Continental Illinois Corp. v. C.I.R.

• Decision Date: 09 July 1993
• Docket Number: Nos. 92-2435,92-3191,s. 92-2435
• Citation: 998 F.2d 513
• Parties: -5308, 93-2 USTC P 50,400 CONTINENTAL ILLINOIS CORPORATION, also known as Continental Bank Corporation, Petitioner-Appellant, Cross-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee, Cross-Appellant.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 513

998 F.2d 513

72 A.F.T.R.2d 93-5308, 93-2 USTC P 50,400

CONTINENTAL ILLINOIS CORPORATION, also known as Continental Bank Corporation, Petitioner-Appellant, Cross-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee Cross-Appellant.

Nos. 92-2435, 92-3191.

United States Court of Appeals Seventh Circuit.

Argued May 3, 1993.

Decided July 9, 1993.

Roger J. Jones (argued), Joel V. Williamson, Arthur I. Gould, Thomas C. Durham, Francis A. Lavelle, Honey L. Goldberg, Mayer, Brown & Platt, Chicago, IL, Mary P. Taylor, Evanston, IL, for petitioner-appellant in No. 92-2435.

Gary R. Allen, David E. Carmack, Charles Bricken (argued), Dept. of Justice, Tax Div., Appellate Section, Washington, DC, for respondent-appellee in No. 92-2435.

Michael M. Conway, Paul S. Caselton, John L. Snyder, Marilyn D. Franson, Hopkins & Sutter, Chicago, IL, for First Chicago Corp., amicus curiae.

Michael J. Waldman, Saul M. Shajnfeld, Bankers Trust Co., New York City, for Bankers Trust Co., amicus curiae.

Roger J. Jones (argued), Joel V. Williamson, Arthur I. Gould, Thomas C. Durham, Francis A. Lavelle, Mayer, Brown & Platt, Chicago, IL, Edward C. Rustigan, Winnetka, IL, Mary P. Taylor, Evanston, IL, for petitioner-appellee in No. 92-3191.

Abraham N.M. Shashy, Jr., I.R.S., Gary R. Allen, David E. Carmack, Charles Bricken (argued), James A. Bruton, Dept. of Justice, Tax Div., Appellate Section, Washington, DC, for respondent-appellant in No. 92-3191.

Before POSNER and COFFEY, Circuit Judges, and WILLIAMS, Senior District Judge. ^*

POSNER, Circuit Judge.

The Internal Revenue Service assessed substantial deficiencies against the Continental Illinois National Bank for the years 1975 through 1979. Continental challenged these deficiencies in the Tax Court, which conducted several trials that have produced the rulings, some in favor of Continental, some in favor of the IRS, that the parties have brought before us on this appeal and cross-appeal. 55 T.C.M. (CCH) 1325 (1991); 58 T.C.M. (CCH) 790 (1991); 61 T.C.M. (CCH) 1916 (1991). The parties and the amici have favored us with more than two hundred pages of briefs, rich in detail that we can ignore. The issues are straightforward. They concern just two types of loan: "net loans" made to foreign borrowers, and "CAP loans."

"Net loans" are loans net of any tax that the borrower's country imposes on the interest. In a gross loan, the parties agree to an interest rate, and the interest is paid to the lender subject to any obligation that local law imposes on the borrower to withhold the tax that the lender owes on the interest. Thus, if the agreed rate of interest is 12 percent and the withholding rate 25 percent, the borrower remits only 9 percent interest to the lender and pays the rest to the local taxing authority. In a net loan, the parties agree upon the interest that the lender will be entitled to receive net of any local tax on it; this protects the borrower against an unexpected increase in the tax rate. Determination of the tax due on the interest for such a loan generally requires computing a grossed-up interest income figure (which we'll call x) that will generate the same amount of tax that would have been due had the form of the loan not been changed from gross to net. To compute x requires first computing what we will call r, the rate that, after subtraction of (in our example) 25 percent of the rate, equals the agreed-upon after-tax interest rate. So: r - .25r = 9%; r = 12%. The grossed-up income (x) is simply r times the amount of the loan. What we are calling x and r will nowhere be specified in the loan contract. They are artifacts created in order to make sure that net lending will not be used to reduce the lender's tax liability to the foreign country. In both the gross and the net loan the lender receives (in our example) 9 percent on his money after tax. The difference is that in the gross loan a change in the tax rate will raise or lower the amount of money the lender can take out of the country because his entitlement is to interest before the tax on it is computed or paid, and a change in the tax rate will therefore change what he can take out, while in a net loan a change in the tax rate will not affect the amount of money that he can take out of the country because the contract for such a loan entitles him to a fixed amount of interest over and above the local tax, whatever that tax may be.

The Internal Revenue Code allows a taxpayer to credit against the federal income tax that he must pay on income earned in a foreign country any income tax that he paid to that country on the same income. 26 U.S.C. § 901. In our example of a gross loan, the lender can thus set off the 3 percent interest that is withheld from his foreign interest income and paid over to the foreign taxing authority against his federal tax obligations. In the case of a net loan, however, for a long time either the IRS took the position, or Continental believed it was the IRS's position, that the only taxable income received by the lender was the agreed-upon after-foreign-tax rate; since no foreign tax had been taken out of that income, no foreign tax credit was available. In 1976 Continental learned that it was the IRS's position that the lender's taxable income was x, the grossed-up amount, and that any foreign tax paid on x could be taken as a foreign tax credit. Continental launched a study of all its net loans to determine how much foreign tax had been withheld, and it attempted to credit the amounts withheld against its federal income tax, restating its taxable income to include those amounts. In terms of our example, it reported x as taxable income and claimed a foreign tax credit of .25x. We shall see that this restatement promised Continental a net tax savings.

The first issue is whether Continental's inability to produce tax receipts for the amounts withheld is fatal to its claiming those amounts as foreign tax credits. Continental makes two arguments that it is not, one that the Tax Court correctly rejected, the other that it erroneously accepted. The first argument is that the foreign tax credit attaches irrevocably when the borrower (or other foreign debtor of the U.S. taxpayer) "withholds" for taxes moneys that would otherwise go to the lender (or other U.S. creditor), even if those moneys are never paid over to the foreign taxing authority. We disagree. Put aside the awkwardness that the "withholding" involves no subtraction from what would be due the lender were there no foreign tax, because the lender's entitlement is net of that tax. The important point is that it is a foreign tax credit that the Internal Revenue Code allows, not a foreign fraud credit. If Continental's position prevailed, American businessmen would have strong incentives to collude with foreign businessmen in overwithholding foreign taxes, since such overwithholding would generate foreign tax credits for the American at no cost to the foreigner. It is true that if the foreigner withholds more than is actually due (or collectable), pocketing the difference, the American will have a higher taxable income. But every extra dollar of taxable income will be creditable against U.S. income tax, and the result will be a net tax benefit. Suppose the American is in the 30 percent bracket. Then the phantom additional dollar of foreign income will create a 30cents tax liability and a $1 tax benefit, for a net benefit of 70cents.

This is reason enough why the IRS insists that the foreign tax not merely be withheld, but paid to the lawful taxing authority. And it is an insistence grounded in the language of the Internal Revenue Code. The amount allowed as a foreign tax credit is the amount of any foreign tax "paid or accrued," and if accrued taxes when paid differ from the amount of the credit taken that amount must be readjusted accordingly. 26 U.S.C. §§ 901(b)(1), 905(c).

Continental presented letters from its borrowers stating that they had indeed paid the taxes they withheld on Continental's net loans. These letters are the basis of its second argument, which the Tax Court accepted, that even if the foreign tax credit does not attach at the moment of "withholding," actual payment was adequately proved. The regulations require that the taxpayer submit "the receipt for each such tax payment," or in lieu thereof "a photostatic copy of the check, draft, or other medium of payment showing the amount and date thereof, with certification identifying it with the tax claimed to have been paid, together with evidence establishing that the tax was paid for taxpayer's account as his own tax on his own income." Treas. Reg. §§ 1.905-2(a)(2), 2(b)(1). The borrowers' letters did not comply with these straightforward requirements. We cannot imagine on what basis the requirements might be thought an abuse of the Internal Revenue Service's necessarily broad power to prescribe the methods of proving entitlement to lucrative tax benefits. Continental complains that the enforcement of the requirements against it is "unfair," because had it only realized before 1976 that net loans could generate foreign tax credits, it would have required its borrowers to furnish it with tax receipts. But that is tantamount to arguing that the IRS was under a judicially enforceable obligation, when it changed its position on the foreign tax credit status of net loans (if it changed its position--which is unclear, but also on the view we take of the case unnecessary to clear up), to relax its normal rules for proving payment of foreign taxes so that taxpayers could take maximum advantage of the new position. In effect, by not relaxing its rules on proof, the IRS changed its position on the foreign tax credit status of net loans prospectively. Continental insists on full retroactivity. There is no basis in law, public policy, natural justice, or any other source of norms for such an insistence with respect to so artificial an...