December 20, 2006

Creditable Foreign Taxes as an Expense in Applying the Economic Substance Profit Test--

Here We Go Again?

By

James M. Peaslee*

I. Introduction

In broad terms, the common law economic substance doctrine requires that a

transaction generating net tax benefits have a nontax purpose in order to be recognized. That

purpose is most often the expectation of a nontrivial pretax profit (i.e., a profit disregarding tax

effects). The quest for lucre is, after all, the ultimate goal of the core activities of most commer-

cial enterprises. For transactions in which foreign income taxes are paid, it can be critical to de-

termine if the foreign taxes will be equated to U.S. taxes in calculating pretax profits–and there-

fore will be disregarded–on the ground that they are creditable against and therefore replace U.S.

tax, or instead will be considered an expense.

This question was much mooted several years back, as the Government pressed

the expense argument. That position fared poorly in the courts. In response, the Government

retreated to some degree, and it appeared that the cannons had fallen silent. However, as ex-

plained below, the issue has again been joined. The IRS is asserting the argument in audits and,

possibly, may exhume it as a way of fashioning future guidance on cross-border arbitrage trans-

actions. The change in control of the House of Representatives means that the economic sub-

stance codification proposal of years past is more likely to become law. One version of the pro-

posal would etch into stone the treatment of foreign taxes as expenses.

* Partner, Cleary Gottlieb Steen & Hamilton LLP

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For the reasons given below, the author believes that foreign taxes should not be

treated as expenses in applying the profit test. The main reason is that the test does not do a

good job (or even an adequate job) of separating the wheat from the chaff. There are many

transactions in which the taxpayer should be allowed credits that would fail a profit test if foreign

taxes were counted as a charge. While hesitating to put words in the mouths of others, it seems

likely that most proponents of the expense approach would not want to apply it across the board

in the sense of denying credits in any transaction that fails the profit test. Rather it would be ap-

plied only to abusive transactions.1 However, if the profit test were applied to deny credits only

in abusive transactions—defined according to some other standard—it would not fulfill the basic

function of a test, to determine what passes and what fails.

It may be that some proponents of the foreign-taxes-are-expense view are more

rigid in their thinking that I have surmised and do believe that the lack of an anticipated post-

foreign tax profit is a sufficient reason to deny credits in a transaction. I think the practical effect

of adopting that view and enforcing it in an evenhanded way would be an administrative break-

down. There is already in place a complex system for calculating profits from transactions to

justify credits, which is section 904. Applying the foreign-taxes-are-expense principle across the

board would require taxpayers to also calculate post-foreign tax profits according to the princi-

ples of the economic substance doctrine. The doctrine is ordinarily applied to individual transac-

tions or arrangements, not to the groups of activities that are combined into baskets under section

904. Further, the allocation of expenses would differ. For example, interest expense would be

allocated based on tracing rather than assets. It would not be possible to assume that the profit

test would be met in the ordinary course on the ground that taxpayers act rationally to make

money, because a rational business person would ignore creditable foreign taxes as an expense. 1 This has been the Government approach. See footnote 37, below, and accompanying text.

2

Surely no one would consciously support the creation of a transaction-specific system for limit-

ing credits based on profits that parallels section 904 (an AMT for the foreign tax credit limita-

tion). However, it would seem hard to avoid if the premise were accepted that a post-foreign tax

profit test should be applied to all categories of transactions.

The balance of this article will discuss the background to the controversy and the

recent events suggesting it is back, and then review the arguments for and against the treatment

of foreign taxes as an expense.

II. The Story Unfolds

A. Notice 98-5

The tale begins two days before Christmas 1997 when the IRS issued the now de-

parted Notice 98-5 (1997-2004).2 The Notice threatened the adoption of regulations that would

curb foreign tax credit abuse by, in effect, treating foreign income taxes as an expense in apply-

ing the profit leg of the economic substance test. The regulations generally would have applied

to credits for withholding taxes and credits for net income taxes generated in cross-border arbi-

trage transactions.3

2 1998-1 C.B. 337, revoked by Notice 2004-19, 2004-1 C.B. 606. 3 More specifically, the Notice announced that regulations would be issued denying credits in “abusive ar-

rangements” involving withholding taxes or cross-border tax arbitrage transactions. An arrangement would be considered abusive where the expected economic profit from the arrangement was insubstantial com-pared to the value of the foreign tax credits expected from the arrangement. In computing profits, foreign taxes were to be treated as an expense. The same was true for interest expense incurred in borrowings that were part of the arrangement. The Notice did not define the term “arrangement,” and stated that the proper grouping of transactions and investments into arrangements would depend on all relevant facts and circum-stances. The Notice did not apply to withholding taxes on dividends if the holding period requirement of section 901(k) was met and the transaction did not involve cross-border arbitrage. (Section 901(k) is de-scribed below.) Although the Notice did not say so, the conceptual underpinning for the Notice appeared to be the common law economic substance doctrine. For further discussion of Notice 98-5, see James M. Peaslee, “Economic Substance Test Abused: Notice 98-5 and the Foreign Law Taxpayer Rule,” Tax Notes, April 6, 1998, 79.

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In 2001, the Government lost the foreign-taxes-are-expenses argument in two

cases involving years prior to 1997, IES Industries, Inc. v. United States4 and Compaq Computer

Corp. v. Commissioner.5 The cases involved schemes to capture the benefit of withholding taxes

imposed in respect of dividends on stocks and had awful facts (from the taxpayer’s perspective

as a litigant). The transactions were unrelated to the taxpayer’s business, involved very little risk

and had been flogged by a promoter. A significant part of the Government’s argument was that

the transactions lacked a nontax motive because the taxpayer anticipated a post-foreign tax loss.6

The taxpayers convinced the courts that their profit motive should be tested by looking to pre-

foreign tax income (which conformed to taxable income for a taxpayer claiming foreign tax cred-

its). The Government also contended that the transactions should be ignored because they did

not meaningfully change the taxpayer’s position (specifically lacked risk).

In Notice 2004-19, the IRS announced the withdrawal of Notice 98-5.7 An ac-

companying press release noted that recent cases had not looked kindly on the theory underlying

the Notice. The IRS stated that it disagreed strongly with “the result” in the cases, but nonethe-

less had decided to combat foreign tax credit abuses in a different way.8 Notice 2004-19 identi-

4 253 F.3d 350 (8th Cir. June 14, 2001). 5 277 F.3d 778 (5th Cir. December 28, 2001). 6 The taxpayer bought shares of stock just before the record date for the payment of a dividend subject to

withholding taxes and sold the shares very shortly after the purchase (but in such a way that it was the re-cord holder eligible for the dividend). The taxpayer included the dividend (gross before the withholding tax) in its taxable income and claimed a credit for the withholding tax. The tax made the dividend partly tax free (the taxpayers had room under section 904 to claim the credits). The taxpayer sold the stock ex-dividend at a loss reflecting the decline in value attributable to the dividend and claimed a capital loss on the sale. The investment made an economic profit before all taxes because the pre-tax dividend was more than the loss on sale of the stock and transaction expenses. It lost money, however, if the tax was treated as an additional expense.

7 Notice 2004-19, 2004-1 C.B. 606. 8 The press release included the following: “Treasury and the IRS have decided not to issue regulations as

described in Notice 98-5. This decision was influenced by recent court cases involving foreign tax credit transactions that clearly produced results inconsistent with the purpose of the foreign tax credit rules. The

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fied a number of tax law doctrines that might be employed to combat abusive transactions (sub-

stance over form, step transaction doctrine, debt-equity principles, section 269, the partnership

anti-abuse rules, and the substantial economic effect rule governing partnership allocations). The

2004 Notice also announced initiatives being taken to better match credits with the related in-

come.

Although the IRS tried to put a good face on it, Notice 2004-19 was fairly read by

many as a retreat from a systematic attempt to disallow credits in transactions based on the lack

of a post-foreign tax profit.

B. Congressional Actions Enacted in 1997, section 901(k) disallows credits for foreign taxes withheld from

dividends paid on stock where the taxpayer is not exposed to some risk. This result is accom-

plished in an administratively elegant way by requiring the taxpayer to hold the stock for at least

16 days (disregarding days on which risks are substantially offset through hedges). Had this rule

been in effect in the years at issue in Compaq and IES, it would have denied the credits to those

taxpayers (or at least would have required them to commit to material trading risks to get them).

Notice 98-5 came after the enactment of section 901(k) and did not apply to withholding taxes

imposed on dividends in transactions meeting the 16 day holding period test.

courts held that the approach taken in Notice 98-5 did not support the IRS's proposed disallowance of for-eign tax credits in those cases. Treasury and the IRS disagree strongly with the result in those cases, but have concluded that the approach described in Notice 98-5 is unlikely to be an effective tool for addressing transactions that abuse the foreign tax credit rules. Accordingly, Notice 2004-19 withdraws Notice 98-5, and describes the approaches Treasury and the IRS are using to address transactions and arrangements structured to give rise to inappropriate foreign tax credit results.” Treasury Release, February 17, 2004, 2004 TNT I32-17.

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The year 2001 brought not only IES and Compaq but also the introduction by

Congressman Doggett of a bill to codify the economic substance doctrine.9 The bill stated that a

transaction has economic substance only if (1) it changes in a meaningful way (apart from Fed-

eral income tax effects) the taxpayer’s economic position, and (2) the taxpayer has a substantial

nontax purpose for entering into the transaction and the transaction is a reasonable means of ac-

complishing such purpose.10 Among other things, the bill was intended to clarify the law by es-

tablishing that the economic substance test is conjunctive and requires both (1) and (2). Stated

differently, a transaction that meaningfully changes the taxpayer’s economic position but lacks a

nontax purpose would fail the statutory test. Of particular interest for present purposes, the pro-

posed legislation treated foreign taxes as an expense in calculating pre-tax profits for taxpayers

relying on a profit motive to show economic substance.

The Doggett bill with some changes passed the Senate in 2003 and in later

years.11 The legislation continued to include the expense rule for foreign taxes. The proposal

met a chilly reception in the House and never became law.

9 H .R. 2520 (Abusive Tax Shelter Shutdown Act), introduced by Lloyd Doggett on July 17, 2001, a few

weeks after IES was decided. The treatment of foreign taxes as expenses is just one of the problems with this proposal. The other concerns are beyond the scope of this article. For the author’s views, see “Reve-nue Raisers in the Senate Jobs Bill—Unintended Consequences and Better Choices,” Tax Notes, February 2, 2004, 621; “Economic Substance Codification Debate: Fun With Fallacies,” Tax Notes, June 9, 2003, 1567; “Economic Substance Codification Gets Worse,” Tax Notes, May 19, 2003, 1101; “More Thoughts on Proposed Economic Substance Codification,” Tax Notes, May 5, 2003, 747.

10 Lest they be forgotten, it is worth mentioning that the bill also included substantive rules governing transac-

tions with tax-indifferent parties. For a description of and criticism of those additional rules (which have been carried over into subsequent versions of the bill passed by the Senate), see James M. Peaslee, “Reve-nue Raisers in the Senate Jobs Bill—Unintended Consequences and Better Choices,” Tax Notes, February 2, 2004, 621.

11 It was first passed as part of the CARE Act of 2003 (S. 476). It was also included in Senate-passed ver-

sions of the Safe, Accountable, Flexible, and Efficient Transportation Equity Act of 2004 (S.1072) (“2004 Transportation Bill”), the Jumpstart Our Business Strength Act (S. 1637, passed in 2004), and the Tax Re-lief Act of 2005 (S. 2020). It has been included in bills introduced in 2006 (see S. 1321 and S. 3738). This list is not all inclusive.

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The later Senate versions of the proposal differed from the Doggett bill by provid-

ing that the economic substance clarification applies only when a court determines that the eco-

nomic substance doctrine is relevant.12 This change was better than nothing but its effect is un-

certain. The premise is that the economic substance test applies only to inherently abusive trans-

actions. Another view is that the test is a general canon of construction of all federal tax law and

thus applies broadly to all transactions and tax measures absence clear evidence that Congress

intended a contrary result. In most transactions, its requirements are met without difficulty, so

there is no need for an explicit analysis.

In 2005, the Joint Committee on Taxation staff developed a more flexible version

of the bill that responded to some of the criticisms that had been made of the measure.13 Among

other changes, the revised proposal dropped the rule treating foreign taxes as an expense.14 The

version of the proposal included by the Senate in later bills did not reflect the JCT staff’s work

product, perhaps because the staff proposal carried a lower revenue estimate.15

In 2004, there was additional legislation affecting the foreign tax credit that is

relevant to this discussion. The American Jobs Creation Act of 2004 (“AJCA”) added section

901(l), which extended the minimum holding period rule of section 901(k) (applicable to divi-

dends) to withholding taxes on interest, royalties and all other types of income other than divi-

dends. This completed the legislative response to the type of withholding tax capture transac-

tions addressed in Notice 98-5. In addition, the AJCA reduced the number of limitation baskets

12 Compare the 2004 Transportation Bill, which has the new language, with the CARE Act, which did not. 13 See Joint Committee on Taxation Staff, “Options to Improve Tax Compliance and Reform Tax Expendi-

tures,“ January 27, 2005 (JCS-02-05), 2005 TNT 18-18. 14 It also dropped the substantive rules for transactions with tax-indifferent parties referred to in footnote 10,

above. 15 See, e.g., the Tax Relief Act of 2005 (S. 2020), as passed by the Senate on November 18, 2005.

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under section 904 to two (passive category income and general category income). One of the

separate categories that was eliminated was high withholding tax interest.

C. Current Events

Turning first to the executive branch, the IRS has continued to raise in audits the

argument that foreign taxes are an expense. A 2006 Chief Counsel Advice indicates that for tax-

payers outside of the circuits that decided IES and Compaq, the IRS will continue to assert the

Government’s litigation position in those cases.16 The transaction at issue is not something you

would want to brag about to your mother. Not surprisingly, the advice makes other alternative

arguments for denying the sought after credits.17

Going perhaps one step farther than this advice, some IRS officials apparently be-

lieve that the lack of an expected post-foreign tax may be a sufficient reason to deny credits in a

transaction even if the transaction is not in other respects a “tax shelter.” Under this view, a

transaction that involves cross-crediting (generating net credits that are used to offset U.S. taxes

16 See ILM 200620022 (January 30, 2006), 2006 TNT 98-20. The argument is as follows: “In reaching this

conclusion [that the taxpayer did not anticipate a pre-tax profit], we note that Taxpayer resides in the Sec-ond Circuit, which is not bound to follow the portions of the Fifth and Eighth Circuit decisions in Compaq and IES that conclude that, for purposes of the economic substance analysis, the pretax profit should be de-termined without taking into account the cost of the expected foreign tax on the transaction. The failure of those courts to subtract the economic cost to the taxpayer of the foreign tax undermines the test's purpose of determining whether the taxpayer had a real potential for profit apart from the transaction's U.S. tax bene-fits (i.e., the foreign tax credit). In determining whether a taxpayer had a reasonable possibility of eco-nomic profit, all of a taxpayer's items of income and expense must be taken into account. Economically, a foreign tax is no different from any other expense, and therefore foreign taxes are properly treated as a cost that reduces economic profit. If a taxpayer's return is negative before U.S. tax consequences are taken into account, as is the case here, it necessarily follows that the benefit of the foreign tax credit motivated the transaction. Ignoring foreign taxes as a cost in determining the pre-U.S. tax return on a transaction would deprive the economic substance test of the very measure it is designed to illuminate -- the return on the transaction prior to the claimed U.S. tax benefits. Additionally, it is noteworthy that the bulk of Taxpayer's own analysis of its probable return from the transaction subtracted the Country X tax in determining its ex-pected ‘cash profit.’”

17 The credits at issue were for foreign taxes in respect of a built-in gain that did not exist for U.S. tax pur-

poses, so the taxpayer was claiming credits without reporting the associated income. Also, the taxpayer was a transitory owner of the property that generated the credits (and expected to and did sell that property back to the original owner), opening itself up to an attack (which is set out in the advice) that the credits should be denied on step transaction grounds.

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imposed on another transaction) and would not be undertaken without the credits (as evidenced

by the lack of a sufficient post-foreign tax profit) is inherently an abusive tax shelter transaction

in which credits should be denied.

In a letter submitted to the Senate Finance Committee last May, Commissioner

Everson stated that the IRS was taking steps to combat abusive foreign tax credit arbitrage trans-

actions.18 Since that time, IRS and Treasury officials have stated that they plan to issue pro-

posed regulations in the near term that will curb foreign tax credit arbitrage transactions.19 A

critical piece of the package that does not seem to have been ironed out is the theory for limiting

credits (presumably there needs to be one). There has been some speculation that lacking better

choices, the Government may dip again into the economic substance well.

The change in control of the House increases the chances that the next Congress

will adopt some type of economic substance codification measure. Congressman Rangel, the

new head of the Ways & Means Committee, was one of the co-sponsors of the Doggett bill.

Nonetheless, it is impossible at this point to be sure about what will happen. The criticisms of

the measure have been quite severe, even by those who are not generally considered in the

pocket of tax promoters, such as the IRS and Treasury. Concerns over the technical merits of the

18 See letter dated May 19, 2006 from Commissioner Everson to Senator Grassley, 2006 TNT 114-21. The

letter describes arbitrage transactions in somewhat elliptical terms as follows: “In addition, cross-border fi-nancing transactions are being structured to generate abusive FTC results. In the case of U.S. lender trans-actions, a U.S. person makes a loan to a foreign person in a transaction structured to shift a portion of the borrower's foreign tax liability to the U.S. lender. In the case of U.S. borrower transactions, a U.S. person borrows from a foreign person in a manner that allows the U.S. person to pay creditable foreign taxes in lieu of deductible interest. In both types of cases, the FTCs are used to shelter unrelated foreign source in-come. These structured financing transactions often result in the duplication of tax benefits through the use of certain structures designed to exploit inconsistencies between U.S. and foreign laws. We are aware of 11 structured financing transactions with an estimated $3.5 billion at issue in these cases.” The letter stated that the IRS had formed an Issue Management Team to develop and coordinate responses to these types of transactions.

19 See the BNA Daily Tax Report for November 14, 2006 describing statements made at a University of Chi-

cago tax conference by Treasury International Tax Counsel Hal Hicks and IRS Associate Chief Counsel (International) Steven Musher.

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proposal led the Joint Committee staff (again not known as a friend of tax abusers) to develop a

substantially modified version of the bill. To round out the picture, economic substance codifi-

cation is strongly opposed by the NYSBA, ABA (Section of Taxation), AICPA and TEI.20 Per-

haps now that the prospects of passage are greater, the substantive merits of the proposal will be

thought through more carefully. Surely no one wants another experience like the one with sec-

tion 470, and it will happen if the bill becomes law.21

It is also worth noting that significant progress has been made in combating tax

shelters since the codification proposal first surfaced in 2001. AJCA adopted a number of sig-

nificant penalty and reporting measures. The recent trend of economic substance cases has been

in the Government’s favor. All of these factors may reduce the revenue estimate, which, to be

somewhat cynical, appears to have been a significant reason for many to support the proposal.

At any rate, despite its warts, the legislation may move forward as it has in the

past in the Senate, and if it does, the policy question whether to treat foreign taxes as an expense

will be squarely presented.

20 See, e.g., May 21, 2003 letter and report from the New York State Bar Association, Tax Section, 2003 TNT

102-19; January 4, 2006 letter from the American Bar Association Section of Taxation, 2006 TNT 3-16; December 23, 2005 letter from the American Institute of Certified Public Accountants Tax Executive Committee, 2006 TNT 3-19; and January 10, 2006 letter from Tax Executives Institute, 2006 TNT 7-19. In a number of cases, these letters are one of a number of communications from these organizations on this topic with a consistent theme.

21 See Notice 2007-4, December 13, 2006, 2006 TNT 240-4, the third notice allowing taxpayers to ignore the

section 470 as it applies to partnerships between taxable and tax-exempt partners (including foreigners) during a transition period while Congress figures out how to fix the section. The analogy to section 470 is not far fetched. The special rules in the proposed economic substance bill governing transactions with tax-indifferent parties would seem to have the effect of rewriting many basic tax rules governing conventional commercial transactions between taxable domestic persons and foreign persons. See the article cited in footnote 10, above.

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III. The Arguments

A. Clearing Away the Dividend Capture Debris

Before considering the arguments for and against treating foreign taxes as an ex-

pense, let us clear the air about Compaq and IES. The cases are not favored in Government cir-

cles, and they have become the much maligned symbols for the argument that foreign taxes are

not expenses. Those despising the results in these cases have sometimes embraced the following

logic: the cases are wrong, and the foreign-taxes-are-not-expenses argument won the day for the

taxpayers, so that argument must be wrong.

It is possible, however, to disagree with the result in Compaq and IES without

concluding that foreign taxes must be treated as expenses. The economic substance doctrine re-

quires (in its conjunctive form) both nontax consequences and a nontax motive.22 The cases in-

volved no significant nontax consequences (no real risk) and no post-foreign tax profit. Accord-

ingly, the taxpayer could have lost based on the absence of nontax consequences even if it had a

profit motive. Thus, a negative reaction to the holdings does not tease out which factor is the

critical one. Also, it would be unfortunate to react too strongly to Compaq and IES given that the

tax strategy involved in the cases (dividend capture without meaningful risk) has been curbed

already by the enactment of section 901(k).

Another complaint about Compaq and IES is that the taxpayers got a windfall

benefit by claiming credits for withholding taxes that were not charged to the stock buyer eco-

nomically (because the stock traded as if the marginal buyer were not allowed credits). For

22 The IES and Compaq courts both found that there was a meaningful change in the taxpayer’s position and a

nontax motive (a profit motive) and accordingly did not decide if the lack of a change in position would have been enough to deny credits. There is a split of authority on this issue, although it seems to play less of a role in determining the actual outcome in cases than might be expected.

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compelling administrative reasons, current law does not generally try to identify who bears the

burden of a tax. At any rate, an economic profit test applied treating foreign taxes as an expense

works exactly backwards as a way of identifying transactions in which windfall credits are gen-

erated. A taxpayer is more likely to fail a post-foreign tax profit test where it bears the economic

burden of the foreign tax than where it does not.23

B. Cost or Substitute Tax?

The basic arguments for and against treating foreign taxes as an expense are eas-

ily stated.

The argument for is that the purpose of the economic substance test is to prevent

taxpayers from entering into transactions that produce no material economic benefits for the tax-

payer in a world without U.S. income taxes. If there were no credits for foreign income taxes,

those taxes would be an economic cost like rent or interest. Thus, a transaction that fails to earn

a profit after foreign taxes has solely a U.S. tax motivation, so the desired U.S. tax benefit should

be denied.24

The argument against is that treating foreign taxes as an expense cuts against the

economic function of the credit. A credit mechanism allows a taxpayer to be indifferent between

paying taxes abroad or in the United States. A rational business person would not distinguish

between a U.S. tax and a creditable foreign tax in evaluating a transaction, so why should the

economic profit test force an irrational result by requiring such a distinction? Recently, the IRS

23 Thus in the AB partnership example in the paragraph after footnote 29, below, AB earns interest of 7 per-

cent and is charged a withholding tax of 15 percent that reduces the after-foreign tax return to 5.95 percent, below its funding cost of 6 percent. Suppose that the borrowers were required as an economic matter to pay interest of 7 percent and had to do so in a market that gave no credit in pricing the instruments for withholding taxes. The borrower in that case would need to gross up the interest on the bonds to pay 7 per-cent net (in other words pay interest of 8.235 percent and withhold 1.235 of tax). In that case, AB would get a windfall if it was entitled to the credits but would make an after-foreign tax profit of 1 percent.

24 This is the argument made by the IRS in a recent Chief Counsel Advice. See footnote 16, above.

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recognized this basic business logic in fashioning regulations allocating creditable foreign taxes

among members of a partnership under section 704.25

Both of these arguments can be criticized as being circular. Requiring a taxpayer

to treat taxes as an expense like interest or rent effectively assumes that there is no credit. Oth-

erwise, the tax would in fact be different from interest or rent. Treating foreign taxes as equiva-

lent to U.S. taxes because of the credit assumes the credit is available. If the validity of the ar-

guments really does depend on first deciding if a credit is allowed, then it would seem that the

profit test is not a very good way to determine if credits should be allowed.

A straightforward reason for choosing as a starting point that the credit is avail-

able is that the credit is in fact a benefit granted by the Code. If a taxpayer meets the Code re-

quirements, it should be allowed the credit unless there is a reason to override the statutory text.

However, the economic substance doctrine has always been an overlay on top of technical Code

language. It seeks to ensure that statutory language is not used to achieve absurd results Con-

gress cannot have intended. So, to put the question directly, is it absurd to think that Congress

25 The regulations were adopted by T.D. 9292, October 19, 2006, 2006 TNT 202-5. They are based on the

premise that an allocation must be made based on the partners interests in the partnership because special allocations cannot have substantial economic effect. T.D. 9292 explains the point as follows:

“The temporary and proposed regulations clarified the application of the regulations under section 704 to foreign taxes paid or accrued by a partnership and eligible for credit under section 901(a) (creditable foreign tax expenditures or CFTEs). While allocations of CFTEs that are dispropor-tionate to the related income may have economic effect in that they reduce the recipient partner's capital account and affect the amount the recipient partner is entitled to receive on liquidation, this effect will almost certainly not be substantial after taking U.S. tax consequences into account. For example, the after-tax economic consequences to a foreign or other tax-indifferent partner whose share of the tax expense is borne by a U.S. taxable partner will be enhanced by reason of the allo-cation, and there is a strong likelihood that the after-tax economic consequences to a U.S. partner will not be substantially diminished since the allocation of the CFTE increases the allowable for-eign tax credit and results in a dollar-for-dollar reduction in the U.S. tax the partner would other-wise owe.”

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intended to allow credits in a transaction that generates income before foreign tax but a loss if

foreign taxes are considered an expense?26

A transaction in which foreign taxes eat up all or most of the expected pre-tax

profits is one in which the effective tax rate (foreign taxes divided by pre-tax profits) is high and

certainly higher than the U.S. statutory rate. It can be argued that because the purpose of the for-

eign tax credit is to avoid double taxation, it would make sense to apply the economic substance

test to ignore any transaction (and on that basis disallow credits) that involves a high effective

foreign tax rate.

This argument might be more appealing absent section 904. That section prevents

double taxation by calculating the U.S. taxes imposed on foreign source income and then allow-

ing credits only up to that amount. For purposes of the calculation, taxes and income are

grouped into limitation baskets. The broader the categories (and thus the more activities are

grouped together), the greater the likelihood that taxpayers will be able to cross-credit taxes (use

excess credits from one transaction to reduce U.S. taxes imposed on another transaction). The

grouping of transactions together into limitation baskets was done by Congress with full knowl-

edge that it allows cross-crediting within baskets.27 AJCA just reduced the number of baskets

from nine to two. The legislative history cites simplicity and the desire to reduce double taxation

and make U.S. businesses more competitive as some of the reasons for the change.28 There is no

26 The discussion here focuses on the profit leg of the economic substance test. A transaction that does not

meaningfully change the taxpayer’s economic position might be vulnerable to attack even if it earned a pre-foreign tax profit.

27 The 1986 Blue Book has an extensive discussion of cross-crediting and baskets and indicates that Congress

wanted to reduce cross-crediting by increasing the number of baskets, while still consciously allowing cross-crediting within baskets. See Joint Committee on Taxation Staff, General Explanation of the Tax Re-form Act of 1986, May 4, 1987, JCS-10-87, pages 861-865.

28 “The Committee believes that requiring taxpayers to separate income and tax credits into nine separate tax

baskets creates some of the most complex tax reporting and compliance issues in the Code. Reducing the

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conceptually pure “right” answer as to where to draw the line, as evidenced by the number of

times section 904 has been changed over the years.

Even with the 2004 changes, the section 904 calculations are complex and highly

articulated. It would require a book to describe all of the rules. In broad terms, and glossing

over many details, the section requires taxpayers to divide up gross income based on whether it

is foreign or domestic under the Code’s source rules. Then foreign source income is divided into

different baskets. Finally, expenses are allocated to foreign source income in the baskets to de-

termine foreign source taxable income. The rules for allocating expenses are sometimes based

on factual connections but sometimes not. The main one that is not is for interest, which under

section 864(e) is allocated based on assets, determined at the level of an affiliated group. The

calculations are done not just year by year but over a period of years, because excess credits can

be carried back and over to different taxable years. Taxpayers with significant foreign income

spend untold quantities of time and effort doing these calculations.

A taxpayer that enters into a transaction expecting to claim foreign tax credits that

may be challenged under the economic substance doctrine presumably has done all of the 904

calculations and has determined that it has room to use the credits, either currently or in carry-

over years. Otherwise, the IRS would not challenge the credits on economic substance grounds.

Thus, the taxpayer has done what the Code asks in demonstrating that double taxation is in-

volved.

So the proper question to ask in applying the economic substance profit test is not

whether Congress intended for credits to be conditioned on passing an income test, but rather

number of foreign tax credit baskets to two will greatly simplify the Code and undo much of the complex-ity created by the Tax Reform Act of 1986. The Committee believes that simplifying these rules will re-duce double taxation, make U.S. businesses more competitive, and create jobs in the United States.” H.R. Rep. No. 108-548, part 1.

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whether it intended that there be two such income tests: section 904 and a separate one under

common law.

The common law calculation would differ from the one under section 904 in three

key respects: First, the activities would not be grouped according to section 904 baskets; rather

the income test would be applied to specific transactions. Notice 98-5 applied to “arrangements”

and adopted a facts and circumstances test for determining the scope of an arrangement.29 Using

an “arrangement” as the unit of measurement is inherently vague. Second, the test would not

seem to distinguish between foreign and domestic source income (presumably a taxpayer would

be equally motivated to earn either). Third, the allocation of expenses would not take account of

special rules that apply under section 904. Specifically, interest expense would presumably be

allocated based on a tracing of debt (the approach in Notice 98-5). For a multinational company

with many funding sources, this would be an interesting exercise, particularly given the eco-

nomic premise of section 864(e) that money is fungible.

The difference in approaches may be illustrated by an example. Imagine that in

2007, an industrial company A with contacts around the world decides that it can evaluate coun-

try risk and wants to make money by investing in debt obligations of foreign borrowers. To do

so, it sets up a partnership (called AB) with a professional money manager B. A puts up most of

the equity capital and B puts up some (B’s interest is greater than 10 percent). AB buys debt in-

struments (bonds and loans) of foreign obligors. It finances 90 percent of the purchases with a

revolving line of credit from a bank. The loan is a recourse obligation only of AB and not of its

partners. Draws on the bank loan are made as needed to purchase investments. The investments

secure the bank loan. Suppose the borrowing cost is 6.67 percent (or 6 percent measured as a

percentage of the assets financed with the loan). The assets have an average pre-tax yield of 7 29 See footnote 3, above.

16

percent but are subject to a withholding tax that averages 15 percent of the interest income, re-

sulting in an after-foreign tax yield of 5.95 percent. Some of the purchased debt instruments are

subject to a lower stated rate of tax (say 5 percent) but the effective rate is higher because AB

purchases the instruments during an interest accrual period (but more than 15 days before an in-

terest payment date). In that case, AB collects interest payments that are subject in full to the

withholding tax but are interest income for U.S. tax purposes only to the extent of the amount

accrued after the purchase date. When AB makes an investment, it has all the risks and rewards

of owning it and there are no arrangements to transfer ownership in the future to someone else.

AB, and A and B individually, do not hedge the risks of the portfolio (aside from borrowing on a

limited recourse basis from the bank). A and B have substantial assets and activities unrelated to

AB.

The activities of AB on their own are profitable before tax if the foreign withhold-

ing taxes are considered equivalent to U.S. tax and are not profitable if the withholding taxes are

considered expenses.30 As a business matter, it is rational for A and B to evaluate their invest-

ment in AB by ignoring the withholding taxes as an economic cost if they can be credited against

U.S. taxes already due. To the extent they cannot be credited, the foreign taxes represent a real

expense (and indeed may represent a cost greater than other expenses on an after-tax basis).31

30 To the extent AB anticipates trading the portfolio, it might be able to argue that it has a profit motive be-

cause of expected trading profits. Those profits would be domestic source income under section 865, but nonetheless ought to count for purposes of an economic profit test. Assume, however, there are no material anticipated trading profits.

31 If A or B elects to credit foreign income taxes but cannot in fact claim a credit for the AB withholding taxes

because of the section 904 limitation, then it would suffer an additional cost from the existence of the with-holding tax compared to other expenses because the tax would not be deductible.

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In the example, A and B would not be able to credit fully the withholding taxes if

section 904 were applied looking only to the income and expense items of AB.32 However, the

limitation would in fact be applied to A and B and not to AB as a separate entity. The partners

could potentially have room to credit fully the AB withholding taxes under section 904 for at

least two reasons.

First, in calculating the income of AB under economic substance principles, all of

the interest paid to the bank would count as an expense because the borrowing is directly trace-

able to and secured by the investments. Thus, it would seem to be part of the investment ar-

rangement. As indicated above, a different approach applies under section 904. Section 864(e)

takes the view that money is fungible, and all debt finances all activities of a taxpayer. Accord-

ingly, interest expense is allocated based on the taxpayer’s overall asset mix. Not surprisingly,

this rule applies to debt incurred through partnerships.33 The rule often hurts taxpayers but in

this case may help A or B. They have substantial other operations. If those operations are do-

mestic and less leveraged than AB, then a substantial amount of the interest expense of AB may

end up being allocated away from foreign sources (without other unrelated interest expense be-

ing allocated to the AB assets to replace it), creating enough limitation to absorb the AB credits.

Alternatively, even if A and B were heavily leveraged outside of AB, so that the

interest allocation rules did not materially reduce the interest allocated against the AB income, A

or B could have other foreign source income in the same section 904 basket as the AB withhold-

ing taxes. That is particularly likely given the elimination after 2006 of the separate basket for

32 The taxable income would be 100 basis points (measured against the assets) and the taxes would be 105

basis point. The section 904 limitation looking only to AB would be 35 basis points, leaving excess credits of 70 basis points.

33 See Treasury Regulation Section 1.861-9(e).

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high withholding tax interest. In 2007, the credits would either be passive or general limitation

depending on whether the high-tax kick-out rule applies.34 Because of the kick-out rule, the pas-

sive income rules never apply to deny credits for taxes in the passive basket. Instead they pre-

vent the use of low-tax passive income to increase the limitation for general limitation credits.

Stated differently, cross crediting is clearly allowed between high-tax passive income and low-

tax active income. Accordingly, if A or B has enough low-tax general limitation income, the AB

credits could be used.

On these facts, the taxpayer would have a powerful argument that allowing the

credits is consistent with Congressional intent despite the lack of a post-foreign tax profit meas-

ured according to economic substance standards. Congress just got done eliminating a separate

basket for high withholding tax interest. That indicates that cross crediting of withholding taxes

on interest against income in the general limitation basket should be allowed. One reason Con-

gress may have been willing to do that is at the same time (as part of the AJCA) it extended the

minimum holding period rules of section 901(k) to debt by enacting section 901(l). Accordingly,

to claim the credits, AB would have to meet those holding period requirements. Further, the

ability to blend together high-tax passive income with low-tax general limitation income is

clearly contemplated by the statute. The ability to allocate interest expenses based on overall

assets is required by section 864(e) and should not be a one-way street (applies only if it hurts

taxpayers).

Further, if the economic substance doctrine could be applied to disallow credits in

this transaction, where would it stop? There is nothing apparently suspect about the AB partner-

34 The discussion assumes that AB is not a financial services entity, although the analysis would not be much

different if it were, given that financial services income is now included in general category income. The high-tax kick-out rule in section 904(d)(2)(B)(iii)(II) moves items of passive income into the general limi-tation basket if they bear foreign tax at an effective rate greater than the U.S. rate.

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ship except for the fact that it has a high effective foreign tax rate and the taxpayer is seeking

credits for the taxes in order to make the investment work economically. Those facts could

cover many transactions, particularly if foreign taxes are calculated on a transaction-by-

transaction basis. The foreign income base would often differ from “economic profit”. If the no

profits no credits regime were in place and were enforced, taxpayers would have to keep a sepa-

rate record of the profits generated on a transaction-by-transaction basis to justify credits.35 It is

difficult to believe that a Congress that just dropped the number of section 904 baskets to two to

promote simplification of the law would have intended that there be a basketing system parallel

to section 904 that applies to individual transactions.

At this point it is worth taking stock and asking readers for their own views on

whether the economic substance doctrine should be applied in this example to deny credits. If

you agree that it should not be so applied, then you agree that the test should not always be ap-

plied to deny credits where there are insufficient post-foreign tax profits. So far so good. The

question would then remain whether that view means that foreign taxes should never be treated

as expenses or rather should be so treated some of the time.

One way achieve a sometimes result would be to say that profits are always prop-

erly treated as an expense in applying the economic substance profit test, but that test is itself ap-

plied to deny foreign tax credits only selectively. It is hard to get there, however. The test is

admittedly flexible and fact dependent, but the profit component of the test is quite important. If

it is shown (1) that a transaction in fact is expected to make a post-foreign tax loss, (2) a post-

foreign tax loss is the relevant measure of profit for economic substance purposes, and (3) the

35 A difficult practical question would be how to take account of funding costs. Suppose a U.S. corporation

borrows money in the U.S. to invest in equity of a foreign subsidiary whose income is subject to a foreign tax at a rate of 35 percent. If the debt is traceable to the foreign venture and has to be taken into account as a di-rectly allocated expense but is not deductible in the foreign country, it is easy to imagine that the after-tax profit would be very low compared to the credits.

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taxpayer cannot point to another nontax motive, then the taxpayer’s situation would be bleak. It

could potentially argue that a transaction that “does something” but lacks a nontax motive should

survive scrutiny under the economic substance test, but that would be a losing argument at least

in some courts.36 If the economic substance codification bill were enacted, that argument clearly

would be foreclosed, because the proposal would unambiguously require a nontax purpose in

addition to a meaningful change in the taxpayer’s economic position. The taxpayer could argue

that the economic substance doctrine should not apply (is not relevant), but on what basis? Any

transaction that generates excess credits that offset U.S. taxes on unrelated income can be charac-

terized as a tax shelter. Even the IES and Compaq courts did not go so far as to say that the test

is irrelevant to the foreign tax credit. Rather they assumed the doctrine was relevant and applied

it.

It is not clear whether the IRS believes foreign taxes should always be viewed as

an expense or only sometimes. Most likely there is not a consistent view. Notice 98-5 itself re-

flected considerable waffling. Although the Notice clearly imposed a minimum profit require-

ment and calculated profits after foreign taxes, the Notice applied only to limited categories of

transactions (those involving withholding taxes and cross-border arbitrage transactions). The

application to withholding taxes was also idiosyncratic. The Notice did not apply to transactions

subject to section 901(k). Also, after issuance of the Notice, the Treasury exchanged correspon-

36 See, e.g., Long Term Capital Holdings v. United States, 2004-2 USTC Par. 50351, at pages 85,306-85,307:

“Counsel for petitioners repeatedly invoked the argument that objective economic substance is present where a transaction causes change in the economic positions/rights of the parties (other than tax savings), such as the exchange of cash or other consideration for a partnership interest or the purchase of one partner of another’s partnership interest. The Second Circuit rejected this argument in Gilman. Here, even if OTC owned a partnership interest in LTCP or sold such interest to LTCM, such ‘movement’ does not shield the transaction from scrutiny for economic substance and the Government may mount a challenge thereto from the perspective of a prudent economic actor. … [Discusses other cases cited by taxpayer.] In sum, neither case speaks against the prudent investor analysis of Gilman and Goldstein which seeks to determine whether the taxpayer entered into a transaction with a reasonable expectation of profit or purposefully in-curred expense in excess of any reasonably expected gain.” [footnotes omitted]

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dence with a taxpayer group that identified certain approved types of transactions in which tax-

payers were allowed credits for withholding taxes despite an expected after-foreign tax loss.

One of the approved categories was spread banking, which might cover most of the activities of

the AB partnership above.37 Presumably if the Notice were reissued today, withholding taxes

would not be covered at all because of section 901(l), although it says nothing about profits.

The 2006 Chief Counsel Advice mentioned above involves a transaction that has

many unsavory features in addition to the lack of a post-foreign tax profit. Those other features

may have been the real reason for attacking the transaction.

IV. Conclusion

For transactions that are expected to make money before all taxes, but lose money

if foreign taxes are counted as an expense, credits could be disallowed based solely on the ex-

pected loss (1) always, (2) never, or (3) sometimes. The author would vote for never on the

ground that the lack of a post-foreign tax profit is not under the current foreign tax credit system

a reason to disallow credits. A vote for always is very hard to justify under current law. More-

over, the always view if enforced has the potential to create an administrative nightmare as it

would require transaction-by-transaction profit calculations.

A vote for sometimes is always unsatisfactory because it means that the profit test

is a stalking horse for something else. The Government thinks the deal is flawed because of X.

37 In a letter to Assistant Secretary Lubick dated June 3, 1998, the Securities Industry Association proposed a

angel list identified in an appendix. Two days later, Lubick wrote back saying that regulations would in-corporate the proposed list. See 98 TNT 110-12. The list included the following: “It should be clarified that Notice 98-5 generally will not apply to deny credits for withholding taxes (other than withholding taxes arising in connection with an arrangement involving cross- border arbitrage which produces duplicate tax benefits) arising in connection with unhedged spread loans because they do not involve effective trans-fers of tax credits. These loans generally would include certain bank loans, loan participations (acquired at the inception of a loan or at some later point in time in a secondary transaction), and related party lending transactions. However, it should be clarified that short-term acquisitions and dispositions of unhedged spread loans will be tested under the Notice 98-5 profit test. As provided in Notice 98-5, interest and cur-rency hedges alone generally should not cause a loan to be treated as hedged.”

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However, since X is not a basis for denying credits under current law, the Government uses the

profit test instead, because it can be tied to some recognized tax theory. That approach lacks

transparency and promotes arbitrariness. How do you explain it to the field in a way that

achieves uniformity among taxpayers? A better way would be to decide first if X is really a con-

cern. If it is, then decide if the concern translates into a legal argument for denying credits under

current law. If it does, then use the argument to deny the credits. If it does not, then leave the

taxpayers alone, and either move on to something else or change the law if that is appropriate.

The proposal to codify the economic substance doctrine brings the question of

how to treat foreign taxes into sharp focus. The codification measure would always require a

nontax purpose for a transaction to survive an economic substance challenge, and always require

foreign taxes to be treated as an expense in calculating profits (if profit seeking was the nontax

purpose). It follows that a transaction would fail the economic substance test (so that credits

would be denied) if it was expected to produce no significant post-foreign tax profit and the test

applied. Under the proposed statute, the test would apply when a court finds it to be relevant. In

the author’s view, the test is always relevant, so the effect may be to disallow credits in these cir-

cumstances across the board. At any rate, enactment of the statute without clarifying the point

would leave the tax credit system in a most uncertain state for a long time as these issues get

sorted out. The practical effect may be the creation of a transaction-specific income measure-

ment system that duplicates section 904 but differs from it in material ways. Query whether any

fully-informed member of Congress would want to be associated with such a mess. One AMT is

enough.

1655056

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