Legal ruling 1997-2

Franchise Tax Board - Legal Division
PO Box 1720
Rancho Cordova CA 95741-1720

916 845 3309

FAX: 916 845 3648

Kathleen Connell, Chair
Ernest J. Dronenburg, JR., Member
Craign L. Brown, Member

December 17, 1997

Application of 18 CAL. code of Regs. §25137(b)(1)(B) Totimber and Mineral Royalties Asrental Equivalents in the Property Factor


Are royalty or other payments paid for timber and mineral interests in the nature of a "profit a prendre" properly characterized as a rent equivalent under 18 Cal. Code of Reg. §25137(b)(1)(B) for purposes of the property factor?


Corporation A entered into a contract with State X, under which it would extract oil from State X's land, and remit to the state cash or oil in kind equal to one eighth of the cash value of the extracted oil. In exchange, Corporation A acquired title to the remaining oil extracted, which it sold.

Corporation B entered into a contract with Corporation Y, under which it would sever timber from Corporation Y's land and pay a specified amount per cubic foot of timber extracted.

Law and Analysis

Corporations which derive income from sources within and without the state are required to apportion their business income under Section 25128, Rev. and Tax. Code. One of the factors in the apportionment formula described by that section is the property factor. The property factor is described in Section 25129, Rev. and Tax. Code, as follows:

The property factor is a fraction, the numerator of which is the average value of the taxpayer's real and tangible personal property owned or rented and used in this state during the income year and the denominator of which is the average value of all the taxpayer's real and tangible personal property owned or rented and used during the income year.

Section 25130 defines "average value" of owned property as "original cost," reflecting the taxpayer's actual capital invested in a state. Under Section 25130, rented property is valued at eight times the net annual rental rate, which is the "annual rental rate paid by the taxpayer" (emphasis added), reflecting the taxpayer's actual cash outlay for the lease of property in a state. 18 Cal. Code of Regs. §25130(b)(4)(B) provides that the term "annual rent" does not include:

Royalties based on extraction of natural resources, whether represented by delivery or purchase. For this purpose, a royalty includes any consideration, conveyed or credited to a holder of an interest in property which constitutes a sharing of current or future production of natural resources from such property, irrespective of the method of payment or how such consideration may be characterized, whether as a royalty, advance royalty, rental or otherwise.

Thus, under the standard property factor rules, a royalty payment for extracted oil or timber would not qualify as "annual rent." That rule reflects that interests which provide a right to extract timber or oil and gas, whether or not denominated as a "lease" in the contract, are not in fact leaseholds under real property law. Even if an interest described by 18 Cal. Code of Regs. §25130(b)(4)(B) is described in state or foreign country local law as a "lease," if the effect of the right granted is substantially the same as described in the regulation, payments made pursuant to that right are not properly treated as a payment for a leasehold interest. The fundamental nature of the rights granted under the agreements will control the characterization of such agreement in real property law and for tax purposes (see Atlantic Oil Co. v. County of Los Angeles (1968) 69 Cal.2d 585, at 593-594).

Limiting the application of the term "rent" to payments made pursuant to a leasehold, exclusive of royalty payments for natural resources, is also consistent with the language of the nonbusiness income allocation rules of the Uniform Division of Income for Tax Purposes Act (UDITPA), Section 25124, Rev. and Tax. Code, which provides that "[n]et rents and royalties from real property located in this state are allocable to this state." The fact that the term "rents" is distinct from the term "royalties" in that section indicates that the drafters of UDITPA considered royalty payments as distinct from rental payments.

The rights described in 18 Cal. Code of Regs. §25130(b)(4)(B) are a distinct interest in real property, known as a "profit a prendre" in common law. A profit a prendre is a right to enter the "soil of another" and "take soil or produce of the land" (Black's Law Dict., (6th ed. 1990) p. 1211). Varieties of profits a prendre include rights to extract timber, oil and gas, hard minerals, etc. A profit a prendre may be unlimited in duration or limited to a term of years. In either case, it is an estate in real property (Atlantic Oil Co. v. County of Los Angeles, supra, 69 Cal. 2d 585, 594, citing Dabney-Johnston Oil Corp. v. Walden (1935) 4 Cal.2d 637, 649).

A profit a prendre is distinguishable from a leasehold, even where it is an interest for a term of years, in that a leasehold conveys to the lessee exclusive possession of the property (see generally, 42 Cal.Jur.3d, Landlord and Tenant, §76 and §80; Heilbron v. Kings River & Fresno Canal Co., (1888) 76 Cal.11). In contrast, the right of use of a holder of a profit a prendre with respect to the applicable land is limited to the "right of entry" and "the right to use such of the surface as is necessary and convenient for the exercise of the profit" (Black's, supra, citing Costa Mesa Union School Dist. of Orange County v. Security First Nat. Bank (1967) 254 Cal.App.2d 4).

Notwithstanding the general property factor rule, 18 Cal. Code of Regs. §25137(b)(1)(B) provides:

If property owned by others is used by the taxpayer at no charge or rented by the taxpayer for a nominal rate, the net annual rental rate for such property shall be determined on the basis of a reasonable market rental rate for such property.

In Appeal of Proctor [sic] and Gamble, Cal. St. Bd. of Equal., Sept. 26, 1989 (hereinafter Procter and Gamble), the taxpayer was granted rights to harvest timber from lands owned by the province of Alberta, Canada. The Board of Equalization held that 18 Cal. Code of Regs. §25137(b)(1)(B) provided authority which required the use of a "reasonable market rental rate" for such property. In addition, the Board also held that the entire area of timberland available for use under the agreement should be included in determining reasonable market rental value, citing 18 Cal. Code of Regs. §25129(b), which includes in the general property factor the taxpayer's property "available for or capable of being used during the income year."

Thus, despite the fact that a profit a prendre interest in the property of another is not a real property leasehold interest, the Board of Equalization, relying upon the phrase "property owned by others . . . used by the taxpayer" in regulation 18 Cal. Code of Regs. §25137(b)(1)(B), declared that the taxpayer's rights to harvest timber on land owned by a third party must be represented in the property factor.

In Atlantic Oil Co., supra, the California Supreme Court cited Callahan v. Martin (1935) 3 Cal.2d 110, 123 , for the proposition that "royalty return . . . is rent, or so closely analogous as to partake the incidents thereof." The Atlantic Oil case also cited Denio v. City of Huntington Beach (1943) 22 Cal.2d 580, 596 for the proposition that "the words ‘royalty’ and ‘rent’ . . . ‘are used interchangeably to convey the same meaning’; i.e., ‘the compensation which the occupier pays the landlord for that species of occupation which the contract between them allows’ [citations]." This language was relied upon by the court in Comptroller of the Treasury v. Shell Oil Company (1985) 65 Md. App. 252, 500 A.2d 315, allowing the taxpayer to include an eight multiple of its royalty payments in its property factor, as substantially equivalent to "rent."

Thus, while the general property factor provisions of Sections 25129-25131, Rev. and Tax. Code, do not support the inclusion of royalty payments under a profit a prendre in the property factor as rent, there is support in the language of the Section 25137 regulation, as applied by the Procter and Gamble opinion, for inclusion of royalty payments as sufficiently equivalent to a rental to be treated as such under 18 Cal. Code of Regs. §25137(b)(1)(B).

Because such royalties are treated as rent for the limited purposes of that regulation, payments of royalties between unrelated parties, neither of which is compelled to enter into the contract, will (absent unusual circumstances) be an arm's length price and therefore represent fair value for the taxpayer's use of the land. Fair market value is the amount at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of the relevant facts (Black's, supra p. 547). Accordingly, the actual amount paid under the royalty agreement will ordinarily be treated as the reasonable market rental rate. As such, royalty payments are capitalized at an eight multiple under Section 25130.

Treatment of royalty payments as the "reasonable market rental rate," capitalized at an eight multiple, also avoids the extraordinary self-compliance and administrative costs in obtaining expert appraisals of "market values" for land subject to a profit a prendre, allowing, as does the ordinary rental rule, an eight-multiple value to stand as a rough proxy for the value of property of another used during the income year. If Procter and Gamble, supra, were read to require use of formal appraisal methodology for valuation of such land uses, the resulting administrative consequences would be enormously difficult and costly. This would be particularly true with respect to property located around the world in a world-wide apportioning trade or business in order to properly determine both the numerator and denominator components of the property factor. Much of the virtue of the simplicity of the "rough approximation" and "practical tax administration" represented in the basic rationale of an apportionment system would be lost (see, generally, Chase Brass v. Franchise Tax Board (1970) 10 Cal.App.3d 457, 471).

The provisions of 18 Cal. Code of Regs. 25137(b)(1)(B) do not support inclusion of a property factor value for property of another which a taxpayer has "available for use during the income year." The terms of the regulation specifically provide property factor relief only for property of another "used by the taxpayer." The provisions of 18 Cal. Code of Regs. §25129(b), which allow property factor representation for property which is owned or rented by the taxpayer and which is "available for use during the income year," relate to the general property factor rules and not to Section 25137, Rev. and Tax. Code. As noted above, those general property factor rules which require capitalization of rents in the property factor do not allow representation of values as rent other than payments under a true leasehold. Limiting the application of 18 Cal. Code of Regs. §25137(b)(1)(B) to property of another actually used, not available for use, comports with the purpose of Section 25137. Section 25137 applies only when the taxpayer's business activity is not properly represented by the normal allocation and apportionment rules. The normal apportionment rules allow representation of the taxpayer's owned or rented property which is available for use during the income year because the taxpayer has a substantial capital interest, or cash outlay, in property in the state where the property is owned or rented. If none of these conditions (business activity, capital interest or cash outlay) is satisfied, the statutory requirements of Sections 25129 and Section 25137 are not satisfied, and the taxpayer cannot have a represented value in the property factor.


Despite the limitations of 18 Cal. Code of Regs. §25130(b)(4), the specific provisions of 18 Cal. Code of Regs. §25137(b)(1)(B), as applied by the Board of Equalization in the Procter and Gamble opinion, authorize capitalization of royalties paid with respect to a property interest in the nature of a profit a prendre, to the extent actually used by the taxpayer, as a substantial equivalent to a rental, reflected at an eight-multiple capitalization rate. Thus, royalty payments made by corporations A and B with respect to their oil and gas and timber rights, respectively, are treated as rent for purposes of 18 Cal. Code of Regs. §25137(b)(1)(B).

Drafting Information

The principal author of this ruling is Michael E. Brownell of the Franchise Tax Board Legal Division. For further information regarding this ruling, contact Mr. Brownell at the Franchise Tax Board Legal Branch, P.O. Box 1720, Rancho Cordova, California 94751-1720.