Most tax professionals are aware of the limitations imposed on the utilization of foreign tax credits under Sec. 904. In general, the total allowable amount of credit for foreign taxes paid or accrued cannot exceed the taxpayer's total U.S. tax multiplied by a ratio equal to the taxpayer's foreign-source income divided by his or her entire taxable income for the year. Under Sec. 904(d), taxpayers must apply this limitation separately with respect to the passive and general limitation categories of income. Taxpayers may carry unused foreign tax credits back one year and forward 10 years and must calculate these carryforwards and carrybacks separately for each category, or "basket," of income.
A lesser-known limitation under Sec. 907 applies to foreign taxes paid or accrued in connection with foreign oil and gas income. Taxpayers must pay governments of many foreign countries a royalty on oil and gas production within the country, as well as a tax on the net income generated from those activities. In some instances, a portion of the royalty may be characterized as income tax. This recharacterization results in a high rate of foreign tax imposed on foreign oil and gas income that is creditable against the U.S. tax, subject to special limitation rules.
Foreign Oil and Gas Income and Tax Credit Limitations
In 1975, Congress enacted Sec. 907, which provides a separate credit limitation on credit for foreign taxes paid on foreign oil and gas income. In 1991, the IRS issued final regulations in this area, effective for tax years beginning after Dec. 31, 1982. In general, Sec. 907 prevents excess foreign tax credits from foreign oil and gas income from offsetting U.S. tax on other foreign-source income. In particular, Sec. 907 contains an additional limitation, layered on top of the restrictions imposed by Sec. 904, on credits for foreign taxes paid or accrued related to certain types of foreign oil and gas income. Sec. 907(a) limits the foreign tax credit for taxes paid on foreign oil and gas extraction income (FOGEI) and foreign oil-related income (FORI) to (1) for individuals and trusts, FOGEI and FORI multiplied by the taxpayer's U.S. effective tax rate before credits, and (2) for corporations, FOGEI and FORI multiplied by the highest corporate tax rate.The amount disallowed by this limitation is carried back to the first preceding tax year and then carried forward for 10 succeeding years. Any FOGEI or FORI credits that make it through the limitations of Sec. 907(a) are then subject to the more familiar limitations under Sec. 904 mentioned above.
For tax years beginning before Jan. 1, 2009, the above limitations applied only to taxes imposed on FOGEI. Taxes imposed on FORI were subject to special rules recharacterizing them as noncreditable deductible expenses to the extent that the foreign law imposing the FORI taxes was structured or operated so that the amount of tax imposed with respect to FORI would be materially greater than the amount of taxes imposed on other types of income. This facts-and-circumstances test was generally satisfied if there was a shifting from a tax on FOGEI to a tax on FORI. For tax years beginning after Jan. 1, 2009, the limitations under Sec. 907(a) were expanded to include FORI in the definition of combined foreign and gas income, and the recharacterization rules were eliminated.
Sec. 907 and Regs. Sec. 1.907(c)-1 set forth detailed definitions of what types of income constitute FOGEI and FORI. FOGEI includes income derived from sources outside the United States from the extraction of minerals from oil or gas wells located outside the United States and from the sale or exchange of assets used in extracting those minerals. If the taxpayer has an economic interest in the minerals in place, extracting them will result in gross income from extraction in every case. The term "minerals" means hydrocarbon minerals extracted from oil and gas wells, including crude oil or natural gas. It also includes incidental impurities from these wells, such as sulfur, nitrogen, or helium. The term "minerals" does not include hydrocarbon minerals derived from shale oil or tar sands (Regs. Sec. 1.907(c)-1(f)).
FORI includes income from the processing of oil and gas into their primary products, from the transportation or distribution and sale of oil and gas and their primary products, from the disposition of assets used in these activities, and from the performance of any other related service. FOGEI and FORI may also include interest income earned on the working capital of a person engaged in those activities and gain or loss from a Sec. 988 transaction (foreign exchange gain and loss) to the extent the gain or loss is directly related to the foreign oil and gas operations. In addition to the types of income enumerated in the Code and regulations, other income or loss may be FOGEI or FORI if, under the facts and circumstances, the income or loss is directly attributable to the foreign oil and gas activities.
The FOGEI and FORI characterization applies not only to the taxpayer's directly held business operations but also to income or loss received by the taxpayer from its ownership interest in a partnership or S corporation or from its beneficial interest in a trust. Accordingly, to the extent that a partnership's income is considered FOGEI or FORI, the partner's distributable share of the income or loss and related foreign tax credit may also be treated as FOGEI or FORI (Regs. Sec. 1.907(c)-2(f)). The regulations provide that the lookthrough rules under Regs. Sec. 1.904-5 apply to determine whether the partner's distributive share of income or loss and foreign tax credit is FOGEI or FORI. The application of the lookthrough rules under Sec. 904 is generally favorable to the taxpayer. These rules allow a less-than-10% limited partner or corporate general partner to treat a distributive share of partnership income from the partnership as passive income not subject to the limitations imposed by Sec. 907. The lookthrough rules, however, do not apply to the extent the partnership interest is held in the ordinary course of the partner's active trade or business. A partnership interest is considered to be held in the ordinary course of a partner's active trade or business if the partner is engaged in the same or a related trade or business as the partnership. In the context of a trust, a beneficiary's distributive share of income and foreign tax credit from a trust is considered FOGEI or FORI to the extent the trust's income and foreign tax credit are considered to be from FOGEI or FORI.
FOGEI and FORI Foreign Tax Credit Limitation Examples
For taxpayers that are individuals or trusts, the calculation of the limitation can be demonstrated by the following examples:
Example 1: In year 1, the taxpayer's FOGEI and FORI in Country A are $450,000, on which there is a local foreign income tax of $225,000. In Country B, the taxpayer has a loss from oil and gas extraction and related activities of $100,000. The taxpayer's net FOGEI and FORI is $350,000 ($450,000 ‒ $100,000). The taxpayer's overall worldwide taxable income is $1,750,000, the total U.S. tax imposed on that income before credits is $416,500, and the maximum amount of FOGEI and FORI credit was utilized in the prior year. The taxpayer's overall effective tax rate is 23.8% ($416,500 ÷ $1,750,000 = 23.8%). Thus, the taxpayer's maximum allowable foreign tax credit from FOGEI and FORI is 23.8% × $350,000, or $83,300. The excess, $141,700 ($225,000 − $83,300), can be carried forward 10 years and continues to be treated as foreign oil and gas taxes subject to the same limitations. The allowable FOGEI and FORI credit of $83,300 is now combined with other general-limitation-type foreign tax credits subject to the limitations of Sec. 904.
Example 2: In year 2, the taxpayer's FOGEI and FORI in Country A are $500,000, on which there is a local foreign income tax of $200,000. In Country B, the taxpayer's FOGEI and FORI are $350,000, on which there is a local foreign income tax of $100,000. Also assume the taxpayer's overall worldwide taxable income is $5 million, and the total U.S. tax imposed on the income before credits is $1,980,000. The maximum amount of creditable foreign taxes from FOGEI and FORI for the tax year is $336,600 ($1,980,000 ÷ $5,000,000 = 39.6%; $850,000 × 39.6% = $336,600). Under Sec. 907, the taxpayer may claim the entire $300,000 of foreign taxes imposed in year 2 plus $36,600 of the carryover from year 1. The excess carryover, $105,100 ($141,700 − $36,600) will be carried forward.
For corporate taxpayers, the calculation of the limitation does not consider the effective tax rate of the taxpayer for the tax year. Rather, under Sec. 907(a)(2)(A), the maximum allowable credit is calculated by multiplying the corporation's net FOGEI and FORI by the highest rate of tax specified under Sec. 11(b), currently 35%.
These limitations do not apply to taxpayers that elect to take a deduction for foreign taxes paid or accrued rather than claiming a credit.
Taxpayers who receive foreign oil and gas income, expense, and foreign tax credit information from either a passthrough entity or from a beneficial interest in a trust must rely on the disclosures provided to them on footnotes to Schedules K-1. Currently, no specific line items or codes on Schedule K-1 are used to identify FOGEI and FORI and the related foreign tax credit to the entity's investors or beneficiaries. This can result in inconsistencies in the treatment of those items among partners and beneficiaries, as well as an increased audit risk for them.
In addition to the lack of detail on Schedules K-1 with respect to FOGEI and FORI, guidance is lacking on the forms used to report foreign tax credits. The FOGEI and foreign tax credit limitations are calculated and disclosed on Form 1116, Foreign Tax Credit (Individual, Estate, or Trust), and on Form 1118, Foreign Tax Credit—Corporations. The most recent version of the instructions to Form 1116 briefly mentions Sec. 907 and the limitation. Specifically, when referring to Part III, line 10, "Figuring the Credit," the instructions merely point out that special rules apply to the carryback and carryforward of foreign taxes paid or accrued on foreign oil and gas income. In addition, when referring to Part III, line 12, the instructions indicate there may be a reduction to the foreign tax credit for taxes on combined foreign oil and gas income. The instructions provide the mechanism for calculating the limitation. However, most tax software programs are not able to calculate this limitation or to track the separate carryovers created by the FOGEI and FORI limitations.
Tax professionals should be aware of other considerations when calculating the credit limitations on foreign oil and gas income, including the impact on the FOGEI and FORI calculation when a loss or related deduction is suspended under passive loss or at-risk limitations under Secs. 469 and 465, respectively. Also, in the case of a trust where distributions have been made to a beneficiary, a portion of the trust's foreign oil and gas income and related foreign tax credits must also be treated as distributed to the beneficiary. The trust's FOGEI and FORI calculation should be done net of the beneficiary's distributable share of income and credits from the trust.
A final consideration that is often overlooked is the impact of the alternative minimum tax (AMT) on the FOGEI and FORI credit limitation calculation. For taxpayers subject to AMT, the FOGEI and FORI limitations must be calculated using the taxpayer's effective tax rate for AMT purposes. This credit limitation calculation and the determination of carryover amounts required under the AMT regime add a layer of complexity to this calculation.
As demonstrated throughout this item, the separate tax credit regime applicable to foreign taxes paid or accrued in connection with foreign oil and gas income is complex and can be cumbersome. Care should be taken and caution exercised when determining what constitutes FOREI and FORI and when calculating the credit limitation for regular tax and AMT purposes. Partners or beneficiaries receiving foreign oil and gas income and foreign tax credits from passthrough entities or trusts should consult their tax advisers to ensure that the limitations and special tax situations are dealt with appropriately. Failure to exercise care in this calculation likely will result in an incorrect foreign tax credit claim that may be disallowed by the IRS on audit.
Mindy Tyson Weber is a senior director, Washington National Tax, for RSM US LLP.
For additional information about these items, contact Ms. Weber at 404-373-9605 or email@example.com.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.