Foreign oil and gas tax credits subject to separate credit limitations.

• Author: Costa, Karen Leone

Most tax professionals are aware of the limitations imposed on the utilization of foreign tax credits under Sec. 904. In general, the total allowable amount of credit for foreign taxes paid or accrued cannot exceed the taxpayer's total U.S. tax multiplied by a ratio equal to the taxpayer's foreign-source income divided by his or her entire taxable income for the year. Under Sec. 904(d), taxpayers must apply this limitation separately with respect to the passive and general limitation categories of income. Taxpayers may carry unused foreign tax credits back one year and forward 10 years and must calculate these carryforwards and carrybacks separately for each category, or "basket," of income.

A lesser-known limitation under Sec. 907 applies to foreign taxes paid or accrued in connection with foreign oil and gas income. Taxpayers must pay governments of many foreign countries a royalty on oil and gas production within the country, as well as a tax on the net income generated from those activities.

In some instances, a portion of the royalty may be characterized as income tax. This recharacterization results in a high rate of foreign tax imposed on foreign oil and gas income that is creditable against the U.S. tax, subject to special limitation rules.

Foreign Oil and Gas Income and Tax Credit Limitations

In 1975, Congress enacted Sec. 907, which provides a separate credit limitation on credit for foreign taxes paid on foreign oil and gas income. In 1991, the IRS issued final regulations in this area, effective for tax years beginning after Dec. 31, 1982. In general, Sec. 907 prevents excess foreign tax credits from foreign oil and gas income from offsetting U.S. tax on other foreign-source income. In particular, Sec. 907 contains an additional limitation, layered on top of the restrictions imposed by Sec. 904, on credits for foreign taxes paid or accrued related to certain types of foreign oil and gas income. Sec. 907(a) limits the foreign tax credit for taxes paid on foreign oil and gas extraction income (FOGEI) and foreign oil-related income (FORI) to (1) for individuals and trusts, FOGEI and FORI multiplied by the taxpayer's U.S. effective tax rate before credits, and (2) for corporations, FOGEI and FORI multiplied by the highest corporate tax rate. The amount disallowed by this limitation is carried back to the first preceding tax year and then carried forward for 10 succeeding years. Any FOGEI or FORI credits that make it through the limitations of Sec. 907(a) are then subject to the more familiar limitations under Sec. 904 mentioned above.

For tax years beginning before Jan. 1, 2009, the above...