Atlantic Legal Again Challenges IRS Economic Substance Abuse


The Foundation has filed a friend of the court brief in the U.S. Court of Appeals for the Second Circuit in American International Group v. United States , an important case involving foreign tax credits and the Economic Substance Rule.

The Internal Revenue Code allows U.S. taxpayers who have already paid taxes on income in a foreign country to claim a foreign tax credit for the taxes paid, so as to avoid “double taxation. The economic substance rule is a judicial doctrine that transactions which lack economic substance, because they do not have a purpose or utility apart from their anticipated tax consequences, can be disregarded for tax purposes.

The foreign tax credits at issue on this motion were claimed by American International Group (AIG) in connection with six cross-border financing transactions entered into between 1993 and 1997 by AIG Financial Products Corp. (AIG-FP), a wholly-owned subsidiary of AIG.

In broad summary, the six transactions, which are referred to as “preferred repurchase transactions, all had the same structure. In each transaction, AIG-FP sold preferred stock in a foreign affiliate to a third-party foreign bank and simultaneously undertook a binding contractual obligation to repurchase the preferred stock from the counterparty bank after an agreed term of years at the same price that the bank originally paid for the stock.

As a result of the six transactions, AIG-FP was able to borrow a total of $1.6 billion from foreign banks at favorable interest rates, typically 150 to 200 basis points below LIBOR. These favorable interest rates were made possible by the favorable tax treatment of the foreign lending bank under foreign law. Unlike U.S. tax law, which treats an agreement to sell and repurchase stock as a loan of the purchase price secured by the stock, with the dividends on the stock treated as interest payments, the home country law of the foreign banks treated the banks as the owners of the preferred stock (notwithstanding AIG-FPs obligation to repurchase the stock) and the dividend payments made by the relevant AIG-FP affiliates (also called special purpose vehicles (or SPVs) to the foreign banks were regarded as dividends that were either exempt from foreign tax or subject to tax at a much reduced rate. This favorable tax treatment of the foreign banks enabled them to lend funds to AIG-FP at a lower rate than would have been charged if the payments made to them during the course of the transaction had been subject to full income tax in the banks home countries. AIG in effect shared the foreign banks tax benefit with it, by negotiating a dividend rate well below the return on the SPVs investments. The SPVs invested the money from the sales, paid taxes on the investment income to their host governments, and made payments to the lender banks.

AIG claimed credits for the SPVs foreign tax payments. From AIGs perspective, the benefit of the preferred repurchase transactions was that they allowed AIG-FP to borrow funds at favorable interest rates which AIG was able to invest in portfolios of securities that produced above-LIBOR yields, allowing the SPVs investments to produce profits over the life of the transactions of upwards of $168.8 million.

It is undisputed that AIG complied with the complex regime of rules and regulations that govern a U.S. taxpayers claim for foreign tax credits. It is also undisputed that disallowance of the credits would subject AIG to taxation on the same income in both the U.S. and in a foreign country, contrary to the legislative purpose of the foreign tax credit.

The IRS nevertheless determined that the transactions giving rise to AIGs foreign tax credits lacked economic substance and disallowed the credits.

AIG contends the transactions were examples of profitable “spread banking activity: AIG-FP [the SPV] borrowed funds from each lender, purchased investments, used the return on the investments to pay the lender a suitable rate of interest, and profited from the difference between that interest and the return on the investments. The borrowed funds were received by AIG-FP for its preferred stock in the SPVs; the rest was provided by AIGs own contribution.

AIG argues that the economic substance doctrine does not apply and that in any event the transactions have economic substance because they were expected to generate a pre-tax profit over the life of the transactions of at least $168.8 million. AIG also argues that the purpose of the foreign tax credits is to avoid double taxation, and that it would be doubly taxed if the credits were disallowed. Preventing double taxation is a documented aim of the credits and has been recognized as the purpose of the credits by the Supreme Court. Disallowance of foreign tax credits would subject AIG to taxation on the same income in both the U.S. and a foreign jurisdiction.

The Government claims tax benefits generated that spread profit and that AIG and the lender effectively shifted tax liability from the foreign bank to the affiliate, which allowed the lender to receive its return as a tax-exempt dividend, and AIG to claim foreign tax credits (of more than $48 million) and interest deductions to offset much of the foreign tax paid by the SPV. Those tax savings permitted AIG to negotiate a dividend rate lower than the return on the investments, creating AIG’s profitable spread. Thus, the Government argues, the transactions lack economic substance, because they cannot be said to have purpose, substance, or utility apart from their anticipated tax consequences.

The U.S. District Court for the Southern District of New York (Stanton, J.), ruling on AIGs renewed motion for partial summary judgment, held that the economic substance doctrine should be applied to the six transactions, and therefore any tax benefits must be disallowed, because the tax purposes of those transactions shaped them and they would otherwise not result in a significant profit.

The district court found that AIG cannot exclude consideration of the transactions economic utility and must show that what was done, apart from the tax benefits, is what was intended by Congress. That determination meant that the economic substance doctrine applied and AIG had to establish a profitable purpose in their transactions. It held further that if the effects of that foreign tax benefit are removed, the SPVs cost of borrowing would have roughly equaled its return on the investment income, netting no gain for AIG and no profit from the transactions because AIG and its lenders considered the tax savings on the dividend to be the benefit in the transaction, structured the transactions to get those savings, and negotiated how to divide them.

The district court did, however, certify the case for interlocutory appeal because there are substantial grounds for difference of opinion as to two major legal issues, and the Second Circuit has allowed the appeal.

Two other circuits have adopted the view that under the economic substance test, the foreign tax benefit given to a foreign entity and shared with a U.S. taxpayer should be included in calculating the U.S. taxpayers profit. See Compaq v. Commr , 277 F.3d 778 (5th Cir. 2001); IES Industries Inc. v. United States , 253 F.3d 350 (8th Cir. 2001). In addition, commentaries by leading tax law scholars published since the district courts denial of summary judgment provide support for the view that the district courts ruling on the law is incorrect.

The Foundation filed an amicus brief supporting AIGs appeal. We argued that taxpayers need to minimize uncertainty in planning transactions, and that uncertain application of the tax laws makes it impossible for taxpayers to plan for the future and they are generally entitled to make business plans in reliance on the tax laws as written, without being second guessed because of their desire to structure the transaction in a way that minimizes their tax obligations. Courts should be circumspect in their invocation of the economic substance doctrine to avoid unpredictable adverse impacts on taxpayers and the economy.

The foreign tax credit is intended to make international business of U.S. companies tax neutral. Congress intended through the foreign tax credit to avoid double taxation and Congress and the Treasury have carefully delineated the proper scope of the foreign tax credit through a complex and highly articulated set of statutes, regulations and rulings. The U.S. tax law accommodates the imposition of foreign tax and treats it like a U.S. tax, so long as the U.S. taxpayer had legal liability to pay the foreign tax and in fact did so. The Internal Revenue Code foreign tax credit sections and relevant Treasury regulations are designed to allow a U.S. taxpayer to structure its business transactions as it chooses, even if that choice subjects the taxpayer to foreign tax, but the taxpayer must comply with very complex limitations that put a cap on the amount of credit that may be claimed.

In this case there is no dispute that AIG or its local affiliates paid the foreign taxes that AIG claims as credits. Congress has repeatedly supplemented and revised the foreign tax credit regime to address transactions that Congress determined to be problematic, and Courts should not apply the economic substance doctrine when the statute or regulation reflects a history of detailed consideration by Congress or the Treasury because the economic substance doctrine has the effect of overriding statutory law through a post hoc judicial redetermination of tax consequences..

The doctrine should apply only to a narrow category of cases, when the taxpayer entered into a transaction in which there was nothing of substance beyond a tax deduction can be realized, there is no reasonable possibility of profit and the taxpayer has no business purpose other than obtaining the tax deduction.

To read our brief, click here.