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 Rev. Rul. 78-61

1978-1 C.B. 221

Section 901 -- Foreign Tax Credit

IRS Headnote

Foreign tax credit; Ontario Mining Tax Act. The tax imposed by section 3(1) of the Ontario Mining Tax Act is neither an income tax within the meaning of section 901(b) of the Code nor a tax in lieu of an income tax within the meaning of section 903.

Full Text

Rev. Rul. 78-61

Advice has been requested whether the tax imposed by section 3(1) of the Ontario Mining Tax Act, being chapter 275 of the Revised Statutes of Ontario, 1970, as amended by Chapter 14 of the Mining Tax Amendment Act of 1971 (the Act), is an income tax within the meaning of section 901(b) of the Internal Revenue Code of 1954.

If the profit of a mine located in the Province of Ontario exceeds $50,000, section 3(1) of the Act imposes an annual tax of 15 percent on all the profit of such mine including the first $50,000 of such profit.

Section 3(3) of the Act defines the term "profit" as:

(a) the amount of the gross receipts from the output of the mine during the taxation year; or

(b) in case the ore, mineral or mineral bearing substance, or a part thereof is not sold but is treated by or for the owner, holder, lessee, tenant, occupier, or operator of the mine, the amount of the actual market value of the output at the pit's mouth; or

(c) if there is no means of ascertaining the actual market value of the output at the pit's mouth, the amount at which the mine assessor appraises such output . . .; less the expenses allowed by section 3(3)(d) through (n) of the Act. (Emphasis added.)

The term "pit's mouth" refers to the loading point at the mine's ground level of the conveyor or other transportation facility that delivers a mineral substance to the pick-up point for shipment from the mine property to market or that delivers it to the treatment or manufacturing plant.

The term "output" is defined by section 1(i) of the Act as all mineral substances:

raised, taken or gained from any mine or land in Ontario which [a] have been sold, or [b] have been incorporated in a manufacturing process, or [c] have been treated or partially treated at any mill, smelter or refinery on or off the mining premises from which they were taken, and the product thereof has been sold.

The Act is designed to tax only the profit derived from the extraction of output in Ontario (the "mining function") in contrast with the profit attributable to manufacturing that output (the "manufacturing function") or concentrating, milling, smelting, refining, or otherwise treating that output (the "treatment function"). Because profit from the mining function is essentially the value of output at the pit's mouth reduced by deductions for allowable expenses, it is necessary under the Act to determine the aggregate value at the pit's mouth of output (a) that is sold without treatment or manufacture, (b) that is incorporated in a manufacturing process, and (c) that is treated and then sold.

Output that is sold without treatment or manufacture is described in section 1(i) of the Act as ". . . mineral substances . . . which have been sold." Under section 3(3)(a) the value of output sold without treatment or manufacture is the gross sales receipts received therefor. The value of such output is included in computing the mining profit for the taxable year in which the output is sold. Output incorporated in a manufacturing process is described in section 1(i) of the Act as ". . . mineral substances . . . incorporated in a manufacturing process . . ." The market value at the pit's mouth of such output is estimated pursuant to section 3(3)(b) of the Act. For example, to arrive at "actual market value" of a mineral incorporated in the manufacturing process, the Ontario mine assessor sometimes takes the actual sales price per ton received by a company from incidental sales of a mineral not incorporated in a manufacturing process or, if none, then an independent arm's length price, and discounts its price, usually not more than 20 percent. The mine assessor then multiplies this discounted figure by the number of unsold tons of the mineral incorporated in the manufacturing process to arrive at the actual market value of such mineral. The market value of the above output is included in computing the mining profit for the taxable year when the mineral is incorporated in a manufacturing process rather than when materials manufactured from such output are sold.

Output that is treated prior to being sold is described in section 1(i) of the Act as ". . . mineral substances which have been treated or partially treated at any mill, smelter or refinery on or off the mining premises from which they were taken, and the product thereof has been sold." The market value at the pit's mouth of such output is included in computing the mining profit for the taxable year in which such output is actually sold. If no actual market value can be attributed to the output under section 3(3)(b) before treatment, the market value at the pit's mouth of treated output is appraised under section 3(3)(c). The mine assessor is required, under Ontario law, to appraise the market value at the pit's mouth of output that is treated by reducing the sales proceeds of the treated output by: (1) the treatment and marketing costs of the treated output; (2) a 15 percent allowance for depreciation of the treatment equipment; (3) all administrative and general expenses attributable to treatment; and (4) a profit allowance for treatment.

The profit allowance for treatment is a set figure equal to 8 percent of the original cost of the concentrating facilities if output is only concentrated or milled, 16 percent of the original cost of the smelting facilities if output is concentrated and smelted, and 20 percent of the original cost of the refining facilities if the output is concentrated, smelted, and refined. However, the profit allowance for treatment cannot be less than 15 percent or more than 65 percent of the combined net profit from the mining and treatment functions.

Once the value of output sold during the taxable year without being treated or manufactured, the value of output sold during the taxable year that has been treated, and the value of output incorporated in a manufacturing process during that year, are determined, the total value is then reduced by the deductible expenses enumerated in section 3(3)(d) through (n) of the Act.

Expenses that are deductible in computing profit from output in section 3(3)(d) through (n) of the Act are generally similar to deductions allowed under the income tax laws of the United States.

Nondeductible expenses under the Act include:

(1) all development expenses paid or incurred by a mining company prior to a mine's commencing production in Ontario if the mine commenced production prior to January 2, 1965, or if and to the extent the ore taken from the mine was not smelted in Canada; (2) any exploration expenses for ascertaining the existence, extent, location, or quality of any mineral deposit paid or incurred prior to the development stage of the mine;

(3) all expenses incurred for exploration and development work in Ontario that did not result in a producing mine, even though the taxpayer may have had a producing mine somewhere else in Ontario to which these expenses were not connected;

(4) except for a minor provincial tax on surface property and for sales and excise taxes on the purchase of goods and equipment, all Dominion, municipal, and Province of Ontario taxes including the Ontario Corporate Income Tax;

(5) any loss on the sale of the property on which the mine is located;

(6) cost or other depletion including any expense incurred in acquiring the real property on which the mine is located or in acquiring the right to mine, or an option on the right to mine, such mineral deposits;

(7) all royalties paid in respect of, or for the output of, mines located on private property, including not only payments to a person on account of that person's economic interest in the minerals in place but also payments that would be regarded under Federal income tax law as rent for the use of the land on which the mine is located;

(8) all interest paid on borrowed money including that paid on bonds issued by the taxpayer at a discount; and

(9) most expenses for annual shareholder meetings and distribution of notices and reports to shareholders, advertising expenses other than for promoting of sales and recruitment of employees, bank charges for storage of securities, 50 percent of directors' fees and expenses, stock exchange fees, transfer and registration fees, membership fees in chambers of commerce or similar organizations, subscriptions to nonmining publications, and salaries or expenses not directly connected with mining or treatment.

Section 901(b) of the Code generally allows qualifying United States taxpayers to claim a foreign tax credit for the amount of any income, war profits, or excess profits taxes paid or accrued during the taxable year to any foreign country or to any possession of the United States. Section 1.901-2(b) of the Income Tax Regulations provides, in part, that the term "foreign country" includes any foreign state or political subdivision thereof.

Section 903 of the Code provides that the term "income, war profits, and excess profits taxes" shall include a tax paid in lieu of a tax on income, war profits, or excess profits otherwise generally imposed by any foreign country or by any possession of the United States. Section 1.903-1(a) of the regulations lists the following requirements for a qualifying "in lieu of" tax: (1) that the country has in force a general income tax law; (2) that the taxpayer claiming the credit would, in the absence of a specific provision applicable to such taxpayer, be subject to such general income tax; and (3) that such general income tax is not imposed upon the taxpayer thus subject to such substituted tax.

The first question presented is whether the tax imposed by the Act is an indivisible tax or is divisible into separate taxes on three separate tax bases under section 3(3)(a), (b), and (c) of the Act.

Generally, a foreign tax is divisible into separate taxes if it is levied on more than one separate tax base and the tax on each base is separately computed. See Rev. Rul. 74-435, 1974-2 C.B. 204; Rev. Rul. 59-208, 1959-1 C.B. 192, as amplified by Rev. Rul. 63-268, 1963-2 C.B. 290; and Lanman & Kemp-Barclay & Co. of Columbia v. Commissioner, 26 T.C. 582 (1956).

Under the Act gross receipts from the sale of output that is not treated or manufactured are added together with the estimated market value of ouput at the pit's mouth that is incorporated in a manufacturing process and with the appraised market value of output at the pit's mouth that is treated and sold. The total is then reduced by the expenses in section 3(3)(d) through (n) of the Act attributable to the three types of output referred to in section 3(3)(a), (b), and (c) of the Act in arriving at the profit or the base on which the tax is levied. Thus, in computing the mining profit subject to tax under the Act, the value of the three types of output referred to in section 3(3)(a), (b), or (c) of the Act and the expenses attributable thereto are so interwoven as to constitute a single tax base upon which the tax is computed rather than three separate tax bases. Accordingly, the tax imposed by section 3 of the Act is an indivisible tax.

The second question presented is whether the tax imposed by section 3 of the Act qualifies as an "income tax" within the meaning of section 901(b) of the Code.

Whether a foreign tax qualifies as an income tax within the meaning of section 901 of the Code depends on whether that tax constitutes an "income tax" as determined from an examination of the Federal income tax laws of the United States. Biddle v. Commissioner, 302 U.S. 573 (1938), 1938-1 C.B. 309, and Bank of America Nat'l T. & S. Ass'n v. United States, 459 F.2d 513, 518 (Ct. Cl. 1972), cert. denied, 409 U.S. 949 (1972). Thus, the courts have often said that a foreign tax will be considered to be an income tax within the meaning of section 901 only if that tax is the substantial equivalent of the income tax in the United States sense. See e.g., Commissioner v. American Metal Co., 221 F.2d 134 (2d Cir. 1955); and F. W. Woolworth Co. v. Commissioner, 54 T.C. 1233 (1970), nonacq. on another issue, 1971-2 C.B. 4.

Whether a foreign tax is the substantial equivalent of an income tax in the United States sense "depends primarily on the measure of the tax or the tax base." Rev. Rul. 69-653, 1969-2 C.B. 152. Thus, to qualify as an income tax in the United States sense, a foreign tax must, at the very least, satisfy several requirements. Whether these requirements are met is determined by reference to the entire class of taxpayers subject to the foreign tax and not on a taxpayer-by-taxpayer or transaction-by-transaction basis. Bank of America Nat'l T. & S. Ass'n v. United States, and Rev. Rul. 64-260, 1964-2 C.B. 187. Moreover, when a tax is imposed on a limited tax base or on a limited class of taxpayers and the tax includes a provision that violates one of these requirements, then the importance of that aberrational provision is necessarily increased by the limited scope of the tax base or class of taxpayers.

The first requirement relevant to the instant case is that the gain on which the foreign tax is levied must be realized in the United States sense, The United States Federal income tax, a tax of general application, does tax in certain limited situations the constructive or deemed receipt of income. However, as a whole the Federal income tax is imposed on gain actually realized. Eisner v. Macomber, 252 U.S. 189 (1920), 3 C.B. 25. A substantially equivalent degree of realization is required with respect to foreign taxes. Commissioner v. American Metal Co., Keasbey & Mattison Co. v. Rothensies, 133 F.2d 894 (3d Cir. 1943), and Lanman & Kemp-Barclay & Co. of Columbia.

The second requirement relevant to the instant case is that a foreign tax will not be considered to be an income tax in the United States sense unless its purpose is to reach net gain and it is so structured as to be almost certain of doing so. Bank of America Nat'l. T. & S. Ass'n v. United States, 459 F.2d 513 (Ct. Cl. 1972); Bank of America Nat'l T. & S. Ass'n v. Commissioner, 61 T.C. 752 (1974). Generally, a foreign tax is almost certain to fall on net gain if levied on income computed in such a manner that it is very unlikely that taxpayers generally subject to that tax will have to pay it when they have no net gain. See the United States Court of Claims decision in Bank of America Nat'l T. & S. Ass'n v. United States, at 524, wherein it was stated that the ". . . only question is whether it is very unlikely or highly improbable that taxpayers subject to the impost would make no profit or would suffer a loss." See also Allstate Ins. Co. v. United States, 419 F.2d 409 (Ct. Cl. 1969).

Certain foreign taxes on gross dividends, interest, and royalties have been held to qualify as income taxes in the United States sense. See, e.g., Rev. Rul. 73-106, 1973-1 C.B. 343. These taxes qualify because it is presumed that the expenses ordinarily connected with such income will almost never exceed that income. Therefore, a foreign tax imposed on such income will be almost certain of reaching net gain. Bank of America Nat'l T. & S. Ass'n v. United States. Additionally, similar taxes have long been imposed by the United States on dividends, interest and royalties paid to nonresident aliens and foreign corporations (which are not effectively connected with the conduct of a trade or business in the United States) as a basic part of the United States income tax system. See sections 871(a)(1)(A) and 881(a)(1) of the Code. The thrust of these United States tax provisions is realistically directed against net gain or profit. See Bank of America Nat'l T. & S. Ass'n v. Commissioner, 61 T.C. 752 (1974).

However, expenses incurred in producing gross trade or business income are not inherently so slight as to insure that they will almost never exceed the amount of that gross income and thus not produce a loss. For this reason a foreign tax on income from engaging in business in the foreign country that does not permit the deduction of the generally significant expenses incurred in producing that income is not almost certain to fall on net gain. Such a tax is not creditable. Cf. Rev. Rul. 74-435, 1974-2 C.B. 204, wherein this rationale was applied to sustain the creditability of a Swiss communal tax on business income. See also Keasbey & Mattison Co. v. Rothensies; and Continental Insurance Co., 40 B.T.A. 540 (1939).

In Keasbey & Mattison Co. v. Rothensies, the court held that Quebec Mining Tax not to be a creditable income tax in part because it restricted allowable deductions only to expenses incurred in the mining operation itself and failed to allow deductions for the significant expenses incident to the general conduct of the mining business. The Court of Claims in Bank of America Nat'l T. & S. Ass'n v. United States interpreted the Keasbey opinion as involving: . . . a mining business which obviously could either have lost or made money in any particular year. In that context, it was significant that "the expenses incident to the general conduct of the business, as distinguished from the cost incurred in the mining operation, are not deductible" (133 F.2d at 898); those non-deductible expenses could easily have made the difference between a net profit and a loss. For that business it could not possibly have been said that the tax would always, or almost always, reach some net gain. (Emphasis added.)

The final requirement relevant to the instant case is that in order for a foreign tax to qualify as an income tax in the United States sense, the tax in question must be imposed on the receipt of income by the taxpayer rather than on transactions such as sales or the exercise of a privilege or a franchise, such as exploiting natural resources. Commissioner v. American Metal Co.; Keasbey & Mattison Co. v. Rothensies; and Rev. Rul. 57-62, 1957-1 C.B. 241. Furthermore, a tax, such as an excise tax that is imposed on subjects other than the receipt of income, is not creditable even if the measure of the tax base is net income. St. Paul Fire and Marine Insurance Co. v. Reynolds, 44 F. Supp. 863 (D. Minn. 1942); Motland v. United States, 192 F. Supp. 358 (N.D. Iowa 1961); and Rev. Rul. 58-3, 1958-1 C.B. 263.

Whether a tax is a privilege, excise, or income tax must be determined by examining the foreign law in its entirety. Thus, for example, to the extent that a tax is imposed on a tax base that includes a nonrealization event, does not allow for the deduction of expenses, or is a condition for permission to engage in a certain business, then these factors and others, will be considered in determining the nature of the tax. Commissioner v. American Metal Co.; Keasbey & Mattison Co. v. Rothensies; and, Elias Mallouk v. Commissioner, 34 B.T.A. 269 (1936).

In the present case, the tax imposed by section 3 of the Act is an indivisible tax imposed on a very limited tax base; that is, it falls on profit from only three items: (1) the sale of mineral output; (2) the incorporation of mineral output in a manufacturing process; and (3) the sale of treated mineral output. Because section 3(1) of the Act imposes a tax when output is incorporated in a manufacturing process under section 3(3)(b), this indivisible tax, in part, is not imposed on the receipt of realized income in the United States sense in violation of requirements (1) and (3) above.

Also, the tax imposed by section 3(1) of the Act denies or limits the deduction of sufficient expenses in computing profit from the mining function on treated output under section 3(3)(c), on manufactured output under section 3(3)(b), and on output sold without treatment or manufacture under section 3(3)(a), to make it possible for the taxpayer to show a net gain and thus have to pay the Ontario Mining Tax, even though it had a net loss in the United States sense from mining. Thus, the tax is not almost certain of falling on net gain, as the following discussion indicates.

First, a tax free recovery of invested capital has always been a characteristic of an income tax in the United States sense. However, like the Quebec Mining Tax discussed in the Keasbey decision and unlike the Code, the Act allows no deduction for the taxpayer's expense in acquiring the ore body because cost or other depletion, the cost of acquiring the right to mine or an option in the right to mine, and any loss on the sale of the real property on which the mine is located are all nondeductible. Because the Act does not allow a taxpayer to recover the taxpayer's cost (invested capital), it is effectively taxing that capital.

Second, although much of the financing for mining ventures may be derived from loans, the Act prohibits the deduction of all interest expense, regardless of the amount or purpose for which it was incurred.

Third, under Federal income tax law, royalties paid by a mining company to a landowner or other person on account of that person's economic interest in the minerals in place are not included in the mining company's income. However, under the Act, a mining company cannot exclude or deduct from its gross mining profit the royalties it pays to a landowner on account of the latter's economic interest in the minerals in place. Section 3(5)(d) of the Act denies any deduction for such royalties paid in respect of, or for the output of, mines located on private property.

Fourth, the Act permits no deduction either currently or through depletion for any exploration expense incurred for ascertaining the existence, extent, location, or quality of any mineral deposit and paid or incurred prior to the development stage of a mine.

Fifth, prior to the 1969 taxable year the Act did not permit through depletion or otherwise the recovery of any development expenses paid or incurred prior to a mine commencing production in Ontario. In 1969, however, section 3(3)(n) was adopted. That section allows a taxpayer to deduct annually 10 percent of the pre-production development costs (but not exploration costs) of a producing mine in Ontario. This deduction is not available, however, to all mining companies, but only to metal mining companies that brought a mine into production after January 1, 1965, and that smelt the ore taken from that mine in Canada. The inability to deduct this significant expense by some mining companies could make the difference between a net gain and a net loss.

In summary, the Act denies or limits the deduction of significant expenses in computing profit from the mining function on treated output under section 3(3)(c), on manufactured output under section 3(3)(b), and on output sold without treatment or manufacture under section 3(3)(a). Accordingly, the tax imposed by section 3(1) of the Act fails to satisfy the second requirement discussed above because it is not almost certain of falling on net gain in the United States sense.

This conclusion is bolstered by the fact that the amount of profit on which the tax is paid in the case of treated output may be artificially inflated or understated by the use of a treatment allowance formula. As previously indicated, this formula is used because the tax imposed by the Act is a tax on the mining function. That is, it is levied only on profit attributable to extraction of output in Ontario (the mining function) as opposed to net profit from the taxpayer's entire operation. Because both a mining and treatment profit may be embodied in the actual receipts from the sale of treated output, to arrive at the market value at the pit's mouth of such output, the Ontario mine assessor deducts, under section 3(3)(c) of the Act, the costs attributable to the treatment function and a profit allowance for treatment. This profit allowance is set at 8 percent of the original cost of the concentrating facilities if output is only concentrated or milled, 16 percent of the original cost of the smelting facilities if output is concentrated and smelted, and 20 percent of the original cost of the refining facilities if output is concentrated, smelted, and refined. However, the profit allowance for treatment cannot be less than 15 percent or more than 65 percent of the combined profit from the mining and treatment functions.

The use of the set profit allowance may inflate or understate the portion of profit attributable to the mining function. This is because the 65 percent limitation on the amount attributable to treatment assures that at least 35 percent of the gain will be considered as attributable to the mining function. This would be the case even when no portion or gain from treated output was actually attributable to the mining function. Under these circumstances it cannot be said that the tax is almost certain of falling on net gain from the mining function.

Regarding the third requirement of an income tax discussed above, the court in Keasbey held that a Quebec mining tax was a tax upon the mining privilege or an excise tax as opposed to an income tax. The court said that the tax, although designated as a tax on annual profits, is in reality a tax on the mining privilege, measured on the basis of gross value of the output determined under a prescribed formula, less certain deductions, and that the value of the mining output was the basis of the levy independent of either realization of gain or derivation of profits.

Although the tax imposed by the Act is levied upon a base designated as profit, the fact that the tax fails to meet the United States realization and net gain requirements, as heretofore outlined, and the fact that the tax is structured to yield taxable profit from the extraction of output (the mining function) by a formulary shifting of profit derived from treating that output (the treatment function), indicate that such tax is actually a production or severance tax on the mining privilege, such as the Quebec Mining Tax in the Keasbey case. This view is supported by the fact that the Act forbids the mine operator from carrying away from the mine any ore until the weight thereof has been correctly ascertained and entered in the books of account, and the fact that the mine's assessor can enter any mine to take samples for the purpose of determining the value of the ore.

Accordingly, for the above reasons the tax imposed by the Act is not the substantial equivalent of an income tax within the meaning of section 901(b) of the Code.

The final question is whether the tax imposed by section 3(1) of the Act is a tax in lieu of an income tax within the meaning of section 903 of the Code and the regulations thereunder.

Section 1.903-1(a)(3) of the regulations provides, in general, that a credit may be claimed under section 901 of the Code for a section 903 tax if the taxpayer is not subject to the foreign country's general income tax but is subject to a substituted tax. In addition to the tax imposed by the Act, Ontario has in force both corporate and personal income tax laws of general application that are imposed on profits from mining operations. Therefore, because the tax imposed by the Act is imposed in addition to, instead of in substitution for, a general income tax law, the tax imposed by the Act does not satisfy the requirements of section 1.903-1(a) for an in lieu of tax that would be creditable under section 901. Allstate Ins. Co. v. United States, and F. W. Woolworth.