The latest round on FTCs and net loans.

• Author: Yu, Angela W.Y.
• Position: Foreign tax credits

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...