Opinion ID: 548352
Heading Depth: 1
Heading Rank: 4

Heading: iran agreement

Text: 80 This final appeal presents the question of whether Gulf, as one of a particular group of oil companies, continued to hold an economic interest in Iranian oil and gas under a 1973 Agreement with Iran and the National Iranian Oil Co. (NIOC). Resolution of this question will determine whether, in tax year 1974, 34 Gulf can take a percentage depletion deduction under I.R.C. Sec. 611 on proceeds from Iranian oil sales, and whether, in tax year 1975, 35 Gulf can claim a foreign tax credit under I.R.C. Sec. 901 (rather than a deduction under I.R.C. Sec. 164) for Iranian income taxes paid during 1975. 36 The Commissioner appeals the Tax Court's decision reported in Gulf Oil Corp. v. Comm'r, 86 T.C. 115 (1986), that Gulf did possess an economic interest under the 1973 Agreement. 81 Whether Gulf possesses an economic interest under the 1973 Agreement is a question of law involving statutory construction and interpretation over which we exercise plenary review. We find that Gulf possessed an economic interest, as a matter of law, under the 1973 Agreement and we will thus affirm the Tax Court's decision. Consequently, the percentage depletion deduction under I.R.C. Sec. 611 in tax year 1974 and the foreign tax credit for Iranian income taxes paid under I.R.C. Sec. 901 in tax year 1975 are proper.
82 Iran became the sole owner of all its minerals and refineries when the Iranian oil industry was nationalized in 1951. National Iranian Oil Co. (NIOC) was organized at the time of nationalization to operate oil fields and refineries formerly run by Anglo-Iranian Oil Co., Ltd. (now known as the British Petroleum Co., Inc.). All NIOC shares were held by the Iranian government. Subsequently, Iran began negotiating with various oil company representatives to formulate a plan for resumption of the development and operations of the Abadan Refinery and the south Iranian oil fields. During this time, Iran mandated that all petroleum products produced in, or exported from, Iran were to be purchased from NIOC at the wellhead. Purchasers could then resell those products to affiliated and third-party customers. 83 A group of oil companies (the Consortium), including Gulf, entered into an agreement with Iran and NIOC on October 29, 1954 (the 1954 Agreement). The agreement consisted of two parts: Part I related to the Consortium's exploration, production, purchase and sale of Iranian crude oil, natural gas, and refined petroleum products; Part II comprised a final settlement between Iran and Anglo-Iranian Oil Co., Ltd. relating to outstanding claims between them resulting from the 1951 nationalization. Part I's stated objective was to provide for the effective marketing of these Iranian products, to be achieved through use of the capital, management and technical skills of the Consortium. The term of the agreement was twenty-five years, with the right to renew for three additional five-year periods. 37 84 Pursuant to the 1954 Agreement, the Consortium formed two Dutch operating companies to function in a defined area of southern Iran known as the agreement area. One company was to explore and produce the crude oil, natural gas, and petroleum products; the other to refine those products. The products were produced for Iran, the holder of legal title to the minerals in place since the 1951 nationalization. Although the operating companies had the right to explore, produce and refine, Iran and NIOC retained several rights, such as the right to audit the accounts of the operating companies, to obtain technical data and other information pertaining to operations under the agreement, and to inspect the operating companies' technical activities. 85 The 1954 Agreement permitted each Consortium member to designate one of its subsidiaries as a trading company (registered in Iran) which was required to purchase from NIOC and to resell in Iran for export. 38 With respect to crude oil, the trading companies were required to purchase all that the exploration and production company produced, other than that used in the company's operations and the amount required by NIOC to meet Iran's internal consumption. The amount of crude oil and natural gas to be produced by the operating companies, after an operational loss allowance, was that required by NIOC for Iranian internal consumption plus NIOC's optional crude oil amount as in-kind payment from the trading companies, 39 and that required by the trading companies for resale. Title to crude oil and natural gas purchased passed from Iran to the trading companies at the wellhead, as it had since the 1951 nationalization. The trading companies paid NIOC a fixed percentage 40 of the 1954 Agreement's posted prices for the crude oil and natural gas, then resold in Iran at prices which were also regulated by the agreement. In addition to these stated payments to NIOC by the trading companies, NIOC received a sufficient amount of crude oil and gas to satisfy Iranian internal consumption. The trading companies were required to pay Iranian income tax on their profits from resale in Iran, although deductions were permitted for operating costs, the purchase price paid to NIOC, and a discount. 86 Acting through NIOC, Iran retained ownership of all the assets, while the operating companies had the right to use all fixed assets and facilities within the agreement area. Nonetheless, the operating companies were obligated, over the term of the 1954 Agreement, to replace these assets at their own expense, and the trading companies provided the financing for any new or additional assets or facilities. In recognition of the commitment to replace these assets, a fixed assets charge was included in the operating costs for the first ten years of the agreement. When a new or additional asset or facility was built or purchased for NIOC's benefit, cost or book value amount reimbursement, through an additional inclusion in operating costs, was permitted over ten years. The trading companies were also required to pay the operating companies' exploration, development and working capital costs, service fees, and maintenance of the assets and facilities used for operations. NIOC was obligated to pay that portion of the operating costs attributable to production required for Iranian internal consumption. 87 On September 17, 1954, in response to a request by Gulf's trading company, the Internal Revenue Service issued a ruling (the 1954 Ruling) on the 1954 Agreement, stating that the arrangement had all the essential characteristics of a lease, 86 T.C. at 122, thereby creating an economic interest which would allow percentage depletion, and which would qualify the Iranian income taxes as creditable foreign income taxes. Prior to 1973 (when another sale and purchase agreement was entered into), parties to the 1954 Agreement amended that agreement four times; 41 however, the Consortium continued to operate using the same basic structure of the 1954 Agreement until 1973. 88 On July 19, 1973, 42 the Consortium entered into another sale and purchase agreement with Iran and NIOC (the 1973 Agreement). 43 3] The stated objective, taken from the preamble, was to develop and exploit Iran's hydrocarbon resources optimally, ensuring that Iran's crude oil and other products were accessible to consumers worldwide. The agreement stated Iran's determination that NIOC would exercise full and complete ownership, operation and control of the petroleum industry's mineral reserves, assets and administration. WHEREAS with a view to the full realization of the[se] objectives ..., the Parties ... agree that the general relationship of Iran/NIOC and the above mentioned oil companies shall be revised and adjusted as set forth in this Agreement;.... 86 T.C. at 123-124. The term of this agreement was twenty years. 44 As occurred under the 1951 nationalization, NIOC retained exclusive ownership of assets, facilities and reserves, and title to the crude oil and other petroleum products passed to each trading company at the wellhead. Consistent with the terms of the 1954 Agreement, the 1973 Agreement also required that each trading company pay Iranian income tax on its resale profits. 89 The trading company concept was continued under the 1973 Agreement, and the trading companies were still required to purchase from NIOC and to resell in Iran for export. The two operating companies, however, were dissolved. 45 Pursuant to the 1973 Agreement, the Consortium formed a new joint stock company which, under a five-year renewable service contract, was to explore, drill and produce in accordance with NIOC's directives. NIOC funded the new joint stock company, including all required operations capital; however, the trading companies were required to advance, annually, 40 percent of NIOC's annual budgeted capital expenditures for operations as a prepayment for crude oil purchases. Each annual prepayment was to be amortized over ten years, and then set off against crude oil payments due to NIOC. The 1973 Agreement also permitted a payment set off for the amount the operating companies had not yet recovered by prior operating cost adjustments for the cost or book value of assets used or under construction as of March 20, 1973. The trading companies recouped the prepayments and the balance of the operating companies' reimbursements through production purchases. 90 Under the 1973 Agreement, NIOC was entitled to an annual amount of crude oil to satisfy Iran's internal consumption requirements plus an amount for export. 46 By September 1 of each year, after allowing for NIOC's quantity entitlements, NIOC was to notify the trading companies of the amount of crude oil that would be available to them in the following year; and, by October 1, the trading companies set forth their requirements. If, after all the trading companies' nominations were in, any excess crude oil remained for the following year, that excess became available to NIOC for export. However, if NIOC had no need, the trading companies could then purchase the excess. Therefore, each year, NIOC was committed to produce a quantity of crude oil and other petroleum products that would satisfy its own entitlement plus the Consortium's final nominations. After actual production, if NIOC had underestimated the total amount available, the trading companies could revise their nominations up to the increased level of the actual production. If NIOC either had overestimated the total amount available or, by force majeure, could not produce the amount required for export, NIOC and the trading companies ratably reduced their available quantities. If the ratable reduction was insufficient, only the trading companies' available quantities were to be reduced. 91 The trading companies' crude oil purchase pricing under the 1973 Agreement was composed of four parts: crude oil operating costs, limited to NIOC's costs for extracting the crude oil; 12.5 percent of the applicable posted crude oil price (the stated payment); a balancing margin; 47 and, interest. The trading companies' crude oil resale pricing regulations corresponded with those under the 1954 Agreement. Natural gas purchases were handled differently under the 1973 Agreement. Trading companies were now obligated to purchase all natural gas NIOC did not require for internal consumption. None of the trading companies' required annual prepayments (40 percent of NIOC's annual budgeted capital expenditures for operations) was allocated to a natural gas prepayment. 92 Gulf did not request a new Internal Revenue Service ruling concerning its economic interest status under the 1973 Agreement. However, the Internal Revenue Service did issue a ruling (the 1980 Ruling) on the 1973 Agreement on May 15, 1980, pursuant to another Consortium member's request. The 1980 Ruling indicated that the oil companies possessed nothing more than an economic advantage under the agreement; they did not hold an economic interest. Therefore, percentage depletion deductions and foreign tax credits would no longer be available. 93 In tax year 1974, Gulf reported a percentage depletion deduction under I.R.C. Sec. 611 of $121,641,999 for depletion of hydrocarbons in Iran; in tax year 1975, Gulf reported an Iranian foreign income tax credit under I.R.C. Sec. 901(f) of $320,691,083. 48 The Commissioner fully disallowed both entries, contending that Gulf no longer held an economic interest in Iranian gas and oil in place under the new 1973 Agreement. However, of the foreign tax credit amount reported, the Commissioner did allow a deduction of $289,760,918, 49 rather than a tax credit. 50 Finally, the Commissioner added a $2,801,811 capital gain under I.R.C. Sec. 1231, determined to be realized and reportable (pursuant to I.R.C. Secs. 451 and 1231) in tax year 1975 as a result of credits Iran gave to Consortium members for fixed assets under Article 10 of the 1973 Agreement. 51 The Tax Court disagreed with the Commissioner, finding that Gulf had demonstrated that it had made and was continuing to make investments in the production of the minerals, which investments could be recovered solely by means of production of those minerals. 86 T.C. at 136. Therefore, Gulf continued to possess an economic interest, not merely an economic advantage, in the Iranian minerals in place after execution of the 1973 Agreement. The Commissioner appeals from this decision. 94 We turn to the dispositive legal question of whether Gulf possesses an economic interest under the 1973 Agreement. Only the owner of an economic interest in a depletable resource may take annual depletion deductions. Treas.Reg. Sec. 1.611-1(b). With respect to foreign tax credits, a United States citizen or corporation is allowed a credit under I.R.C. Sec. 901(a) for income taxes paid or accrued during the taxable year to any foreign country or United States possession. I.R.C. Sec. 901(b)(1). Nonetheless, income taxes paid or accrued during the taxable year to any foreign country in connection with the purchase and sale of oil and gas extracted in that country are not to be considered as tax for purposes of I.R.C. Sec. 901 if (1) the taxpayer has no economic interest in the oil or gas to which I.R.C. Sec. 611(a) applies, and (2) either the purchase or sale is at a price which differs from the fair market value for such oil or gas at the time of such purchase or sale. 52 I.R.C. Sec. 901(f). 95 Thus, if Gulf does not possess an economic interest under the 1973 Agreement, its tax implications are twofold. First, Gulf will not receive the benefit of a percentage depletion deduction for tax year 1974 under I.R.C. Sec. 611. Second, Gulf will not receive the benefit of a foreign tax credit under I.R.C. Sec. 901 for the Iranian income taxes paid in 1975; rather, those income taxes will have to be reported as a deduction under I.R.C. Sec. 164. 96
97 The test for the recognition of an economic interest was stated by the U.S. Supreme Court in Palmer v. Bender, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489 (1933): an economic interest exists where a taxpayer has acquired, by investment, any interest in the oil in place, and secures, by any form of legal relationship, income derived from the extraction of the oil, to which he must look for a return of his capital. Id. at 557, 53 S.Ct. at 226; see also Treas.Reg. Sec. 1.611-1(b). The Commissioner contends that under the 1973 agreement, Gulf's interest fails both prongs of the Palmer test. 98 The first prong has proven difficult for the courts to apply. As the Tax Court here recognized, the meaning of economic interest is vague. Many courts have found it difficult to single out one recurring factor that clearly indicates such ownership. Tidewater Oil Co. v. United States, 339 F.2d 633, 637, 168 Ct.Cl. 457 (1964). There is clearly no requirement that a holder of an economic interest must possess legal title, for an economic interest and a legal interest are two separate entities. Economic interest does not mean title to the oil in place but the possibility of profit from that economic interest dependent solely upon the extraction and sale of the oil. Kirby Petroleum Co. v. Comm'r, 326 U.S. 599, 604, 66 S.Ct. 409, 411, 90 L.Ed. 343 (1946). 99 In Palmer v. Bender, the Supreme Court stated that 100 the lessor's right to a depletion allowance does not depend upon his retention of ownership or any other particular form of legal interest in the mineral content of the land. It is enough, by virtue of the leasing transaction, he has retained a right to share in the oil produced. 101 287 U.S. at 557, 53 S.Ct. at 227 (emphasis added); see also Thomas v. Perkins, 301 U.S. 655, 661, 57 S.Ct. 911, 913, 81 L.Ed. 1324 (1937). Therefore, the fact that Iran holds legal title, as it has since the 1951 nationalization, is not determinative of whether Gulf possesses an economic interest under the 1973 Agreement. See Comm'r v. Southwest Exploration Co., 350 U.S. 308, 76 S.Ct. 395, 100 L.Ed. 347 (1956) (tax law deals in economic realities, not legal abstractions). 102 The Supreme Court has proposed several factors to consider in determining whether an economic interest in minerals in place exists. Paragon Jewel Coal Co. v. Comm'r, 380 U.S. 624, 633-34, 85 S.Ct. 1207, 1211-12, 14 L.Ed.2d 116 (1965); Parsons v. Smith, 359 U.S. 215, 225, 79 S.Ct. 656, 663, 3 L.Ed.2d 747 (1959). See also Costantino v. Comm'r, 445 F.2d 405, 409 (3d Cir.1971). More recently, in Freede v. Comm'r, 864 F.2d 671, 674 (10th Cir.1988), cert. denied, 110 S.Ct. 52, 107 L.Ed.2d 21 (1989), the Court of Appeals for the Tenth Circuit discussed five different factors to be considered. 53 See also Tidewater Oil Co., 339 F.2d at 637. All of the factors enumerated by the courts are simply considerations that we may examine in determining the existence of an economic interest in the particular case before us. Indeed, the Supreme Court has recognized the problems that arise in applying these stated principles to the peculiar circumstances of each case. Paragon Jewel Coal Co., 380 U.S. at 627, 85 S.Ct. at 1208. 103 In the past, we have utilized the Paragon Jewel Coal factors in determining whether an economic interest exists, noting that perhaps the most important factor to consider is whether, under the contract, the taxpayer has the right to exhaust the mineral deposit to completion or whether, through a contract provision which empowers the owner to terminate the contract at will, the taxpayer is subject to the owner's will. Whitmer v. Comm'r, 443 F.2d 170, 173 (3d Cir.1971); see also Costantino, 445 F.2d at 409. 104 In determining that certain miners did not possess an economic interest in coal in place, the Court in Paragon Jewel noted that (1) the miners' investments were in movable equipment rather than in the coal in place; (2) their equipment investments could be recovered through depreciation rather than by depletion; (3) the contracts between the miners and the landowners were completely terminable without cause on short notice; (4) the landowners retained all the capital interest in the coal in place, rather than surrendering any portion to the miners; (5) the landowners owned the coal at all times, even after it was mined, precluding the miners from selling or keeping any of it; (6) the landowners retained all proceeds from the sale of the coal; and, (7) the miners could look only to the landowners for all sums due under their contracts. Paragon Jewel Coal Co. v. Comm'r, 380 U.S. at 633-34, 85 S.Ct. at 1211-12, citing Parsons v. Smith, 359 U.S. at 225, 79 S.Ct. at 663. 105 Applying the Paragon Jewel Coal factors to the circumstances of this case, we conclude that Gulf has an economic interest in the Iranian hydrocarbons under the 1973 Agreement. The Consortium members invested substantial capital, under the 1954 Agreement, in Iranian plant assets and facilities which, at the time of the 1973 Agreement, the members had not fully recovered. Some of these assets (e.g., buildings) were obviously not movable. Because Iran held legal title to all assets since the 1951 nationalization, Gulf could not have depreciated any of those assets to recoup the invested capital. 54 Also, other than Iran and NIOC, the Consortium held the exclusive right, through the trading companies, to sell the minerals, thereby demonstrating that it clearly retained a right to share in the oil produced. See Palmer, 287 U.S. at 557, 53 S.Ct. at 226. Finally, with regard to the contract being terminable at will, the 1973 Agreement was a long term contract (with a term of twenty years), rather than one terminable at will by Iran or NIOC without cause on short notice. 106 We are unpersuaded by the Commissioner's assertion that Gulf possesses merely an economic advantage under Helvering v. Bankline Oil Co., 303 U.S. 362, 367-68, 58 S.Ct. 616, 618, 82 L.Ed. 897 (1938). We agree that where a taxpayer merely processes the mineral and is not engaged in production, that taxpayer may have an economic advantage from production, but has no economic interest in the mineral in place. Bankline Oil Co., 303 U.S. at 367-68, 58 S.Ct. at 618. As well, where a taxpayer has no capital investment in the mineral deposit, a mere economic advantage derived from production through a contractual relation to the owner does not constitute an economic interest. Bankline Oil Co., 303 U.S. at 367, 58 S.Ct. at 618; see also Treas.Reg. Sec. 1.611-1(b)(1). Here, however, Gulf and the other members of the Consortium have, in fact, made capital investments in Iranian plant assets and facilities that were still not recovered. Moreover, the Tax Court found that Gulf had made, and was continuing to make, investments in the production of the minerals. 86 T.C. at 136. 107 The second prong of the Palmer test, that the return on the investment must be realized solely from the extraction of minerals, has been interpreted to mean that the taxpayer must look solely to the extraction of oil or gas for a return of his capital. Southwest Exploration Co., 350 U.S. at 314, 76 S.Ct. at 399. In allowing depletion deductions, for which possession of an economic interest is a requisite, Congress was trying to encourage mineral discovery and development. Tidewater Oil Co., 339 F.2d at 637. Depletion allowances are based on the theory that the extraction of minerals gradually exhausts the capital investment in the mineral deposit.... [The allowance] is designed to permit a recoupment of the owner's capital investment in the minerals so that when the minerals are exhausted, the owner's capital is not impaired.... Southwest Exploration Co., 350 U.S. at 312, 76 S.Ct. at 397-98. The test for the right to depletion is whether the taxpayer has a capital investment in the oil in place which is necessarily reduced as the oil is extracted. Kirby Petroleum Co., 326 U.S. at 603, 66 S.Ct. at 411. The investment test requires only an economic commitment to look to production of the mineral for income. Southwest Exploration Co., 350 U.S. at 316, 76 S.Ct. at 399. 108 We begin our analysis of the second prong with the specific term of the 1954 Agreement, under which Consortium members were operators or producers, which the 1954 Internal Revenue Ruling characterized as the equivalent of a lease. The Commissioner claims that under the 1973 Agreement the Consortium's role was changed substantially and they became merely purchasers. The Commissioner asserts that Gulf's profits were derived from the purchase (at the wellhead) and resale of the oil, rather than from the extraction and sale of the oil. We note, however, that the 1973 Agreement provided for recoupment of capital investments by set off, over time, in the trading companies' purchase prices from NIOC. Thus, there was capital invested prior to the 1973 Agreement which had not been recovered and could only be recovered through the profits made by way of purchase at the wellhead, which depended on extraction of the oil. Clearly, Gulf had an economic commitment to look to the production of oil for a return on its investment. See Southwest Exploration Co., 350 U.S. at 316, 76 S.Ct. at 399. 109 Further, the Commissioner argues that it was by no means clear that production, followed by the trading companies' purchases and subsequent resales of oil, was the only means by which the Consortium members could recover their investment. Yet the Tax Court found that the 1973 Agreement established no other method for the Consortium members to recover their investments, 86 T.C. at 136, and we reach the same conclusion. 110 Finally, we turn to the Commissioner's challenge of the Tax Court's finding that the 1973 Agreement merely revised and adjusted the 1954 Agreement. We have reached our conclusion that Gulf held an economic interest in the Iranian gas and oil deposits under the 1973 Agreement independent of this finding. Thus, we need not review the Commissioner's contention that the Tax Court erred by determining that Gulf possessed an economic interest because the 1973 Agreement was a modification and extension of the 1954 Agreement.
111 We conclude that Gulf possesses an economic interest in Iranian oil and gas deposits under the 1973 Agreement. Gulf is therefore entitled to a depletion deduction for tax year 1974 and a foreign tax credit for tax year 1975.