Exxon Corporation v. Commissioner

113 T.C. No. 24UNITED STATES TAX COURT
EXXON CORPORATION AND AFFILIATED COMPANIES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 23331-95, 16692-97. Filed November 2, 1999.
Held: Petroleum revenue tax paid by
petitioners to the United Kingdom was not
paid in exchange for specific economic
benefits and constitutes a creditable foreign
tax under sec. 901, I.R.C.
Robert L. Moore II, Jay L. Carlson, Bradford J. Anwyll,
Kevin Lee Kenworthy, Patrick James Thornton, Richard Steven
Klimczak, Susan Ann Friedman, and David B. Blair, for
petitioners.
Allan E. Lang, Raymond L. Collins, Martin Van Brauman, and
Roberta L. Shumway, for respondent.
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SWIFT, Judge: The issue for decision is whether petroleum
revenue tax (PRT) petitioners paid to the United Kingdom for 1983
through 1988 constitutes, for U.S. income tax purposes, a
creditable income or excess profits tax under section 901 or a
creditable tax in lieu thereof under section 903.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in question,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
FINDINGS OF FACT
The parties have stipulated numerous facts and admissibility
of numerous exhibits. The stipulated facts are so found.
During the years in issue, petitioners constituted an
affiliated group of more than 175 U.S. and 500 foreign subsidiary
corporations. Petitioner Exxon Corp. was the common parent of
the affiliated group, with its principal place of business in
Irving, Texas. Hereinafter, petitioners will be referred to
simply as “Exxon”.
The businesses in which Exxon was engaged primarily involved
exploration for and production, refining, and sale of crude oil,
natural gas, and other petroleum products.
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Exxon’s North Sea Licenses
The North Sea presents one of the harshest working
environments in the world. As of the mid-1960's, oil and gas
companies had not attempted production of oil and gas in
conditions as severe and difficult as those that existed in the
North Sea, and oil and gas companies generally lacked experience
and technology to explore for and to recover oil and gas from the
North Sea.
Under Article 2 of the Geneva Convention on the Continental
Shelf, Apr. 29, 1958, 15 U.S.T. 473 (ratified in U.S. Apr. 12,
1961), various countries were granted jurisdiction and control
over seabed areas adjacent to their coastlines. Individual
treaties were negotiated between countries bordering the North
Sea to fix boundaries between their respective offshore areas.
In the Continental Shelf Act, 1964, ch. 29, sec. 1 (Eng.),
the United Kingdom implemented provisions of the 1958 Geneva
Convention on the Continental Shelf with regard to the United
Kingdom portion or segment of the North Sea. Hereinafter, such
portion or segment will be referred to simply as the North Sea.1
1
The Petroleum (Production) Act, 1934, 24 & 25 Geo. 5, ch. 36
(Eng.), vested in the United Kingdom ownership of all oil and gas
resources within Great Britain and authorized the U.K. Secretary
of State for Trade and Industry to grant exploration and mining
licenses. The Continental Shelf Act, 1964, ch. 29, sec. 1
(Eng.), extended to the North Sea the United Kingdom’s license
powers under the Petroleum (Production) Act, 1934, supra.
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In May of 1964, the United Kingdom first issued to oil and
gas companies licenses for exploration of and, if commercial oil
and gas reserves were discovered, for development and production
of oil and gas resources in the North Sea. The next three United
Kingdom license rounds relating to the North Sea took place in
August of 1965, September of 1969, and June of 1971. During
these four license rounds, crude oil prices generally remained at
approximately $3 per barrel.
In 1970, oil discoveries were reported in the North Sea.
However, oil reserves in the North Sea remained unproven. The
North Sea was considered a marginal oil prospect, and oil
production did not begin in the North Sea until 1975.
In the first four license rounds, the United Kingdom offered
areas that covered almost all of the North Sea, but oil and gas
companies did not apply for most of the areas because of the
risks and uncertainties involved. Of the areas offered,
applications for licenses were received for only 35 percent of
the areas. Licenses for a number of areas not applied for when
first offered included what in later years became the largest and
most profitable oil-producing fields in the North Sea.
The areas that turned out to be the most significant oil
fields in the North Sea were licensed by the end of the fourth
license round in 1971.
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With regard to North Sea petroleum resources, the United
Kingdom generally used a discretionary licensing system under
which the United Kingdom selects oil companies to which licenses
are issued from a pool of companies that apply for the licenses.
This enabled the United Kingdom to further governmental
objectives such as rapid and appropriate exploitation of North
Sea petroleum resources. In contrast, under an auction licensing
system, licenses are issued to the highest bidders who are not
necessarily the most financially sound or competent companies to
develop petroleum resources associated with the licenses.
Further, at least in the 1960's and early 1970's, due to
uncertainties and risks associated with exploitation of North Sea
petroleum resources, it was generally expected that with regard
to the North Sea resources, the United Kingdom would not raise as
much revenue from an auction licensing system as from a
discretionary licensing system.
In June of 1971, as part of the fourth license round that
was generally conducted on a discretionary basis, the United
Kingdom experimented with an auction system and invited bids for
15 areas. The winning bid (by Exxon and Shell) for one of the
auctioned areas (involving a field adjacent to where Exxon and
Shell had already discovered oil) was for £21 million, but the
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average bid price with respect to the remaining 14 areas that
were available under the auction was less than £1.2 million.2
At the time, in the 1960's and early 1970's, the United
Kingdom concluded that the financial terms of the discretionary
North Sea licenses that it issued to Exxon and to other oil and
gas companies were appropriate for the particular circumstances
of the United Kingdom, which at the time had virtually no
indigenous oil and gas production and which was in competition
with other countries for resources that the oil industry would
allocate to the North Sea.
After the fourth license round in 1971 in which the United
Kingdom had experimented with an auction licensing system, the
United Kingdom has continued to use, with limited exceptions, a
discretionary licensing system. The United Kingdom and most
major oil-producing countries other than the United States rely
primarily on discretionary licensing systems with regard to the
recovery of petroleum resources.
Generally, under the discretionary licenses issued by the
United Kingdom for exploitation of North Sea petroleum resources,
terms of the licenses required licensees to pay to the United
Kingdom up-front fees based on the size of the areas subject to
2
In these cases, the parties generally refer to U.K. pounds,
without providing U.S. dollar equivalents. We, therefore, in
this opinion also use U.K. pounds, and we leave for the Rule 155
computation questions relating to proper exchange rates between
U.K. pounds and U.S. dollars.
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the leases followed by escalating annual fees and a 12½-percent
royalty based on gross value of total oil and gas production at
the wellhead. The 12½-percent royalty rate was approximately the
same as the royalty rate that was used by most oil-producing
countries throughout the world. The terms of the licenses also
required the licensees to conduct seismic survey work and to
drill a specified number of exploratory wells.
Royalties due under the North Sea licenses issued by the
United Kingdom were allowed to be paid in kind by the oil
companies.
To actually operate in the North Sea, oil and gas companies
holding licenses were required to pay the license fees and
royalties and to complete exploratory work programs specified in
the licenses.
During 1972 and early 1973, the Public Accounts Committee
(PAC) of the U.K. House of Commons held hearings on U.K. tax and
energy policies with regard to the North Sea. At the time, there
were indications that crude oil prices might increase
significantly, although the price increases that later occurred
as a result of the 1973-74 Arab oil embargo were not anticipated.
In February of 1973, PAC issued a report summarizing the
discretionary licensing system that primarily had been used by
the United Kingdom for the first four license rounds for the
North Sea. In the 1973 report, PAC made no recommendation that
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the discretionary licensing system be changed to an auction
system or that the 12½-percent royalty rate associated with North
Sea licenses be increased.
In the 1973 report, PAC also reviewed the then existing U.K.
corporation tax applicable to oil company profits to be earned
from North Sea oil and gas and expressed concern that the U.K.
corporation tax was poorly structured in that petroleum companies
could offset profits from North Sea oil and gas activity by
losses from unrelated activities. PAC also recommended
legislative changes to the U.K. corporation tax to increase the
effective U.K. tax rate on profits relating to North Sea oil and
gas production. In that report, no recommendation was made to
impose a tax similar to the PRT.
In October of 1973, war broke out in the Middle East,
leading to the embargo by the Organisation of Petroleum Exporting
Countries (OPEC) on exports of crude oil to the United States
and, by the end of 1974, to a 5-fold increase in world crude oil
prices.
During 1974, the U.K. economy was experiencing a serious
recession with high inflation and severe balance of payment
problems. Because of the United Kingdom’s dependence on imported
crude oil, the 1974 increase in the price of crude oil
exacerbated the United Kingdom’s fiscal crisis. As a result, in
July of 1974, the U.K. Secretary of State to Energy issued a
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report to the U.K. Parliament (1974 White Paper) in which it was
concluded that unless the United Kingdom modify its tax regime,
the United Kingdom would receive only a small portion of North
Sea oil and gas company profits. In the 1974 White Paper, it was
also recommended: (1) That the United Kingdom modify its tax
regime with regard to North Sea oil and gas production activity
in order to, among other things, eliminate the ability of oil and
gas companies to offset profits from North Sea operations by
losses realized by the companies elsewhere in the world, and
(2) that the United Kingdom assert increased control over oil and
gas companies’ North Sea operations.
No recommendation was made in the 1974 White Paper to make
any significant change to the United Kingdom discretionary
licensing system for the North Sea.
Between 1976 and 1988, there were seven additional license
rounds conducted by the United Kingdom relating to the North Sea.
Over the years, North Sea licenses were issued and
administered, and the related fees and royalties were collected
by the U.K. Ministry of Power, the U.K. Department of Technology,
the U.K. Department of Energy, and the U.K. Department of Trade
and Industry. At no time have North Sea licenses been
administered, or have the related fees and royalties been
collected, by the U.K. Treasury or by the U.K. Inland Revenue.
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Significant uncertainties, risks, and investment commitments
for Exxon were associated with Exxon’s North Sea licenses --
risks that insufficient oil deposits would be discovered, that
oil resources that might be discovered would not be commercially
exploitable, and that the large capital and operating costs
associated with exploring for and developing oil and gas
resources in the North Sea would be lost.
The licenses between the United Kingdom and Exxon regarding
North Sea petroleum resources were entered into in good faith.
They were negotiated at arm’s length. They constituted
enforceable contracts under U.K. law.
License fees and royalties that have been collected by the
United Kingdom from oil and gas companies with regard to North
Sea petroleum resources have constituted a substantial source of
income to the United Kingdom.
Through 1992, Exxon has paid to the United Kingdom more than
£16 billion in royalties in connection with the North Sea
licenses it received. Under the licenses Exxon received and
taking into account risks and costs associated therewith at the
time the licenses were issued, the fees and royalties Exxon paid
to the United Kingdom for the licenses to exploit North Sea
petroleum resources constituted reasonable and substantial
compensation therefor.
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Ring Fence Tax and PRT
As indicated, during the Arab oil embargo world crude oil
prices increased approximately 5-fold. As a result, in 1975, out
of concern that the U.K. corporation income tax might fail
effectively to tax anticipated extraordinary profits to be
realized by oil and gas companies, the U.K. Government enacted a
new tax regime on income earned from oil and gas recovery
activities in the North Sea. The new tax regime consisted of the
ring fence provisions of the U.K. corporation income tax (Ring
Fence Tax) and PRT. The Ring Fence Tax and PRT replaced the U.K.
corporation income tax as it otherwise would have applied to
activities of oil and gas companies in the North Sea.
The purpose and objective of the United Kingdom in enacting
the Ring Fence Tax and PRT were to accelerate tax revenues
relating to development of North Sea petroleum resources and to
tax extraordinary profits of oil and gas companies relating to
the North Sea.
To make it more difficult for oil and gas companies to
offset profits derived from the North Sea with losses and
expenses from unrelated activities, the Ring Fence Tax was
enacted as a modified or customized version of the U.K.
corporation income tax and was made applicable to activity of oil
and gas companies in the North Sea in lieu of the general
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provisions of the U.K. corporation tax generally applicable to
U.K. corporate taxpayers.
The Ring Fence Tax applies3 only to companies producing oil
and gas and to related activities in the North Sea, and it erects
a “ring fence” around oil and gas activities in the North Sea by
requiring oil and gas companies to segregate income and expenses
attributable to North Sea activity from income and expenses
attributable to activity unrelated to the North Sea.
The Ring Fence Tax was enacted under the U.K.’s sovereign
taxing power, and under U.K. law it constitutes a tax on income.
The Ring Fence Tax is structured as a corporate income
tax.
Along with other U.K. taxes such as the U.K. corporation
income tax and the Ring Fence Tax, under U.K. law, PRT was
intended, is structured, and is regarded as a tax. PRT was
imposed unilaterally by the United Kingdom and was administered
as a tax by the U.K. Inland Revenue.
With regard to North Sea oil and gas recovery activities,
the Ring Fence Tax and PRT are imposed in substitution for, and
not in addition to, the generally applicable U.K. corporation
tax. Oil and gas companies operating in the North Sea are
liable, with regard to such activity, for the Ring Fence Tax and
3
In this Opinion, we often use the present tense to describe
provisions of the Ring Fence Tax and PRT even though PRT was
eliminated in 1993.
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PRT, not for the otherwise generally applicable U.K. corporation
tax.
In order to provide uniform administration of the Ring Fence
Tax and PRT, in 1975 the Oil Taxation Office of the U.K. Inland
Revenue was established and was delegated that responsibility.
The fees and royalties due under the licenses issued by the
United Kingdom to Exxon and other oil and gas companies regarding
the North Sea were not modified, supplemented, or altered by the
PRT that was enacted in 1975.
Gross income relating to North Sea oil and gas recovery
activities, with limited exceptions, constitutes the tax base for
PRT, and losses relating to activity outside the North Sea ring
fence are not allowed to offset income from activity occurring
within the North Sea ring fence. PRT is imposed on income
relating to extraction of oil and gas from the North Sea, income
earned by taxpayers providing transportation, treatment, and
other services relating to oil and gas resources in the North Sea
(tariff receipts), and income relating to sale of North Sea
assets (disposal receipts).
Interest income, income from sales of purchased and resold
crude oil, and income relating to sale of gas exempt from PRT
liability are not included in the income base for PRT purposes.
In computing net profits for PRT purposes and on which PRT
liability is calculated, all significant costs and expenses,
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except interest expense, of producing taxable income relating to
North Sea petroleum resources are currently deductible. To
prevent the use of intercompany debt as a means of avoiding or
minimizing liability under the Ring Fence Tax and PRT, deductions
for interest expense are limited under the Ring Fence Tax and are
not allowed under PRT.
Initial calculations of profits under PRT are made at the
field level, with current deductions from gross revenue generally
allowed for all ordinary as well as capital expenses relating to
the field. Current deductions are allowed for, among other
things, costs of exploration and appraisal activities, start-up
activities, operations, production, storage, treatment,
transportation, administrative and overhead activities, buildings
and structures (if placed on the seabed or used in production,
measurement, transportation, or initial treatment and storage of
petroleum products), and abandonment activity relating to a
field, as well as costs of conducting arm’s-length sales of
petroleum products and of exploring and evaluating areas outside
a field that do not result in discovery of new fields.
As indicated, under PRT, current deductions are not allowed
for interest expense, and current deductions are not allowed for
costs of acquiring licenses from private parties, for payments to
private parties holding overriding royalty and similar interests
in a field, for expenses incurred in producing income exempt from
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PRT, and for payments of tax that should have been paid by
foreign contractors providing services to the taxpayer in the
North Sea.
Under PRT, operating losses from any period are carried back
or carried forward without limit to income associated with the
field.
Additional prominent features of PRT, as originally enacted
and as amended over the years, may be described generally as
follows:
(1) As an incentive to development of marginal North
Sea fields, an “oil allowance” or exemption from PRT is
allowed for each field in an amount equivalent to the
value of 500,000 metric tons of oil per 6-month period
up to a total of 10 million metric tons over the life
of the field;4
(2) A tariff receipts allowance is allowed, which for each
6-month chargeable period exempts from PRT tariff receipts
attributable to transportation of up to 250,000 metric tons
(i.e., up to 1,875,000 barrels) of oil from each field);
(3) Various nonfield-specific expenses are deductible
against income from a field (e.g., exploration,
appraisal, and research expenses);
(4) As a limit on the amount of PRT that would be
owed, a “safeguard” provision limits the amount of PRT
payable in each 6-month period in which it applies
except to the extent that adjusted profits from a field
exceed 15 percent of accumulated capital investment in
a field and then PRT only applies to 80 percent of such
adjusted profits;
4
Over the life of each field, the oil allowance or exemption
varied from 75 to 35 million barrels of crude oil.
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(5) An exemption from PRT is allowed for revenue relating
to North Sea natural gas production derived from pre-July
1975 contracts with the British Gas Corporation;
(6) Upon abandoning fields, carryover of unused losses
are allowed without limit to other North Sea fields;
(7) PRT was enacted as a “prior charge” to the Ring
Fence Tax which means that PRT is computed, assessed,
and paid before the Ring Fence Tax, and PRT is
deductible in computing the Ring Fence Tax;
(8) Of the limited types of expenses that are not allowed
as deductions for PRT purposes, interest expense is the only
nonallowable expense that is significant, and in lieu of
interest expense, a deduction is allowed for “uplift”
(discussed further, infra).
Because of the above features of PRT, activities in a North
Sea field generally are not subject to PRT until they reflect a
cumulative profit.
PRT liability of a company is to be paid only in cash, not
in kind.
On a number of occasions, in response to changes in world
oil markets and in order to make certain adjustments to PRT,
provisions of PRT were amended by the United Kingdom. Such
amendments that, over the years, have been made to PRT are not
particularly significant to the issue before us and generally are
not described herein.
As indicated, in order to minimize PRT avoidance through
intercompany interest charges, interest expense deductions
relating to North Sea oil and gas recovery activities are not
allowed in computing PRT liability. Current deductions from
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income, however, are allowed for what is referred to as uplift,
consisting of amounts equal to 35 percent of most capital
expenditures relating to a North Sea field (over and above the
current deductions allowed in computing PRT for 100 percent of
such capital expenditures).5 The deduction for uplift is
provided in lieu of a deduction for North Sea related interest
expenses.
Similar to the cost of capital expenditures to which uplift
relates and on the basis of which uplift is calculated, uplift is
allowable in full as a current deduction at the time the related
capital expenditures are incurred and fully deducted. Allowances
for uplift are computed and determined only during the period of
time prior to when an activity in a field becomes profitable, the
period during which interest expense relating to a field
typically is necessary. Once calculated and determined, unused
uplift may be carried back or carried forward without limit.
In calculating Exxon’s PRT liability, for 1975 through 1988,
the cumulative total amount of uplift deduction allowed to Exxon
was £1.8 billion, almost twice the cumulative total £900 million
interest expense that under PRT was not allowed as a deduction to
Exxon.
5
As originally enacted in the Oil Taxation Act of 1975 and
until amended in 1979, the rate of the uplift allowance was 75
percent.
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Based on industry data that is in evidence and that was
gathered from Exxon and approximately 33 other oil companies
involved in North Sea oil and gas production, the cumulative
total uplift allowed the companies for 1975 through 1988 was
£12.4 billion, as compared to cumulative total interest expense
not allowed the companies under PRT of £8.6 billion. In the
Appendix to this Opinion, for 1975 through 1988, we set forth the
amount of uplift and other deductions allowed to Exxon and to the
other oil and gas companies and the amount of ring fence interest
expense not allowed to Exxon and the other oil and gas companies
in the computation of PRT liability.
As a result of the special allowances such as oil, tariff
receipts, safeguard, and uplift, PRT represents and constitutes a
tax on a subset of net income subject to the Ring Fence Tax.
Through 1992, Exxon had interests in 23 oil-producing North
Sea fields, but significant PRT was paid only with regard to five
of the fields (Brent, Forties, Dunlin, Fulmar, and North
Cormorant). More than 60 percent of total PRT paid by Exxon
through 1992 was paid with respect to only one field -- the Brent
field which was the highest oil-producing field in the North Sea.
Generally for the industry, the bulk of PRT was paid with
respect to a limited number of the largest and most profitable
fields. More specifically, through 1988, approximately 75
percent of total cumulative PRT collected by the United Kingdom
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was paid by only five oil and gas companies which owned the
largest and most profitable fields in the North Sea.
Because of the special allowances, small oil and gas
companies with interests in marginal fields typically owe no PRT
with regard to fields licensed to them.
Pre-existing licensees (i.e., companies such as Exxon to
whom North Sea licenses were issued prior to enactment of PRT in
1975) were obligated to pay PRT upon its enactment in 1975 and in
subsequent years even though they were in full compliance with
terms of their pre-1975 North Sea licenses. All PRT paid by
Exxon during the years in issue and the character of which is in
dispute in these cases was paid by Exxon with respect to fields
licensed to Exxon before 1975 and before PRT was enacted.
As a result of paying PRT, Exxon neither received any
special benefits under the North Sea licenses that it had been
issued before 1975, nor received any special benefits from the
United Kingdom in obtaining new North Sea licenses after 1975.
By 1979, with the rise of oil prices relating to the Iranian
Revolution, there was a general perception that the PRT rate was
too low and that the United Kingdom ought to be collecting more
PRT from oil companies operating in the North Sea. In 1982,
however, with a drop in world oil prices, there was a general
perception that the PRT rate was too high and that PRT and
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increased operating costs were becoming a disincentive to North
Sea oil and gas development activity.
As a result of the above increases and decreases in world
oil prices and the changing perceptions regarding PRT and the PRT
rate, in 1979, 1980, 1982, and 1993 the tax rate for PRT was
changed from the original rate of 45 percent as enacted in 1975
to the rates indicated:
1979 1980 1982 1993
PRT Rate 60% 70% 75% 50%
In 1993, PRT was eliminated for all subsequent North Sea oil
and gas activity under licenses to be issued thereafter, and, as
indicated, the PRT rate was reduced to 50 percent for existing
licenses.
For 1975 through 1988, Exxon paid £3.5 billion in PRT,
approximately 11 percent of the approximate total £32 billion in
PRT that was paid to the United Kingdom by all oil and gas
companies for those years.
Because primarily of timing differences associated with
calculations of PRT at the field level and because PRT was
deductible in computing the Ring Fence Tax, for any 1 year
companies may owe PRT but no Ring Fence Tax, they may owe Ring
Fence Tax but no PRT, and they may owe both PRT and Ring Fence
Tax or neither. These differing results are not inconsistent
with the objective of PRT to tax extraordinary profits and to
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accelerate tax revenues relating to development of North Sea
petroleum resources.
OPINION
With limitations not here pertinent, taxpayers may claim
credits under section 901 against their Federal income taxes for,
among other things, the amount of income and excess profits taxes
paid to foreign countries. See sec. 901(b)(1). As an exemption
from tax, the credit provisions of section 901 are to be strictly
construed. See Inland Steel Co. v. United States, 230 Ct. Cl.
314, 677 F.2d 72, 79 (1982); Bank of Am. Natl. Trust & Sav.
Association v. United States, 61 T.C. 752, 762 (1974), affd.
without published opinion 538 F.2d 334 (9th Cir. 1976).
Under regulations applicable to the years in issue, foreign
levies are to be regarded as income or excess profits taxes if
they satisfy two tests: (1) The foreign levies constitute taxes,
and (2) the predominant character of the taxes is that of an
income tax in the U.S. sense. See sec. 1.901-2(a)(1), Income Tax
Regs.
Generally, governmental levies imposed by and paid to
foreign countries are to be treated as taxes if they constitute
compulsory payments pursuant to the authority of the foreign
countries to levy taxes. The regulations, however, also provide
that foreign levies will not be regarded as taxes to the extent
that payors of the levies receive specific economic benefits,
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directly or indirectly, from the foreign countries in exchange
for payment of the levies. See sec. 1.901-2(a)(2), Income Tax
Regs. The regulations also provide that economic benefits that
foreign Governments do not make available on substantially the
same terms to substantially all persons subject to the generally
imposed income tax (such as a concession to extract Government-
owned petroleum) will be regarded as specific economic benefits.
See sec. 1.901-2(a)(2)(ii)(B), Income Tax Regs.
Exxon acknowledges that the licenses it received from the
United Kingdom to exploit North Sea petroleum resources
constitute the receipt of specific economic benefits and
therefore that Exxon is to be treated under the regulations as a
“dual capacity” taxpayer and as subject to the regulations with
regard thereto under sections 1.901-2(a)(2) and 1.901-2A, Income
Tax Regs. Thereunder, dual capacity taxpayers (who pay levies
and who also receive specific economic benefits from the
Government) have the burden to establish the extent, if any, to
which foreign levies they pay constitute taxes -- as opposed to
payments for the specific economic benefits received -- either by
relying on the regulations’ safe harbor method or on the facts
and circumstances method. See sec. 1.901-2A(c)(1) and (2),
Income Tax Regs. Exxon herein relies on the facts and
circumstances method, and Exxon is required to establish, under
all of the relevant facts and circumstances associated with its
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payment of PRT, what portion, if any, of PRT paid by it to the
United Kingdom constitutes taxes, as distinguished from payments
in exchange for the license rights it received.6 See sec. 1.901-
2A(b), (c), Income Tax Regs.
With regard to the second test involving the predominant
character of the foreign taxes, the regulations provide, among
other things, that foreign taxes will be treated as income taxes
in the U.S. sense if the foreign taxes operate in such a manner
as to reach net gain in the normal circumstances in which they
6
Sec. 1.901-2(a)(2)(i), Income Tax Regs., provides as
follows:
Notwithstanding any assertion of a foreign country to
the contrary, a foreign levy is not pursuant to a
foreign country's authority to levy taxes, and thus is
not a tax, to the extent a person subject to the levy
receives (or will receive), directly or indirectly, a
specific economic benefit (as defined in paragraph
(a)(2)(ii)(B) of this section) from the foreign country
in exchange for payment pursuant to the levy. Rather,
to that extent, such levy requires a compulsory payment
in exchange for such specific economic benefit. If,
applying U.S. principles, a foreign levy requires a
compulsory payment pursuant to the authority of a
foreign country to levy taxes and also requires a
compulsory payment in exchange for a specific economic
benefit, the levy is considered to have two distinct
elements: a tax and a requirement of compulsory
payment in exchange for such specific economic benefit.
In such a situation, these two distinct elements of the
foreign levy (and the amount paid pursuant to each such
element) must be separated. No credit is allowable for
a payment pursuant to a foreign levy by a dual capacity
taxpayer (as defined in paragraph (a)(2)(ii)(A) of this
section) unless the person claiming such credit
establishes the amount that is paid pursuant to the
distinct element of the foreign levy that is a tax.
* * *
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apply. See sec. 1.901-2(a)(3)(i), Income Tax Regs. More
specifically, the regulations provide that foreign taxes will be
treated as income taxes if and only if the taxes, judged on the
basis of their predominant character, satisfy each of the
realization, gross receipts, and net income requirements of
section 1.901-2(b), Income Tax Regs.
Generally, under section 1.901-2(b)(4)(i), Income Tax Regs.,
foreign taxes will be regarded as satisfying the net income
requirement if, measured by their predominant character, they
permit recovery of the significant costs and expenses relating to
the income or if they provide other allowances that effectively
compensate for nonrecovery of such costs and expenses.7
7
Pertinent language of sec. 1.901-2(b)(4)(i), Income Tax
Regs., is as follows:
(4) Net Income–(i) In general. A foreign tax
satisfies the net income requirement if, judged on the
basis of its predominant character, the base of the tax
is computed by reducing gross receipts * * * to
permit–-
(A) Recovery of the significant costs and
expenses (including significant capital expenditures)
attributable, under reasonable principles, to such
gross receipts; or
(B) Recovery of such significant costs and
expenses computed under a method that is likely to
produce an amount that approximates, or is greater
than, recovery of such significant costs and expenses.
* * *
A foreign tax law that does not permit recovery of one
or more significant costs or expenses, but that
(continued...)
- 25 -
The regulations also provide that taxes either are or are
not to be regarded as income taxes in their entirety for all
persons subject to the taxes. See sec. 1.901-2(a), Income Tax
Regs. Respondent does not interpret this provision as requiring
that, in order to qualify as an income tax, a tax in question
must satisfy the predominant character test in its application to
all taxpayers. Rather, respondent interprets this provision as
requiring that in order to qualify as an income tax a tax must
satisfy the predominant character test in its application to a
substantial number of taxpayers.
On brief, respondent explains the net income test as
follows: PRT satisfies the net income test if its base is
computed by reducing gross receipts to permit recovery of
significant costs and expenses attributable to gross receipts,
or, if some of these costs and expenses are not deductible,
recovery of such costs and expenses computed under a method that
is likely to produce an amount approximating or exceeding the
nondeductible costs or expenses.
The parties have stipulated that PRT meets the realization
and gross receipts requirements of section 1.901-2(b)(2), (3),
Income Tax Regs., that PRT constitutes a compulsory payment
7
(...continued)
provides allowances that effectively compensate for
nonrecovery of such significant costs or expenses, is
considered to permit recovery of such costs or
expenses. * * *
- 26 -
imposed by the United Kingdom within the meaning of section
1.901-2(a)(2)(i), Income Tax Regs., and that PRT does not
constitute a soak-up tax within the meaning of section 1.901-
2(c), Income Tax Regs. The only issues before us are whether PRT
paid by Exxon is to be treated as a tax (as opposed to payment
for specific economic benefits) and whether the predominant
character of PRT may be regarded as an income tax in the U.S.
sense and thereby as satisfying the net income test.8
PRT and Compensation for Specific Economic Benefits
The evidence in these cases establishes that PRT paid by
Exxon does not constitute compensation in exchange for license
rights or other specific economic benefits received by Exxon.
Upon enactment of PRT and upon or in exchange for payment of PRT,
Exxon was granted no additional rights, under its licenses or
otherwise, with respect to North Sea petroleum resources.
8
Of the total £3.2 billion in PRT that Exxon paid for 1983
through 1988 respondent would allow approximately £1.2 billion
as creditable taxes for U.S. tax purposes under the United
States-United Kingdom Income Tax Treaty, Dec. 31, 1975, 31 U.S.T.
5668 (U.S./U.K. Tax Treaty). Respondent contends that the £2
million balance does not qualify under secs. 901 or 903 for
credit against Exxon’s Federal income tax liability. Neither
party herein makes any argument that what amount of PRT is or is
not creditable under the U.S./U.K. Tax Treaty is in any way
relevant to the issue addressed in this Opinion (namely, the
amount, if any, of PRT that is creditable under the provisions of
secs. 901 or 903). If the issue herein is resolved in favor of
respondent, the parties have reserved for subsequent resolution
the question as to the appropriate amount of PRT that would be
creditable under the U.S./U.K. Tax Treaty.
- 27 -
Exxon’s rights to explore for, develop, and exploit petroleum
resources in the North Sea during the years in issue arose from
and were dependent upon licenses Exxon obtained from the United
Kingdom in prior years (before PRT was enacted) and on Exxon’s
payment to the United Kingdom of license fees and royalties due
under those licenses.
The United Kingdom’s purpose in enacting PRT in 1975 was to
take advantage of rising oil prices and to ensure that the United
Kingdom realize an appropriate share of excess profits to be
realized by Exxon and by other oil and gas companies from
exploitation of petroleum resources in the North Sea under the
licences granted to them.
License fees owed and paid by Exxon under terms of the
discretionary licenses (consisting of the up-front fees, annual
fees, and 12½-percent royalties) represented substantial and
reasonable compensation to the United Kingdom for the licenses.
As indicated, through 1992 the oil and gas companies have paid to
the U.K. Government more than £16 billion in royalties alone in
connection with the North Sea licenses.
Under its sovereign taxing power, the United Kingdom
intended to and did impose PRT as a tax, not as payment for
specific economic benefits. Respondent stipulates that PRT was
not negotiated but was imposed unilaterally, as a compulsory
payment, and that PRT was enacted and is administered as a tax
- 28 -
under U.K. law -- all characteristics of taxes, not of payments
for specific economic benefits.
The parties herein rely heavily on expert witnesses -- from
the petroleum industry, from the U.K. Government, and from legal,
tax, accounting, and economic professions –- as to the character
of PRT as a tax or as payment for specific economic benefits.
The basis of the opinions rendered by respondent’s economic
experts seems to be that, in hindsight, oil companies “got a good
deal” when they entered into North Sea license agreements, that
the licenses turned out to be more valuable than anyone
anticipated at the time the licenses were issued, and therefore
that the oil companies “probably felt there was an implicit
contract” to pay some type of additional charges, and that these
additional charges (whatever they may be called, however they are
administered, and regardless of their features) should be
regarded as what respondent’s expert witnesses refer to as
“economic rent” (i.e., as deferred payments in exchange for the
licenses granted in earlier years to the oil companies) and not
as taxes.
Respondent’s experts overemphasize the fact that North Sea
licenses issued by the United Kingdom to the oil and gas
companies in the late 1960's and in the 1970's were issued
largely without an auction system. As we have found, throughout
the world most countries traditionally have not relied on auction
- 29 -
systems to issue licenses for the right to exploit petroleum
resources.
In considering North Sea licenses Exxon received and under
which it operated in the North Sea, respondent’s experts fail to
recognize and to give proper weight to the significant
uncertainties, risks, and investment commitments associated with
oil and gas exploration and production in the North Sea that, at
the time the licenses were issued to Exxon, were associated with
the licenses -- risks that insufficient oil and gas deposits in
the North Sea would be found, that petroleum resources that might
be discovered would not be commercially recoverable, and that the
large investments required to explore for oil and gas and to
operate in the North Sea would be lost.
Respondent’s experts speculate that in light of increased
oil prices in the late 1970's and early 1980's, the United
Kingdom could have set the license fees higher and obtained
higher revenues under the North Sea licenses. That, however, is
not the proper inquiry. We are not particularly concerned with
speculation, about whether in retrospect the United Kingdom
extracted all the revenues it could have from oil companies under
the licenses. Rather, as Exxon’s witnesses emphasize, the proper
focus is whether PRT was imposed and paid “in exchange for” North
Sea license rights. This is the focus of the regulations under
section 901 and that focus is to be maintained here. See
- 30 -
sec. 1.901-2(a)(2), Income Tax Regs; see also Phillips Petroleum
Co. v. Commissioner, 104 T.C. 256, 297 (1995).
In Phillips Petroleum Co., we held that Norway’s Special Tax
on oil and gas activity in the Norwegian sector of the North Sea
constituted, for U.S. Federal income tax purposes, a creditable
tax under section 901. Norway’s Special Tax is similar in a
number of significant respects to PRT.
Under temporary Treasury regulations applicable to the years
involved in Phillips Petroleum Co., Norway’s Special Tax was to
be treated as a tax as long as “no significant part of the charge
[represents] compensation for the specific economic benefit
received”. See sec. 4.901-2(b)(2)(iii), Temporary Income Tax
Regs., 45 Fed. Reg. 75649 (Nov. 17, 1980), as applicable to 1979
to 1982. Applying that test, we held in Phillips Petroleum
Co. v. Commissioner, supra at 289-297, that Norway’s Special Tax
constituted a tax and not payment for specific economic benefits.
The Norway Special Tax was enacted in 1975 and was imposed
on oil and gas companies operating under discretionary licenses
granted by Norway requiring payment of initial fees, annual fees,
and 10-percent royalties. We concluded that by payment of the
Special Tax the oil and gas companies were not granted additional
rights under their licenses, that the fees and royalties paid
under the licenses represented substantial compensation for such
licenses, that the Special Tax constituted a tax and not an
- 31 -
additional royalty, and that the purpose of the Special Tax was
to impose taxes on excess and unexpected profits, not to impose
additional charges on oil companies for rights to extract oil,
and therefore that the Special Tax constituted a tax, not a levy
in exchange for specific economic benefits. In Phillips
Petroleum Co. v. Commissioner, supra at 295, we explained:
The word “tax” in [the U.S.] * * * is generally
understood to mean an involuntary charge imposed by
legislative authority for public purposes. It is
exclusively of statutory origin. Tax burdens and
contractual liabilities are very different things. A
tax is compulsory, an exaction of sovereignty rather
than something derived by agreement. A tax is a
revenue-raising levy imposed by a governmental unit.
It is a required contribution to the governmental
revenue without option to pay. A royalty refers to a
share of the product or profit reserved by an owner for
permitting another to use a property. [Citations
omitted.]
In Phillips Petroleum Co., we then concluded that the
Norwegian Special Tax was enacted:
to take advantage of a new profit situation created by
surging oil prices, and to receive a larger share of what
Norway saw as extraordinarily high and unforeseen profits
generated from Norwegian resources, and at the same time to
allow petroleum companies to earn a reasonable profit. [Id.
at 292.]
Phillips Petroleum Co. v. Commissioner, supra, supports our
finding and conclusion herein that PRT is not to be regarded as
payment in exchange for specific economic benefits Exxon received
under its North Sea licenses.
- 32 -
All of the PRT the character of which is in dispute in these
cases was paid by Exxon with respect to oil production from
fields licensed to Exxon before 1975 and before PRT was enacted.
As one of respondent’s experts acknowledges, Exxon did not
receive any special benefits under its licenses, or otherwise,
for paying PRT, and Exxon in later years, as a result of paying
PRT, did not receive any special advantages in obtaining
additional North Sea licenses.
The credible and persuasive evidence strongly supports and
we conclude that all PRT paid by Exxon for the years in question
constitutes taxes, not payments for specific economic benefits.
PRT and the Net Income Test
The purpose, administration, and structure of PRT indicate
that PRT constitutes an income or excess profits tax in the U.S.
sense. The provisions of PRT include in the tax base, with
limited exceptions, income earned from North Sea-related activity
and permit allowances, reliefs, and exemptions that effectively
compensate for nondeductibility of certain oil company expenses,
particularly interest.
Although a deduction is not allowed for interest expense
related to North Sea operations, uplift, oil, safeguard, and
tariff receipts allowances provide sufficient relief to offset
for nonallowance of a deduction for interest expense. See sec.
1.901-2(b)(4)(i), Income Tax Regs. For 1975 through 1988,
- 33 -
representative industry data indicate that oil companies received
uplift allowances alone of £12.4 billion as compared to North
Sea-related interest expense not allowed of £8.6 billion.
Evidence at trial covering approximately 88 percent of total
oil production in the North Sea and 98 percent of total PRT paid
by oil companies during 1975 through 1988 shows that special
allowances and reliefs under PRT significantly exceed the amount
of disallowed interest expense for Exxon and other oil companies.
These special allowances and reliefs reduce the base of PRT to a
subset of net income representing excess profits and establish
that, in its predominant character, PRT constitutes and is to be
treated as an income tax.
Although PRT does not allow a deduction for interest expense
-- certainly a significant expense -- under the special
provisions allowed (particularly uplift), the oil companies are
provided under PRT allowances that effectively compensate for the
nondeductibility of interest expense.
As explained by the Government official who on April 10,
1975, first presented for formal legislative consideration the
proposed Ring Fence Tax and PRT to the U.K. House of Lords, “In
fact, of course, this tax [PRT] represents an excess profits
tax.”
Respondent’s experts assert that uplift provides too “crude”
a substitution for a deduction for interest expense, that PRT
- 34 -
fails to provide an allowance that “mimics” interest expense, and
that the relationship of PRT allowances to nonrecoverable
expenses is not sufficiently “predictable”. We reject these
labels as merely argumentative and as without merit.
We note statements in respondent’s pretrial brief, in
respondent’s counsel’s opening statement, and in a number of
respondent’s experts’ reports or testimony that in essence
acknowledge the “income” or “profits” nature of PRT. One of
respondent’s experts testified contrary to prior published
statements he has made regarding PRT and its nature as an “excess
profits tax”.
In Texasgulf, Inc. & Subs. v. Commissioner, 107 T.C. 51(1996), affd. 172 F.3d 209 (2d Cir. 1999), we held that the
Ontario Mining Tax (OMT) satisfied the net income test of the
section 901 regulations and constituted a creditable income tax.
Among other things, we relied on industry data showing that a
special processing allowance available to taxpayers in computing
OMT liability adequately compensated for significant nonallowed
costs, including interest. The evidence, among other things,
indicated that the processing allowance, in the aggregate for the
industry, exceeded the amount of significant nondeductible costs.
See id. at 66.
On appeal, the Court of Appeals for the Second Circuit
focused on how OMT applied to the mining industry as a whole and
- 35 -
on return-by-return data (rather than on aggregate industry data
on which this Court in its opinion in Texasgulf, Inc. & Subs.,
had focused) and affirmed this Court’s opinion. Noting that only
33 percent of the income tax returns showed nonrecoverable
expenses in excess of the processing allowance and that, of the
income tax returns that reflected OMT liability, only 16 percent
showed nonrecoverable expenses that exceeded the processing
allowance, the Court of Appeals concluded that the taxpayer had
met its burden of proving that under OMT the taxpayer was
effectively compensated for nonrecoverable costs.
In its opinion in Texasgulf, Inc. & Subs. v. Commissioner,
172 F.3d at 216, the Court of Appeals for the Second Circuit
expressly noted that, where available, quantitative and empirical
evidence relating to taxpayer and to industry experience in
calculating and paying foreign taxes is appropriate and relevant
in analyzing the net income requirement. The Court of Appeals
explained as follows:
the language of sec. 1.901-2--specifically,
“effectively compensate” and “approximates, or is
greater than”--suggests that quantitative empirical
evidence may be just as appropriate as qualitative
analytic evidence in determining whether a foreign tax
meets the net income requirement. * * * [Id.]
In Texasgulf, Inc. & Subs. v. Commissioner, 107 T.C. at 64-65,
70, we used similar language to describe the type of evidence
that may be used in evaluating the nature of foreign taxes for
- 36 -
purposes of section 901. See also Texasgulf, Inc. v. United
States, ___ Fed. Cl. ___ (Oct. 15, 1999).
Credible expert witness testimony, industry data, and other
evidence in these cases establish that allowances available under
PRT effectively and adequately compensate Exxon for expenses
disallowed under PRT and that PRT, in its predominant character,
constitutes a tax in the nature of an excess profits tax (i.e.,
an income tax) in the U.S. sense.
Respondent contends that Exxon’s industry data is biased in
favor of large oil and gas companies like Exxon and that a
company-by-company analysis indicates that a majority of the
companies operating in the North Sea for a majority of years did
not have uplift allowance greater than or equal to nonrecoverable
interest expense. As Exxon points out, however, respondent’s
approach ignores the fact that PRT was designed to tax excess
profits from North Sea oil and gas production which generally
were earned by major oil and gas companies which owned the
largest and most profitable fields in the North Sea. Through
1988, approximately 75 percent of PRT was paid by only five major
companies. Small companies with licenses for marginal fields,
because of the special allowances, typically owe no PRT, and for
companies which owe no PRT it is irrelevant whether uplift is
adequate to offset nonallowed interest expense. Through 1988, 34
of the 79 oil companies included in the studies paid no PRT.
- 37 -
We agree with Exxon that if a company-by-company approach is
used to analyze the effect of uplift and other allowances, some
particular focus should be given to those companies which earn
excess profits from North Sea oil production and which pay PRT.
This is the type of empirical and particular industry data that
would seem particularly relevant. Of the 45 companies which
through 1988 paid approximately 98 percent of total PRT paid to
the United Kingdom, 34 companies or 76 percent (and accounting
for 91 percent of total PRT paid through 1988) had uplift
allowance in excess of nonallowed interest expense. If the oil
allowance is factored into the data, 39 of 45 companies or 87
percent (and accounting for 94 percent of total PRT paid through
1988) had allowances in excess of nonallowed interest expense.
We conclude that PRT constitutes a tax, that the predominant
character of PRT constitutes an excess profits or income tax in
the U.S. sense, and that PRT paid by Exxon to the United Kingdom
for the years in issue is creditable under section 901 against
Exxon’s U.S. Federal income tax liability.
In light of our resolution of the above issues, we need not
address Exxon’s alternative argument that PRT qualifies under
section 903 as a creditable tax in lieu of an income tax.
To reflect the foregoing,
Decisions will be entered
under Rule 155.
- 38 -
APPENDIX
PRT Paid by Exxon and Comparison of Exxon’s
PRT Special Allowances to its Ring Fence
Interest Expense (1975-1988) (in U.K. Pounds)
Safeguard Nonallowed
Tariff Allowance Ring Fence
PRT Paid By Uplift Oil Receipts Safeguard Deduction Total Interest
Year Exxon Allowance Allowance Allowance Allowance Equivalent Allowances Expense
1975 0 8,959,359 0 0 0 0 8,959,359 1,533,000
1976 0 105,625,116 0 0 0 0 105,625,116 8,628,000
1977 0 5,867,192 21,360,737 0 0 0 27,227,929 46,008,000
1978 16,078 58,511,216 23,173,022 0 0 0 81,684,238 56,960,000
1979 17,837 133,451,025 12,682,868 0 0 0 146,133,893 116,828,000
1980 20,510,300 449,294,439 33,021,404 0 0 0 482,315,843 164,140,000
1981 100,458,130 168,296,228 42,728,040 0 0 0 211,024,268 139,546,000
1982 119,239,356 544,618,089 50,992,174 1,105,951 0 0 596,716,214 107,783,000
1983 423,014,556 70,420,726 88,959,862 3,456,109 118,415,934 157,887,912 320,724,609 22,397,000
1984 965,101,175 144,402,403 136,924,700 13,149,141 252,148,968 336,198,624 630,674,868 7,246,000
1985 984,865,434 27,666,094 166,966,203 23,309,676 318,580,059 424,773,412 642,715,385 10,065,000
1986 194,654,714 16,913,408 67,417,623 32,668,303 414,997,698 553,330,264 670,329,598 67,244,000
1987 321,598,479 24,183,485 72,943,737 30,801,424 415,223,138 553,630,851 681,559,497 84,374,000
1988 371,670,157 22,900,846 58,943,277 31,344,050 115,289,728 153,719,637 266,907,810 98,351,000
Totals 3,501,146,216 1,781,109,626 776,113,647 135,834,654 1,634,655,525 2,179,540,700 4,872,598,627 931,103,000
PRT Paid by 34 Companies and Comparison of
Companies’ PRT Special Allowances to their Ring
Fence Interest Expense (1975-1988) (in U.K. Pounds)
Safeguard Nonallowed
Tariff Allowance Ring Fence
PRT Paid By Uplift Oil Receipts Safeguard Deduction Total Interest
Year 34 Companies Allowance Allowance Allowance Allowance Equivalent Allowances Expense
1975 0 549,645,555 13,959 0 0 0 549,659,514 66,542,527
1976 0 551,570,154 33,419 0 0 0 551,603,573 285,303,726
1977 0 371,995,678 97,374,963 0 0 0 469,370,641 441,409,166
1978 430,689,327 1,699,237,659 153,852,120 0 0 0 1,853,089,779 461,981,340
1979 1,156,589,715 551,928,097 105,214,447 0 0 0 657,142,544 704,165,739
1980 2,197,291,915 1,366,859,351 328,456,501 0 0 0 1,695,315,852 863,608,555
1981 2,396,943,312 1,435,689,699 519,913,143 0 18,948,155 27,068,793 1,982,671,635 841,824,111
1982 3,176,093,221 1,351,596,634 656,231,353 8,960,856 231,062,739 330,089,627 2,346,878,470 824,298,172
1983 5,572,524,246 1,490,033,648 851,539,832 33,884,463 644,892,193 859,856,257 3,235,314,200 767,424,949
1984 6,369,523,079 981,248,452 1,186,636,787 60,199,128 669,948,021 893,264,028 3,121,348,395 832,922,625
1985 5,760,629,333 1,054,005,842 1,337,372,027 135,511,998 733,604,214 978,138,952 3,505,028,819 708,244,278
1986 1,366,854,617 347,209,776 685,332,228 128,623,314 1,272,258,531 1,696,344,708 2,857,510,026 674,092,084
1987 1,912,894,346 324,720,056 763,354,267 135,830,479 1,349,555,544 1,799,407,392 3,023,312,194 540,583,476
1988 1,503,526,701 318,463,734 647,660,574 135,573,763 586,517,012 782,022,683 1,883,720,754 634,094,662
Totals 31,843,559,812 12,394,204,335 7,332,985,620 638,584,001 5,506,786,409 7,366,192,440 27,731,966,39 8,646,495,410