Herbel, who owned 10 percent of Malibu's stock, states as follows:

Due to the audit of Malibu Petroleum, Inc. and Subsidiaries, it is determined that your share of the corporation's taxable income is $178,869.00. Therefore, taxable income is increased $178,869.00 for 1988. * * *

The notice of deficiency issued to Mr. Webb, who owned 90 percent of Malibu's stock, states as follows:

Due to the audit of Malibu Petroleum, Inc. and Subsidiaries, it is determined that your share of the corporation's taxable income is $1,609,823.00 rather than the loss of $32,755.00 as reported on your 1988 tax return. Therefore, taxable income is increased $1,642,578.00 for 1988. ***

Discussion

The issue presented in these consolidated cases is whether the payment of $1,850,000 received by Malibu during 1988 pursuant to the settlement agreement is includable in Malibu's gross income for 1988, as determined by respondent. The payment was made by Arkla to settle a contractual dispute between Malibu and Arkla over the so-called take or pay provisions set forth in section 9 of the contract. Respondent determined in the subject notices of deficiency that the settlement payment constituted income to Malibu in 1988, and that each of Malibu's stockholders is required to include in income for 1988 his pro rata share of the payment, pursuant to the rules applicable to S corporations. Sec. 1366(a).

Petitioners, Malibu's stockholders, take the position that the payment is in the nature of a deposit or loan which will become income only as, and to the extent that, Arkla chooses to recoup the payment by taking natural gas produced from Malibu's interest in wells covered by the contract. In support of that position, petitioners argue that the settlement agreement imposes on Malibu a "fixed and unconditional obligation" to repay the full amount of the payment to Arkla, and, under certain circumstances, it requires Malibu to repay the unrecouped balance of the payment in cash. Petitioners also argue that, while the settlement agreement gives Arkla the right to recoup the payment in kind from future production, it does not impose an obligation on Arkla to purchase any minimum quantity of gas from Malibu.

According to petitioners, the effect of the settlement agreement is to give "Arkla the option either to seek repayment by delivery of gas in kind or to forego recoupment and await repayment in cash upon depletion of the Contract Wells." Petitioners argue that the settlement agreement "effected the creation of a loan in its traditional sense". In support of this argument, petitioners cite the opinion of the Supreme Court in Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990), and the opinions of this Court and its predecessor in Arlen v. Commissioner, 48 T.C. 640 (1967); Veenstra & DeHaan Coal Co. v. Commissioner, 11 T.C. 964 (1948); and Summit Coal Co. v. Commissioner, 18 B.T.A. 983 (1930). Petitioners also argue that the settlement agreement is “a contingent and executory contract" and that Malibu has no right to keep the settlement payment made thereunder until the condition set forth therein is satisfied; i.e., until, and to the extent, Arkla recoups the advance payment by purchasing gas under the contract.

Respondent argues that in form and in substance the subject payment is not a loan but is a prepayment for natural gas. Respondent notes that the settlement agreement itself describes the payment as a "prepayment in advance for natural gas", and that the other language used in the settlement agreement is consistent with a sale of gas, rather than a loan. Respondent also notes that no loan documents, such as promissory notes, were executed by the parties, and no interest was charged on the unrecouped balance of the payment. Finally, respondent notes that the treatment of the payment by the parties suggests that it was an advance payment for the sale of gas and not a loan. In this regard, respondent points out that Arkla booked the payment to an account entitled "Gas Purchased In Advance of Delivery”, an asset account and not a loan account, and that minutes of a meeting of Malibu's board of directors state that the payment "constitutes prepayment in advance for gas to be delivered by Malibu Petroleum, Inc."

Respondent argues that the payment does not constitute a loan because "the maker of the payment, Arkla, has no right to demand a refund of the payment in cash as long as the recipient of the payment, Malibu, does not terminate the Gas Contract and maintains certain levels of production from the wells subject to the Gas Contract." Respondent also argues

that the cases cited by petitioners, such as Commissioner v. Indianapolis Power & Light Co., supra, are "completely inapplicable or clearly distinguishable.”

Respondent notes that Malibu reports income under the cash receipts and disbursements method of accounting and, citing section 1.451-1(a), Income Tax Regs., argues that Malibu is required under that method of accounting to include the payment in income in the year of receipt. Respondent acknowledges that section 1.451-5(g), Income Tax Regs., provides an exception to the general rule in section 1.451-1(a), Income Tax Regs., for certain advance payments treated as mortgage loans pursuant to section 636(a). However, respondent argues that the subject payment is not eligible for the exception for two reasons. First, it is not an "advance payment”, as defined by section 1.451-5(a), Income Tax Regs., because Malibu is not a taxpayer using an accrual method of accounting as required by that provision. Second, it is not a "production payment" for purposes of section 636(a) because "recoupment by Arkla can occur by gas deliveries or by a cash repayment (but not by cash payments from the sale of the minerals), the payment from Malibu fails to satisfy the Treas. Reg. §1.636–3(a) criteria".

Finally, respondent asserts that "there are genuine issues as to material facts", and that summary judgment is not proper. See Rule 121. All Rule references are to the Tax Court Rules of Practice and Procedure. In support of that position, respondent relies on two affidavits attached to respondent's objection, one by an employee of Arkla's successor corporation, NorAm Gas Transmission Co. (NorAm), and one by an attorney for NorAm.

The issues in this case involve the tax treatment of the consideration paid by Arkla under the settlement agreement, as opposed to Arkla's right of recoupment set forth in paragraph 2 of the settlement agreement. However, the first issue presented by petitioners' motion for summary judgment is whether Arkla's right of recoupment is a carved-out production payment, as described by section 636(a), such that the settlement transaction must be treated as a mortgage loan on the mineral property. Section 636(a) provides as follows:

SEC. 636(a). CARVED-OUT PRODUCTION PAYMENT.-A production payment carved out of mineral property shall be treated, for purposes of this

subtitle, as if it were a mortgage loan on the property, and shall not qualify as an economic interest in the mineral property. In the case of a production payment carved out for exploration or development of a mineral property, the preceding sentence shall apply only if and to the extent gross income from the property (for purposes of section 613) would be realized, in the absence of the application of such sentence, by the person creating the production payment.

The regulations promulgated under section 636(a) define the term "production payment" to mean "in general, a right to a specified share of the production from mineral in place (if, as, and when produced), or the proceeds from such production. Such right must be an economic interest in such mineral in place." Sec. 1.636–3(a)(1), Income Tax Regs.

Petitioners never explicitly argue that section 636 governs the settlement between Malibu and Arkla. However, they argue at length that the definition of production payment set forth in section 1.636–3(a), Income Tax Regs., is "inconsistent with the express language of Section 636 *** [and] with the legislative history" of section 636 to the extent that it limits the definition to cases in which the right to production is "an economic interest in such mineral in place." Sec. 1.636-3(a)(1), Income Tax Regs. According to petitioners, no such limitation was intended by Congress, and section 1.6363(a), Income Tax Regs., "must be declared invalid." In making this argument, petitioners in effect concede that Arkla's right of recoupment under the settlement agreement is not an economic interest in the minerals in place, but they argue that it should nevertheless be treated as a mortgage loan pursuant to section 636(a).

We agree with the proposition, implicit in petitioners' argument, that Arkla's right of recoupment or refund is not “an economic interest in such mineral in place", as required by section 1.636–3(a)(1), Income Tax Regs. Generally, courts have applied a two-part test for determining whether there is an economic interest. See, e.g., Freede v. Commissioner, 864 F.2d 671, 673–674 (10th Cir. 1988), revg. 86 T.C. 340 (1986); Christie v. United States, 436 F.2d 1216, 1218 (5th Cir. 1971). In Freede v. Commissioner, supra at 674, the court described the two-part test as follows: "(1) there must be an interest, acquired by capital investment, in the minerals in place; and (2) the return on the investment must be realized solely from the extraction of the minerals." In this

case, it is readily apparent that Arkla was not required to look solely to the extraction of the minerals for a return of its payment of $1,850,000. To the contrary, the settlement agreement provides that Arkla would receive "the unrecouped balance of the Prepayment" in the event that the contract were terminated by Malibu or the wells became substantially depleted. Therefore, since Arkla is not required to look solely to the extraction of the minerals for return of its payment, Arkla's right of recoupment is not an economic interest in minerals in place. See, e.g., Anderson v. Helvering, 310 U.S. 404 (1940); Christie v. United States, supra at 1220-1221; Commissioner v. Estate of Donnell, 417 F.2d 106, 115 (5th Cir. 1969), affg. in part and revg. in part 48 T.C. 552 (1967). Accordingly, Arkla's right of recoupment does not constitute a "production payment" within the meaning of section 636. Sec. 1.636–3(a)(1), Income Tax Regs.

Notwithstanding Arkla's lack of an economic interest in the mineral in place, petitioners argue that Congress intended to apply "Section 636 loan treatment in all cases without regard to whether the 'purchaser' acquired an interest in the minerals which would constitute an 'economic interest' within the traditional meaning of the term." Thus, petitioners take the position that Arkla's right of recoupment under the settlement agreement is a "production payment" within the meaning of section 636(a), with the result that the consideration paid by Arkla under the agreement is required to be treated as a mortgage loan. We disagree.

Section 636 was added to the Internal Revenue Code by the Tax Reform Act of 1969, Pub. L. 91-172, sec. 503(a), 83 Stat. 487, 630. In order to address petitioners' argument that section 1.636-3(a)(1), Income Tax Regs., is invalid, it is necessary to review the tax treatment of production payments prior to the passage of section 636.

Before section 636 became law, the owner of a mineral property who sold, or carved out, a portion of his future production was required to treat the consideration received for the production payment as ordinary income, subject to depletion, and to include such amount in income in the year received. Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958). The courts had adopted the Commissioner's view that the transaction was essentially an assignment of expected income for a fixed or determinable period of time, and, thus,