Foreign LLC's Income Is Not Exempt from U.S. Tax under U.K. - U.S. Treaty

(Parker Tax Publishing January 2020)

The Tax Court held that the income of a United Kingdom (U.K.) limited liability company (LLC), whose sole income-producing asset for the years at issue was a multi-purpose support vessel that was chartered by a U.S. company to assist in decommissioning oil and gas wells in the U.S. Outer Continental Shelf in the Gulf of Mexico, was not exempt from tax under a bilateral income tax treaty between the United States and the U.K. As a result of provisions in the Treaty, the LLC was deemed to have a U.S. permanent establishment, and the Treaty thus did not exempt the LLC's income from U.S. federal income tax. Adams Challenge (UK) Limited v. Comm'r, 154 T.C. No. 3 (2020).

Adams Challenge (UK) Limited (Adams Challenge) is a U.K. private limited liability company whose sole income-producing asset during 2009 - 2011 was a multi-purpose support vessel (the Challenge Vessel). The Challenge Vessel was chartered by a U.S. company to assist in decommissioning oil and gas wells and removing debris on portions of the U.S. Outer Continental Shelf (OCS) in the Gulf of Mexico. During 2009 - 2011, Adams Challenge derived gross income of $45 million from the charter.

Under Code Sec. 882(a)(1), foreign corporations are subject to federal income tax on income effectively connected with the conduct of a trade or business within the United States. Generally, under Code Sec. 7701(a)(9), the term "United States" does not include the OCS. However, Code Sec. 638 provides that, for purposes of applying federal income tax provisions with respect to mines, oil and gas wells, and other natural deposits, the term "United States" includes "the seabed and subsoil of those submarine areas" within the OCS. A bilateral income tax treaty (Treaty) between the United States and the U.K. provides that a U.K. enterprise is not subject to federal income tax unless it conducts business in the United States through a U.S. permanent establishment. Under the Treaty, an enterprise is deemed to have a U.S. permanent establishment where activities are carried on offshore in connection with the exploration or exploitation of the sea bed and sub-soil and their natural resources.

Adams Challenge did not file a timely federal income tax return for 2009 or 2010 and, as a result, the IRS prepared a substitute for return for each year. On December 13, 2013, Adams Challenge filed a delinquent Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, for 2011. This return reported approximately $2.7 million of effectively connected income, claimed total deductions of approximately $2.4 and reported taxable income of almost $400,000.

In 2014, the IRS issued a notices of deficiency to Adams Challenge for 2009 - 2011. The IRS determined that, for 2009 and 2010, Adams Challenge had effectively connected income of almost $13.6 million and $19.1 million, respectively, and that, for 2011, Adams Challenge had underreported its effectively connected income by almost $10 million. The IRS subsequently increased the deficiencies for 2010 and 2011. For 2010, the IRS argued that Adams Challenge's effectively connected income was almost $12.4 million and, for 2011, the IRS argued that Adams Challenge should be allowed no deductions and increased its taxable income to $12.6 million. Adams Challenge alleged that it erroneously reported more than $2.7 million of gross income on its 2011 return and that its effectively connected income for that year was zero. Adams Challenge contended that none of the income derived from the charter of the Challenge Vessel was subject to federal income tax as a result of the Treaty. The IRS argued that it was all subject to income tax.

The Tax Court cited Code Sec. 635 and Reg. Sec. 1.638-1(c)(4) in holding that Adams Challenge's activities were conducted on the OCS with respect to oil and gas wells and its activities were related to the exploitation of oil and gas wells. As a result, Adams Challenge was engaged in a trade or business within the United States and, under Code Sec. 882(a)(1), its activities were effectively connected with that U.S. trade or business. The court said that Adams Challenge's charter income was thus subject to federal income tax unless exempted by the Treaty.

In determining whether the Treaty applied, the court noted that Adams Challenge's activities were carried on offshore in connection with the exploitation of the sea bed and sub-soil and their natural resources. The court found that, under article 21 of the Treaty, Adams Challenge was thus deemed to have a U.S. permanent establishment, and the Treaty therefore did not exempt its charter income from federal income tax.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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