Riggs Nat. Corp. & Subsidiaries v. C.I.R.
| Decision Date | 12 January 1999 |
| Docket Number | No. 98-1039,98-1039 |
| Citation | 163 F.3d 1363 |
| Parties | , 83 A.F.T.R.2d 99-438, 99-1 USTC P 50,185 RIGGS NATIONAL CORPORATION & SUBSIDIARIES, Appellant, v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Appellee. |
| Court | U.S. Court of Appeals — District of Columbia Circuit |
Appeal from the United States Tax Court (No. TAX-24368-89).
Thomas C. Durham argued the cause for appellant. With him on the briefs were Joel V. Williamson, Kim Marie Boylan, and Stephen M. Feldhaus.
Charles Bricken, Attorney, United States Department of Justice, argued the cause for appellee. With him on the brief were Loretta C. Argrett, Assistant Attorney General, and David English Carmack, Attorney.
Stephen D. Gardner was on the brief for amicus curiae National Foreign Trade Council, Inc.
Before: WALD, SILBERMAN, and TATEL, Circuit Judges.
Opinion for the Court filed by Circuit Judge SILBERMAN.
Riggs Bank, asserting that it had paid taxes to the Brazilian government with respect to interest income on loans it had made to the Central Bank of Brazil, claimed foreign tax credits under § 901 of the Internal Revenue Code. The Commissioner disallowed the credits on the theory that Riggs was not "legally liable" for the tax under Brazilian law, and the Tax Court denied Riggs' petition for relief. We reverse.
Riggs National Corporation's subsidiary Riggs Bank was one of numerous banks that made loans to the Central Bank of Brazil during the early to mid-1980s as part of a plan to rescue Brazil from a debt crisis. Riggs' loans were so-called "net loans." In a net loan, the borrower contractually agrees not only to pay interest to the lender, but also to pay any local (Brazilian) tax that the lender owes on that interest income. Every interest payment the lender receives is then free of local tax--the borrower has paid it. By contrast, in a "gross loan," the lender remains subject to local tax liability. In either type of loan, which party technically conveys the tax payment to the local government is of little moment. In a gross loan, either the lender could remit the tax to the local government or the borrower could withhold that amount and remit it to the local government on behalf of the lender. So too in a net loan (where the concept of "withholding" does not really apply because the interest payments are free of local tax), either the borrower could remit the tax to the local government or the borrower could send to the lender both the guaranteed net loan interest payment and the appropriate amount of tax payment on the understanding that the lender would then remit the tax to the local government. (In practice in Brazil, the borrower does the "withholding" of the local tax in the gross loan situation and the "paying" of the local tax in the net loan situation.) The real difference between gross loans and net loans lies not in who licks the stamp on the envelope to the Brazilian government, but in who bears the economic burden of the tax.
The key feature of a net loan is its placement of the risk of a change in the local tax rate on the borrower. If the local tax rate rises after the parties have set the interest rate, the lender continues to receive the same interest payment free of local tax--it is the borrower who suffers. On the other hand, if the local tax rate falls after the parties have set the interest rate, the lender still continues to receive the same interest payment free of local tax--but now the borrower has become better off because his assumed tax liability is lower.
Computing the lender's tax liability on a gross loan is easy: one simply multiplies the local tax rate by the amount of interest income. So if the local tax rate is 25% and the interest payment is $12 (assume a 12% interest rate and $100 principal), the lender's local tax liability is $3. Computing the lender's local tax liability on a net loan--which, recall, is assumed by the borrower--is slightly more complicated. The parties' loan agreement sets forth the interest income as an after-tax amount, which presumably would be smaller than the before-tax amount in a gross loan because, all things being equal, a borrower entering a net loan will get a lower interest rate in exchange for assuming the lender's tax liability. To maintain parity between the tax revenue from net loans and gross loans, the Brazilian government requires that the after-tax income specified in the parties' net loan agreement be adjusted--"grossed-up"--into a hypothetical before-tax amount. The "gross-up" adjustment requires one to look at the interest rate selected by the parties in their net loan agreement, then assume that the parties had chosen the gross loan form rather than the net loan form, and extrapolate the interest rate the parties would have agreed upon if they had entered a gross loan. 1
The foregoing is best illustrated by an example. Suppose a lender extends a $100 net loan to a borrower, specifying a 9% annually compounded interest rate, and assume a local tax rate on interest income of 25%. In the first year of the loan, the lender will receive interest income of $9 (i.e., 9% of the $100 principal), and this income will be free of local tax. The borrower of course pays the $9 interest payment to the lender. How much local tax does the borrower pay--on the lender's behalf--to the local government? We identify the interest rate the parties would have agreed upon had they selected the gross loan form, which is the interest rate necessary to provide the lender with the same $9 interest income if the lender had to pay his own local tax obligation. The answer is 12%. That interest rate would yield interest income of $12 to the lender in the first year of the loan; the local tax on this income would be $3 (i.e., 25% of $12); and the lender would be left with $9 at the end of the day. 2
The lender's Brazilian tax liability is only half of the story. In calculating his United States tax liability, the lender must include in gross income the interest payment he receives from the borrower and the Brazilian tax paid (on his behalf) by the borrower to the Brazilian tax collector. Old Colony Trust Co. v. Commissioner of Internal Revenue, 279 U.S. 716, 729, 49 S.Ct. 499, 73 L.Ed. 918 (1929); 26 U.S.C. § 61 (1994). But there is potentially also a benefit to our lender under U.S. tax law: the Internal Revenue Code allows a taxpayer to take as a credit against his U.S. tax liability on income earned in a foreign country the amount of foreign tax he has paid on that same income. Id. § 901.
This brings us to the dispute between Riggs Bank and the Commissioner. Riggs claims it is entitled to foreign tax credits in the amount of the Brazilian taxes paid on its behalf by the borrower, the Central Bank of Brazil, pursuant to a net loan agreement. The Commissioner disagrees, arguing that under Brazilian law, there was no obligation on either Riggs or the Central Bank to pay a tax given the Central Bank's tax-immune status as a governmental entity, and so any payments made were voluntary and not a "creditable" tax for purposes of the foreign tax credit.
It is important to understand the nature of appellant's economic incentive in seeking the foreign tax credit to appreciate the Commissioner's concern. The lender's gross cash inflow is unaffected by the availability of the credit--the lender, pursuant to the net loan agreement, continues to receive the same guaranteed interest rate. Nor is there any effect on the lender's Brazilian tax liability; by definition, in a net loan, the lender has passed his Brazilian tax obligation to the borrower. The economic advantage stems, rather, from the effect on the lender's U.S. tax liability. Although the lender's U.S. tax liability increases by the U.S. tax rate multiplied by the amount of Brazilian tax paid on his behalf by the borrower, the lender's U.S. tax liability simultaneously decreases by the entire amount of the Brazilian tax. The key point is that the foreign tax credit is a credit--not a deduction. So long as the U.S. tax rate is less than 100%, the decrease in U.S. tax liability outweighs the increase. And the lender can then apply this excess tax credit toward offsetting the rest of his U.S. tax liability on this same foreign source income.
In 1983, appellant and several other banks contemplating extending net loans to the Central Bank of Brazil were well aware of the potential tax benefit just described and that a precondition to qualifying for the foreign tax credit was establishing that there was indeed a Brazilian tax for which they would be liable. Although, as we have noted, it was undisputed that Brazil imposed a tax on interest income paid by Brazilian borrowers to non-Brazilian lenders, the Central Bank is no ordinary Brazilian borrower. Rather, the Central Bank is a governmental entity and thus immune from tax on its own income under the Federal Constitution of Brazil. It might have been thought that the Central Bank's own tax immunity would not bear on its obligation to pay the tax on any loan, including a net interest loan, for in such a transaction the Central Bank would not really discharge its own tax obligation, but rather a tax obligation contractually assumed from the lender. But there was authority in Brazilian law for the proposition that the tax-immune status of an entity such as the Central Bank shielded not only its own income, but also the interest income of a foreigner who lends to that tax-immune entity...
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