IRS ISSUES FINAL REGULATIONS RELATING TO THE LIMITATION ON THE FOREIGN TAX CREDIT WITH RESPECT TO TAXES PAID ON FORI.

Under section 907(a), an oil producer's creditable foreign oil and gas extraction taxes are limited to a certain percentage of foreign oil and gas extraction income (FOGEI). FOGEI is foreign- source taxable income derived from the extraction of minerals from oil and gas wells or from the sale or exchange of assets used in the extraction activity. Section 907(b) provides that the extraction taxes on FOGEI, along with the producer's creditable taxes on income from "downstream trades or businesses" (other FORI) may only be allowed by section 904 as credits against the United States tax on FORI, and not other income.

The proposed regulations had defined FOGEI narrowly "so as to include within the definition only income which a producing country would tax excessively." The final regulations adopt the rule that FOGEI and other FORI is defined to include interest on reasonable amounts of working capital and other amounts that are directly related to the taxpayer's extraction, processing, and other activities described in section 907(c)(1) and (2).

The final regulations also provide rules which base the definition of "extraction income" on the taxpayer's dependence on the amount of minerals discovered or extracted for his consideration, even if the taxpayer does not have an economic interest in the minerals in place. Regulations under section 901 provide that a taxpayer may elect the foreign tax credit at any time during the 10- year period of limitations contained in section 6511.

The Service also noted that, under section 1441, a person claiming to be exempt from withholding shall provide a withholding agent with duplicate copies of either Form 1078 or a statement asserting citizenship or residency in the United States. The Service has revised the regulations under this provision and now requires that the withholding agent shall mail one copy of the filed document to the Internal Revenue Service Center, Philadelphia, PA 19255. (Full text in this issue.)

ACTION: Final regulations.

SUMMARY: This document contains final Income Tax Regulations relating to the limitation on the foreign tax credit with respect to taxes paid on foreign oil related income. The Tax Reduction Act of 1975 changed the applicable tax law. The regulations provide the public with the guidance needed to comply with the subject limitation added by that Act and will affect all taxpayers claiming a foreign tax credit for taxes paid with respect to foreign oil related income. In addition, this document contains final Income Tax Regulations relating to the period during which a taxpayer may elect to claim the foreign tax credit. Also, this document contains final Income Tax Regulations relating to the mailing address to be used for filing Forms 1078 or withholding exemption statements,

DATES: The amendments to section 1.907(c)-1 are applicable for taxable years ending after December 31, 1974 and beginning before January 1, 1983. The amendment to section 1.901-1(d) is applicable for taxable years ending after December 31, 1953. The amendment to section 1.1441-5(c) is applicable November 9, 1987.

FOR FURTHER INFORMATION CONTACT: Richard Chewning of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C., 20224, Attention: CC:LR:T. Telephone 202-566- 6384 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

BACKGROUND

Limitation

This document contains amendments to the Income Tax Regulations (26 CFR Part 1) under section 907(c)(1) and (2) of the Internal Revenue Code. Amendments were proposed to conform the regulations to section 601(a) of the Tax Reduction Act of 1975 (89 Stat. 54). They do not reflect the changes in section 907(c) made by section 211(b) of the Tax Equity and Fiscal Responsibility Act of 1982 (96 Stat. 449), hereafter referred to as TEFRA.

On June 27, 1984, the Federal Register published as final regulations amendments to the Income Tax Regulations (26 CFR Part 1) under section 907 of the Internal Revenue Code (49 FR 26208) (1984 final regulations). The notice which preceded the 1984 final regulations was published on November 17, 1980 (45 FR 75695) (1980 notice). Section 1.907(c)-1(e) and (f) of the 1984 final regulations reserved certain rules that would apply in defining a taxpayer's foreign oil and gas extraction income and foreign oil related income. On June 27, 1984, the Federal Register published the notice of proposed rulemaking for those reserved rules (49 FR 26258) (1984 notice). A public hearing was neither requested nor held. After consideration of all comments regarding the 1984 notice, the amendments as set forth below are adopted by this Treasury decision.

Election Period

This document also contains an amendment to section 1.901-1(d) of the Income Tax Regulations (26 CFR Part 1) under section 901(a) of the Internal Revenue Code.

Mailing Address

In addition, this document amends section 1.1441-5(c) of the Income Tax Regulations (26 CFR Part 1) under section 1441 of the Internal Revenue Code.

EXPLANATION OF PROVISIONS

Limitation

Prior to the enactment in 1975 of section 907, foreign oil and gas producers were generating excess foreign tax credits attributable to their producing operations. The excess credits arose because the effective foreign tax rate on income from the extraction of oil and gas often far exceeded the U.S. rate on that income. In addition, there were serious questions whether payments made to certain countries, that were called taxes and were claimed as foreign tax credits, were in reality deductible royalty payments. Moreover, the excess credits generated by extraction income could be used to offset the U.S. tax on the producer's other foreign-source income even though that other income was frequently low taxed income completely unrelated to the oil and gas business.

In order to address these problems, Congress enacted section 907(a) and (b). In the first instance, section 907(a) limits the producer's creditable foreign oil and gas extraction taxes to a certain percentage of foreign oil and gas extraction income (FOGEI). FOGEI is foreign-source taxable income derived from the extraction of minerals from oil or gas wells or from the sale or exchange of assets used in the extraction activity.

Secondly, section 907(b) (as in effect prior to TEFRA) provides that these extraction taxes on FOGEI, as limited by section 907(a), along with the producer's creditable taxes on income from downstream trades or businesses (other FORI) may only be allowed by reason of section 904 as credits against the U.S. tax on foreign oil related income (FORI) (and not other income). FORI is composed of FOGEI and "other FORI." "Downstream" trades or businesses include the processing of minerals from oil or gas wells into primary products, marketing and transporting the minerals or primary products, and the selling or exchanging of assets used in these trades or businesses.

Interest Income

The 1980 notice of proposed rulemaking (45 FR 75695) generally defined FOGEI narrowly so as to include within the definition only income which a producing country would tax excessively. For example, in a situation where an oil and gas producer is required to make monthly payments of royalties and taxes to the producing country, the producer may temporarily invest the funds which it sets aside to make the monthly payments in assets that generate interest income. Under the 1980 notice, the interest income earned on those temporary investments would not have been either FOGEI or other FORI. The special section 907(b) foreign tax credit limitation would, therefore, not have applied with the result that foreign taxes, if any, paid on that income, even though attributable to the extraction activity, would have been creditable against income that was not foreign oil related income.

The 1984 notice provided, and this regulation adopts without change, the rule that FOGEI and other FORI is defined to include interest on reasonable amounts of working capital and other amounts that are directly related to the conduct by the taxpayer of extraction, processing, and other activities described in section 907(c)(1) and (2).

Service and Rental Income

The 1980 notice contained a rule (proposed section 1.907(c)- 1(b)(2)) providing that income from the performance of extraction services would be extraction income, even in the absence of an economic interest in the minerals in place, if the consideration received for those services depended in whole or in part on the amount of minerals discovered or extracted. The 1984 final regulations eliminated the above specific provision for extraction services. Those regulations provided, however, that income that is directly related to (rather than directly derived from) the conduct of the section 907(c)(1) and (2) activities may be FOGEI or other FORI. The definition of directly related income was reserved. The 1984 notice defined directly related income to include only income derived from the performance of certain described services and from the lease or license of property used by the lessor, licensor, or another person in the active conduct of the section 907(c)(1) and (2) activities. The earlier 1980 "income based on output" test was eliminated. These final regulations reinstate the income based on output test. Accordingly, the definition of directly related FOGEI includes income from extraction services which is based on output.

Election Period

This provision amends section 1.901-1(d) to state that a taxpayer may elect the foreign tax credit at any time during the 10- year period of limitations prescribed by section 6511(d)(3)(A) of the Internal Revenue Code.

Mailing Address for Withholding Exemption Statements and Forms 1078

Section 1.1441-5 provides that a person claiming to be exempt from withholding shall provide a withholding agent duplicate copies of either Form 1078 or a statement asserting citizenship or residency in the United States. This provision revises section 1.1441-5(c) to provide that the withholding agent shall mail one copy of the filed document to the Internal Revenue Service Center, Philadelphia, PA 19255.

DISCUSSION OF COMMENTS

Limitation

The comments from the public received on the 1984 notice stated that the income based on output test which was abandoned in the 1984 notice should be reinstated. The commentators asserted that the income based on output test is supported by the legislative history of section 907. They pointed out that the House Report on section 907 as introduced in 1974 reflects the intention that FOGEI should be interpreted broadly to include income from any arrangement where the facts demonstrate that the income is "essentially profits from the extraction of crude oil." H.R. Rep. No. 1502, 93rd Cong. 2d Sess. 45 (1974). This intention was expressed in the context of the specific recognition by the Ways and Means Committee of "the changing relationships between the foreign governments of the countries where oil and gas wells are located and the petroleum companies operating in those countries. . . ." H.R. Rep. No. 1502, supra at 64.

In this regard and in response to the comments, these final regulations reinstate the income based on output test.

One commentator requested that the final regulations clarify that the proceeds (including interest) received from the nationalization (or expropriation) of an asset (or oil concession) of a petroleum company used in an activity described in section 907(c)(1) or (2) may be either FOGEI or other FORI. In response to this comment, these final regulations so provide that those proceeds will be FOGEI or other FORI under section 1.907(c)-1(e)(6).

SPECIAL ANALYSES

It has been concluded that these regulations are interpretative and that the notice and public comment procedural requirements of 5 USC 553 do not apply. Accordingly, these regulations are not subject to the requirements of the Regulatory Flexibility Act of 1980 (5 U.S.C. Chapter 6), and a Regulatory Flexibility Analysis is not required and has not been prepared. It has been determined that these regulations are not major regulations subject to Executive Order 12291. Accordingly, a Regulatory Impact Analysis is not required and has not been prepared.

DRAFTING INFORMATION

The principal author of these final regulations is Richard Chewning of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices in the Service and Treasury Department participated in the development of these regulations.

LIST OF SUBJECTS IN 26 CFR SECTIONS 1.861-1 THROUGH 1.997-1

Income taxes, Aliens, Exports, DISC, FSC, Foreign Investment in U.S., Foreign tax credit, Source of income, United States investment abroad.

LIST OF SUBJECTS IN 26 CFR SECTIONS 1.1441-1 THROUGH 1.1465-1

Income taxes, Aliens, Foreign corporations.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR Part 1 is amended as follows:

INCOME TAX REGULATIONS (26 CFR PART 1)

Paragraph 1. The authority for Part 1 continues to read in part:

Authority: 26 U.S.C. 7805. * * * Section 1.1441-5(c) also issued under 26 U.S.C. 1441(c). * * *

Par. 2. Section 1.901-1 is amended by revising paragraph (d) to read as follows:

Section 1.901-1 Allowance of credit for taxes.

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(d) PERIOD DURING WHICH ELECTION CAN BE MADE OR CHANGED. The taxpayer may, for a particular taxable year, claim the benefits of section 901 (or claim a deduction in lieu of a foreign tax credit) at any time before the expiration of the period prescribed by section 6511(d)(3)(A) (or section 6511(c) if the period is extended by agreement).

Par. 3. Section 1.907(c)-1 is amended by adding the text of paragraphs (e) (3), (4), (5), and (6) and (f) to read as set forth below.

Section 1.907(c)-1 Definitions relating to FORI and FOGEI.

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(e) TERMS AND ITEMS COMMON TO OTHER FORI AND FOGEI.

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(3) INTEREST ON WORKING CAPITAL. Other FORI and FOGEI may include interest on bank deposits or on any other temporary investment which is not in excess of funds reasonably necessary to meet the working capital requirements and the specifically anticipated business needs of the person that is engaged in the conduct of the activities listed in paragraphs (b) and (c) of this section.

(4) EXCHANGE GAIN OR LOSS. Exchange gain (and loss) may be other FORI and FOGEI.

(5) ALLOCATION. Interest income and exchange gain (or loss) described, respectively, in paragraphs (e)(3) and (4) of this section are allocated among other FORI, FOGEI, and any other class of income relevant for purposes of the foreign tax credit limitations under any reasonable method which is consistently applied from year-to-year.

(6) FACTS AND CIRCUMSTANCES. Income not described elsewhere in this section may be FOGEI or other FORI if, under the facts and circumstances in the particular case, the income is in substance directly attributable to the activities described in section 907(c)(1) or (2). For example, assume that a producer in the North Sea suffers a casualty caused by an explosion, fire, and resulting destruction of a drilling platform. Insurance proceeds received for the platform's destruction in excess of the producer's basis is extraction income if the excess constitutes income from sources outside the United States. In addition, income from an insurance policy for business interruption may be extraction income to the extent the payments under the policy are geared directly to the loss of income from production and are treated as income from sources outside the United States. Also, if an oil company's oil concession or assets used in extraction activities described in section 907(c)(1)(A) and located outside the United States are nationalized or expropriated by a foreign government, or instrumentality thereof, income derived from that nationalization or expropriation (including interest on the income paid pursuant to the nationalization or expropriation) is FOGEI. Likewise, if a company's assets used in the activities described in section 907(c)(2)(B) through (D) and located outside the United States are nationalized or expropriated by a foreign government, or instrumentality thereof, income (including interest on the income paid pursuant to the nationalization or expropriation) derived from the nationalization or expropriation will be other FORI. For this purpose, nationalization or expropriation is deemed to be a sale or exchange. In further example, assume that an oil company has an exclusive right to buy all the oil in country X from Y, and instrumentality of the foreign sovereign which owns all of the oil in X. The oil company does not have an economic interest in any oil in country X. Y has a temporary cash-flow problem and demands that the oil company make advance deposits for the purchase of oil not yet delivered. In return, Y grants the oil company a discount on the price of the oil when delivered. Income represented by the discount on the later disposition of the oil is other FORI described in section 907(c)(2)(D). The result would be the same if Y credited the oil company with interest on the advance deposits, which had to be used to purchase oil (the interest income would be other FORI).

(f) DIRECTLY RELATED INCOME -- (1) IN GENERAL. This paragraph (f) includes in other FORI and FOGEI income from the performance of directly related services (as defined in paragraph (f)(2) of this section) or from the lease or license of related property (as defined in paragraph (f)(3) of this section). This paragraph (f) does not apply to a person if --

(i) Neither that person nor a related person (as defined in paragraph (f)(4) of this section) has FOGEI described in paragraph (b) of this section (other than paragraph (b)(4) thereof) or other FORI described in paragraph (c) of this section (other than paragraph (c)(7) thereof), or

(ii) Less than 50 percent of that person's gross income from sources outside the United States which is related exclusively to the performance of services and from the lease or license of property described in paragraph (f)(2) and (3) of this section, respectively, is attributable to services performed for (or on behalf of), leases to, or licenses with, related persons, but

(iii) Subdivision (ii) of this paragraph (f)(1) will not apply to a person if 50 percent or more of that person's total gross income from sources outside the United States is FOGEI and other FORI (as both described in subdivision (i) of this paragraph (f)(1)).

A person described in subdivisions (i) or (ii) of this paragraph will, however, have directly related services income which is FOGEI if the income is so classified by reason of the income based on output test set forth in paragraph (f)(2)(i)(B) of this section.

(2) DIRECTLY RELATED SERVICES -- (i) FOGEI. (A) Income from directly related services will be FOGEI as that term is defined in paragraph (b)(1) and (3) of this section, if those services are directly related to the active conduct of extraction (including exploration) of minerals from oil and gas wells. Paragraph (b)(1) of this section provides that, in order to have extraction income, a person must have an economic interest in the minerals in place. However, paragraph (b)(3) of this section recognizes that income arising from "other circumstances" is extraction income if that income is in substance attributable to the extraction of minerals.

(B) An example of "other circumstances" under paragraph (b)(3) of this section is the "income based on output test." This income based on output test provides that, if the amount of compensation paid or credited to a person for services is dependent on the amount of minerals discovered or extracted, the income of the person from the performance of the services will be directly related services income which is FOGEI. This test will apply whether or not the person performing the services has, or had, an economic interest in the minerals discovered or extracted.

(ii) OTHER FORI. With regard to the determination of directly related services income which is other FORI, directly related services are those services directly related to the active conduct of the operations described in section 907(c)(2)(B) through (D). Those services include, for example, services performed in relation to the distribution of minerals or primary products or in connection with the operation of a refinery, or the types of services described in section 1.954-6(d) (other than paragraph (d)(4) thereof) which relate to foreign base company shipping income.

(iii) RECIPIENT OF THE SERVICES. Directly related services described in paragraph (f)(2)(i) and (ii) of this section may be performed for any person without regard to whether that person is a related person.

(iv) EXCLUDED SERVICES. Directly related services do not include insurance, accounting or managerial services.

(3) LEASES AND LICENSES. A lease or license of related property is the lease or license of assets used (or held for use) by the lessor, licensor, or another person (including the lessee or a sublessee) in the active conduct of the activities described in section 907(c)(1)(A) or (c)(2)(A) through (D). The leases or licenses described in this paragraph (f)(3) include, for example, a lease of a means of transportation under a bareboat charter hire, of drilling equipment used in extraction operations, or the license of a patent, know-how, or similar intangible property used in extracting, transporting, distributing or processing minerals or primary products. This paragraph (f)(3) applies without regard to whether the parties are related persons.

(4) RELATED PERSON. A person will be treated as a related person for purposes of this paragraph (f) if (i) that person would be so treated within the meaning of section 954(d)(3) (as applied by substituting the word "corporation" for the word "controlled foreign corporation"); or (ii) that person is a partnership or partner described in section 707(b)(1).

(5) GROSS INCOME. A foreign corporation shall be treated as a domestic corporation for the purpose of applying the gross income rules in paragraph (f)(1)(ii) and (iii) of this section.

Par. 4 Section 1.1441-5(c) is revised to read as follows:

Section 1.1441-5 Claiming to be a person not subject to withholding.

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(c) DISPOSITION OF STATEMENT AND FORM. The duplicate copy of each statement and form filed pursuant to this section shall be forwarded with a letter of transmittal to Internal Revenue Service Center, Philadelphia, PA 19255. The original statement shall be retained by the withholding agent.

Lawrence B. Gibbs