St. Mary's Law Journal

The Reasonable Expectation Requirement for Oil and Gas Production Payments after Yates v. Commissioner.


This article addresses the issue of whether an interest in nonproducing oil and gas property constitutes a production payment or an overriding royalty. The significance of the interest depends on whether a lease or sale has been created for the purposes of establishing taxable income. The most relevant determining factors exist at the time the interest is created. The landmark case, Yates v. Commissioner, set the guidelines from which the courts analyze the appropriate facts and circumstances of each case. This study discusses the relationships of the legal concepts which define the production payment and the differences in tax consequences for various types of production payments within I.R.C. §636.

The Yates decision represents a case of first impression where the sole termination of an interest burdening “unproven property” was made by a percentage-of-the-reservoir formula. The economic interest test was developed to determine whether a taxpayer was entitled to a depletion allowance. An overriding royalty interest creates a continuing economic interest in the minerals and therefore results in a lease situation. Conversely, even though a production payment qualifies as an economic interest, if it is treated by the Service as a loan under I.R.C. section 636, a sale results. The Yates court correctly held that a percentage-of-the-reservoir termination “formula alone does not satisfy petitioners’ obligation to show that the formula had substance.” This “substance” must be shown by the application of the Morgan test at the time of creation of the interest and not at some uncertain and speculative time in the future. Preferential tax treatment should be established to encourage exploration of new fields, to increase secondary recovery from mature reservoirs and to improve the economics of natural gas usage.


St. Mary's University School of Law

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