Lance W. Behnke, Bracewell & Giuliani LLP, Seattle
Elizabeth L. McGinley, Bracewell & Giuliani LLP, New York City
Volumetric production payments, or VPPs, are non-operating interests in oil and gas properties that entitle the holder to a specified volume of the hydrocarbons produced from identified properties, delivered to the purchaser free of costs and taxes, in exchange for a cash payment at closing. Production payments contracts effectively are nonrecourse loans with implicit interest rate and commodity hedges and, for US bankruptcy law purposes, VPPs are treated as a conveyance of a property interest to the holder.
Producers may benefit from VPPs by obtaining a lower cost of capital relative to traditional lending arrangements, shifting production and commodity price risk to the investor and maintaining control of the properties and production in excess of quantities necessary to satisfy the VPP. Financial investors are attracted to VPPs because they can gain exposure to commodity prices without exposure to production costs, and limit their risk in the event of a bankruptcy of the issuer.
When a VPP is issued, the purchaser commonly makes a single cash payment in exchange for the right to specified daily or monthly volumes of scheduled production. Production short falls are made up in subsequent periods, adjusting for variation in commodity prices and an interest charge. The scheduled production typically is only a fraction of expected production, providing the issuer a cushion to cover its operating expenses and production volatility. Investors may accept physical delivery of the hydrocarbons or they may contract with the producer to immediately repurchase the production at the market price, and receive payment in cash.
There are a variety of ways to syndicate a VPP but the most common is through a sale of the VPP by the producer to a trust. The trust then enters commodity price and interest rate hedges and issues notes to investors bearing interest at the fixed or floating rate expected to be earned on the assets of the trust.
How are VPPs treated for federal income tax purposes?
The federal income tax treatment of VPPs is directly addressed in Section 636 of the Internal Revenue Code and related Treasury regulations. The tax code provides that VPPs generally are treated as nonrecourse debt secured by the burdened property, and not as a depletable economic interest in the underlying property.
To qualify for treatment as a loan, the VPP must convey a right to a specified share of the production from minerals in place (if, as, and when produced), or the proceeds from such production. It may burden more than one mineral property, but the holder may look only to the production from such burdened properties for payments under the agreement. Importantly, at closing, the VPP must have an expected economic life of shorter duration than the economic life of one or more of the mineral properties burdened thereby.
Treasury regulations do not provide any additional guidance regarding how much shorter the VPP's duration must be relative to the economic life of the burdened property. However, the Internal Revenue Service issued guidance that, to obtain an advance ruling that a contract is a production payment treated as a loan, the taxpayer must show that it is reasonably expected, at the time the right is created, that it will terminate upon the production of not more than 90% of the reserves then known to exist with respect to the burdened property and the present value of the production expected to remain after the right terminates is 5% or more of the present value of the entire burdened property, determined at the time the right is created.
Even if the foregoing requirements for classification as a note are met, a VPP is not treated as debt if the proceeds of the production payment are carved out for exploration and development of the burdened property. Expenditures for the exploration and development of burdened property include expenditures to ascertain the existence, location, extent or quality of a deposit of mineral or incident to and necessary for the preparation of the deposit for production. Such expenditures do not include costs relating primarily to production of the mineral. The proceeds of a VPP are treated as carved out for exploration and development only to the extent the proceeds are required to be used or pledged for use in future exploration or development of the burdened property and may not be used for the exploration or development of any other property or for any other purpose.
VPPs treated as mortgage loans
When a VPP is properly treated as a mortgage loan for federal income tax purposes, the producer does not recognize any taxable income when the VPP is sold. For federal income tax purposes, the producer continues to be treated as the owner of the burdened properties and, as the production occurs and is delivered to the holder of the VPP, the producer is treated as having sold the production for its fair market value and applied the proceeds to repay principal and interest due to the holder.
The purchaser of the VPP is treated as making a nonrecourse loan to the producer, secured by the burdened property. Thus, it is not the holder of an economic interest in the burdened property and is not entitled to depletion deductions. Instead, the purchaser treats the payments received under the VPP as return of capital and interest.
How is interest accrued on a VPP?
VPPs sold for cash generally are treated as contingent payment debt instruments for federal income tax purposes because the amount of each payment is unknown at the time it is issued. Given such uncertainty, it is not apparent how interest should accrue on the instrument. The Treasury regulations, however, provide a methodology for accruing interest over the anticipated term of the VPP, referred to as the noncontingent bond method. Under the noncontingent bond method, interest generally accrues over the term of the instrument at a rate equal to the yield on a comparable noncontingent debt instrument.
There are four steps to applying the noncontingent bond method. First, when the VPP is issued, the issuer determines the "comparable yield" for the VPP, that is, the yield at which the issuer would expect to have issued debt with terms and conditions similar to the VPP but with a fixed rate of interest. Second, the issuer constructs a schedule of projected payments to be made with respect to the VPP assuming the VPP's yield is the comparable yield. Third, interest accruals are attributed to each day included in the projected payment schedule.
The last step in the process for determining interest reported with respect to the VPP is adjusting the amounts accrued for any differences between actual payments and the projected payment schedule. A positive adjustment occurs when the actual amount paid exceeds the projected amount, while a negative adjustment occurs when the actual amount paid is less than the projected amount.
All adjustments are netted for the tax year. A net positive adjustment is treated as additional interest for the year. A net negative adjustment first reduces the interest accrued on the VPP for the current year, then is treated as an ordinary loss to the extent of interest previously accrued on the VPP, and any excess adjustment is carried forward to future years. If any net negative adjustment remains at the time of a sale or retirement of the VPP, it is treated as a reduction in the proceeds received.
VPP trusts
To facilitate sales of VPPs, the VPPs initially may be sold to a trust which enters into commodity price hedges that, together with the VPP, are intended to produce a desired fixed return. Interest rate hedges may also be acquired by the trust if the desired return is a variable rate linked to an index. The trust then issues notes to investors bearing interest at such fixed or variable rate. The holders of the notes still bear production risk with respect to the VPP.
For federal income tax purposes, the trust commonly is treated as a grantor trust and the holders of the notes are treated as if they directly owned their pro rata share of the assets of the trust, the VPP and the hedges. The holders may be eligible to treat the VPP and the hedges as a single integrated instrument for federal income tax purposes. If such integration rules apply, the resulting instrument would not be subject to the noncontingent bond method described above, but would merely accrue interest ratably at the stated rate.
Special tax considerations for foreign owners of VPPs
Generally, foreign holders of debt of a US issuer are subject to 30% withholding on interest received, unless the interest qualifies as "portfolio interest" or the withholding is reduced or eliminated under an applicable tax treaty. The portfolio interest exemption is not available for certain contingent interest, such as interest determined by reference to sales or receipts. The return earned on a VPP, based upon the market price of the production of the issuer, thus could be excluded from portfolio interest and subject to withholding. Accordingly, foreign investors in VPPs should carefully review any applicable tax treaty for an available exemption from or reduction in withholding.
In addition, foreign persons generally are not subject to US tax on gain on the sale of debt or equity issued by US persons, but the exemption does not apply to gain on interests in US real property. As discussed above, the Internal Revenue Code treats VPPs as mortgage loans, which generally are not treated as US real property interests. However, the Treasury regulations under Internal Revenue Code Section 897 provide that a VPP will be treated as an interest in US real property when it conveys a right to share in the appreciation in value of the mineral property. Specifically, a production payment that conveys a right to a specified quantum of oil or gas, including a percentage of production, is treated as conveying a right to share in the value of the property. Accordingly, a VPP constitutes an interest in US real property for this purpose and the gain on the sale of a VPP by a foreign person would be subject to US federal income tax withholding.
Conclusion
The scope of buyers for VPPs, including financial investors, is growing. VPPs present an interesting opportunity for issuers to obtain cost-effective financing and investors to get exposure to commodities without the risk of production costs, but the tax consequences to both parties may be complex. Any evaluation of whether a VPP is an economic source of financing or a suitable investment should include careful consideration of all federal, state, local and foreign tax consequences.
About the authors
Bracewell has served as counsel in the purchase and sale of billions of dollars of VPPs. Behnke and McGinley each have extensive experience relating to tax issues affecting issuers and purchasers of VPPs.
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