The Tax Court held that a U.K. limited liability company's charter income from decommissioning oil and gas wells and removing debris on the U.S. outer continental shelf (OCS) was effectively connected income (ECI) and subject to U.S. income tax based on Sec. 638 and the U.S.—U.K. tax treaty.
Facts: Oil and gas companies that work on mining activities in the Gulf of Mexico are subject to decommissioning requirements by the U.S. Department of the Interior. These obligations include the removal of all mining structures, including excavating around damaged rigs, severing metal components from toppled platforms, plugging abandoned wells, and removing metal debris from the seabed upon the termination of each lease.
In 2009, EPIC Diving & Marine Services LLC (EPIC) won a bid to decommission oil and gas wells in the Gulf of Mexico on the OCS. The OCS is all submerged land, subsoil, and seabed that belongs to the United States. In the Gulf of Mexico, the OCS extends up to 200 nautical miles from the U.S. coastline. Because EPIC did not have the proper marine vessel to do the job, it leased the M.V. Adams Challenge (Challenge Vessel) with its crew from Adams Challenge Ltd. (Adams Challenge), a U.K. company. Adams Challenge consisted solely of the Challenge Vessel, which was its only income-producing asset. The Challenge Vessel was equipped with state-of-the-art specialized systems to decommission the oil and gas wells in the Gulf of Mexico. EPIC used the Challenge Vessel from 2009 to 2011 on 11 decommissioning projects.
Issues: Adams Challenge did not file U.S. federal tax returns for 2009 and 2010 and filed a delinquent 2011 Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, in 2013, in which it reported ECI of $2,736,450 and taxable income of $369,821. In 2014, the IRS sent Adams Challenge a notice of deficiency for tax years 2009—2011. For 2009, the IRS determined that Adams Challenge had ECI of $13,595,167, and for 2010, in an amended pleading, the IRS determined that the company's ECI was $21,380,541. For 2011, the IRS concluded that Adams Challenge had underreported ECI by $9,897,975.
Sec. 7701(a)(9) defines the United States as "only the States and the District of Columbia." However, Sec. 638, added in 1969, expands the definition of the United States to include the OCS but only "with respect to mines, oil and gas wells, and other natural deposits." Regs. Sec. 1.638-1(c)(4) further specifies that "[p]ersons, property, or activities are within the United States ... only to the extent such persons, property, or activities are engaged in or related to the exploration for, or the exploitation of, mines, oil and gas wells, or other natural deposits."
Adams Challenge gave seven arguments for the Tax Court to examine. The first three arguments related to Sec. 638. Adams Challenge argued that:
- Its work of decommissioning oil and gas wells and removing debris did not constitute exploitation because all wells on which the Challenge Vessel worked had either never produced or had ceased production several years previously.
- Sec. 638(1) defines the United States to include only "the seabed and subsoil" of the OCS, and thus activities on the water's surface are not covered by the statute.
- The income in question was not Subpart F income as defined in the Internal Revenue Code. Adams Challenge cited Ocean Drilling & Exploration Co., 988 F.2d 1135 (Fed. Cir. 1993), in which the Federal Circuit resolved that insuring a drilling platform did not constitute Subpart F income in the United States and thus is not ECI, based on the definition that the United States includes only the 50 states and the District of Columbia.
The next four arguments looked to the U.S.—U.K. income tax treaty, especially Article 21, "Offshore Exploration and Exploitation Activities." Adams Challenge argued that:
- The treaty language that refers to activities "in connection with" exploration or exploitation is narrower than the language in Regs. Sec. 1.638-1, which refers to activities "related to" exploration or exploitation. Adams Challenge could not cite any U.S. tax authority or case law to support this argument, only a very selective reading of Black's Law Dictionary.
- The treaty covers only "drilling activity," specifically, the Senate Foreign Relations Committee's report on the Third Protocol to the 1975 U.S.—U.K. treaty. The provision stated that the treaty was only supposed to cover "the activities of certain U.S. independent drilling contractors" in the U.K. sector of the North Sea and the OCS.
- Its income from chartering the Challenge Vessel was "shipping income," and under treaty Article 8(1), "[p]rofits of an enterprise of a Contracting State from the operation of ships or aircraft in international traffic shall be taxable only in that State." Therefore, any income earned from chartering the Challenge Vessel would be taxable only in the U.K.
- If the Tax Court ruled that Adams Challenge did have a U.S. permanent establishment, then it should be charged only on the percentage of time that the vessel spent at the decommissioning sites.
Holding: The Tax Court rejected all of Adams Challenge's arguments and contentions, holding that:
- Exploitation includes pre-production, production, and post-production activities, and the latter includes decommissioning of oil and gas wells and removing debris. The court cited Shell Oil Co., 952 F.2d 885, 890 (5th Cir. 1992).
- Sec. 638 does cover activity on the water's surface. Regs. Sec. 1.638-1 gives specific examples of how activities above the water's surface still can be related to the exploitation of oil mines and wells.
- Sec. 638 expanded the definition of what was considered "in the United States" to include the OCS and that Adams Challenge's charter income from activities on the OCS was Subpart F income.
- The treaty language "in connection with" the exploitation of oil mines and wells is not narrower than the phrase "related to" used in Regs. Sec. 1.638-1. The treaty states, "When determining the application of U.S. tax, the Treaty provides that any term not defined therein shall have the meaning it has under U.S. law, particularly under U.S. tax law" (Art. 3(2)).
- The treaty does not apply only to drilling activity. Treasury's technical explanation of the treaty states that exploration and exploitation activities "include, but are not limited to, the exploration for and extraction of oil, minerals, and natural gas," the court noted (emphasis added by the court).
- The charter income from the vessel should not be categorized as shipping income under the treaty.
- Adams Challenge was deemed to have a U.S. permanent establishment because its activities were carried on offshore "in connection with the ... exploitation ... of the sea bed and sub-soil and their natural resources" under Article 21. Also, the court ruled that all the Challenge Vessel's activities were inseparable components of its duties under its contract with EPIC and in support of its mission. As such, all the activities were "related to," and were carried out "in connection with," the exploitation of oil and gas wells on the OCS, and all of Adams Challenge's activities on the OCS were subject to U.S. income tax.
- Adams Challenge (UK) Ltd., 154 T.C. No. 3 (1/8/20)
— By Richard Seo, CPA, and David R. Silversmith, CPA, CFP, CFE, partner and tax manager, respectively, at Crowe LLP in New York.