On January 8, 2020, the Tax Court issued its opinion in Adams Challenge UK Limited v. Commissioner, 154 T.C. No. 3. The issue presented in Adams Challenge UK Limited v. Commissioner was whether a United Kingdom private limited liability company, whose vessel was leased to a U.S. company operating on portions of the U.S. Outer Continental Shelf (OCS) received income effectively connected with a U.S. trade or business pursuant to IRC § 882(a)(1), thereby giving rise to a U.S. income tax liability.

Effectively Connected Income in Adams Challenge UK Limited v. Commissioner

IRC § 882(a)(1) provides that a foreign corporation engaged in trade or business within the United States during the taxable year is taxed on its income that is effectively connected with the conduct of a trade or business in the United States. Effectively connected income generally includes all income, gain, or loss from sources within the United States. IRC § 864(c)(3). IRC § 861 sets forth general rules for the sourcing of income. Generally, U.S. source income includes compensation for labor or personal services performed in the United States, as well as income from renting or leasing property located in the United States. IRC § 861(a)(3) and (4).

Expansion of Geographic Scope of “United States” – IRC § 638 (offshore areas part of U.S.)

Through the adoption of IRC § 638, Congress expanded the geographical scope of the term “United States” to include the OCS for purposes of applying the provisions of Chapter 1 of the Code (normal taxes and surtaxes), because from sea to shining sea wasn’t quite broad enough. Manifest destiny, and all.

The Treasury Regulations promulgated* in response to IRC § 638 state that activities engaged in or related to the exploration for, or the exploitation of oil and gas wells in the OCS are deemed to be within the United States. Treas. Reg. § 1.638-1(c)(1). Interestingly, “exploitation” is not defined, so naturally my mind went to pirates shanghaiing a derrick 35 miles of the coast of Biloxi, and claiming it for Freedomton.

*Author’s Note: The word “promulgate” is derived from the Latin “promulgare,” which traces its root to “mulgere,” which relates to something literally issuing forth from a cow. So, when a regulation is “promulgated,” the Treasury is literally “mooing forth” rules…bet you’ll remember that more than the Adams Challenge (U.K.) opinion in 20 years…And now you know…

Taxability under U.S / U.K. Bilateral Treaty

Article 7(1) of the Treaty provides that business profits of an enterprise of a contracting state shall be taxable only in that state unless the enterprise carries on business in the other contracting state through a permanent establishment situated therein. Article 21 of the Treaty creates a special rule for activities carried on in connection with exploitation of natural resources. Specifically, an enterprise of a member of one contracting state, which member carries on exploration activities or exploitation activities in the other contracting state, shall be deemed to be carrying on business in that other state through a permanent establishment situated therein.

Thus, the Tax Court in Adams Challenge (U.K.) found the lease of the U.K. owned vessel to exploit oil wells in the OCS (no telling how close to Biloxi) created a nexus sufficient to establish that the lease/charter income was effectively connected income subject to U.S. tax.

(154 T.C. No. 3) Adams Challenge (UK) Ltd. v. Commissioner

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