taxpayer must acquire by investment an interest in minerals in place
The interest must involve some legal or equitable ownership
Importance: Denotes Ownership. Relevant applications:
Depletion deductions
Intangible drilling/development cost deductions
Purchase/sale and lease/sublease determinations (characterization of income from the disposition of property—capital gain or ordinary income)
Retain EI LEASE
~Retain EI SALE
To whom production income is taxable
If Sale:
Amount Realized – Basis = Cap Gain/Loss
Gap Gains taxed at 20%
If Lease:
Bonus – Percentage Depletion = ordinary income
Ordinary Income Taxed at 39.6%
Basic Rule TP must look to MINERALS IN THE GROUND
Two-Part Test
Palmer v. Bender
An investment in the minerals in place; and
A return of that investment through production. (i.e., income must be derived from extraction
§ 1.611-1(b)(1)
“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.”
