On January 8 2020, the US Tax Court released an opinion in Adams Challenge (UK) Ltd. v. Commissioner granting summary judgment to the IRS on the taxability of income from a vessel charter on the US Outer Continental Shelf (OCS). Establishing that activities connected with decommissioning oil and gas wells on the OCS are taxable as income effectively connected with the conduct of a trade or business within the US (effectively connected income), the opinion has important implications for taxpayers performing services on the OCS.
The taxpayer, a UK affiliate of offshore support and vessel management firm Adams Offshore WLL, owned a multipurpose support vessel, which it chartered to a client to perform decommissioning work on the OCS in the Gulf of Mexico. The vessel was chartered with a crew, but the crew members were not employees of the taxpayer; instead, the crew members were employees of an affiliate of the taxpayer. The decommissioning work related specifically to shuttered wells that had suffered hurricane damage and were not actively producing oil or gas. The taxpayer did not file timely US tax returns for 2009 or 2010, but did file a return for 2011; on audit, the IRS determined that the taxpayer had effectively connected income for all three years, and that the taxpayer’s 2011 income was underreported.
Effectively connected income includes income from sources within the US, which in turn includes compensation for labour performed in the US and income from leasing property located within the US. At issue in the case was the geographical definition of the “United States” under section 638. Although the OCS is not normally considered part of the US for tax purposes, Treas. Reg. § 1.638-1(c)(4) includes it with respect to activities “related to the exploration for, or the exploitation of, mines, oil and gas wells, or other natural deposits.”
Concluding that decommissioning was a mandatory and integral part of exploitation activity, the Tax Court held that the taxpayer’s income was related to the exploitation of oil and gas wells, and thus was effectively connected income from within the US. The court further held that the US-UK tax treaty, which applied to the case, did not change this result, as the Offshore Exploration and Exploitation Activities article of the treaty provided that the taxpayer had a permanent establishment in the US as a result of its activity on the OCS. The Tax Court’s holding gives an expansive reading to the “exploitation” requirement that encompasses both pre- and post-production activities, even where (as here) some of the wells subject to decommissioning never actually produced oil or gas. Companies operating on the OCS should carefully consider the implications of this broader definition for their own activities.
A key consideration which was not addressed in this opinion, and which thus remains to be considered, is the availability of deductions. Where, as here, a taxpayer fails to file a US tax return in the mistaken belief that it is not subject to taxation in the US, section 882(c)(2) provides that it shall not receive the benefit of any deductions or credits that would offset its effectively connected income -- i.e., it is subject to taxation on a gross basis. The Third Circuit has held in Swallows Holding, Ltd. v. Commissioner that deductions and credits are available only where the taxpayer’s US return was timely filed, preventing the taxpayer from waiting for an IRS challenge before filing. While the US-UK treaty provides that deductions should be available to offset permanent establishment income, the interaction of section 882(c)(2) with tax treaties has not been clearly established. As the Adams Challenge case proceeds, this will likely be an issue of great interest.
To guard against the loss of deductions and credits, regulations under section 882 permit foreign taxpayers to timely file protective US returns, which will prevent the taxpayer from being taxed on a gross basis in the event the IRS determines that the taxpayer does have effectively connected income. The consequences of failing to file a protective return can be disastrous, as in InverWorld, Inc. v. Commissioner, where the taxpayer was essentially subject to US tax twice on the same income. While the precise contours of section 638 as applied to activities adjacent to core oil and gas exploration and exploitation remain hazy, companies who suspect, based on the broad reading given to this provision in Adams Challenge, that they may have US effectively connected income should take care to timely file protective returns.
Mark Martin
T: +1 713 319 3976
Thomas Bettge
T: +1 713 319 2173
