The Internal Revenue Service recognizes that "foreign government audits of U.S. taxpayers have become more frequent and, at times, more aggressive." (1) Consequently, the number of foreign tax contests and payments made by taxpayers to resolve those contests are on the rise. The IRS has signaled through its training materials and litigating positions an increased aggressiveness in contesting foreign tax credit claims. Missteps by taxpayers in this area can be costly and result in avoidable double taxation. This article focuses on practical steps that taxpayers may take to protect their foreign tax credit claims that result from the payment of contested foreign taxes.
The Basics of Foreign Tax Credits
Section 901(b) allows a foreign tax credit for the payment of foreign taxes. However, the ability to claim this credit is not unrestricted. Among other requirements, (2) the foreign tax payment must be compulsory (i.e., it cannot exceed the amount of taxes owed under foreign law). The rationale for this requirement is clear: "[a] system under which the United States Treasury pays out foreign tax credits without first demanding that American companies effectively and practically reduce their foreign tax payments would create a moral hazard." (3) The IRS explains the moral hazard by saying that taxpayers would "otherwise have no incentive to challenge any foreign tax whether or not properly imposed, thereby transferring the foreign tax cost to the United States." (4)
Payment of foreign taxes is compulsory if the taxpayer, to the extent possible, reduces its foreign tax liability by 1) reasonably interpreting and applying the foreign law and 2) exhausting all "effective and practical" remedies. There is often overlap in the analysis of these prongs by the IRS and courts.
Reasonably Interpreting and Applying Foreign Law
Determining what constitutes a "reasonable interpretation and application of foreign law" is fact-intensive and can resemble shooting at a moving target, because foreign courts and taxing authorities may change their positions (especially as those governments and their officials change). But there are some safe harbors. For example, taxpayers may rely on advice obtained in good faith from their foreign tax advisors. (5) Taxpayers who avail themselves of this safe harbor should be prepared to provide evidence of the advice received, analysis undertaken, and avenues of relief considered and, if the advice is not pursued, the reasons for not pursuing it. (6)
A taxpayer is also "not required to alter its form of doing business, its business conduct, or the form of any business transaction in order to reduce its liability under foreign law for tax." (7) However, taxpayers should proceed with caution if their decision will ultimately increase their overall foreign tax liability over time. For example, the IRS determined that a surcharge paid by a taxpayer was not compulsory because the taxpayer could have avoided the surcharge by electing to pay the tax earlier than was required by law. (8) Similarly, the decision to surrender an entity's losses to a U.K. parent instead of a subsidiary is inconsistent with applying the foreign law in a way that would minimize foreign tax liability when such a decision resulted in the taxpayer's incurring additional U.K. taxes. (9)
A taxpayer's interpretation of foreign law is not reasonable "if there is actual notice or constructive notice" that the taxpayer's interpretation or application of the law is likely wrong." Examples of actual notice include published foreign court decisions or other guidance, and when a taxpayer knowingly fails to charge a foreign affiliate an arm's-length price for goods or services." An example of constructive notice is when the IRS reallocates income from a taxpayer's foreign affiliate to its domestic affiliate. The IRS contends that such reallocation results in actual notice to the domestic affiliate and constructive notice to the foreign affiliate that its interpretation and application of foreign law are likely wrong. (12) Therefore, the foreign tax paid on the income that was reallocated to the domestic affiliate is not "compulsory" and does not qualify for a foreign tax credit if the foreign affiliate fails to exhaust all effective and practical remedies to obtain a refund of the foreign tax paid on the reallocated income." The IRS contends that this constructive notice requires the foreign affiliate to pursue its effective and practical remedies to recover any foreign tax paid on the reallocated income.
Exhausting All "Effective and Practical" Remedies
Only a few cases address the extent to which a taxpayer must exhaust available remedies before claiming a foreign tax credit. And each of those cases is unique and fact-specific. Although this may make the waters difficult to navigate at times, the cases and IRS administrative guidance do provide some guiding lights. For example, "a taxpayer need not undertake extraordinary efforts to contest a foreign tax liability," (14) and "the statute, the regulations, and the applicable revenue rulings do not" require "a taxpayer to exhaust all litigation remedies before being entitled to a foreign tax credit." (15) Instead, the taxpayer must pursue remedies that are "effective and practical" considering "the amount at issue and likelihood of success." (16) The IRS summarizes this requirement as "taxpayers may ordinarily take a reasonable business approach, weighing costs and benefits, in settling foreign income tax issues." (17)
Taxpayers who decide to pay the foreign tax because the remedies available are not effective and practical should be prepared to defend that decision. For example, it is reasonable not to pursue further remedies if the statute of limitations has passed for filing a refund claim and the applicable treaty does not provide an exception." Similarly, a remedy is not...