Firm Seeks Production Payment Exception Under Debt-Equity Regs

This purpose of this letter is to provide comments on a very limited aspect of the proposed section 385 regulations (the "Proposed Regulations"). These comments reflect my views and were not prepared on behalf of a client.

This letter focuses on mineral property interests known as production payments that in certain instances are mandated by section 636 of the Internal Revenue Code of 1986, as amended (the "Code"), to be treated as debt for all purposes of the Code. For production payments and other property interests and instruments that are mandated by existing provisions of the Code to be treated as debt, this letter advocates that an exception should be provided in the final Treasury regulations ("Regulations") under section 385 from the "indebtedness in part" provisions in section 1.385-1(d) of the Proposed Regulations, the "documentation and information" provisions in section 1.385-2(b) of the Proposed Regulations, and the "issuance in a distribution, for certain stock, or for certain assets" provisions in section 1.385-3(b)(2) of the Proposed Regulations, including the "funding rule" provisions in section 1.384-3(b)(3) of the Proposed Regulations.

In general, the Proposed Regulations are intended to apply to corporations that are part of an Expanded Group ("EG") as defined in section 1.385-1(b)(3) therein and, in certain limited instances, corporations that are members of a Modified Expanded Group ("MEG") as defined in section 1.385-1(b)(5) therein.¹ Section 1.385-1 (d) of the Proposed Regulations provides authority for the Commissioner of the Internal Revenue Service (the "Commissioner") to treat an Expanded Group Instrument ("EGI") issued by one member of the MEG to another member of the MEG as debt in part and equity in part. Section 1.385-2(b)(2) of the Proposed Regulations seeks to impose strict documentation and information requirements on taxpayers desiring to have an EGI treated as debt for federal income tax purposes. This documentation and information must be prepared within the time constraints of section 1.385-2(b)(3) of the Proposed Regulations for the EGI to be classified as debt. And, section 1.385-2(b)(4) of the Proposed Regulations seeks to require that the documentation and information required by section 1.385-2(b)(2) be maintained for all taxable years that the EGI is outstanding and until the period of limitations expires for any return with respect to which the tax treatment of the EGI is relevant. Section 1.385-3 of the Proposed Regulations seeks to provide that an EGI issued by a corporation that is a member of the EG to another corporation that is also a member of such EG in a distribution, in an exchange for EG stock (other than in an exempt exchange) or in exchange for property in certain asset reorganizations will be treated per se as stock, including an EGI issued in a transaction subject to the funding rules of section 1.385-3(b)(3). While these provisions in the Proposed Regulations are intended to backstop the proposed regulations issued under section 7874 of the Code to curtail certain "inversion" transactions, they may have, in certain cases, unintended results.

For example, section 636(a) of the Code provides that a production payment carved out of a mineral property shall be treated for purposes of subtitle A (income taxes) of the Code as a mortgage loan. Section 636(b) of the Code further provides that a production payment retained on the sale of a mineral property shall be treated for purposes of subtitle A of the Code as a purchase money mortgage loan. A production payment is defined in section 1.636-3(a)(1) of the Regulations as a "right to a specified share of the production from mineral in place (if, as, and when produced), or the proceeds from such production. Such right must be an economic interest in such mineral in place." Further, "[s]uch right must have an economic life (at the time of its creation) of shorter duration than the economic life of one or more of the mineral properties burdened thereby. A right to mineral in place which can be required to be satisfied by other than the production of mineral from the burdened mineral property is not an economic interest in mineral in place. A production payment may be limited by a dollar amount, a quantum of mineral, or a period of time. A right to mineral in place has an economic life of shorter duration than the economic life of a mineral property burdened thereby only if such right may not reasonably be expected to extend in substantial amounts over the entire productive life of such mineral property." Treas. Reg. § 1.636-3(a)(1). Thus, if a mineral property interest meets the definition of a production payment in section 636 and the Regulations thereunder, section 636 mandates that the mineral property interest is treated as debt for all purposes of the income tax provisions of the Code.

Subjecting a mineral production payment that must be treated as debt under section 636 of the Code to the rules provided for in the Proposed Regulations would undermine the preexisting intent of section 636, cause unnecessary record-keeping and uncertainty for issuers of production payments who have structured their mineral property interests as production payments counting on debt treatment, and create the potential for conflict between section 636 and section 385 and the Regulations under each section. For example, the documentation creating the mineral production payment likely satisfies the requirements of section 1.385-2(b)(2) of the Proposed Regulations so that further testing under that section or section 1.385-2(b)(4) of the Proposed Regulations should not be required. Moreover, because section 636, once satisfied, mandates debt treatment for all purposes of the income tax provisions of the Code, production payments satisfying the section 636 requirements issued by one member of the MEG to another member of the MEG should not be subject to the "indebtedness in part" provisions of section 1.385-1 of the Proposed Regulations. Moreover, the issuance of a production payment to a member of the EG should not be subject to the special rules for reclassification as stock in section 1.385-3 of the Proposed Regulations because section 636 specifically mandates debt treatment.

Accordingly, Regulations interpreting section 385 of the Code should include a provision that states that production payments and other instruments or property interests for which debt treatment is mandated by a specific section of the Code are excepted from the application of those Regulations,

I hope that these limited comments will be helpful in determining the content of the final Regulations promulgated under section 385 of the Code. Please feel free to contact me on (713) 651-2984 or at itbradford@liskow.com should you have any questions.