IRS's Foreign Tax Credit Position Challenged In US Court

by Glen Shapiro, LawAndTax-News.com, New York

24 June 2009

A US-based bank is challenging a USD235m assessment for back taxes, penalties and interest imposed by the Internal Revenue Service in a case which draws attention to the issue of international corporate taxation and the Obama administration’s determination to restrict illegitimate foreign tax credit claims.

According to documents filed in the US District Court in Boston, the case centers on a financing deal entered into between Sovereign Bancorp, a unit of Spain’s Banco Santander, and UK-based Barclays Bank.

Under this arrangement, in 2003 and 2004 Sovereign borrowed just under USD1.2bn from Barclays through a Delaware subsidiary at a more favourable interest rate than those prevailing at the time. The transaction gave rise to tax liability for Sovereign’s UK subsidiary, for which the bank claimed a credit in the US under foreign tax credit rules. However, the claim was ultimately rejected by the IRS which also refused a deduction for interest paid on the loan.

In the court documents, Sovereign argues that the IRS’s refusal to grant a foreign tax means it is facing double taxation. However, the IRS counters that the transaction lacked economic substance and was structured with little purpose other than to generate tax benefits for the bank.

A crackdown against alleged abuse of foreign tax credit rules and other aspects of the international tax regime by multinationals has become a key focus of the Obama administration’s tax policy as it seeks to prevent revenue leakage and coerce more companies to invest domestically.

According to IRS Commissioner Doug Shulman, from 2000 to 2007, the amount of foreign tax credits claimed by US firms and individuals rose by 71% and 133% respectively. This trend, he argues, is just one of the reasons why the United States, and other governments, should focus tax compliance efforts on policing the increasingly complex world of international taxation.

“With the continued cooperation and commitment among nations and organizations, such as the OECD and JITSIC (Joint International Tax Shelter Information Center), we will create the right climate – an inhospitable climate for tax evasion and offshore secrecy,” he told the Organization of Economic Cooperation and Development in a recent address.

In 2007, the IRS moved to block abusive foreign tax credit generators with regulations that sought to disallow foreign tax credits for foreign taxes purportedly paid in connection with certain artificially engineered, highly structured transactions. Transactions addressed by the regulations are structured so that a US taxpayer voluntarily subjects itself to foreign tax where an ordinary business transaction generally would result in little or no foreign tax paid by the US taxpayer.

However, the fluid nature of international tax arbitrage means that when one corporate tax planning avenue is closed, another opens up elsewhere.

The closure of foreign tax credit loopholes forms part of the US Treasury’s international tax reform program, announced last month and enshrined in Obama’s 2010 budget. “Some US businesses use loopholes to artificially inflate or accelerate these credits,” the Treasury’s statement explained. “The administration would close these loopholes, raising USD43.0bn from 2011 to 2019.”

According to the Treasury’s outline of the reforms, two steps will be taken to rein in foreign tax credit schemes. First, a taxpayer's foreign tax credit would be determined based on the amount of total foreign tax the taxpayer actually pays on its total foreign earnings. Second, a foreign tax credit would no longer be allowed for foreign taxes paid on income not subject to US tax. If legislated, these measures would go into effect in 2010.

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