The creditability of foreign taxes: form vs. substance.

• Author: Wilkinson, Brett R.

The U.S. Supreme Court's recent decision in PPL Corp (1) is a significant development in determining which foreign taxes are creditable against U.S. income tax. U.S. law allows taxpayers to claim a credit for foreign income, war profits, and excess profits taxes paid or accrued. The specific purpose of the credit is to mitigate the risk of double taxation that would otherwise impede international business activity.

The caveat, however, is that credits are allowed only for foreign taxes that are similar to the U.S. income tax, which makes sense because there is a risk of double taxation only when foreign taxes duplicate U.S. income tax. The problem for taxpayers and the IRS is how to decide whether a foreign tax is sufficiently similar to U.S. income tax to warrant allowing a foreign tax credit. Since 1983, Treasury regulations have provided guidelines for determining whether a foreign tax qualifies. Historically, however, the IRS has adopted a hard line (and very legalistic) stance in applying these guidelines.

Experts have accused the IRS of openly adopting a "form over substance" approach to determining which foreign taxes qualify.2 The IRS's approach unduly disqualifies taxes that are substitutes for the U.S. income tax from being creditable. It makes little sense to disallow a credit (and thus expose taxpayers to double taxation) simply because a foreign tax does not conform to a particular pattern but has the same ultimate effect as U.S. income tax.

commentators celebrated, (4) but the Third Circuit (5) sided with the IRS, embracing the notion that a foreign tax must meet the regulations' strict form. The U.S. Supreme Court, however, concluded that the emphasis should be on the substance of the foreign levy and not simply the form. In fact, the Supreme Court was willing to rearrange the foreign tax formula to demonstrate that the tax was economically equivalent to an excess profits tax--a clear rejection of the legalistic approach

In 2010, PPL Corp. challenged the IRS's form-over-substance approach and prevailed in the Tax Court, (3) which many the IRS favors. Taxpayers now have a much stronger basis for believing that the IRS will be forced to alter its approach.

This article examines the implications of the Supreme Court's PPL decision, arguing that the Court's decision highlights the flaws in the regulations many tax experts have previously identified. Nonetheless, the Court's decision may not be sufficient to resolve the problem, and Congress or Treasury may have to fix these flaws. The Supreme Court's decision has provided the necessary rationale for Congress or Treasury to take action.

The Foreign Tax Credit as a Solution to Double Taxation

Most governments view double taxation of the same income as undesirable, and many therefore allow a tax credit for taxes paid to other governments on foreign-source income. The United States falls within this group. The challenge for the U.S. government is to ensure that taxpayers are relieved of double taxation but are not permitted to credit nontax expenses (such as mineral royalties) or taxes that are not based on income (such as wealth taxes or gross receipts taxes) against their U.S. income tax liability.

To achieve this end, Congress enacted Sec. 901, which specifically restricts the foreign tax credit to foreign "income, war profits, and excess profits taxes." The problem, however, lies in defining what is an income tax. In Biddle, (6) the Supreme Court pointed out that the reference point should not be the language of the foreign tax law itself but rather "whether it is the substantial equivalent of payment of the tax as those terms are used in our own statute." The task of clarifying the meaning of Sec. 901 and setting standards for comparing a foreign levy to U.S. income taxes has been left to the regulations.

Income Tax Defined

Regs. Sec. 1.901-2 defines a foreign levy as an income tax if it meets two specific conditions. First, it must be a tax, and second, its predominant character must be an income tax in the U.S. sense, which means it "is likely to reach net gain in the normal circumstances in which it applies." (7)

Reaching net gain requires that a tax meet three requirements: (1) There must be a realization of income event (realization), (2) the starting point for measuring the tax base must be gross receipts (gross receipts), and (3) reasonable expenses must be deducted from gross receipts in figuring the tax base (net income). The IRS has applied these requirements in a very mechanical way, which is the root cause of taxpayers' concern.

One Example: The Cash Flow Tax

In 1998, Charles E. McLure Jr. and George R. Zodrow, economics professors who had been advisers to the Bolivian government, (8) documented their concerns about the IRS's interpretation of the requirements for meeting the net income requirement. The Bolivian government was contemplating adopting a cash flow tax, which it later abandoned in favor of a more traditional income tax, specifically because of the IRS's opposition to allowing foreign tax credits for cash flow taxes.

McLure and Zodrow provide compelling evidence that the proposed Bolivian tax was economically equivalent to an excess profits tax and thus should have been creditable under Sec. 901. The IRS resisted because the cash flow tax included the proceeds of borrowed amounts in the tax base even though the base also allowed corresponding deductions when loan proceeds were repaid. Nonetheless, the IRS stated that its "concern was for form (whether the [cash flow tax] met the mechanical tests specified in the [section]901 regulations) rather than the economic substance of...