Rev. Rul. 76-215

Advice has been requested whether any portion of, or any amount attributable to, a share of oil production received by an Indonesian Government entity under the circumstances described below is an "income tax" creditable under section 901(b) or section 903 of the Internal Revenue Code of 1954 or deductible under section 164(a)(3).

P is a domestic corporation engaged, with its affiliated companies, in the production, transportation, refining, and marketing of petroleum and petroleum products in the United States and abroad. S is a wholly owned United States subsidiary of P that joins with P in the filing of a Federal income tax return on a consolidated basis. Under the law of 1971 Regarding State Oil and Natural Gas Mining Enterprises ("Pertamina Law"), all oil located in Indonesia is the property of the Indonesian Government. Pertamina, an Indonesian legal entity, wholly owned by the Government of Indonesia, was formed with the exclusive right to explore, develop, mine, and market Indonesian oil and gas.

Under Article 12 of the Pertamina Law, Pertamina may enter into production sharing contracts with non-government parties for the purpose of performing any of the above functions, provided such contracts conform with government regulations and are approved by the Indonesian President.

S presently holds several production sharing contracts that apply to different geographical regions within the jurisdiction of the Government of Indonesia. S entered into one such contract, a 30 year production sharing contract ("Contract"), with Pertamina in January 1975. The Contract is terminable by Pertamina only if S commits a major breach of the Contract and conclusive evidence of that breach is proved by arbitration or final court decision.

Under the Contract, S is required to: (1) invest in each of the first 6 years of the Contract in exploration operations alone, a minimum amount averaging over 1,000x dollars; (2) pay Pertamina a signature bonus of 1,250x dollars on the signing of the Contract; (3) make various charitable contributions; and (4) pay Pertamina certain production bonuses when production reaches a certain level. In addition, S must pay for all equipment used in its Indonesian operations and all expenses incurred in exploration, development, extraction, production, transportation, and marketing.

To recover the foregoing expenditures S must look solely to the extraction of oil or gas and the income therefrom. Specifically, S may recover such costs in barrels of oil prior to the division of oil between S and Pertamina, but such recovery may not exceed an amount equal to 40 percent of the value of all barrels of oil produced and saved from the Contract area during the year. With respect to the recovery of costs allowed under the Contract, S may not include as recoverable costs the signature bonus, the production bonuses, and interest on money borrowed for petroleum operations.

S may carry forward and recoup the costs recoverable to the extent such costs, together with the recoverable costs incurred during the subsequent taxable year, do not exceed 40 percent of the value of all barrels of oil produced and saved from the Contract area during that year.

Pertamina and S divide the production that remains after recovery of S's allowable operating costs. The Contract provides that S is "entitled to take and receive" 30 percent of the remaining production and Pertamina is entitled to the other 70 percent of such production. Pertamina is required by Article 14(1)(b) of the Pertamina Law, however, to deposit 60 percent of remaining production in the Indonesian Treasury. Thus, after recovery of operating costs, S receives 30 percent of remaining production and Pertamina and the Indonesian Treasury receive 10 percent and 60 percent, respectively.

The Contract recites that S remains subject to and Pertamina must discharge the following Indonesian taxes of S: all Indonesian income taxes such as the corporate income taxes imposed by the Corporation Tax Ordinance of 1925, as modified ("Corporation Tax"), and income taxes based on income and profits including all dividend, withholding, and other taxes imposed on the distribution of S's income or profits; the transfer tax; certain import and export duties; and exactions in respect of property, capital, net worth, operations, remittances, or transactions including any tax or levy on or in connection with operations performed thereunder by S, its contractors, or subcontractors. In Rev. Rul. 69-388, 1969-2 C.B. 154, it was stated that the Corporation Tax is an income tax.

Under Article 15 of the Pertamina Law the receipt by the Indonesian Treasury of its share of production represents payment of, and relieves Pertamina and S from liability for, all of the foregoing taxes.

The Contract recites that S's annual income for Indonesian tax purposes is: (1) the total "sums" received from disposing of 30 percent of the oil produced from the Contract area during the year after the deduction (recovery) of S's allowable operating costs; plus (2) an amount equal to what S's Corporation Tax would be thereon.

The income under one production sharing contract is computed separately from the income under other production sharing contracts held by S. Thus, a loss under one contract may not be offset against income earned under other contracts.

S acquires title to its share of production at the point of export. S has primary responsibility for marketing the share of production of Pertamina and the Indonesian Government (hereinafter collectively referred to as "the Government"). However, both S and the Government are entitled to take and receive their respective portions of the oil in kind.

Section 901(b) of the Code authorizes qualifying United States taxpayers to claim a foreign tax credit for the amount of any income tax paid or accrued during the taxable year to any foreign country or to any possession of the United States. Section 1.901-2(b) of the Income Tax Regulations provides, in part, that the term foreign country includes any foreign state or political subdivision thereof.

Section 164(a)(3) of the Code provides, in part, that foreign income taxes are allowed as a deduction for the taxable year in which paid or accrued.

Section 903 of the Code provides, in part, that the term "income taxes" as used in section 901 and section 164(a)(3) shall include a tax paid in lieu of a tax on income war profits, or excess profits otherwise generally imposed by any foreign country.

If a payment is in fact made to a foreign government by a taxpayer or on the taxpayer's behalf, then before that payment can be deducted or credited under the above sections, it must first be established that such payment is a tax. If it is in fact a tax, it must then be determined whether such tax qualifies as either an income tax or a tax in lieu of an income tax.

Principles developed under Federal law, not state or foreign interpretations or designations, determine whether an arrangement falls within the meaning of the word "tax" as used in a Federal statute. With respect to section 131 of the Revenue Act of 1928, the predecessor to section 901 of the Code, the Supreme Court of the United States stated in Biddle v. Commissioner, 302 U.S. 573 (1938), 1938-1 C.B. 309 that:

. . . there is nothing in its language to suggest that in allowing the credit for foreign tax payments, a shifting standard was adopted by reference to foreign characteristics and classifications of tax legislation.

The same principle was held applicable to section 164 of the Code in Aaron Dubitzky, 60 T.C. 29 (1973).

In addition, nothing in the legislative history of section 903 of the Code indicates that the word tax as used therein should be measured by different criteria than the word tax under section 901. See S. Rep. No. 1631, 77th Cong., 2nd Sess. 131 (1942) [1942-2 C.B. 504].

Under Federal law amounts paid to a government or its agency for the privilege of using or purchasing the government's property or as payment for a special privilege cannot generally qualify as taxes. See, for example Sands v. Manistee River Improvement Co., 123 U.S. 288 (1887); Aaron Dubitzky; Benjamin Mahler, 8 P.H. BTA Mem. 795 (1939), aff'd (on this issue) 119 F. 2d 869 (2d Cir. 1941); and Rev. Rul. 61-152, 1961-2 C.B. 42, which defined tax under section 164 of the Code to exclude a ". . . payment for some special privilege granted or service rendered . . ." by a government. A royalty received by a government would fall within such exclusion.

A mineral royalty is essentially a fixed percentage of production or payment: (1) based on production (whether in cash or in kind), or a share of net profits from production, received by a person with a right to the minerals in place; (2) for permitting another to extract and take those minerals; and (3) payable only from the minerals produced or the proceeds derived from the disposition of those minerals. See Burton Sutton Oil Co. v. Commissioner, 328 U.S. 25 (1946), 1946-1 C.B. 237; Kirby Petroleum Co. v. Commissioner, 326 U.S. 599 (1946), 1946-1 C.B. 69; Cox v. United States, 497 F.2d 348 (4th Cir. 1974); Logan Coal & Timber Ass'n v. Helvering, 122 F.2d 848 (3rd Cir. 1941); and United States Steel Corp. v. United States, 270 F. Supp. 253 (S.D.N.Y. 1967).

The Contract provides but one source of revenue for the Government and that source is the Government's retained share of production. The Government has legal title to all oil located in Indonesia, and must look solely to a percentage of production for compensation for the exhaustion of oil deposits.

Before gross production is divided between the Government and S, S is entitled to recover its annual operating costs (including pre-production costs). However, S may not recover its signature and production bonuses or the interest paid on borrowed money used for petroleum operations. In addition, S may not recover its annual operating costs in excess of 40 percent of the value of all barrels of oil produced and saved from the Contract area during the year.

Without these prohibitions and limitations, S's costs, including interest and bonuses paid, could, in some years, equal the value of all the oil produced and saved from the Contract area during the year, leaving nothing to compensate the Government for the taking of its property. Thus, the effect of the 40 percent limitation and the other prohibitions is to assure that the Government will retain a fixed percentage of oil produced in any year regardless of whether S has any net gain from such production. Such an assured share of production retained by the mineral owner is characteristic of a royalty and not of a tax within the United States concept of the terms.

In addition, the fact that the Government retains separately computed amounts under each production sharing contract assures that the Government will retain its share of production without regard to whether S operates in Indonesia at a gain or loss. This is consistent with the view that the Government's share of production constitutes a royalty.

Furthermore, the fact that the Government is assured a share of production regardless of whether S realizes income also supports the conclusion that such share of production represents a royalty rather than payment of an income tax. For example, if S did not dispose of its share of production for a particular year, S would realize no income subject to Indonesian tax because, under the Contract, its income is defined as: (1) the amount realized from the disposition of its share of oil produced from the Contract area during the year after the deduction of its allowable operating costs; plus (2) an amount equal to its Corporation Tax thereon. Yet, the Government's share of production would remain the same. This is characteristic of a royalty.

Under the principles discussed above the Government's share of production is a royalty and is, therefore, excluded from S's income. With respect to United States principles of taxation, the terms royalty and tax are mutually exclusive. Because the Government's share of production is a royalty, no portion of such production may be characterized as a tax.

Because all oil located in Indonesia is the property of the Government, and because S's Contract provides in substance for a division of the oil within the Contract area between S and the Government, the Government is merely retaining a share of the oil it already owns. A tax cannot be considered to have been paid by S or on S's behalf to Indonesia from Indonesia's share of production, because Indonesia's share of production was always the property of Indonesia and was not acquired from S. In summary, no tax was paid under the Contract.

Accordingly, no part of the Government's share of production is a tax, and, therefore, no credit may be taken by S under section 901(b) or section 903 of the Code and no deduction may be taken by S under section 164(a)(3).

Pursuant to the authority contained in section 7805(b) of the Code, the instant Revenue Ruling shall not be applied to amounts claimed as taxes paid or accrued to Indonesia, for taxable years beginning before June 30, 1976, under production sharing contracts entered into before April 8, 1976.

Rev. Rul. 69-388 holds that tax paid pursuant to a contract executed under Indonesian Law No. 1 of January 10, 1967, is a tax in lieu of an income tax under section 903 of the Code and is a creditable tax for purposes of the foreign tax credit. To the extent such Revenue Ruling implies that all contracts executed under the authority of Indonesian Law No. 1, of January 10, 1967, result in the imposition of foreign taxes creditable under section 901 and section 903, Rev. Rul. 69-388 is modified to remove that implication.

¹ Also released as IR-1608, dated May 7, 1976.