Timothy A. Rybacki, Separation Anxiety: the Repatriation of Foreign Tax Credits Without Associated Income via the Technical Taxpayer Rule's Joint and Several Liability Provision

• Citation: Vol. 19 No. 3
• Publication year: 2005

COMMENTS

SEPARATION ANXIETY:

THE REPATRIATION OF FOREIGN TAX CREDITS WITHOUT ASSOCIATED INCOME VIA THE TECHNICAL TAXPAYER RULE'S JOINT AND SEVERAL LIABILITY PROVISION^*

In February 2005, as much to its own surprise as anyone else's, Doyle auction house of New York sold a pair of century-old paintings for an impressive $590,400.¹An art aficionado might say that just over a half million dollars for two masterpieces is to be expected-after all, "priceless" often conjures images of the world's most important works of art. The masterpieces at the center of this bidding war? Oil on canvas of dogs playing poker.²

Described by the auction house as an image "'seared' into the American conscience," A Bold Bluff depicts the wily "Judge St. Bernard" with a poor hand and a pile of chips at the center of the table while the other dogs warily search his poker face.³Predictably, the second of the two paintings concludes the scene with the St. Bernard revealing his paltry cards and collecting his winnings amid a circle of dismayed faces.

Although the Luxembourg tax authority must rarely receive comparison to an old poker-playing St. Bernard, "a bold bluff," as discussed further infra, might just as aptly describe the crucial testimony of its deputy director before the Court of Claims in Guardian Industries Corp. v. United States.⁴The Court relied heavily on this foreign official's testimony and held in favor of Guardian

Industries Corp. ("Guardian"), thereby affirming the taxpayer's right to a direct foreign tax credit while failing to repatriate the underlying income of its Luxembourg subsidiaries.⁵The Guardian Industries decision, therefore, was a damaging blow to the U.S. tax authorities' increasingly crucial fight against the income and tax credit separation schemes of U.S.-based multinational corporations.

Income and tax credit separation is alarmingly problematic for the U.S. government because, after achieving separation, U.S. parent corporations routinely bring the tax credits home while leaving the taxable income abroad in foreign subsidiaries.⁶An increase in available tax credits exclusive of additional taxable income can save these corporations millions of dollars at every instance, all at the expense of the American tax base.⁷For example, when the IRS rebuffed Guardian's use of a common separation scheme, it denied nearly $3 million of Guardian's claimed foreign tax credits for a single year.⁸Guardian, however, sued the United States, arguing that the government did not have the necessary regulations or judicial precedent to block the tax benefits from flowing through its separation set-up.⁹

The regulation at the base of the separation problem is the "technical taxpayer rule."¹⁰The rule eschews the U.S. tax system's preference for substance-over-form to identify the party technically eligible to receive a foreign tax credit.¹¹In the context of a single-entity tax return, credit eligibility resides with the party that is liable to pay the foreign tax on income earned in the foreign country.¹²In other words, an individual person or business cannot claim a foreign tax credit unless it was "legally liable" for the foreign tax.¹³

When multiple entities join to pay their foreign taxes as a consolidated unit, the technical taxpayer rule hinges on the more complex analysis of which parties are "jointly and severally liable [for taxes owed to the foreign government] under foreign law."¹⁴U.S. parent corporations often take advantage of this rule by interposing a hybrid entity atop the foreign consolidated filing group. At this point, the United States becomes dependent upon the foreign country's imposition of joint and several liability on lower- tier U.S.-owned subsidiaries to prevent the repatriation of foreign tax credits without the associated income.¹⁵This was the context for debate in Guardian

Industries, with Luxembourg as the local foreign country.¹⁶Similar debates have already emerged in Australia, Germany, and Italy.¹⁷

Id.

Unfortunately for the U.S. government, a foreign country desirous of U.S. corporate investment has a substantial incentive to exploit the technical taxpayer "loophole" by thwarting a finding that local U.S.-owned subsidiaries in a consolidated group are subject to joint and several tax liability within its borders.¹⁸If no such liability is imposed in the foreign country, it may become an appealing international locale for U.S. operating subsidiaries because of the potential for separation. After attracting U.S.-owned operations, the foreign country may also achieve a second benefit by having created a strong incentive for these subsidiaries to reinvest their income within the local foreign economy, as repatriation to the United States would negate the benefits of separation.

In response to the growing magnitude of this separation problem, the United States initiated a broad assault in Guardian Industries by challenging the taxpayer's assertion that the Luxembourg government did not impose joint and several liability on the members of a Luxembourg fiscal unitary group.¹⁹

The Court requested the testimony of a Luxembourg tax official, who essentially asserted that even if the parent of the Luxembourg group failed to pay the group's tax, the Luxembourg government would not proceed against any lower-tier member to collect even the tax proportionally corresponding to that single entity's income.²⁰In other words, the requisite liability was not present to bar separation. The U.S. government took exception with that hypothetical conclusion, finding it remarkably out-of-touch with what Luxembourg-or any nation dependent on collecting corporate tax revenue- would surely do if the parent of a consolidated group defaulted on the entire group's tax payment.²¹In light of the foreign incentives already discussed, perhaps the U.S. government's assessment was correct and the Luxembourg official's testimony was merely a bold bluff aimed to further Luxembourg's reputation as a tax-friendly setting for U.S. multinational corporations to conduct operations.²²In any event, this problem is ultimately of the U.S. government's making as the technical taxpayer rule's joint and several liability provision has opened the door to such incentive-laden foreign facilitation of tax credit and income separation.

Undeterred by losing Guardian Industries, the IRS and the Treasury Department have signaled that eliminating this brand of separation is a top priority for 2006.²³The question, therefore, remains how the government will tackle the current technical taxpayer rule's dependence on foreign-imposed joint and several liability in the local foreign countries of U.S.-based controlled foreign corporations. Thus far, the government has indicated that it wants to remain within the framework of the current technical taxpayer rule instead of writing a new regulation from scratch that would ideally match tax credits with the earner of the income.²⁴The IRS appears poised to tweak the current rule by capitalizing on perceived "wiggle room" in the meaning of "liability" and

"joint and several liability," as they appear in the technical taxpayer rule.²⁵

However, this Comment argues that no such flexibility exists in these well- defined terms, the manipulation of which would be an unsatisfactory means to stem the tide of harmful separation practices.

Part I of this Comment discusses how U.S.-based multinational corporations practically create separation schemes by using "check-the-box" elections to bring tax credits home through hybrid business entities. Part II describes the transaction at issue in Guardian Industries and analyzes court decisions and IRS rulings that interpret the technical taxpayer rule's application to this type of transaction. Part III examines the uniformly held definition of joint and several liability throughout American jurisprudence and its meaning and application in tax law. Part IV scrutinizes the Court's holding and the government's arguments in Guardian Industries to exemplify the current problems with retaining the joint and several liability provision and achieving the ideal interpretation of the technical taxpayer rule. Finally, to preserve the common law definition of joint and several liability as it applies to international tax law, Part V urges the IRS to work towards preventing separation by removing this provision from the technical taxpayer rule instead of manipulating its meaning to serve the overarching policy of the foreign tax credit.

I. WHAT IS AT STAKE IN SEPARATION SCHEMES AND HOW TAXPAYERS

ACCOMPLISH THEM

Consider a U.S. corporation (USCorp) that has earned $15 million of foreign source income that the United States will tax at the normal rate of 35%. The corporation will be liable for $5.25 million of U.S. tax at the end of the year.²⁶Suppose also that USCorp earns an additional $10 million from operations of a wholly-owned entity in France, subject to French income tax of

30%, or $3 million. If USCorp can bring home a tax credit of $3 million from taxes paid to France and simultaneously avoid bringing home the additional

$10 million of foreign source income earned in France, USCorp will have achieved an advantageous result. USCorp will apply the $3 million tax credit to the $15 million of foreign source income already in its possession, thereby lowering the amount of U.S. tax due in the current year to $2.25 million-a savings of $3 million from the otherwise owed $5.25 million. In light of these substantial stakes, this Comment now briefly discusses background material relevant to the practical achievement of a separation scheme.

A. A Brief Background of the Foreign Tax Credit

The current foreign tax credit provisions represent an attempt to relieve U.S. taxpayers of double taxation on income sourced from foreign jurisdictions.²⁷The United States taxes domestic corporations (and citizens) on any income they earn on planet earth in a given year.²⁸However, for every dollar paid to a foreign...