16. Creditable Taxes on Oil Payments Where No Economic Interest Exists (sec. 1035(e) of the bill) Present law Under present law, as amended by the Tax Reduction Act of 1975, no foreign tax credit is allowable for payments to a foreign country in connection with the purchase and sale of oil or gas where the taxpayer has no economic interest in the oil or gas and either the purchase or the sale is at a price which differs from the fair market price of the oil or gas. This provision was intended to deny any foreign tax credit to oil companies with respect to oil or gas which is owned by the foreign government (e.g., oil which is described as nonequity oil or buyback oil) where payments for the purchase of the oil owned by the foreign country are disguised in part as the payment of a tax. Issue The issue is whether taxpayers who have had an economic interest in foreign oil, but which have been forced into an altered arrangement so that they no longer have an economic interest in a particular oil field, should be subject to this provision without some provision for a transitional period. Explanation of provision This provision was suggested by Senator Hansen. The provision requires that section 901 (f) is not to apply with respect to the purchase and sale of oil or gas from a field if the taxpayer has had an economic interest in the oil in that field and if, on or before March 29, 1975, the taxpayer has made an investment with respect to the field. This will be the case notwithstanding the fact that the taxpayer purchases the oil or gas from that field at less than the fair market value, including a discount which reflects compensation for the prior investment, or sells at a price which differs from the fair market value for the oil or gas. However, section 901 (f) will apply in any case for taxable years beginning after 1985. The provision does not apply to any field with respect to which no investment was made on or before March 29, 1975, even if the field is located within the same concession area as another field which is subject to the exception added by this provision. These investments will be subject to the test of the oil or gas being bought and sold at an arm's-length price.' This provision will affect the U.S. oil companies operating abroad which have been subject to nationalization and which do not have substantial excess foreign tax credits from other foreign countries. It has been reported that this provision will benefit Mobil Oil Company and other major oil companies operating in Iran. Revenue effect. It is estimated that will result in a decrease in budget receipts of $34 million in fiscal year 1977 and of $40 million in each year thereafter through 1985. I 17. Foreign Tax Credits Arising Through Oil and Gas Production Sharing Contracts (sec. 1035(f) of the bill) Present law Under present law, a foreign tax credit is allowable only for income, war profits, and excess profits taxes paid or accrued to a foreign country or to a possession of the United States. Amounts paid to a foreign government or a possession in other forms (such as royalty payments for the rights to develop natural resources) are allowed only as a deduction, even if designated by the foreign country as a tax. The service is given authority to determine what payments qualify as income taxes and thus are allowed as credits rather than as deductions. Issues Questions have arisen as to whether payments to a foreign government qualify as income taxes in the case of production sharing contracts. Under these agreements the government retains ownership of the mineral property while the oil company provides the services of drilling and producing the oil. The oil company is generally compensated for its costs by receiving the first production from the property, with the remainder of the production divided between the oil company and the foreign government according to negotiated percentages. Under these agreements part of the share of the production received by the foreign government (or by a government-owned entity which in turns makes payments to the foreign government) is designated as an income tax payment by the foreign government and claimed as a credit by the oil company. The Internal Revenue Service recently issued Revenue Ruling 76215, 1976 I.R.B. No. 23, holding that the contractor under a production-sharing contract in Indonesia is not entitled to a foreign tax credit for payments made by the government-owned company to the foreign government. The grounds for this holding were, in part, that since the foreign government already owns all of the oil and gas, there is no payment to the government by the contractor. Furthermore, even if a payment by, or on behalf of, the contractor could be identified, the IRS views such a payment as more in the nature of a royalty than a tax. The issue is whether taxpayers should be allowed to continue to treat these payments as creditable taxes for a period of time while the production sharing arrangements with the Indonesian Government are renegotiated. Explanation of provision This provision was suggested by Senator Bentsen. The provision allows a limited foreign tax credit for a limited period in the case of production-sharing contracts to which Revenue Ruling 76-215 applies. Under this provision, amounts which are designated by a foreign government under certain production-sharing contracts as income taxes are treated as creditable income, war profits, and excess profits taxes even though the amounts would not otherwise be treated as creditable taxes. The provision only applies to taxes not creditable by reason of that ruling. However, the total amount treated as creditable taxes under this provision is not to exceed the lesser of two amounts. The first amount is the total foreign oil and gas extraction income with respect to production-sharing contracts covered under the rule multiplied by the U.S. corporate tax rate (generally 48 percent) less the otherwise allowable (if any) foreign tax credits attributable to income from those contracts. The second amount is the total foreign oil and gas extraction income multiplied by the U.S. corporate tax rate (generally 48 percent) less the total amount of the otherwise allowable foreign tax credits (if any) attributable to the total foreign oil and gas extraction income. This provision will apply only to production-sharing contracts entered into before April 8, 1976, and will apply only with respect to taxes designated as having been paid under such contracts before January 1, 1982. This provision affects Huffington Oil Company, Natomas Company, and a number of other small oil companies. Revenue effect It is estimated that this provision will decrease budget receipts by $23 million in fiscal year 1977 and $27 million in fiscal year 1978. 18. Source of Underwriting Income (sec. 1036 of the bill) Present law Under present law, the source of insurance underwriting income is unclear. Neither the Internal Revenue Code nor the Income Tax Regulations set forth a specific rule for determining the source of insurance underwriting income. It is the position of the Internal Revenue Service, however, that the source of such income is to be determined on the basis of where the incidents of the transaction which produce the income occur. Under this rule, income produced from insurance underwriting contracts negotiated and executed in the United States, regardless of the location of the insured risks, is generally deemed to be from sources within the United States. This rule apparently applies even though the insurance contract is actually written by a foreign company. Issue The source rule presently applied by the IRS to insurance underwriting income is vulnerable to artificial manipulation by taxpayers. By simply changing the place where a contract is negotiated and executed, a taxpayer can change the source of the underwriting income produced by the contract. That source rule in some situations also can result in double taxation. It is not uncommon for United States corporations doing business abroad through foreign subsidiaries to negotiate and execute insurance contracts in the United States which cover its overseas operations. The insurance policies, however, frequently must be issued in the foreign jurisdiction in which the insured's risk is located in order to comply with local insurance laws or for other business reasons. Although the underwriting income in these circumstances generally would be subject to foreign taxation, the income would be deemed United States source income, which in turn would reduce the amount of the foreign tax credit available to the taxpayer. The issue is whether, in place of the source rule applied by the IRS, a new source rule should be adopted under which the source of insurance underwriting income would be the location of the risk insured. Explanation of provision This provision was suggested by Senator Fannin. The provision establishes that the source of insurance underwriting income is to depend upon the location of the risk. Underwriting income derived from the insurance of U.S. risks would be income from sources within the United States. All other underwriting income would be considered income from sources without the United States. The new source rule is not intended to change existing law with respect to the determination of whether foreign source income is effectively connected with the conduct of a trade or business within the United States. This provision benefits the American International Group, Inc. 19. Third-tier Foreign Tax Credit Under Subpart F (sec. 1037 of the bill) Present law Under present law, when amounts which are foreign base company income are included in the income of a domestic corporation under subpart F, a proportionate part of the foreign taxes paid by the foreign corporation are deemed paid by the domestic corporation, and a foreign tax credit is available to the domestic corporation with respect to those taxes. These rules are substantially parallel to the foreign tax credit rules on actual distributions. However, this deemedpaid credit is available for subpart F income only if the controlled foreign corporation is a first-tier foreign corporation (which must be at least 10-percent owned by a domestic corporation) or a second-tier foreign corporation (which must be at least 50 percent owned by a firsttier foreign corporation). Issue The issue is whether the foreign tax credit rules with respect to amounts included in income under subpart F should be consistent with the rules applicable to dividends actually distributed. Explanation of provisions This suggestion was made by the staff in order to provide the same tax treatment under Subpart F as applies generally in the case of the foreign tax credit for third-tier subsidiaries. The provision makes two changes to the present rules for computing a foreign tax credit with respect to amounts included in income under subpart F. First, the amendment provides that the foreign tax credit is applicable with respect to foreign taxes paid by a third-tier foreign corporation whose undistributed income is taxed to the shareholder. Second, the amendment liberalizes the stock ownership test applicable to second-tier foreign corporations. Under the provision, a foreign corporation qualifies as a secondtier foreign corporation if at least 10 percent of its voting stock is owned by a first-tier foreign corporation, at least 10 percent of the voting stock of which must be owned by a domestic corporation. A foreign corporation qualifies as a third-tier foreign corporation if at least 10 percent of its voting stock is owned by a second-tier foreign corporation. This will affect any company with subpart F income which has a third-tier foreign subsidiary. Revenue effect This provision will reduce budget receipts by $4 million in fiscal year 1977, $10 million in fiscal year 1978, and $10 million in fiscal year 1981. 20. Bank Deposits in the United States of Nonresident Aliens and Foreign Corporations (sec. 1041 of the bill) Present law. Present law provides, in general, that interest, dividends and other similar types of income of a nonresident alien or a foreign corporation are generally subject to a 30-percent tax on the gross amount paid if such income or gain is not effectively connected with the conduct of a trade or business within the United States (secs. 871(a) and 881). However, a number of exemptions have been provided in the Code from this 30-percent tax on gross income including an exemption for interest derived from bank accounts. In addition, various income tax treaties of the United States provide for either an exemption or a reduced rate of tax for interest and dividends paid to foreign persons if the income is not effectively connected with the conduct of a trade or business within the United States. Issue The question is whether the present exemption for bank deposit interest which would otherwise expire at the end of the year should be made permanent. Explanation of provision This is a House provision which was not changed by the Senate Finance Committee. The provision continues the exemption in present law for interest on deposits with persons carrying on the banking business without any termination date. The present exemption for interest of deposits expires for interest paid after December 31, 1976. The provision makes the exemption for interest on deposits permanent by eliminating the language of present law which would terminate the provision for interest paid after December 31, 1976. This affects many banks, particularly those located near a U.S. border and those with significant international business. Revenue effect It is estimated that this provision will reduce budget receipts by $55 million in fiscal year 1977, $115 million in fiscal year 1978, and $145 million in fiscal year 1981. 21. Sales or Exchanges Giving Rise to Dividends (sec. 1042 of the bill) Present law Under present law, a distribution by a foreign corporation of appreciated property is treated in the same manner that similar distributions from a domestic corporation to an individual shareholder are treated. That is, the shareholder is treated as having received a dividend equal to the fair market value of the property and the distributing corporation reduces earnings and profits by the basis of the property distrib |