Economic Substance and the Foreign Tax Credit: The Second Circuit Exacerbates a Split Among Circuits

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By Philip Morrison, Esq.

McDermott Will & Emery, Washington, DC

Bad facts make bad law.1 Every first-year law student learns this adage. Unfortunately, few judges ever worry about it enough in cases with bad facts. Most just go ahead and make bad law to address the perceived problems presented by the bad facts.  The so-called foreign tax credit generator cases are good examples.  Complex transactions intentionally structured to take advantage of foreign versus U.S. tax law arbitrage opportunities look queer enough that judges have misconstrued the nature of the foreign tax credit ("FTC") and misapplied the economic substance doctrine ("ESD") to deny FTCs. The resulting bad law may stretch beyond the FTC generator cases.

The Second Circuit's recent combined decision in two such cases is one such example.2 Its conclusion, while consistent with a recent Federal Circuit decision,3 is directly contrary to the conclusions reached in similar cases more than a decade ago in the Fifth and Eighth Circuits.4 While the taxpayer in the Federal Circuit cases have filed writs of certiorari requesting that the Supreme Court resolve this split, the likelihood of the Court taking the cases, as is true for any tax case, must be rated as small.  That is unfortunate because the Second and Federal Circuits' views add an intolerable level of uncertainty regarding the availability of the FTC in virtually any complex, low-margin situation.5

The critical point in all five cases6 is whether foreign taxes should be counted as an expense in calculating pre-tax profit for purposes of the ESD.  The Fifth and Eighth Circuits7 say no; the Second and Federal Circuits8 say yes.

It is difficult for this commentator to understand the Second and Federal Circuits' reasoning as a FTC technical or policy matter.9 The very fact that foreign income taxes can be credited against U.S. income tax indicates that foreign income taxes should be considered equivalent to U.S. income tax. One is a substitute for the other.  A person does not pay U.S. tax on the same income on which one pays foreign tax at a rate equivalent to the U.S. rate. If this was not evident from the nature of the FTC itself, the legislative history makes it clear.10

Using conclusory, circular reasoning, the Second and Federal Circuits toss this logical approach out the window. They state that "tax independent considerations" must motivate transactions and conclude that FTCs were critical to the transactions at issue. They then conclude, in a stunning non sequitur, that foreign taxes must be counted as an expense in computing pre-tax profit. And if foreign taxes are an expense, there is no profit.  Since there is no profit, there is no economic substance. Therefore, the FTCs must be denied. Sure foreign taxes are an expense, but so are U.S. taxes. If the goal is to identify pre-tax profit, why should one be counted and the other not? Critically, neither court ever addresses why foreign taxes are different from U.S. taxes in this analysis.

The illogic of the Second and Federal Circuits' analysis is evident when it is applied to a "domestic" repo.

In the AIG case, the FTCs were those taken with respect to foreign taxes imposed on a foreign entity whose stock was sold to a foreign bank and then contracted to be repurchased (via a forward) by AIG. As readers know, that creates a hybrid transaction—a secured borrowing for U.S. tax purposes with interest deductions; the actual ownership of the shares for foreign tax purposes with exempt dividends. A deduction in the United States and no inclusion abroad is the arbitrage at work—the tax "juice" that allows the banks to accept a lower return on their "loans."

Apparently AIG also engaged in several repo transactions with foreign banks in the same years using stock of domestic entities.  In those cases, there were no FTCs involved. The parallel element (to the FTC) involved in these domestic deals was the elimination in consolidation of the dividend from the wholly owned domestic entity to its parent.11 But the IRS didn't challenge any of those repos. It didn't because the secured loan treatment of repos has long been accepted,12 and no authority exists to deny consolidation of U.S. corporations because of tax arbitrage that may be involved in a transaction involving them.  The elimination in consolidation of inter-company dividends (or the DRD), however, was no less critical in those cases than the FTCs were in the cases challenged. And the parallel IRS logic would claim that the taxpayer was "generating" excluded (or deductible) dividends.

If the Second and Federal Circuits applied their ESD reasoning to the "domestic" repo situations, they would have to conclude that pre-tax profit in those cases must be computed without reference to the U.S. tax benefit (the dividend exclusion or deduction) "generated" in the transactions.  If they did, they'd find no economic substance in standard repo cases.  A reasonable court would be unlikely to go so far. The "bad facts" present (the tax arbitrage) just couldn't reasonably compel a conclusion that the ESD demanded a denial of tax consolidation basics. Instead, a proper response would be for a court to suggest to Congress that it address the cross-border arbitrage in the statute if it thinks a transaction seems too hokey and too rich. This is exactly the route that the Second and Federal Circuits should have taken. Instead, they depart from the Fifth and Eighth Circuits' correct reasoning that foreign taxes are not a cost to be deducted in computing pre-tax profit. In so doing, they potentially expand the application of the ESD well beyond structured transactions like the so-called FTC generators.

If the Supreme Court resolves this conflict in favor of the Fifth and Eighth Circuits' views, the bad law will be corrected and Congress can solve any resulting dislike of the underlying tax arbitrage through legislation. Otherwise, taxpayers will be faced with trying to determine economic substance of any transaction subject to foreign tax by counting the foreign tax as a cost.

Counting foreign taxes as a cost to be deducted in computing pre-tax profit, of course, could mean that many foreign investments could fail the ESD. While the Second Circuit helpfully declares that the lack of their brand of pre-tax profit is not the end of the inquiry, it then unhelpfully states that "the transaction's overall economic effect" must be looked at. Unfortunately, that analysis appears to be no more than a "smell test," a subjective, me´lange of considerations that are virtually impossible to apply with any predictability of outcome to other cases.

Even worse, the Second and Federal Circuits take into account the tax benefits and motives of the unrelated foreign bank counterparties to determine the propriety of the U.S. taxpayers' claim of a FTC. Ignoring the indirect subsidy and technical taxpayer rules of Reg. §1.901-2(e), §1.901-2(f), these courts have invented their own broad concept of whether the economic incidence of a foreign tax is borne by the taxpayer. If an unrelated, private foreign party shares its own foreign tax benefits with a U.S. counterparty, apparently the U.S. taxpayer is not entitled to a FTC for the foreign taxes it actually pays. While perhaps an understandable reaction to the tax arbitrage involved in these cases, this remarkable conclusion unmoors FTC law from predictability.

In summary, the Second and Federal Circuits' decisions in the so-called FTC generator cases considerably expand the scope of the ESD and misconstrue the nature of the FTC, contrary to decisions from over a decade ago in the Fifth and Eighth Circuits.  If the Supreme Court fails to resolve this conflict in favor of the Fifth and Eighth Circuits' approach, the application of the ESD in many foreign transactions will become highly unpredictable. It is in every U.S. multinational's interest to see this conflict resolved and resolved in favor of the Fifth and Eighth Circuits' reasoning.

This commentary also appears in the December 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see DuPuy, 6020 T.M., The Creditability of Foreign Taxes -- General Issues, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.

  1 Sometimes this is phrased as "Hard cases make bad law."

  2 Bank of New York Mellon Corp. v. Commissioner, AIG, Inc. v. United States, 801 F.3d 104 (2d Cir. 2015).

  3 Salem Financial, Inc. v. United States, 786 F.3d 932 (Fed. Cir. 2015).

  4 Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001); IES Industries, Inc. v. United States, 253 F.3d 350 (8th Cir. 2001).

  5 The U.S. District Court for the District of Massachusetts, in Santander v. United States, No. 1:09-cv-11043-GAO (D. Mass. Nov. 13, 2015), decided a case identical to Bank of New York Mellon in favor of the taxpayer. If the First Circuit were to affirm, that would present an even starker split in the circuits which might encourage the Supreme Court to grant cert.

  6 As well as in Santander and another case likely to go to trial in Minnesota, Wells Fargo v. United States, No. 0:09-cv-02764-PJS-TNL (D. Minn. Nov. 10, 2015).

  7 And the District of Massachusetts.

  8 And the District of Minnesota.

  9 As a matter of equity it might be more understandable.

  10 The FTC rules "treat the taxes imposed by the foreign country as if they were imposed by the United States." H.R. Rep. No. 83-1337 (1954).

  11 Alternatively, a DRD could have been claimed.

  12 See, e.g., Nebraska Department of Revenue v. Loewenstein, 513 U.S. 123 (1994); Rev. Rul. 74-27, 1974-1 C.B. 21.