This on-demand webcast features partners Sean Wheeler, Jeffery Muñoz and Tim Fenn, and focuses on both perpetual and term trusts with an emphasis on the following characteristics: purpose, formation and operation, governance, conveyances of mineral interests, securities law issues, risks to public unit holders and mitigation strategies, and tax considerations. The Q&A below includes highlights from the presentation.

Watch the full “Oil and Gas Webcast Series: Exploring Royalty Trusts” webcast. The on-demand webcast is available online through September 23, 2013.

What is a royalty trust?

Sean Wheeler: A royalty trust is a state law trust, typically set up in Delaware. It is created by a sponsor, which is the entity that owns the mineral interest. That entity transfers an interest in those minerals to the trust, which is administered by a trustee. When the sponsor creates the trust, it divides the trust into interests that we call units and sells those units to the public in an IPO. Typically it sells a portion of those units, it may sell 30 percent of the units, it may sell 40 percent of the units, or higher. These units are typically listed on a national securities exchange, most often the New York Stock Exchange.

The purpose of a royalty trust is typically to monetize producing assets. This is similar to a Master Limited Partnership (MLP) in that a royalty trust has tax advantages over traditional corporate forms. It doesn’t pay any entity tax and it distributes substantially all of the entity’s cash flow. But, there are a couple differences from an MLP: A royalty trust has no general partner; it has a trustee, but that trustee does not manage the business, it just administers the cash flow that comes off of the mineral interests. There are no incentive distribution rights as you might be familiar with in an MLP, and a royalty trust is essentially a liquidation vehicle. The entity’s purpose is to conserve and distribute the trust’s assets.

What are the types of mineral interests associated with royalty trusts?

Jeffrey Muñoz: There are basically three types of interests that you will see that are transferred to the trust in connection with these transactions. There’s an overriding royalty interest, net profits interest and a production payment.

An overriding royalty interest is an interest produced at the surface free of the of expenses of production. So, an override is the easiest one of these types of instruments to calculate and to understand what you are going to receive in connection with that interest, because it really is just a percentage of the oil and gas that is produced. There is no deduction for costs or expenses for drilling or for anything else. It is just a pure percentage of the hydrocarbons produced.

A net profits interest is a non-operating, non-expense bearing interest that represents a share of the gross production from a lease that is determined by the net profits received in connection with the ownership and operation of the lease. The costs of the production are taken into account in computing what you will receive from a net profits interest, but the owner of a net profits interest is never going to have to pay any additional amount for that, hence the name net profits. If you look at the revenues that are produced in connection with that interest, you subtract out the costs of the production. Which costs of production are going to be deducted is often negotiated or discussed in connection with setting up these trusts.

The other interest that you will see in a lot of these types of transactions is a production payment. A production payment can be a net profits interest or an overriding royalty interest which is just limited in term in some fashion, either by volume or by a fixed quantity of proceeds.

How does the type of interest impact the tax treatment of a royalty trust?

Tim Fenn: The kind of interest transferred to the royalty trust, i.e., a net profits interest, an overriding royalty interest,  or a production payment, usually comes down to an economic decision for the sponsor as to whether they want to transfer a term interest or a perpetual interest to the trust. That decision has tax implications. To a large extent the difference in tax effect lies in the fact that a term interest is treated most typically as a production payment for federal income tax purposes. With a production payment, the transaction is non-taxable to the sponsor because the production payment is treated like a debt instrument for tax purposes. In contrast, with a conveyance of a perpetual royalty interest or a net profits interest, the sale of the interests is a taxable transaction to the extent of the interests sold to the public. As a result, only the portion of the interest that is sold to the public is taxable, and what’s retained by the sponsor is not taxable.