Wind Energy Part 3 -- Royalties
I’ve discussed whether the rents from a wind energy deal would be rental income (ordinary income) or gain from the sale of something (presumably capital gain), but what about “royalties”?
Wind leases typically provide for additional payments based, in some fashion, on the income produced by wind energy production. However, unlike oil and gas production, the lessor in a wind transaction doesn’t actually own the production – the electricity. Contrast that with the characterization, for tax purposes, of oil and gas production. In oil and gas production, each owner of an “economic interest” is considered to own his share of production (and will, therefore, have to pay tax on his share of the production). So, a royalty in the oil and gas arena is actually considered to be ownership of production. However, in a wind lease, it seems pretty clear that the income is being produced from the sale of electricity – not from the actual sale of wind. Therefore, it would seem to follow that all of the income from the sale of electricity would be taxed to the developer/lessee. Any “royalty” that was paid would be more in the nature of rent that is simply measured by the income generating activities of the lessee – much like a shopping mall lease.
That conclusion really has no practical effect. That is, the “royalties” would be taxable in the same fashion as any other rent coming due under the arrangement. It is simply semantics. However, when you’re dealing with land-owners who are familiar with royalties in the oil and gas context, it may be a disservice to your client to refer to them as royalties.
But there may be a bundle of rights in a wind energy project that is equivalent, or at least analogous, to the rights of royalty holders of oil and gas production. In the oil and gas context, a royalty is the bundle of rights that gives the holder a non-executory right to oil and gas production. That bundle of rights is carved out of the mineral estate. And, it is considered, for federal income tax purposes, to be an “economic interest,” or property. Mightn’t there be a similar bundle of rights that can be carved out of a larger bundle of rights that, for tax purposes, is considered to be an “economic interest,” or property? If so, how “big” does that bundle of rights have to be for it to gain the status of an “economic interest,” or property, for federal income tax purposes?
