Tax Considerations in Various Oil Transactions

This paper considers tax aspects of transactions involving production payments. In addressing engineers, it is fitting and proper that the terms be first defined. What is a production payment? It is essential that a production payment be dischargeable only out of runs accruing to a property and the holder of the payment must look exclusively to the proceeds of the sale of production accruing to the payment for its satisfaction and liquidation. It is also essential that the payment be of limited duration - that it not last for the life of the property or properties. The payment in most instances is free and clear of all costs of operation and development and is dischargeable out of a specified fraction of the runs. The size of this fraction will vary, depending, in part, upon the nature of the transaction involved. A production payment is normally payable out of a stated percentage of the runs until from the sales proceeds of such runs there has been paid a specified sum of money. The amount of a payment may also be stated in terms of barrels of oil or cubic feet of gas. It is possible to create a true production payment which is based on neither a dollar amount nor units of production. Such a payment would have attributed to it a specified percentage of the net proceeds from the operation of the properties and would terminate when the remaining reserves under the properties reach an agreed percentage of total reserves. Types of Production Payments What are the kinds of production payments? Basically there are two types of production payments - the reserved payment and the carved out payment. A reserved payment is created where the owner of a property or properties assigns all of his leasehold or working interest to another and in such assignment reserved to himself a production payment. A carved out payment is one which is assigned out of a larger depletable property; for example, if A, the owner of an oil and gas lease, assigns to B 75 per cent of the runs accruing to such lease unit B has received from the proceeds of the sale of such runs the sum of $100,000, A has carved a payment out of his leasehold estate. There are two types of carved out payments.