CHAPTER 10 U.S. TAX CONSIDERATIONS RELATING TO A DECISION TO UNDERTAKE A MINERAL EXPLORATION AND DEVELOPMENT PROGRAM IN A FOREIGN COUNTRY

• Jurisdiction: United States

International Minerals Acquisition and Operations
(Oct-Nov 1974)
CHAPTER 10
U.S. TAX CONSIDERATIONS RELATING TO A DECISION TO UNDERTAKE A MINERAL EXPLORATION AND DEVELOPMENT PROGRAM IN A FOREIGN COUNTRY
Michael F. Klein, Jr.
Price Waterhouse & Co.
New York, New York

TABLE OF CONTENTS

SYNOPSIS

I. INTRODUCTION

II. TYPES OF ENTITIES

III. TAX ASPECTS OF A U.S. ENTITY ENGAGING IN A FOREIGN MINERALS VENTURE

A. Exploration Expenditures

1. Foreign Exploration Expenses

2. Recapture of Exploration Expenses

B. Development Expenses

C. Depletion

1. General

2. Computation of Percentage Deduction

3. Computation of Cost Depletion

D. Foreign Taxes

1. General

2. Types of Foreign Tax Credits

3. Limitations

a. Overall vs. per-country

b. Foreign Mineral Income

c. WHTC Limitation

IV. TAX CONSIDERATIONS AFFECTING PARTICULAR TYPES OF U.S. ENTITIES

A. Foreign Branch

B. U.S. Subsidiary

C. Western Hemisphere Trade Corporation

D. Possession Corporation

E. Liquidation or Sale of U.S. Subsidiary

F. Jointly Owned Mineral Ventures

V. UTILIZATION OF FOREIGN ENTITY

A. Taxation of Undistributed Income

B. Liquidation or Sale

VI. TAX IMPLICATIONS COMMON TO ALL TYPES OF OPERATIONS IN FOREIGN COUNTRIES

A. Allocations Among Related Entities (Section 482)

B. Expropriation Losses

1. Treatment of Losses

2. Special Carryforward Provision

C. Tax Treaties

1. Purpose of Treaties

2. General Pattern of Treaties

3. Reduced Withholding Taxes

VII. REPORTING REQUIREMENTS

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I. Introduction

The purpose of this paper is to explore the major U.S. tax consequences of varying interrelated decisions which can have a major effect on the overall economic success of an overseas mining venture. The overriding tax strategy concern of the U.S. parent should be how to repatriate the expected profits from a proposed mining operation in a foreign country to the United States at the least combined effective tax rate (foreign and U.S.). A second concern should be obtaining maximum tax benefit from development and the start up expenses incurred in bringing the mine to the operating stage. A third concern should be obtaining U.S. tax benefit from any loss which might result from nationalization of the venture.

The choice of the type of entity used to conduct the operation is extremely important, since different U.S. tax rules apply to different types of entities. Regardless of the entity chosen it will be subject to income tax in the foreign country, although in some countries a local corporation may be taxed somewhat differently than, for example, a branch of a U.S. corporation. But in the main, the difference in the total overall effective tax rate results from U.S. tax consequences.

Briefly, if a U.S. entity is chosen development expenses and initial start-up losses may, through various techniques, be offset against U.S. taxable income of the parent or other members of the affiliated group. When a U.S. entity becomes profitable, its income will be included in a U.S. tax return, but percentage depletion deductions will be allowable and foreign income taxes may be credited against the U.S. tax liability. The combination of these factors may eliminate any U.S. tax on operating profits.

On the other hand, if a foreign entity is used initial start-up losses will not reduce U.S. taxable income since foreign corporations (with very limited exceptions) cannot be included in a U.S. consolidated income tax return (Section 1504(b)(3)). When the foreign corporation becomes profitable its income will generally not be taxed when earned, but rather only when dividend payments are made to the U.S. parent.

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The U.S. parent will then be required to include the dividend in its taxable income, but allowable foreign tax credits may reduce or eliminate any U.S. tax on the dividends.

The preceding discussion is merely an overview of the considerations affecting the choice of an entity, which will be discussed in greater detail throughout this paper.

II. Types of Entities

In the case of a new wholly-owned foreign mining venture, the following entity choices are usually considered:

U.S. Entities

a) A branch of the parent company or an existing U.S. incorporated subsidiary company,

b) A new U.S. incorporated subsidiary company,

1) If the operation is in the Western Hemisphere, the subsidiary may qualify as a Western Hemisphere Trade Corporation.

2) If the operation is in a possession of the U.S., such as Puerto Rico, the subsidiary may qualify as a Possessions Corporation.

Foreign Entities

a) A foreign subsidiary incorporated in the country in which the venture is located.

b) A foreign subsidiary incorporated in a "tax haven" jurisdiction.

In the case of a new foreign mining project operated as a joint venture with one or more other companies and/or the foreign government, the following entity choices are usually considered:

Domestic Entities

a) A U.S. corporation in which stock ownership is divided among the venturers. This corporation might qualify as a Western Hemisphere Trade Corporation or Possessions Corporations if circumstances permit.

b) An unincorporated joint venture in which the U.S. parent or a domestic subsidiary is a partner.

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Foreign Entities

a) A foreign corporation in which stock ownership is divided among the venturers.

b) An unincorporated joint venture in which a foreign incorporated subsidiary of the U.S. parent is a partner.

In general, this paper will discuss these entity choices as if taxes were the only consideration in making the choice. It is recognized, however, that in many situations other considerations inhibit the choice. For example, some foreign countries restrict the holding of mineral rights to entities organized in that country. Where some tax flexibility is possible in these situations, it will be pointed out.

III. Tax aspects of a U.S. entity engaging in a foreign minerals venture

A. Exploration expenditures

Exploration expenses are defined as those expenditures incurred in ascertaining the existence, location, extent, or quality of any deposit of mineral before the beginning of the development stage of the mine (Reg. Section 1.617-1(a)).

Initially, a mineral deposit may be located through geological and geophysical devices often mounted in helicopters and airplanes. Once a deposit has been tentatively identified, exploration may continue by core drilling or the sinking of shafts or tunnels, to determine whether the size and quality of the deposit and mining conditions are such that extraction of the mineral is economically feasible in light of the existing market conditions.

The taxpayer has an option to treat exploration expenditures in either of two ways.

a) Capitalize the expenditures as part of the cost of the property, or

b) Elect under Section 617 to deduct these expenses currently in the year they are incurred subject to future recapture. In the case of foreign exploration, expenditures deductible under Section 617 are sharply limited by an overall dollar limitation, as discussed hereinafter.

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In the event the exploration activities are successful, capitalized exploration expenditures are recoverable only through depletion deductions. If the mine is sufficiently profitable that percentage depletion exceeds cost depletion, tax benefit from the capitalized expenditures is effectively lost.

If the results of the exploration are unsuccessful and the property is abandoned, the capitalized expenditures are allowable as an ordinary deduction under Section 165 in the year of abandonment. If exploration is undertaken on a number of prospects within a broad area of interest, some of which are abandoned and others are ultimately developed, it is unsettled whether the exploration costs attributable to the abandoned properties may be deductible under Section 165, or must be capitalized as part of the cost of the successful finds. In the American Smelting and Refining case (Ct. Claims) 70-1 USTC 9287, the taxpayer was successful in securing a Section 165 deduction under these circumstances.

1. Foreign exploration expenses

In the case of exploration of properties located outside the United States, Section 617(h) limits the amounts deductible currently under that section to $400,000, reduced by the aggregate of all amounts deducted by the taxpayer as exploration expenditures in all prior years (including domestic exploration expenditures) plus domestic exploration expenses deductible in the current year. Any foreign exploration expenditures in excess of this amount must be capitalized and become part of the tax basis of the mineral property concerned, as previously discussed.

For all practical purposes this limitation effectively negates any current deduction for successful foreign exploration expenditures for a company that has been actively engaged in exploration activities, since the $400,000 limitation will have been utilized in prior years.

The alternative of forming a subsidiary corporation to pursue a specific exploration venture in a foreign country can be considered. However, if the subsidiary is included in a consolidated U.S. income tax return, the regulations allow only a single $400,000 limitation to the entire affiliated group of corporations included in that return (Reg. Section 1.1502-16(a)).

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If the subsidiary files a separate return, it is entitled to its own $400,000 limitation provided the property was not transferred to it by the parent or other affiliate in a tax-free transaction. However, unless the subsidiary has other sources of income from which to deduct the exploration expenses, no current tax benefit will be obtained.

2. Recapture of exploration expenses

When a mine reaches the production stage any deductions taken for exploration expenditures under Section 617 are required to be added back to income in...