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The latest round on FTCs and net loans.

The recent opinion of the Seventh Circuit in Continental Illinois Corp., 998 F2d 513 (7th Cir. 1993), aff'g in part and rev'g in part TC Memo 1991-66, provides guidance on the foreign tax credit (FTC) treatment of lenders of net loans and other related issues.

The Seventh Circuit denied FTCs on net loans when Continental Illinois National Bank and Trust Co. could not substantiate that taxes were paid to the foreign tax authorities in the manner prescribed in the regulations. The court reversed the earlier determination of the Tax Court (that had affirmed a long-standing IRS position) requiring the taxpayer to gross up its income by an amount equal to the foreign taxes withheld by the borrower--even if the foreign taxes were not creditable. Other issues addressed included the amount of creditable taxes on net loans made to Brazilian borrowers and the treatment of interest income on "cap loans."

Substantiation and creditability of foreign taxes on netloans

In addressing the issue of adequate documentation or proof, the Tax Court generally has allowed taxpayers to provide either direct evidence (e.g., tax receipts or copies of receipts) or indirect evidence (e.g., direct testimony of person who withheld the tax or written statements affirming that tax had been withheld or paid) to substantiate payment of foreign taxes for purposes of obtaining an FTC; see, e.g., Lederman, 6 TC 991 (1946), or Continental Illinois Corp., supra, and TC Memos 1988-318 and 1989-636.

In reversing the Tax Court, the Seventh Circuit relied on Regs. Sec. 1.905-2(a)(2) and (b)(1), requiring specific items of proof of payment of foreign taxes; thus, Continental's inability to produce tax receipts for the amounts withheld was fatal to claiming those amounts as FTCs. The court agreed with the IRS that the tax must be paid to the lawful taxing authority, not merely withheld, to be creditable. Therefore, borrowers' letters stating that they had paid the taxes withheld from Continental's net loans were not sufficient evidence.

Gross-up of noncreditable taxes in income

The Court of Appeals also determined that it would be inconsistent for the IRS to disallow the FTCs claimed by Continental because of insufficient evidence and at the same time require Continental to gross up its income by the amount of the disallowed foreign taxes (on the theory that the taxes should be treated as paid for purposes of the gross-up provisions). For example, a loan agreement calls for a bank to receive (or net) 9% interest, with any tax obligation falling on the borrower. If the tax rate is 25%, the grossed-up interest would have to be 12%, net of an FTC of 3%, to net the bank 9%. The Service would require the bank to include 12% in income, but also would disallow the FTC of 3% (because of inadequate documentation). The Seventh Circuit's holding affirmed the disallowance of the credit, but required the bank to include only 9% in income. In reaching its conclusion, the court stated:

It would be the tax equivalent of entrapment for the IRS, having in effect invited Continental to restate its net loan income in a form that would permit the bank to claim foreign tax credits, now to insist on taxing the bank on a phantom income figure--the...rate that would have benefited Continental had its claim of foreign tax credits been accepted but that confers no benefit now that the claim has been rejected.

The Court of Appeals' holding is contrary to the position outlined in the IRS's banking industry coordinated issue paper on net loans, which requires taxpayers to include the grossed-up amount of foreign taxes in its income regardless of whether a credit is available for the foreign taxes. Taxpayers that have previously grossed up foreign taxes in income, either on their original tax returns or by reason of an IRS audit adjustment, should consider filing refund claims.

Amount of creditable tax on loans subject to Brazilian taxrebate

Beginning in 1975, the Brazilian government rebated to Brazilian borrowers most of the withholding taxes imposed on interest paid to foreign lenders. The amount of the rebate was viewed by the Service as a subsidy by the Brazilian government to the borrower. The IRS asserted that only the nonrebated portion of the taxes was creditable.

In concurring with the Service on this issue, the Seventh Circuit cited, inter alia, Temp. Regs. Sec. 4.901-2(f)(3) and (f)(3)(ii)(B), as well as Rev. Rul. 78-258, which stated that only the amount of Brazilian taxes withheld that exceeded the government subsidy was creditable. The court also concluded that rebated taxes were not creditable on so-called "repass loans," i.e., loans made to local Brazilian banks that in turn reloaned the money to local borrowers.

The case pertained to Continental's 1977, 1978 and 1979 tax years. The temporary regulations cited, now defunct, were issued in November 1980 with an effective date for tax years ending after June 15, 1979. While fully aware of the implications of the effective date of the regulations, the court stated that, for Continental's 1978 tax year, Rev. Rul. 78-258 was in effect. However, that ruling generally grandfathered foreign taxes imposed on interest accrued or received with respect to loans made before Mar. 16, 1978. In other words, some of the foreign taxes in the case, i.e., amounts paid in 1977 and certain amounts paid in 1978, were technically not covered by the ruling. It is bewildering to see the court applying later authorities to the years in issue if Continental indeed had Brazilian taxes withheld in those years.

It is interesting that the Brazilian loans in question were "net loans." The Seventh Circuit, concurring with the Tax Court, agreed that the Brazilian tax was imposed on the lender (Continental), and noted that Continental had satisfied the IRS that the local taxes on these loans had been paid by the borrower. Accordingly, in computing the FTC, interest on the Brazilian loans must be grossed up by the amount of the foreign taxes withheld. For other net loans--without adequate documentation (as discussed above)--no gross-up was required or allowed. Accordingly, a taxpayer with this type of loan could be viewed as both deducting and crediting foreign taxes in the same year--a practice that is forbidden. The better view, however, should be the one expressed by the court: that there were no foreign taxes when there was inadequate documentation to support that taxes were withheld and paid.

Taxability of interest on cap loans

Beginning in 1972, Continental made "cap" loans to some of its borrowers. The loans required that payments be made based on a floating rate of interest; however, interest in excess of a stated "cap" would be rebated when the loan was repaid (if certain conditions were met). Due to the unexpected inflation in the 1970s, the interest paid by the borrowers regularly exceeded the caps, and Continental subsequently made substantial refunds to its borrowers. Continental did not include in current income interest received in excess of the cap.

The Court of Appeals agreed with the Tax Court (and with the Service), and mandated that the amounts be included in income as received throughout the term of the loans. (Though not cited in the case, the Tax Court has allowed at least one borrower a deduction for interest paid in excess of the "cap"; see Fourth Financial Corp., TC Memo 1985-232.)

The IRS recently withdrew its coordinated issue paper on cap loans, reflecting that it is no longer a common lending practice.


Even though the Seventh Circuit's holding affirms the greater part of the Tax Court's decisions on Continental, the decision nevertheless should provide authority for taxpayers to exclude from income the gross-up of interest on foreign net loans for which inadequate or no documentation exists and an FTC is not allowable. The Service has not yet announced whether it will follow the court's holdings on these issues and reverse its examination position, however.
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Title Annotation:foreign tax credits
Author:Alexander, John
Publication:The Tax Adviser
Date:Jun 1, 1994
Previous Article:IRS Key District raises qualification issues.
Next Article:Foreign corporations are eligible for two extension periods.

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