Foreign Tax Credit - Exhaustion of Legal Remedies & Competent Authority
The U.S. foreign tax credit is a credit against U.S. income tax for income taxes paid (or deemed paid) on the same income to a foreign jurisdiction who has jurisdiction under U.S. sourcing rules to tax the income. There are several subsidiary requirements, but one is that, if there is doubt as to the liability for the foreign income tax, the taxpayer exhaust its legal remedies in the foreign jurisdiction. The concern to which this requirement is addressed is that, with a U.S. tax credit, the taxpayer may really have no incentive to contest imposition of a tax if at a rate less than the effective U.S. tax rate which might give rise to a raid by the foreign government on the U.S. treasury (if a credit is allowed). Hence the requirement that the taxpayer pursue available legal remedies to avoid imposition of the tax.
In a recent decision (IBM v. United States, unofficially reported at 97 TNT 156-3 (8/13/97), the Court of Federal Claims resolved a dispute over whether taxpayer had exhausted its legal remedies. IBM contested its liability in the Italian administrative and court systems and was continuing to do so at the time of the opinion discussed here. The IRS urged, of course, that the legal remedies had not been exhausted; IBM urged otherwise. The court held for IBM on the exhaustion issue. In the course of doing so the Court quoted from the Government's argument as follows:
In certain respects, IBM is just a stakeholder, in effect, in a conflict between the Italian [fisc] and the United States [fisc]. Unfortunately, the United States can't litigate its claim in Italy. And what the regulations contemplate through the exhaustion of remedies requirement is that somebody look out for the United States' interest in this situation, that we -- the foreign tax credit doesn't turn into nothing more than a subsidy to foreign governments, to foreign treasuries.
What the exhaustion of remedies requirement does, and I think Mr. Halvorson quoted an article that said that the exhaustion of remedies requires people to act as if this really mattered to them, that it was their own money at tax [sic], not just foreign tax credit dollars.
What the exhaustion of remedies requirement does is to push them to pursue the foreign litigation. If they had the interim credit and only had to exhaust practical remedies abroad, they'd have less incentive to aggressively represent, to aggressively pursue matters in a foreign country which is what we believe they should be required and the rules contemplate that they be required to do.
Although rejecting the argument in the facts of the IBM case, other taxpayers do need to be concerned that the argument may surface again in their situations and need to protect their ability to pursue foreign legal remedies in order to protect their entitlement to the taxes. This is similar to to the competent authority requirement that the taxpayers preserve their ability to obtain correlative relief in the foreign jurisdiction, so that the competent authority process can obtain consistent relief. So long as procedural bars (i.e., statutes of limitation on refunds in the foreign jurisdiction) are not interposed as a bar to consistent relief, the taxpayer often is little more than a stakeholder when the IRS makes a Section 482 adjustment and quite rightly should punt the matter to the competent authorities to let them duke it out. As in IBM, the taxpayer will still incur transactional costs in dealing with the respective competent authorities as they attempt to develop and present their arguments as to why their respective country has primary taxing jurisdiction, but still in large adjustments, the transactional costs will be a minor part of the overall amount at risk if the competent authorities do not agree to consistent adjustments.