ALERT: Contacts for this Directives has been updated. Questions about this directive should be directed to FTC Management (IBC) PN, Cindy Kim or DCE PN, Louis Elizondo at or Petroleum Industry, Robert McCann. DEPARTMENT OF THE TREASURY INTERNAL REVENUE SERVICE WASHINGTON, D.C. 20224 Large and Mid-Size Business Division October 12, 2004 MEMORANDUM FOR INDUSTRY DIRECTORS, LMSB DIRECTOR, FIELD SPECIALISTS, LMSB DIRECTOR, PREFILING AND TECHNICAL GUIDANCE, LMSB DIRECTOR, COMPLIANCE, SBSE DIRECTOR, INTERNATIONAL DIRECTOR, TEGE FROM: Bobby E. Scott /s/ Bobby E. Scott Industry Director Natural Resources and Construction SUBJECT: Field Directive on IRC § 907 Evaluating Taxpayer Methods of Determining Foreign Oil and Gas Extraction Income (FOGEI) and Foreign Oil Related Income (FORI) INTRODUCTION This memorandum is intended to provide direction to effectively utilize resources in evaluating taxpayer methods of determining under IRC § 907 foreign oil and gas extraction income (FOGEI) and foreign oil related income (FORI). This LMSB Directive is not an official pronouncement of the law or the Service's position and cannot be used, cited, or relied upon as such. BACKGROUND IRC § 907 was enacted in 1975 and final regulations, effective for taxable years beginning after December 31, 1982, were issued in 1991. The Code section limits the creditable foreign taxes assessed on FOGEI to the maximum US tax rate. The basic premise of the statute is to prevent excess foreign tax credits, available because of the very high taxes imposed on FOGEI by producing countries, from offsetting US tax on other foreign source income. The Code section also limits, in more restricted situations, the creditability of foreign taxes imposed on FORI, which encompasses activities downstream from the well, including transportation of the crude oil and gas from the well to the place of sale and processing of the oil and gas. FOGEI is defined in the Code and regulations as taxable income derived from the extraction of minerals from oil or gas wells based on the fair market value (FMV) of the minerals in the immediate vicinity of the well. The regulations under IRC § 907 do not provide specific methods for determining FMV in the immediate vicinity of the well but provide that all the facts and circumstances that exist in the particular case must be considered. The purpose of the flexible fair market value provision is to allow the oil and gas extractor to split the income from the sale of foreign produced minerals between FOGEI and FORI in a reasonable manner. While similar fact patterns should produce similar results, since determination of FOGEI (and FORI) is highly factual, there has been little consistency in either the determination of FOGEI by the industry or in examinations by the IRS of the taxpayers' determination. In order to improve consistency and reduce the administrative burden on both taxpayers and the IRS, this LMSB Directive provides guidance to international examiners (IEs) and specialists on the application of the most two commonly used methods for determining FOGEI (and FORI) when there is no ascertainable market price for the oil and gas in the immediate vicinity of the well. Discussion Methods for Determining FMV in the Immediate Vicinity of the Well Most taxpayers use either a residual (rate of return) method or a proportionate profits method to determine FOGEI. Both of those methods, as well as other methods, are acceptable when applied reasonably and in a manner consistent with the regulations. For example, when comparable costs of transportation or processing are available, taxpayers and IEs may be able to estimate the value of FOGEI through netback adjustments to the sales price of the oil or gas. However, this LMSB Directive focuses on issues related to the more commonly used residual (or rate of return) method and the proportionate profits method. 1. Residual (Rate of Return) Method. FOGEI is determined under the residual (rate of return) method by first calculating FORI and subtracting FORI from the total income from the production and sale of the oil or gas product. A taxpayer determines FORI by applying an assumed after-tax rate of return to the cost of its fixed FORI assets. Because income from the production and sale of oil and gas product is equal to the sum of FOGEI and FORI, once the total income and FORI are established, FOGEI can then be determined by subtracting FORI from total income. In order to apply this method, taxpayers and IEs must: Identify which assets are used in FORI activities; Identify the cost of the assets used in FORI activities; Determine appropriate rates of return for FORI assets; Determine total income from the production and sale of the oil and gas product; and Separately identify FOGEI assets and determine the cost of FOGEI assets in order to test the FORI determination. In most cases, IEs should request a petroleum engineer to evaluate a taxpayer's classification of assets, rate of return assumptions, and calculations. In some cases, an economist may be needed to assist. In all cases, the IE should estimate the tax effect of potential changes before expanding the examination time to permit consultation with engineers and economists. The International Foreign Tax Credit Technical Advisor and the Petroleum Industry Program (PIP) will gather industry data to advise on reasonable rates of return so as to further conserve examination resources. 2. Proportionate Profits Method. FOGEI is determined under the proportionate profits method by allocating total income from the production and sale of the oil or gas product between FOGEI and FORI based on the relative costs of the FOGEI and FORI activities. The proportionate profits method is similar in concept to the proportionate profits method used in Treas. Reg. §1.613-4(d)(4) to determine gross income from mining of hard minerals for purposes of determining allowable percentage depletion. There the formula is: mining costs/total costs x gross sales = gross income from mining non-mining costs/total costs x gross sales = gross income from non-mining The regulations under section 613 require that gross sales represent the sales of the first marketable product and that such sales must be reasonable and representative. Calculations are based on net historic cost. The rate of return is not applicable. These concepts apply as well to the FOGEI determination. However, just as with the residual (or rate of return) method examiners must distinguish which costs are classified as FOGEI and which are classified as FORI. This is necessary since FOGEI would be determined under these formulas by substituting FOGEI costs in the numerator of the first formula, the mining or extraction activity, and FORI would be determined by substituting FORI costs in the numerator of the second formula, the non-mining or non-extraction activity. In applying these formulas to determine FOGEI, gross sales would be the sales of the extracted oil or gas product. Classification of Assets as FOGEI and FORI Assets Based on a review of applicable statutes and regulations (see Attachment 1), certain assets used with respect to producing wells and converting raw well effluent into marketable crude oil and natural gas should be classified as FOGEI assets. Examples of FOGEI assets include: Wells, wellheads, and pumping equipment; Flowlines (see Attachment 1), headers, and manifolds; Desilters and other vessels to remove solid contaminants; In the case of oil production, slug catchers, separators, treaters, emulsion breakers, and stock tanks needed to obtain marketable crude oil; In the case of gas production, primary separation and dehydration equipment needed to arrive at a gaseous stream in which natural gas, condensate, and other hydrocarbons can be recovered; Equipment needed to produce, transport, and inject fluids and gasses into the wells or reservoir; Lines that interconnect above-listed equipment (see Attachment 1); Instrumentation, metering, safety, control, utility, power and other infrastructure-type equipment to provide for operation of the above; and Structures to physically support the above equipment, such as offshore platforms. Examples of FORI assets include: In the case of gas production, lease equipment beyond the primary separator and dehydrator to recover natural gas, condensate, and other hydrocarbons; Lines that carry natural gas beyond the primary separator and dehydration equipment and towards its sales point, as well as, compressors needed to transport natural gas through these lines; Lines that carry marketable crude oil from the premises, as well as, pumps needed to transport crude oil through these lines; and Assets used to process crude oil and natural gas. Taxpayers may allocate assets that support both FOGEI and FORI activities by any reasonable method. Examples of reasonable methods of allocation include the following: A compressor that is used to send natural gas to market (a FORI activity) and also to a reservoir for pressure maintenance (a FOGEI activity, see Attachment 1) may be allocated based on relative throughput; and An offshore platform that supports both primary separation of gases and liquids (a FOGEI activity) and the recovery of condensate from natural gas (a FORI activity, see Attachment 1) can be allocated based on relative space or weight. Most of the disagreements regarding classification of assets between FOGEI and FORI involve transportation and processing assets. Attachment 1 provides a more detailed discussion of the classification of those assets as FOGEI or FORI based on definitions provided in the regulations and on common usage of terms within the oil and gas industry. ATTACHMENT Attachment 1: Discussion of Classification of Assets as FOGEI or FORI Meaning of Extraction for IRC § 907 and the regulations: A key to interpreting the IRC § 907 regulations is to understand the full meaning of certain terms and phrases: FOGEI. Defined at Treas. Reg. §1.907(c)-1(b)(1) as: [T]axable income (or loss) derived from sources outside the United States and its possessions from the extraction (by the taxpayer or any other person) of minerals from oil or gas wells located outside the United States and its possessions or from the sale or exchange of assets used by the taxpayer in the trade or business of extracting those minerals. Amount of FOGEI. Defined at Treas. Reg. §1.907(c)-1(b)(2) as: The gross income from extraction is determined by reference to the fair market value of the minerals in the immediate vicinity of the well. Minerals. Defined at Treas. Reg. §1.907(c)-1(f)(1) as: The term "minerals" means hydrocarbon minerals extracted from oil and gas wells, including crude oil or natural gas (as defined in section 613A (e)). The term includes incidental impurities from these wells, such as sulphur, nitrogen, or helium. The term does not include hydrocarbon minerals derived from shale oil or tar sands. Crude oil and natural gas. IRC § 613A(e) and the underlying regulations provide the following definitions: IRC § 613A(e)(1) Crude oil. The term "crude oil" includes a natural gas liquid recovered from a gas well in lease separators or field facilities. Treas. Reg. §1.613A-7(g) Crude oil. For purposes of IRC § 613A and the regulations under that section, the term "crude oil" means-- A mixture of hydrocarbons which existed in the liquid phase in natural underground reservoirs and which remains liquid at atmospheric pressure after passing through surface separating facilities, Hydrocarbons which existed in the gaseous phase in natural underground reservoirs but which are liquid at atmospheric pressure after being recovered from oil well (casing head) gas in lease separators, and Natural gas liquid recovered from gas well effluent in lease separators or field facilities before any conversion process has been applied to such production. IRC § 613A(e)(2) Natural gas. The term "natural gas" means any product (other than crude oil) of an oil or gas well if a deduction for depletion is allowable under section 611 with respect to such product. Treas. Reg. §1.613A-7(b) Natural gas. The term "natural gas" means any product (other than crude oil as defined in Treas. Reg. §1.613A-7(g)) of an oil or gas well if a deduction for depletion is allowable under IRC § 611 with respect to such product. Immediate vicinity of the well. Not defined in IRC § 907 or the regulations under that section. However, the term has been used for many decades for determining gross depletable income for purposes of depletion: Treas. Reg. §1.613-3 Gross income from the property--Oil and gas wells. In the case of oil and gas wells, "gross income from the property", as used in IRC § 613(c)(1), means the amount for which the taxpayer sells the oil or gas in the immediate vicinity of the well. If the oil or gas is not sold on the premises but is manufactured or converted into a refined product prior to sale, or is transported from the premises prior to sale, the gross income from the property shall be assumed to be equivalent to the representative market or field price of the oil or gas before conversion or transportation. The term "immediate vicinity of the well" would have a meaning for IRC § 907 that is substantially identical to the meaning for depletion. Accordingly, FOGEI is the value of minerals at the bounds of the premises. The IRC § 907 regulations support this conclusion: Under Treas. Reg. §1.907(c)-1(b)(6), the facts and circumstances that may be taken into account in determining the fair market value of oil or gas in the immediate vicinity of the well include the facts and circumstances pertaining to any difference in the producing country between the field and port prices. Within the depletion regulations, the representative market and field price ("RMFP) must be determined when oil or gas is not sold in the immediate vicinity of the well. The RMFP is determined via a survey of representative wellhead sales of oil or gas as the case may be. Representative sales normally include sales after the above described tasks have been completed. The IRC § 907 regulations refer to the definition of crude oil from IRC § 613A (see above). The definition in Treas. Reg. §1.613A-7(g) refers to liquid hydrocarbons that have passed through lease and field separation facilities. For crude oil, Treas. Reg. §1.907(c)-1(d)(5) defines processing as the destructive distillation, or a process similar in effect to destructive distillation, of crude oil into its primary products including processes used to remove pollutants from crude oil. Treas. Reg. §1.907(c)-1(d)(4) defines primary product from oil as all products derived from the processing of crude oil, including volatile products, light oils (such as motor fuel and kerosene), distillates (such as naphtha), lubricating oils, greases and waxes, and residues (such as fuel oil). The processing of crude oil described in the IRC § 907 regulations does not take place on the premises, except in very rare situations. The field separation and treatment steps do not generally yield any of the primary products from oil described in Treas. Reg. §1.907(c)-1(d)(4). Treas. Reg. §1.907(c)-1(f)(6) also indicates that 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. [Emphasis added.] This is further indication that extraction and production are essentially synonymous. Meaning of Transportation: IRC § 907(c)(2) and Treas. Reg. §1.907(c)-1(a)(5) states that FOGEI does not include income to the extent attributable to marketing, distributing, processing or transporting minerals or primary products. Treas. Reg. §1.907(c)-1(d)(2) defines "transportation" as [C]arrying minerals or primary products between two places (including time or voyage charter hires) by any means of transportation, such as a vessel, pipeline, truck, railroad, or aircraft. Thus an extremely literal view of transportation would question the correctness of treating flowlines and interconnecting lines as FOGEI assets, as is done in the text of this LMSB Directive. However, these specific types of lines are carrying raw effluent to and through the field treatment facilities so that it can be converted to crude oil and natural gas. There are other situations where assets that are transporting minerals (especially natural gas) are properly classified as FOGEI assets. Piping natural gas to or within a producing field for the purpose of directly enhancing extraction of additional minerals from the wells is a prime example. The use of natural gas to directly enhance extraction activity can occur in several ways such as: To fuel the engines on oil well pumps, or to generate electricity for the same end purpose; For use in "gas-lift" operations where gas is injected into the production string of oil wells (not the reservoir) to lighten the fluid load and lift fluids towards the wellhead; and To be injected into the reservoir to increase pressure and drive fluids towards producing wells. This is similar to the process of water flooding. Meaning of Processing: At IRC § 907(c)(2)(A), processing is listed as a FORI activity and is defined at Treas. Reg. §1.907(c)-1(d)(4) as: [T]he destructive distillation, or a process similar in effect to destructive distillation, of crude oil and the processing of natural gas into their primary products including processes used to remove pollutants from crude oil or natural gas. The processing of crude oil into its primary products has been discussed earlier. For gas, the primary products are defined at Treas. Reg. §1.907(c)-1(d)(6) as: [A]ll gas and associated hydrocarbon components from gas wells or oil wells, whether recovered at the lease or upon further processing, including natural gas, condensates, liquefiable petroleum gases (such as ethane, propane, and butane), and liquid products (such as natural gasoline). As a result, an activity that normally occurs on the premises (i.e. the recovery of condensate "at the lease") is processing within the meaning of the IRC § 907 regulations so that any assets associated with that activity would be FORI assets.