Economic Substance Rule: District Court Rewrites Tax Code

Congress intended through the foreign tax credit to avoid double taxation. Both 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 foreign tax credit is intended to make international business of U.S. companies “tax neutral.” 

The Internal Revenue Code foreign tax credit sections and relevant Treasury regulations are designed to allow the U.S. taxpayer to structure its business transactions as it chooses, even if that choice subjects the taxpayer to foreign tax. Congress has repeatedly supplemented and revised the foreign tax credit regime to address transactions that Congress determined to be problematic. Courts should not apply the judge-made “economic substance” doctrine when the statute or regulation reflects a history of detailed consideration by Congress or the Treasury.

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 which a tax deduction can be realized and there is no reasonable possibility of profit but the taxpayer has no business purpose other than obtaining the tax deduction. In this case AIG had a clear and legitimate business purpose – to borrow funds at low interest rates and reinvest them at a higher return. AIG was able to do this because of the different tax treatment of the transactions under U.S. law and the laws of the countries in which the lenders and the AIG affiliates which did the borrowing were located.

The tax benefit at issue in this case is a foreign tax credit claimed by AIG. The effect of the claimed credit was to prevent AIG from being subject to double taxation – once by the country in which its foreign affiliate was domiciled and once by the United States. It is undisputed that AIG actually paid taxes on the relevant income in the foreign countries and complied with the statutory and regulatory requirements to receive the tax credit.

The district court treated the foreign taxes as transaction costs that should be included in the “non-tax” analysis, contrary to the rationale of decisions of two other circuits, which concluded in analogous cases. The district court’s reasoning imputed to AIG a higher interest cost – one “grossed up” to adjust for the lenders’ foreign tax exemptions – than it could deduct under U.S. tax law. By requiring the foreign banks’ dividends to be “grossed up” to approximate a comparable rate of taxable interest, the district court increased AIG’s expenses and reduced its pre-tax profitability. It was inappropriate to “gross up” tax exempt income by computing a hypothetical equivalent amount of taxable income in determining the transactions’ pre-tax profitability for purposes of the economic substance test where the direct benefits of such exemption are not at issue and it is unprecedented for the foreign tax treatment of a third party who is not a U.S. taxpayer to affect the determination of whether an unrelated U.S. taxpayer had a reasonable expectation of earning a pre-tax profit.

Issue Areas:

Free Enterprise, Limited Government

Case:

American International Group, INC., v. United States of America, No. 14-0765-cv (Second Circuit)

Read the Amicus Brief:

Question(s) Presented:

Did the district court err in it’s expansion and application of the “economic substance” rule?

Additional Background:

The Supreme Court and this Court have repeatedly held that Congress intended through the foreign tax credit to avoid double taxation. See, e.g., United States v. Goodyear Tire & Rubber Co., 493 U.S. 132, 135 (1989) (“[T]he primary design of the [foreign tax credit] was to mitigate the evil of double taxation.”). See also PPL Corp. v. Comm’r, 133 S. Ct. 1897, 1901 n.2 (2013); Kraft Gen. Foods v. Iowa Dep’t of Rev. & Fin., 505 U.S. 71, 73 (1992).

ALF’s Amicus Brief:

In an amicus brief ALF argues that the district court erred in rewriting the AIG’s tax liabilities because their expansion of the economic substance doctrine defies the complex set of laws, regulations, and rulings, made and carefully delineated by Congress with the help of the Treasury, and confirmed by Supreme Court precedent. 

Taxpayers need to minimize uncertainty in planning transactions, and 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. Ex-post judicial assignment of tax liability, based on arbitrary expansions of judge-made exceptions to tax law, disrupts American plans based on predictable tax laws.  

Contrary to the district court ruling it is incorrect and unprecedented for the foreign tax treatment of a third party who is not a U.S. taxpayer to affect the determination of whether an unrelated U.S. taxpayer had a reasonable expectation of earning a pre-tax profit. Foreign taxes should not be treated as a pre-tax cost of a transaction under the economic substance doctrine because U.S. taxes are not so treated. To be consistent, the analysis should either count all tax law effects or not count any of them. If the effects of tax law, domestic or foreign, are to be accounted for when they subtract from a transaction’s net cash flow, tax law effects should be counted when they add to net cash flow. Amicus curiae asks the Second circuit to side with the Fifth and Eighth circuits in affirming that the tax code is determined by its words, not by a judge’s assessment of the intentions of the parties, by reversing the order of the district court and remand for the entry of partial summary judgment in AIG’s favor. 

Status:

On September 9, 2015, the United States Court of Appeals For The Second Circuit issued an adverse opinion that affirmed the lower court’s application of the economic substance rule.

On March 7, 2016, The Supreme Court denied certiorari.