International Law Update

In litigation involving U.S. citizen with U.S. residence who also had Canadian residence where he spent most of his time as business consultant, Canadian Federal Court of Appeal interprets Canada-United States Income Tax Convention (1980) to require that U.S. citizen should pay Canadian taxes on his business income earned in Canada

By Mike  

In litigation involving U.S. citizen with U.S. residence who also had Canadian residence where he spent most of his time as business consultant, Canadian Federal Court of Appeal interprets Canada-United States Income Tax Convention (1980) to require that U.S. citizen should pay Canadian taxes on his business income earned in Canada

Since 2000, R. H. Lingle, (Appellant), a US citizen, has been working as a consultant in Ontario. Throughout the relevant period, Appellant had both US and Canadian residences. Appellant’s family resided at a US house to which he returned one weekend per month. Appellant and his spouse separated in 2004 and sold their US house in 2006. Designating himself as a non-resident of Canada, Appellant filed income tax returns for 2004 and 2005 tax years on his self-employment business income. Appellant also filed returns in the US for these tax years.

On his Canadian returns, however, he claimed equivalent amounts as treaty deductions pursuant to the Canada-United States Income Tax Convention (1980); TIAS 11087;1469 UNTS 189 [in eff. 1984]; with amending Protocols, 2121 UNTS 364 and 387 (in eff. 1984); 2030 UNTS 236 (in eff.1995) and 276 (in eff. 1997) (the Convention). The Canadian Tax Minister assessed Appellant’s Canadian income tax for 2004 during the period from January 1, 2005 to September 14, 2005. The Minister decided that Appellant was a resident of Canada because his habitual abode lay in Canada during this period. Thus the Convention required Appellant to pay Canadian income taxes on business earnings in these years.

The administrative agency and the Tax Court dismissed Appellant’s appeals. These tribunals relied upon Article IV(2) of the Treaty. These tribunals found that that the Appellant did not have an “habitual abode” in the United States under the Treaty. Mr. Lingle went to the Federal Court of Appeal which unanimously dismisses his appeal. These are substantial excerpts from its opinion.

Paras. 1-2. “The Tax Court of Canada was called upon to decide pursuant to the Convention whether the Appellant was required to pay to Canada the income tax on his Canadian business income. The taxation years in issue were 2004 and nine months of 2005. As between the United States and Canada, Article IV(2) of the Convention sets out five tie-breaker rules in both English and French to assist in determining the jurisdiction in which the income tax is to be paid.”

3. “ … [T]he parties agreed that the Appellant had a permanent home in both Canada and the United States during the relevant periods. They also agreed that they could not use the second tie-breaker as it was impossible to determine in which country the Appellant had his ‘centre of vital interests.’ So the matter fell to be determined on the concept of ‘habitual abode’ found in the third tie-breaker [see Article IV(3)]. …’”

4. “The Tax Court found that [Mr. Lingle] did not have an ‘habitual abode’ in the United States for the purposes of the Convention …I am in substantial agreement with the findings and conclusion of the Tax Court.”

5. “The definition and interpretation of ‘habitual abode’ involves a question of law reviewable on the standard of correctness. [T]he application of the definition to the facts of the case to determine whether the Appellant had an ‘habitual abode’ in both jurisdictions, however, raises a question of mixed fact and law which is immune from review by this Court unless there is an overriding and palpable error: see Housen v. Nikolaisen, [2002] 2 S.C.R. 235 (S.C.C.). I see no such error on the facts of this case.”

6-7. “It would be unwise to attempt to set out a rule or a series of criteria which could fit all situations. The determination in each case will depend on the facts and circumstances of the case. The concept of ‘habitual abode’, as evidenced by the clearer French version of the text (séjourne de façon habituelle) involves notions of frequency, duration and regularity of stays of a quality which are more than transient.”

“To put it differently, the concept refers to a stay of some substance in the jurisdiction as a matter of habit, so that the conclusion can be drawn that this is where the Appellant normally lives. This is consistent with the French definition of ‘habituelle’ found in Le Petit Robert 2006: [1]. ‘Qui tient à l’habitude par sa régularité, sa constance’. [2]. ‘Qui est constant, ou très fréquent.’”

8. “This [interpretation] is also consistent with the commentary on Article IV(2) of the OECD Model where it is stated that, in comparing the stays in two States to determine if and where the individual has an ‘habitual abode’, ‘the comparison must cover a sufficient length of time for it to be possible to determine whether the residence in the two States is habitual and to determine also the intervals at which the stays take place’: see Model Tax Convention on Income and on Capital, OECD Committee on Fiscal Affairs, vol. 1, July 2008, at page C(4)-6.”

9. “In … his memorandum of fact and law and at the hearing, the Appellant submitted that the Tax Court judge applied the wrong test in that she went on to examine the social and economic ties which he had in Canada and the United States during the relevant periods. In doing so, she confused the second and the third tie-breaker. He finds evidence of the judge’s error in the following sentence … of the judge’s reasons for judgment: ‘Considering all the facts before me, his connections with the United States were weak when compared to his settled routine in Canada.’”

10. “This sentence is taken out of context and read in isolation. When the sentence is replaced in its proper context, the Appellant’s argument simply has no merit. What the judge was saying in that sentence is that the Appellant did not have a settled routine in the United States while he had one in Canada which showed that he did regularly, customarily or normally live in Canada.”

11. “The judge’s impugned sentence … [lay in ] her reasons for judgment [as excerpted here]: ‘…In the settled routine of [Appellant’s] life ‘he regularly, normally and customarily lived in Canada.’ He did not have any other contracts, clients or business in the USA. In addition, he spent only 69 days out of 623 days in the relevant period at his home in the United States. It is interesting that these agreed statements explicitly state that the Appellant ‘normally … lived in Canada’ … He did not have an habitual abode in the United States for the purposes of the Treaty because he did not regularly, customarily or normally live in the United States. Considering all the facts before me, his connections with the United States were weak when compared to his settled routine in Canada. Accordingly, the Appellant was a resident in Canada during this period and as such he is taxable on his business income earned as a consultant.’”

12. “To the extent that the [Tax Court’s] sentence per se could be found to be ambiguous, it is, however, clear from a reading of the reasons as a whole … that, at the point where the sentence occurs, the judge had already concluded that the Appellant did not have an ‘habitual abode’ in the United States ‘because he did not regularly, customarily or normally live in the United States.’…”

13. “The [Appellant] argued that the proper test to be applied for determining where a taxpayer has his ‘habitual abode’ is to look at where he or she ‘is habitually present’. He relies upon a tentative conclusion of Dr. J.F. Avery Jones who, the [Appellant] says, is currently a judge on the United Kingdom First Tier Tax Tribunal. In a paper presented at the Fifth Annual International Taxation Symposium in the United States, Dr. Avery Jones reviewed the elusive concept of ‘habitual abode’ and concluded: ‘Perhaps an habitual abode really means ‘is habitually present’, which would be much clearer.’”

14,15. “The Tax Court found that the [Appellant] ‘regularly, normally and customarily lived in Canada’: … By the [Appellant’s] proposed test, the Tax Court found that he was habitually present in Canada, but not in the United States. For these reasons, I would dismiss the appeal with costs.” [The other two judges being in agreement, “the appeal is dismissed.”]

Citation: Lingle v. Regina, 2010 Carswell Nat. 1605; 2010 FCA 152; 2010 D.T.C. 5100 (Eng.); [2010] 5 C.T.C. 162; 403 N.R. 337 (Can. Fed. Ct. App. 2010).

Filed in: Issue 12

Swiss Administrative Court agrees with U.S. taxpayer that bank data does not have to be provided to IRS despite assistance agreement between Switzerland and the U.S.; to justify disclosure, Swiss‑U.S. Double Taxation Convention requires affirmative fraudulent acts, not just mere inaction

By admin  

U.S. President signs bill to increase safety of cruise ship passengers. In response to a series of high‑profile sexual assaults and disappearances on cruise ships in recent years, President Obama, on July 27, signed into law tougher new rules for reporting crimes at sea, improving ship safety and training ship staff on how to collect accurate assault evidence. Critics have long taken to task the $40‑billion cruise line industry; they point out that cruise ships registered in foreign countries have taken advantage of murky lines of jurisdiction to ignore the responsibility for misdeeds that occur on their ships in international waters. The bill, inter alia, requires cruise lines to raise the minimum height of railings from 42 to 54 inches; to install peepholes on passenger stateroom doors and crew members’ quarters as well as add on‑deck surveillance cameras, among other safety improvements. It also mandates that cruise personnel to contact both the FBI and the U.S. Coast Guard as soon as passengers report such serious crimes as homicides, suspicious deaths, missing U.S. nationals, kidnappings or assaults. The law takes effect in 18 months. The U.S. may deny cruise lines entry into U.S. ports that fail to comply and may impose civil penalties of up to $50,000 per violation and criminal penalties of as much as $250,000 and one year’s imprisonment. Several persons who have been sexually assaulted or who have lost a loved one on board say that the new law is a solid first step in protecting cruise passengers. Citation: Los Angeles Times, Washington, D.C., Wednesday, July 28, 2010 (byline of Hugo Martin).

Filed in: 2010 International Law Update, Issue 2

Canadian Federal Court of Appeal rules that investigation into taxpayer’s payment history to decide whether to audit taxpayer, with no reference to criminal charges such as U.S. had filed against taxpayer, did not trigger Canadian Charter protections applicable to criminal investigations

By admin  

Canadian Federal Court of Appeal rules that investigation into taxpayer’s payment history to decide whether to audit taxpayer, with no reference to criminal charges such as U.S. had filed against taxpayer, did not trigger Canadian Charter protections applicable to criminal investigations

On April 1, 2004, a federal grand jury in California released its indictment of Roger Ellingson (Taxpayer) for various offenses. They included illicit drug importation and distribution and the laundering of the proceeds between June 2000 and March 2004. The following day the local U.S. Attorney issued a news release that included Taxpayer’s name.

The special enforcement program (SEP) unit of the Canadian Department of National Revenue (CRA) received a copy of a suspicious transaction referral form (the Referral) on or about April 16, 2004. It came from the HSBC Bank in Penticton, B.C. east of Vancouver.

A notation in the Referral entitled “description of suspicious activity” declares that: “Client brought in $5000.00 in cash all in 20s to be applied to two car loans he has with HSBC. The CSR noticed that the money had the distinct odour of marijuanna [sic]. A further review of the loans revealed that client consistently makes payments to the loans by way of cash.”

Though the Referral came from the Royal Canadian Mounted Police (RCMP) Proceeds of Crime unit, it gave no other information about Taxpayer. The Unit first sent the Referral to Darren Wilms in the Investigations Division (ID) of the CRA. Wilms had routinely come across a Penticton Herald article dated April 7, 2004, alluding to Taxpayer’s U.S. indictment on drug trafficking charges.

The CRA database revealed that Taxpayer had not filed any Canadian tax returns for the years 1997 to 2003. Wilms next sent the Referral, the newspaper article and the database search to David Matheson, an auditor/inspector in the SEP unit. Matheson, however, did not get hold of the grand jury indictment or the U.S. Attorney’s press release.

The SEP unit is a separate unit within the ID that audits taxpayers where the facts suggest they may have earned income from illegal sources; it does not currently conduct criminal investigations. When an auditor concludes that a taxpayer may have committed a criminal offense, however, he or she then refers the file to an ID investigator.

Matheson’s first task was to decide whether the SEP should start an audit. Having the sole responsibility for this file, all Matheson did was to issue the Requirement on July 20, 2004. The record shows no indication of any criminal investigation by the ID nor did any CRA official ever interview the Taxpayer.

Under ¶ 231.2(1)(a) of the Income Tax Act (the ITA), the Minister of National Revenue (Minister) may issue a “requirement letter” where the Minister suspects that there may be unreported income and illegal activity. Under the ITA, the Minister may compel any person to provide documents or information, including a return of income or supplementary return. This letter directed Taxpayer to produce his signed income tax returns from 1999 to 2003, as well as signed statements of his assets, liabilities and personal expenses for those same years (the Requirement). The Taxpayer did not respond but sought judicial review to quash the Requirement.

A Federal Court judge (the Applications Judge or AJ) ruled that, when the SEP issued the Requirement, a penal liability investigation was already underway. This gave rise to protection under the Canadian Charter of Rights and Freedoms (the Charter) in accordance with the Supreme Court of Canada decision in R. v. Jarvis, [2002] 3 S.C.R. 757 (S.C.C.) [Jarvis]. The judge, therefor, quashed the SEP requirement letter of July 20, 2004.

The Minister appealed the AJ’s order. He urged that the SEP official had correctly followed the pre-auditing practices approved in Jarvis, and thus, on the facts of this case, The Canadian Charter of Rights and Freedoms protections do not arise.

According to the Minister, the AJ had ignored key facts and mischaracterized a 1992 Working Arrangement between the RCMP and the CRA. According to the Minister, the AJ erred in holding that the SEP unit functioning under the 1992 Working Arrangement is only able to conduct criminal investigations.

The Federal Court of Appeal agrees with the Minister and allows the appeal. It notes that the “predominant purpose” test in Jarvis does not prevent the Minister from conducting parallel criminal investigations and audits. The timing of such processes, however, is crucial. Auditors can share information they obtain with CRA investigators, provided that the auditors got the information before the criminal investigation got underway. At that point, the adversarial relationship arises and engages Charter protections. The Supreme Court summarized the law in the following words: “…as previously stated, it is clear that, although an investigation has been commenced, the audit powers may continue to be used, though the results of the audit cannot be used in pursuance of the investigation or prosecution.” See Jarvis, ¶ 103.

“Jarvis requires a reviewing court to consider what the dominant purpose in issuing a requirement was: the conduct of an audit or the pursuit of a [criminal] investigation. This is a two step test. The first step is to determine whether there is a clear decision to pursue a criminal investigation based on the evidence. If the answer to the first step is yes, the inquiry ends there and the power to issue a Requirement can no longer be exercised by the Minister.” [¶ 14].

“If there is no clear decision, then the trial judge must embark on a search to determine whether the inquiry or question in issue gives rise to an adversarial relationship. All factors are to be examined including, but not limited to, the questions as framed by the Supreme Court of Canada in Jarvis (hereafter ‘the Jarvis Factors’).”

“In the present case, there is no evidence of a clear decision by either the RCMP or the [ID] of the CRA to embark on a criminal investigation. The record is silent on this point. Accordingly an inquiry in accordance with step two of Jarvis must be conducted. Instead of proceeding in that fashion, the [AJ] chose to state the issue in the following words: ‘…the sole question for determination is as follows. ‘When the Auditor made the decision to issue the Requirement, was a penal liability investigation under way?’ If the answer is ‘yes’, on the authority of Jarvis, it is agreed that the Auditor acted beyond his jurisdiction.’” [¶ 16].

“That is clearly an error of law. As indicated in Jarvis at paragraphs 97 and 103, audits and investigations are permissible on parallel tracks. The issue of whether the [AJ] correctly applied the relevant case law to whether the CRA had the jurisdiction to send the Requirement is a question of law, which suggests the least deferential standard of review. [Cite].” [¶ 17].

“[Applying Factor A :] [a]t the time the Requirement was issued, the inquiry by the CRA through its audit function was responding to mere suspicion of unreported income from illegal activity. While it was open to the CRA to conduct both a criminal investigation and audit, the evidence does not show that the CRA were doing both. Rather the evidence is that the pre-audit inquiry was but a first step in determining whether [Taxpayer] was a non-filer for the taxation years 1999 to 2003. Accordingly, I can see no basis on the present evidence to conclude that the CRA had reasonable grounds to lay criminal charges under the Act at this early stage.” [¶ 19].

Applying Factor B: “While Mr. Matheson was unaware of the indictment at the time he issued the Requirement, presumably the Referral and the grand jury indictment could provide a basis upon which an investigation under the Act could be commenced by the RCMP or criminal investigators within the CRA. This factor favours [Taxpayer].”[¶ 20].

[Under Factor C] “The general conduct of the CRA with respect to [Taxpayer] is also not consistent with the pursuit of a criminal investigation, in that the CRA did not issue a search warrant or conduct an interview. Rather its conduct is consistent with simply gathering information to determine whether to commence an audit.” [¶ 21].

“[Under Factor D],whether a file has been transferred to an investigator is yet another factor in determining whether an adversarial relationship exists. However, by itself it is not conclusive (see Jarvis at paragraph 92). The present case does not involve a situation where the file is first transferred from the audit to investigation section and then returned to the auditor who then issues a requirement for documents. In such circumstances, the Supreme Court of Canada has directed that courts must pay close attention to determine whether an investigations section has truly declined to pursue the case or whether the auditor is merely collecting information on its behalf.”

“Here, the file relating to [Taxpayer] has only been acted upon by Mr. Matheson. It is his undisputed evidence that while the file could have been transferred to the [ID] if he had determined that an offence had been committed, that was not done in this case. While it is true that Mr. Matheson does work as an auditor in the SEP unit, which is part of the [ID], the current policy indicates that the SEP unit only conducts audits and Mr. Matheson said that he had never conducted a criminal investigation. Accordingly, there is nothing in this record to suggest that information was exchanged that could give rise to an adversarial relationship.” [¶¶ 22,23].

“[Under Factors E and F], [t]here is also no evidence of any conduct by Mr. Matheson which could suggest that in his audit function he was being used as an agent of the ID or the RCMP in the collection of evidence. Rather, the record suggests that there was no contact once Mr. Matheson assumed conduct of the file.” [¶ 24].

“[Applying Factor G], In my analysis, the information sought in the Requirement is relevant to [Taxpayer's] tax liability generally and is not only relevant to penal liability. It contains what can only be viewed as a normal CRA request in a situation where the taxpayer has not filed any tax returns and little or no financial information is available. For example, it sought the actual tax returns for the relevant years so as to be reviewed or verified by Mr. Matheson. It also sought information regarding income sources, assets, liabilities and personal expenditures also necessary so as to determine whether a net worth assessment was warranted. Again, in and of itself, this factor does not point to an adversarial relationship.” [¶ 25].

“In this circumstance, the appeal should be allowed, the order of the [AJ] dated August 4, 2005 should be set aside and the Requirement issued by the CRA on July 20, 2004 should be restored.” [¶ 35].

Citation: Ellingson v. Minister of National Revenue, 2006 F. C. A. 202, 2006 D.T.C. 6402 (Eng.) (Can. Fed. Ct. App. 2006).

Filed in: 2006 International Law Update, Issue8

In English suit by U.S. parent corporations of UK companies seeking restitution for discriminatory collection of Advance Corporation Tax, Court of Appeal (Civil Division) (1) dismisses appeals under UK law because anti-discrimination provision of US/UK Double Taxation Convention never became internal law of UK and (2) rules that it should refer questions of EU law under Articles 56 and 57 to European Court of Justice unless case goes before House of Lords

By admin  

In English suit by U.S. parent corporations of UK companies seeking restitution for discriminatory collection of Advance Corporation Tax, Court of Appeal (Civil Division) (1) dismisses appeals under UK law because anti-discrimination provision of US/UK Double Taxation Convention never became internal law of UK and (2) rules that it should refer questions of EU law under Articles 56 and 57 to European Court of Justice unless case goes before House of Lords

After the decision of the European Court of Justice (ECJ) in Hoechst v. Attorney General, Metallgesellschaft v. Attorney General, Joined Cases C 397/98 and C 410/98 [2001] ECR I 1727, [2001] Ch 620 (the Hoechst case), certain parent companies which are citizens of countries other than the United Kingdom (here, two from the United States) which lie outside of the European Union, filed suits in the English Courts against the Commissioners for Her Majesty’s Revenue and Customs (Commissioners) over their liability to pay an Advance Corporation Tax (ACT).

This branch of the litigation specifically deals with the liability to pay ACT in connection with the payment of dividends by companies incorporated in the UK which are subsidiaries of two U.S. parent companies. Following that decision many claims have been made by parents or subsidiaries or both, where the parent is based in another Member State, seeking restitution in respect of ACT which should not have been paid.

There are two main aspects to these claims. First, the U.S. plaintiffs argue that the inability of the non resident parent to join in a group income election violates the US/UK Agreement for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains [31 U.S.T. 5668; T.I.A.S. 968231 of December 1975] [DTC] as incorporated into UK law. Secondly it is said that this inability also breaches Article 56EC.

The first instance court ruled that the legislation did contravene the terms of the DTC, but that the relevant provisions were not part of UK internal law, so that the UK courts could provide no domestic remedy. He also decided that the legislation clearly did not breach Article 56EC, and that hence he should not refer this question to the ECJ.

On appeal to the Court of Appeal – Civil Division, the plaintiffs also raised the question whether this Court should make such a reference after or before a likely further appeal to the House of Lords. The appellate court dismisses the appeal on the first claim and declines at this point to refer the EU law questions to the ECJ.

The following are some key facts from the parties’ Agreed Statement. Bush Boake Allen, Inc. is a company resident in the United States and the direct or indirect parent of three relevant companies domiciled in the UK. Between January 1996 and April 1999, the three subsidiaries paid dividends to their direct or indirect U.S. parents, and paid ACT accordingly amounting in all to £2.2 million surplus ACT.

Gallaher Ltd. is a UK company; at all material times it was a wholly owned subsidiary of a U. S. company, ATIC Group Inc. Between July 1995 and January 1997, Gallaher paid dividends to its parent; on one occasion within that period it made a distribution in the form of shares to its parent which counted as a qualifying distribution and therefore attracted the same liability to pay ACT as did the payment of a dividend. It paid ACT accordingly, amounting in all to £153,762,615. All of this was set off against a levy which is sometimes called “mainstream corporation tax” or MCT.

Acushnet Ltd. is a UK company, and a wholly owned subsidiary of Acushnet International Inc. of the U.S. The subsidiary paid dividends to the parent from 1989 up to and including 1999. On each occasion, the subsidiary also paid ACT. If these U.S. parents and their subsidiaries had been able to join in a group income election, they would have done so.

The U.S. plaintiffs focus on the fact that UK resident subsidiaries of U.S. parents had to pay ACT because they could not join in a group income election, whereas UK subsidiaries of a UK parent could have avoided the need to pay ACT. They allege that this amounts to two violations of law. First, it restricts movements of capital, or payments, or both from the UK subsidiaries to the foreign parents, contrary to Article 56EC. Secondly it consists of an “other or more burdensome” taxation or connected requirement than those imposed upon other similar enterprises, in breach of the DTC.

The U.S. plaintiffs seek the following remedies: (a) a declaration that the ACT provisions as they apply to the plaintiffs contravened the DTC and are, therefore, illegal; (b) restitution or damages for breach of, or failure to comply with, the DTC; (c) a declaration that the ACT provisions as applied to the plaintiffs violated Article 56EC and thus are illegal; (d) restitution and/or damages for these breaches.

The provisions about group income elections which lie at the heart of this case are in section 247. Section 247(1) (ignoring immaterial words) is as follows: “Where a company (‘the receiving company’) receives dividends from another company (‘the paying company’), both being bodies corporate resident in the United Kingdom, and the paying company is (a) a 51% subsidiary of the other … then, subject to the following provisions of this section, the receiving company and the paying company may jointly elect that this subsection shall apply to the dividends received from the paying company by the receiving company (‘the election dividends’)”. While an election is in force, the election dividends are part of the group income of the receiving company. They are thus part of that company’s profits.

DTCs are treaties concluded between sovereign states. Under UK law, treaties are entered into in the exercise of the prerogative power of the Crown. Under UK law, however, treaties are not “self executing.” The intervention of Parliament is needed, either directly by statute or by statutory delegation authorizing another person or body to bring the treaty into effect domestically. In the case of DTCs, Parliament has delegated to Her Majesty the power to bring the treaties into domestic effect by Order in Council.

The UK’s numerous DTCs are all bilateral agreements. Nearly all of them, however, derive from a draft produced, with a supporting commentary, by the Organization for Economic Cooperation and Development (OECD). Among the States which have entered into DTCs with the UK, the ones containing “non discrimination” clauses are Japan, Switzerland and the United States, all non EC countries.

For the U.S. plaintiffs-appellants, what arguably governs here is the above DTC between the U.S. and the UK. Article 24, the non discrimination article, provides that: “Enterprises of a Contracting State, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State shall not be subjected in the first mentioned Contracting State to any taxation or any requirement connected therewith which is other, or more burdensome, than the taxation and connected requirements to which other similar enterprises of that first mentioned State are, or may be, subjected.”

As the lead opinion declares: “The U.S. appellants contend that the ACT provisions … are in breach of the non discrimination article in the [U.S. / UK DTC] and that the non discrimination article is given direct and overriding effect as part of UK law by virtue of the opening words of ICTA section 788(3). This gives rise to two questions: (1) is there a breach of the non discrimination article? (2) if so, is the non discrimination article incorporated as part of UK law by virtue of section 788? The judge below held that there was a breach but that the non discrimination article was not (relevantly) incorporated into UK law.” [¶ 33].

Next, the Court addresses whether the ACT provisions are inconsistent with the non discrimination articles. “The debate on this point turns on the meaning of the following words in the relevant provision of the non discrimination article: ‘other similar enterprises of that first mentioned State’. The case concerns enterprises of one Contracting State (UK) the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State (the USA in this instance), and to the taxation to which the UK subsidiary is subjected in the UK.” [¶ 34].

“[T]he Respondent argues that the non discrimination article is concerned with the taxation of the UK company, not with that of its parent, wherever that may be resident, and that a comparison which requires attention to be given to the tax status of the parent is outside the scope of the non discrimination article.” [¶ 36].

“…[T]he judge [below] was right to hold that the ACT provisions, on their face, are inconsistent with the non discrimination article because the UK subsidiary of a foreign company cannot avoid having to pay ACT when it pays a dividend by entering into a group income election, unlike members of a UK group. To limit the availability of group income elections to subsidiaries of UK companies is a breach of the non discrimination article of the Conventions.” [¶ 44].

The Court of Appeal then considered whether the non discrimination article has been incorporated into UK law in relation to ACT. “The judge held that, even though the non discrimination article was infringed by the ACT provisions, there was no remedy for this under UK law because the provisions of the [DTC] as regard ACT are not incorporated into UK law by section 788.” [¶ 45].

“ACT was introduced by the Finance Act 1972. In the same Act, the two aspects of [MCT] were brought into line, in particular as regards double taxation provisions. By section 100 of that Act, the double taxation provisions of the Income and Corporation Taxes Act 1970 (ICTA) applicable to corporation tax in respect of income ‘shall apply also to corporation tax in respect of chargeable gains’. Section 98(2) effected the introduction into section 497 of what has now become section 788(3)(d), referring to the right to tax credits, such as are provided for in the [DTC]. Section 788(3)(a) has followed its predecessor, as amended, by referring to corporation tax in respect of income and chargeable gains, rather than just to corporation tax.”

“The question is whether, by using the composite phrase, it means only (MCT), or whether it really means no more than ‘corporation tax’, so as to include ACT. Clearly it is an inclusive provision, by contrast with the former phrase which distinguished between corporation tax on one type of profits and that on the other.” [¶ 49].

Salomon v. Customs & Excise Commissioners [1967] 2 QB 116, at 143 further amplifies the English process of granting internal effect to international agreements: “Where, by a treaty, Her Majesty’s Government undertakes either to introduce domestic legislation to achieve a specified result in the United Kingdom or to secure a specified result which can only be achieved by legislation, the treaty, … remains irrelevant to any issue in the English courts until Her Majesty’s Government has taken steps by way of legislation to fulfil its treaty obligations. Once the Government has legislated, … the court must, in the first instance, construe the legislation, for that is what the court has to apply.” [¶ 52]

The Court of Appeal agrees with the judge [below] that the non discrimination article has not been incorporated into UK domestic law insofar as it relates to ACT. “Section 788 is a different kind of provision, which has its equivalents in other fiscal legislation, such as those relating to capital gains tax and to inheritance tax mentioned above. It provides for a class of treaty obligations to be given effect to by Orders in Council. Some such Orders were already in force when section 788 became law, and others could be expected to be introduced by further orders thereafter. I agree that the section gives effect only to certain provisions of DTCs.”[¶ 58].

“Since the section is selective as to what provisions of a [DTC] are given direct effect under UK law, I agree with the judge [below] that it would not be right to approach the question of interpretation with a presumption that it was intended to give effect to all provisions of the DTC. So then the question is what is the natural meaning of the words in paragraph (a): ‘corporation tax in respect of income and chargeable gains’? Is it equivalent to ‘corporation tax’, so as to include ACT, or does it refer only to mainstream corporation tax and exclude ACT?” [¶ 59].

“[The] most powerful indication of the natural meaning of the phrase in paragraph (a) is to be found in the juxtaposition of the short and general phrase ‘corporation tax’ in the opening words with the longer and more specific phrase ‘corporation tax in respect of income and chargeable gains’ in paragraph (a).”

” … I conclude that the paragraph is intended to have a more limited scope, and that it does not extend to ACT. In my judgment, although ACT is certainly ‘corporation tax’ … , it is not ‘corporation tax in respect of income or chargeable gains’. For those reasons, it seems to me that the judge was right to hold that the Appellants have no remedy under UK law as such, by reference to the [DTC].” [¶ 61].

Appellants’ alternative and preferred challenge to the ACT provisions is that the ACT provisions do not square with Article 56EC. Article 56EC provides: “(1). Within the framework of the provisions set out in this Chapter, all restrictions on the movement of capital between Member States and between Member State and third countries shall be prohibited. (2). Within the framework of the provisions set out in this Chapter, all restrictions on payments between Member States and between Member States and third countries shall be prohibited.” [¶ 61].

“[Appellants] do not suggest that we ought to decide whether the ACT provisions are restrictions which are prohibited by Article 56 and not saved by Article 57.1, but rather submits that we ought to refer that question to the European Court of Justice [under Article 334EC].” [¶ 64].

Respondent replied that the Court ought not to consider any such reference because he says it is clear that, even if the ACT provisions are restrictions within Article 56, they are protected by Article 57.1. Alternatively, he contended that no English court should make a reference until after the case has been to the House of Lords (if, as both sides seem to anticipate, it will) because only then would it be clear what, if any, restrictions there are under UK law.

After reviewing the evolution of Articles 56 and 57(1) over the last forty plus years, the Court of Appeal declares as follows. “The [referred] question would be, [that] assuming that UK law does impose restrictions on payments between the UK and third countries (… so that there is no remedy under the [DTC]) and accepting that these restrictions were in place already on 31 December 1993, are those restrictions saved by Article 57.1, as being relevant restrictions on capital movements?” [¶ 71]

“… [I]t seems to me that, if the decision of this court as to the position under UK law were the last word on that point, it would be appropriate to refer to the [ECJ] the question whether the ACT provisions constitute a restriction on capital movements or on payments or both, under Article 56, and, depending on the answer to that, whether they are within the scope of Article 57.1 so as to be of continuing effect despite Article 56.” [¶ 76].

The lead opinion summarizes the Court of Appeal’s conclusions. “[T]he judge [below] was right on the question of the interpretation of the [DTC] and on the effect of section 788, so I would dismiss the appeal as regards those issues. I also consider that he was right not to refer a question under Articles 56 and 57 to the European Court of Justice, though not for the reason that he gave. If this case is to proceed further to the House of Lords, on the questions of domestic law, I would not refer such a question at this stage. Otherwise I would do so.” [¶ 83].

Citation: Boake Allen Limited v. The Commissioners for Her Majesty’s Revenue and Customs, [2006] E.W.C.A. Civ. 25, 2006 WL 63703 (C.A. (Civ. Div.)) (January 31).

Filed in: 2006 International Law Update, Issue 5

In matter of first impression, U.S. Tax Court reviews the “check-the-box” regulations in the context of foreign companies

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In matter of first impression, U.S. Tax Court reviews the “check-the-box” regulations in the context of foreign companies

In the following case, the U.S. Tax Court addresses the interaction between the so-called “check-the-box” regulations and the definition of foreign personal holding company income. In particular, the Court reviews whether the deemed sale of assets immediately after their deemed receipt (pursuant to the check-the-box regulations) from a disregarded foreign entity gives rise to “foreign personal holding company income” (FPHCI).

Dover Corporation is a diversified industrial manufacturer incorporated in Delaware. It is publicly traded and has its main place of business in New York. Dover filed a consolidated income tax return for its group of companies.

In the United Kingdom (UK), Dover conducted its elevator business through a UK subsidiary that in turn owned subsidiary, Hammond & Champness Limited (H&C). In June 1997, Dover sold H&C to a German industrial conglomerate, Thyssen, for the entire issued share capital of H&C. In December 1998, Dover requested the Internal Revenue Service (IRS) to grant an extension of time for H&C to file a retroactive election to be a disregarded entity for Federal tax purposes (9100 relief).

The IRS eventually granted Dover’s request, but stated that “no inference should be drawn from this letter that any gain from the sale of … [H&C's] assets immediately following its election to be disregarded as an entity separate from its owner gives rise to gain that is not foreign personal holding company income as defined in section 954(c)(1)(B) of the Internal Revenue Code.” Section 954(c)(1)(B)(iii) defines FPHCI in part, and is part of Subpart F that concerns controlled foreign corporations (CFCs). Section 951(a)(1)(A)(I) provides that each U.S. shareholder of a CFC shall include in gross income certain amounts, including the “pro rata share” of the CFC’s subpart F income for the taxable year.

Subpart F income includes foreign base company income, which in turn includes FPHCI. Under Section 954©), FPHCI is “the portion of the gross income which consists of: …. (B) Certain property transactions. – The excess of gains over losses from the sale or exchange of property — … (iii) which does not give rise to any income.”

Subsequently, H&C made an election on Form 8833 [Entity Classification Election] to be disregarded as a separate entity. The IRS assessed a federal income tax deficiency for 1996 and 1997 totaling approximately $34 million, due largely to the sale of H&C.

The “check-the-box” regulations issued in December 1996 permit most domestic and foreign businesses organizations (included single-owner organizations) to elect between association and partnership classification for federal tax purposes. Single-owner organizations may elect “to be recognized or disregarded as entities separate from their owners.” (Section 301.7701-1(a)(4), Proced. & Admin. Reg.). The preamble to the final regulations warns that the U.S. Treasury and the IRS will monitor the uses of partnerships in the international context and take appropriate action when partnerships are used to reach results that are inconsistent with rules, policies, or U.S. tax treaties.

The U.S. Tax Court concludes that the Dover’s UK gain on the deemed sale of the H&C assets does not constitute FPHCI to Dover under Section 954(c)(1)(B)(iii).

Dover argues that the check-the-box regulations override the principle that the separate entity status of a corporation may not be ignored for federal tax purposes. Consequently, Dover’s UK subsidiary was deemed engaged in H&C’s business and H&C assets are excluded from the definition of property “which does not give rise to any income.” Thus, Dover’s sale of H&C assets did not give rise to FPHCI under Section 954(c)(1)(B)(iii).

The IRS responds that the deemed sale of the H&C assets was not a sale of property used or held for use in Dover’s UK business. Therefore, the property was not excluded from the definition of property “which does not give rise to any income.” Thus, the deemed sale gave rise to FPHCI taxable to Dover.

“Respondent specifically acknowledges that, for tax purposes, H&C’s disregarded entity election constituted a deemed section 332 liquidation of H&C into Dover UK, whereby H&C became a branch or division of Dover UK. Respondent refers to the disregarded entity election as a ‘check-the-box liquidation’ and states that there is no difference between it and an actual section 332 liquidation.”

“Accordingly, the principal question before us is whether, attendant to a section 332 liquidation, the transferee parent corporation succeeds to the business history of its liquidated subsidiary with the result that the subsidiary’s assets used in its trade or business constitute assets used in the parent’s trade or business upon receipt of those assets by the parent.” [...]

” …[R]espondent, nevertheless, argues: ‘Dover UK must *** use, or hold for such, such assets for the requisite period of time in its trade or business before Dover UK is allowed to exclude from FPHCI the gain from the [deemed] sale of those assets.’ Respondent refuses to attribute H&C’s business history to Dover UK …”

“… [A]s direct result of a section 332 liquidation of an operating subsidiary, the surviving parent corporation is considered as having been engaged in the liquidated subsidiary’s preliquidation trade or business, with the result that the assets of that trade or business are deemed assets used in the surviving parent’s trade or business at the time of receipt. … As stated by respondent on brief, … ‘there is no difference between a check-the-box liquidation and an actual liquidation.’ Therefore, … we conclude that respondent has conceded that Dover UK’s deemed sale of the H&C assets immediately after the check-the-box liquidation of H&C constituted a sale of property used in Dover UK’s business within the meaning of section 1.954-2(e)(3)(ii) through (iv), Income Tax Regs.” [Slip op. 48-54]

Citation: Dover Corp. v. Commissioner of Internal Revenue, No. 12821-00 (U.S. Tax Ct. May 5, 2004).

Filed in: 2004 International Law Update, Issue5

Pursuant to U.S. – Canada Tax Convention, I.R.S. sends variety of data to Canadian tax agency in confidence; where Canadian writer on taxation asked for statistics on volume of mutual aid that goes on, Canada’s Federal Court of Appeal distinguishes between statistics and underlying information and provisionally allows plaintiff considerable access to some, but not to all, statistics sought

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Pursuant to U.S. – Canada Tax Convention, I.R.S. sends variety of data to Canadian tax agency in confidence; where Canadian writer on taxation asked for statistics on volume of mutual aid that goes on, Canada’s Federal Court of Appeal distinguishes between statistics and underlying information and provisionally allows plaintiff considerable access to some, but not to all, statistics sought

In the Canada-United States Convention with respect to Taxes on Income and Capital, [T.I.A.S. 11087; 1469 U.N.T.S. 189, Can. T.S. 1984/15.1 (1984); 2030 U.N.T.S. 236, 276 (1995, 1997)] (the Convention), the two nations agreed to aid each other in collecting their respective taxes where there are cross-border features.

David M. Sherman (plaintiff) is a tax consultant and author. In February 1999, the plaintiff asked the Canadian government to provide him with statistical information showing the extent to which the Canada Customs and Revenue Agency (CCRA) and the U.S. Internal Revenue Service (IRS) had sought each other’s assistance pursuant to Convention Article XXVIA during specified time periods.

These are plaintiff’s specific inquiries. “(1). Since this provision came into force in 1995, how many requests have been made by [the CCRA] to the IRS? How many requests have been made by the IRS to [CCRA]? (2). What were the total dollars involved in collection assistance requested by [CCRA] of the IRS? By the IRS of [CCRA]? (3). What percentage of the requests have been accepted for action by the IRS? By [CCRA]? (4). What percentage of the requests acted on have resulted in successful action by the IRS? By [CCRA]? (5). What percentage of the dollars requested have been collected by the IRS and remitted to [CCRA]? Collected by [CCRA] and remitted to the IRS? (6). Can I get breakdowns of each of the above numbers by year (1995, 1996, 1997, 1998)?” [¶ 4]

The Minister of National Revenue (MNR or defendant), however, declined to reveal the requested information. The MNR argued that the IRS had provided underlying data to Canada in confidence. He relied on Section 13(1)(a) of the Canadian Access to Information Act, R.S.C. 1985, c. A 1 (AIA), which requires government institutions to avoid disclosing information obtained in confidence from a foreign state.

Mr. Sherman unsuccessfully complained to the AIA Commissioner. The plaintiff then sought review in the Federal Court, Trial Division. He alleged that the CCRA had not collected the statistical data itself from the IRS. Instead, what he wants consists merely of CCRA’s compilation of statistics about the collection assistance that Canada had given to, and received from, the U.S. Moreover, the petition at issue would in no way pry into individual taxpayer files or records.

In a ruling limited to the interpretation of AIA Section 13(1)(a), the trial judge disagreed, and dismissed plaintiff’s petition for review. The plaintiff appealed. The Federal Court of Appeal unanimously rules for the plaintiff in significant part.

In the appellate Court’s view, a basic question is whether the MNR, in the context of this Convention, may reveal the very fact of the existence of information obtained in confidence from the IRS as well as the volume, in terms of statistical numbers, of such information without, of course, revealing the contents of the information itself.

“Taken to its limits, [the] conclusion that statistics derived from confidential information are an integral part of that information could and would mean that all statistics about taxation laws and, indeed, government operations to enforce these laws could be withheld. This conclusion, as appears from its wording, carries implications way beyond the scope of application of Section 13(1)(a) of the Act and the scope of application of this mutual tax assistance Convention.” [¶ 23]

The Court first warns that this reading of Section 13(1)(a) does not preclude a refusal to disclose pursuant to other mandatory or discretionary exemptions under the Act which are not now before the Court. It then explains. “In my view, for the statistics generated by the [MNR] to fall within the parameters of Section 13(1)(a), these statistics have to reveal … the contents of the information.”

“Statistical information prepared by the [MNR] which reveals, for example, that 50 requests for assistance relating to the Excise Tax Act and 105 such requests regarding the Income Tax Act were made by the IRS is not disclosure of information itself obtained in confidence from an institution of a foreign government which triggers the application of Section 13(1)(a) and satisfies the meaning of information referred to therein.” [¶ 24]

Finally, the Court applies its reading of Section 13(a)(1) to each question set forth above. “In his question no. 6, … the plaintiff requested the yearly breakdown of the statistics covering the subject matter of his five previous questions. We were told by counsel for the [defendant] and the plaintiff accepts the [defendant's] answer to his question, that no breakdown by year exists. This disposes of question no. 6.”

“Pursuant to question no. 1, the plaintiff seeks access to information regarding the number of requests for assistance made by CCRA to the IRS and by the IRS to CCRA. The record containing information coming from Canada which reveals the number of requests made by CCRA to the IRS is not exempt from disclosure under Section 13(1)(a) of the Act. Nor is the record which contains information as to the number of requests made by the IRS to CCRA when such information comes from Canada, even though the statistic is derived from information obtained in confidence from the IRS.”

“Question no. 2 relates to the total amount of dollars involved in the various requests made for collection assistance. I believe that each amount of money mentioned in each specific request made by the IRS to CCRA is information relating to a taxpayer obtained in confidence by CCRA from an institution of a foreign country. In this sense, it is information under the Convention in a way that statistics about the number of requests is not.”

“So, in my respectful view, is the aggregate of these amounts. While it is true that each amount loses its individuality when aggregated together, I do not think this reasoning applies to the issue of confidentiality. The individual amounts, so to speak, aggregate rather than lose their confidentiality. Therefore, this aspect of the plaintiff’s request falls under the exemption from disclosure pursuant to Section 13(1)(a) of the Act. However, no such exemption under these provisions applies to the total amount of dollars involved in the requests made by CCRA to the IRS.”

“Questions no. 3 and 4 have their focus on action and success. They ensue logically from question no. (1). The plaintiff wants to know the percentage of requests accepted for action and the rate of success. I believe the reasoning applied in answering question no. (1) governs the answer to these two questions and that the conclusion is the same as the one arrived at in question (1). These percentages are not exempt from disclosure.”

“Through question no. (5), the [plaintiff] seeks to obtain information about the percentage of dollars collected and remitted by CCRA and the IRS. As for question no. (2), the amount of money collected on behalf of and remitted to the IRS is exempt from disclosure. To disclose the percentage collected is to reveal the aggregate of the dollars claimed by the IRS, an information that was obtained by CCRA in confidence from a Contracting State.”

“However, notwithstanding that the aggregate of dollars claimed by CCRA falls outside the ambit of the exemption rule, the statistic in terms of percentage and amount of moneys collected and remitted by the IRS is confidential information within the meaning of Section 13(1)(a). The statistic is Canadian information about U.S. information, but the nature of the Canadian information is such that it is actually the U.S. information itself obtained in confidence from the IRS.” [¶¶ 35-39]

“I have come to these conclusions regarding the [plaintiff's] request for access without examining the records. I do not know what form the information sought by the [plaintiff] takes in the record. The record may contain voluminous information exempt from disclosure, and it may be that the information requested cannot be severed from the confidential information therein, thereby making lawful disclosure impossible.” [¶ 41]

“In these circumstances, I believe the better, if not the only sensible, course of action open is to send the matter back to the Trial Division of this Court for an examination of the requested records [which neither party had placed in the appellate record] and a redetermination of the plaintiff’s request in accordance with the findings of this Court on the scope of Section 13(1)(a) of the Act and clause 1 of Article XXVII of the Convention.”

“Should the judge on redetermination, after examination of the material, conclude that part of the [plaintiff's] request for disclosure is not subject to the mandatory exemption under the Act, he should then proceed to assess the [defendant's] claimed discretionary exemptions under ¶¶ 16(1)(b) and ( c) of the Act.” [¶ 43]

Citation: Sherman v. Minister of National Revenue, 25 C.P.R. (4th) 32 (Fed. Ct. App. May 6, 2003).

Filed in: 2003 International Law Update, Issue11

In case where U.S. defendants illegally sold liquor in Canada and avoided Canadian taxes, Fourth Circuit, in matter of first impression in the Circuit, disagrees with other precedent and finds that the common law revenue rule does not preclude prosecution under the wire fraud statute

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In case where U.S. defendants illegally sold liquor in Canada and avoided Canadian taxes, Fourth Circuit, in matter of first impression in the Circuit, disagrees with other precedent and finds that the common law revenue rule does not preclude prosecution under the wire fraud statute

In 1996, David Pasquantino and two others (jointly “defendants”) started smuggling liquor into Canada where taxes on liquor were much higher than in the U.S. The Defendants were convicted of using interstate wires to defraud Canada and the Province of Ontario of excise duties and tax revenues for liquor imports and sales.

The wire fraud statute provided that: “Whoever, having devised or intending to devise any scheme or artifice to defraud … by means of false or fraudulent pretenses … transmits … by means of wire … communication in interstate or foreign commerce, any writings, signs, signals, pictures or sounds for the purpose of executing such scheme or artifice, shall be fined … or imprisoned …”

Defendants appeal their convictions, arguing among other things that the application of the common law revenue rule precludes prosecution under the federal wire statute (18 U.S.C. Section 1343) for using interstate wires to defraud a foreign sovereign of its tax revenue. This is an issue of first impression in the Fourth Circuit.

The U.S. Court of Appeals for the Fourth Circuit, in an en banc opinion upon rehearing, affirms. The Court holds that the common law revenue rule does not preclude prosecution under the wire fraud statute in this case.

At the outset, the Court restates the issue of first impression. The issue here is whether application of the common law revenue rule puts beyond the reach of the federal wire statute the use of interstate wires for purposes of defrauding a foreign sovereign.

Section 483 of The Restatement (Third) of Foreign Relations Law of the United States (1987) describes the common law revenue rule as follows: “Courts in the United States are not required to recognize or enforce judgments for the collection of taxes, fines, or penalties rendered by courts of other states.” Although the U.S. Supreme Court has never discussed the precise scope of the common law revenue rule, it noted that many courts in the U.S. have adhered to the principle that a court need not give effect to the penal or revenue laws of foreign countries.

There is some support for the Defendants’ argument in precedent. In United States v. Boots, 80 F.3d 580 (1st Cir.), cert. denied, 117 S.Ct. 263 (1996), the First Circuit vacated convictions for defrauding Canada and the Province of Nova Scotia of excise duties and tax revenues on imported tobacco because upholding the convictions would amount to penal enforcement of Canadian customs and tax laws. See 1996 International Law Update 52.

“We reject the Defendants’ argument that affirmance of their convictions and sentences for wire fraud would be the functional equivalent of enforcing the revenue laws of Canada and the Province of Ontario, and thus in violation of the common revenue rule. In making this argument, the Defendants, and the First Circuit in Boots for that matter, miss the critical point that prosecution for violation of the federal wire fraud statute, even when the subject of the wire fraud scheme involved is certain tax revenue due a foreign sovereign, does nothing civilly or criminally to enforce any tax judgments or claims that the foreign sovereign has or may later obtain against the defendant. Neither does such prosecution enforce the revenue laws of the foreign sovereign involved. Rather, such prosecution seeks only to enforce the federal wire fraud statute for the singular goal of vindicating our government’s substantial interest in preventing our nation’s interstate wire communications systems from being used in furtherance of criminal fraudulent enterprises. Thus, the fact that the property at issue in the Defendants’ wire fraud scheme belonged to foreign governments by virtue of those governments’ respective revenue laws is merely incidental to prosecution under the federal wire fraud statute.” [Slip op. 21-22].

The dissenter opines that, pursuant to the common law revenue rule, the offenses at issue are not cognizable under the federal wire fraud statute. The revenue rule is a discretionary doctrine guided by constitutional and prudential considerations. Thus, courts need not apply the doctrine in every criminal prosecution because some foreign revenue rule is involved. The traditional rationales of the revenue rule, that foreign revenue laws of another country are issues of foreign relations that are better handled by the legislative and executive branches of the government, apply in this case. Here, the Defendants have been indicted in Canada, and the Executive should decide whether to extradite the Defendants.

Citation: United States v. Pasquantino, Nos. 01-4463, 01-4464, 01-4465 (4th Cir. July 18, 2003).

Filed in: 2003 International Law Update, Issue7

By vote of 7 to 2, U.S. Supreme Court upholds Treasury Regulation dealing with allocation of R&D expenses in Domestic International Sales Corporation over method used by Boeing aircraft company to divert taxes and to maximize export profits

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By vote of 7 to 2, U.S. Supreme Court upholds Treasury Regulation dealing with allocation of R&D expenses in Domestic International Sales Corporation over method used by Boeing aircraft company to divert taxes and to maximize export profits

Since 1971, U.S. manufacturers could obtain special tax treatment of their export sales through a subsidiary qualified as a “domestic international sales corporation” (DISC) under 26 U.S.C. Sections 991-997. For these sales, no tax is payable on the DISC’s retained income until it is distributed to shareholders. The law thus encourages the parent company to maximize the DISC’s share of the profit, and to minimize the parent’s share.

There were three alternative ways for a parent company to divert a limited portion of its income to the DISC. See Section 994(a)(1)-(3). Each of the three assumes that the parent company has sold the product to the DISC at a hypothetical “transfer price” that produced a profit for both seller and buyer when the product was resold to a foreign customer.

U.S. legislation in 1984 allowed the use of a Foreign Sales Corporation (FSC) [see Note below]. Unlike a DISC, an FSC is a foreign corporation, part of its income being taxable in the U.S. Whereas some of a DISC’s income was tax-deferred, the 1984 statute exempted a portion of an FSC’s income from U.S. taxation. As under the DISC scheme, it remains in the parent company’s interest to maximize the FSC’s share of the taxable income (TI) generated by export sales.(The Court notes in its opinion that the differences between the DISC and FSC rules do not affect the outcome of this case.)

Specifically, this case deals with the interpretation of Treasury Regulation 26 C.F.R. Section 1.861-8(e)(3) (1979). It has been governing the accounting for research and development (R&D) expenses under both the DISC and FSC regimes. Boeing Company has used both a DISC and a FSC to maximize its export profits. Of its $64 billion in sales between 1979 and 1987, 67 percent were DISC-eligible export sales. During that period, Boeing spent $4.6 billion on R&D.

As one of the three options for transferring TI from the parent to the DISC, Boeing limited its DISC’s TI to a little more than half of the parties’ “combined taxable income” (CTI). Boeing assumed that the statute and the germane regulations gave it an unqualified right to allocate its R&D expenses to the specific products to which they were factually related, and to exclude any allocated R&D expenses from being treated as a cost of any other product.

After an audit, however, the Internal Revenue Service (IRS) reallocated the R&D costs and thereby decreased the untaxed profits of Boeing’s export subsidiaries and increased the parent company’s taxable profits. It classified all R&D expenses as an indirect cost of all export sales of products in a broadly defined Standard Industrial Classification (SIC) category (e.g., transportation equipment). As a result, Boeing turned out to owe the government $419 million. After paying the assessed taxes, Boeing brought this refund action in a Washington federal court.

The district court gave summary judgment to Boeing, concluding that Section 1.861-8(e)(3) is invalid as applied to DISC and FSC transactions. The U.S. Court of Appeals for the Ninth Circuit reversed, and the U.S. Supreme Court granted certiorari to resolve a conflict between the Eighth and Ninth circuits. In a 7 to 2 vote, the Court, in an opinion by Justice John Paul Stevens, affirms the Ninth Circuit, finding that Section 1.861-8(e)(3) is a proper exercise of the Secretary of the Treasury’s rulemaking authority.

First, Justice Stevens finds that the Secretary is entitled to deference in his interpretation of the statute, and that Boeing failed to show that the statutory text provides otherwise. As for the DISC regulations, the Justice rejects Boeing’s contention that the regulations expressly allow it to allocate and apportion R&D expenses to groups of export sales that are based on a SIC category. The regulations clearly provide that, if the taxpayer chooses the CTI method of transfer pricing (as Boeing did), then the taxpayer may choose to group export receipts according to product lines based either on two-digit SIC codes, or on a transaction-by-transaction basis.

Finally, the Court rejects Boeing’s arguments that the legislative history of the DISC scheme supports its position. “First, whereas the DISC transfer price could be set at a level that attributed over half of the CTI to the DISC, when Congress enacted the FSC provisions in 1984, it lowered the maximum allowable share of CTI attributable to an FSC to 23 percent. … This dramatizes the point that even though the purpose of the DISC and FSC statutes was to provide American firms with a tax incentive to increase their exports, Congress did not intend to grant ‘undue tax advantages’ to firms. … Rather, the statutory formulas were designed to place ceilings on the amount of those special tax benefits. …”

“Second, the 1977 R&D regulation at issue in this suit had been in effect for seven years when Congress enacted the FSC provision. Yet Congress did not legislatively override 26 CFR Section 1.861-8(e)(3) (1979) in enacting the FSC provisions. …” [1111]

[Editorial Note: Soon after its passage, the 1971 DISC statute generated an ongoing controversy between the U.S. and certain other parties to the General Agreement on Tariffs and Trade (GATT) as to whether the DISC provisions were unauthorized subsidies. To remove the DISC system as a quarrelsome issue, the U.S. assured the GATT Council in October 1982, that it would propose legislation to address the concerns of other GATT members. Congress replaced the DISC provisions in 1984 with the FSC system. In 2000, however, the European Union successfully challenged the FSC system before the World Trade Organization (WTO). In November 2000, U.S. President Clinton signed the "FSC Repeal and Extraterritorial Income Exclusion Act of 2000” (26 U.S.C. Section 114), to carry out the WTO recommendations. In August 2001, the WTO Appellate Body concluded (WT/DS108/RW) that the new statute still fails to comply with WTO trading rules. See 2001 International Law Update 141]

Citation: The Boeing Co. v. United States, 123 S.Ct. 1099 (U.S. S.Ct. 2003).

Filed in: 2003 International Law Update, Issue3

In appeal by taxpayer who was being investigated by French tax authority, Fifth Circuit finds that IRS acted in good faith by providing assistance under U.S.-French double taxation treaty

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In appeal by taxpayer who was being investigated by French tax authority, Fifth Circuit finds that IRS acted in good faith by providing assistance under U.S.-French double taxation treaty

Appellant Mazurek was the focus of an investigation by the French Tax Authority (FTA) concerning his civil liability for French taxes. As part of its investigation, the FTA requested that the IRS hand over Mazurek’s pertinent financial information, pursuant to the Convention Between the Government of the United States and the Government of the French Republic for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Tax on Income (hereinafter “Treaty”). Mazurek challenged the FTA’s determination that he was a French resident, and alleged that the FTA could not request his financial information from the IRS until a final determination was reached regarding his residency status. He therefore filed a motion to quash the summons pursuant to I.R.C. Section 7609.

The district court found that an affidavit submitted by the Assistant IRS Commissioner, designated under the Treaty as the Competent Authority for the U.S., properly reviewed the FTA’s request and found it to be supported in the context of the Treaty. Furthermore, the district court held that Mazurek’s arguments were directed at matters of French law most fit to be resolved by French authorities. The district court entered judgment in favor of the IRS. Mazurek appealed.

The U.S. Court of Appeals for the Fifth Circuit affirms, ruling that the United States Internal Revenue Service (“IRS”) did not act in bad faith in turning over the financial records of a private citizen to the French Tax Authority (“FTA”). The Court found that the actions of the IRS squared with precedent and were authorized by the Treaty.

The Court finds that Mazurek failed to properly and accurately identify the controlling issue. It is not whether or not Mazurek was properly identified as a French resident, but rather whether or not the IRS acted in bad faith. The affidavit submitted by the Competent Authority for the U.S. properly established a prima facie case for the actions of the IRS. By failing to advance a claim that the IRS had abused judicial process by using the summons to harass, leverage, or pretextually develop a criminal case, Mazurek failed to address the issue and thus did not succeed in showing that the IRS had acted in bad faith.

United States v. Powell, 379 U.S. 48 (1964), set forth a four-pronged test to determine whether or not the government made out a prima facie case. The burden on the government to produce such a case is minimal. If the court finds that the government has met its slight burden, the analysis shifts to whether or not Mazurek has fulfilled his “heavy” burden of rebuttal, Thus the taxpayer must either (1) rebut the government’s contentions regarding any of the four prongs of Powell, or (2) show that enforcement of the summons at issue would result in abuse of the court’s process.

To qualify as a prima facie case under Powell, the government must show the following four factors: (1) that the investigation was conducted pursuant to a legitimate purpose; (2) that the inquiry is relevant to that purpose; (3) that the information sought is not already within the possession of the IRS; and (4) that the IRS has followed the administrative steps required by the Internal Revenue Code.

The affidavit submitted by the Assistant IRS Commissioner as a Competent Authority for the U.S. satisfied the last three Powell requirements. The IRS’s attempt to fulfill the obligations of the U.S. under the Treaty clearly satisfied the legitimate purpose requirement under the first Powell factor.

After the government established a prima facie case under Powell, the burden shifted to Mazurek. Mazurek, however, did not try to show that enforcement of the summons in the district court would create an abuse of the judicial process. Instead, Mazurek claimed that, since he was not a resident of France for the period of time involved in the FTA investigation and since there has been no final determination on this matter, any request for information covered by the investigation has no legitimate purpose.

The Court finds that Mazurek had misdirected his arguments. He mistakenly focused on the legitimacy of the FTA’s investigation, rather than on the legitimacy of the IRS’s compliance with the FTA’s request. Therefore, Mazurek failed to meet his burden of showing that the IRS had acted improperly.

Mazurek also advances a claim that permitting the FTA to obtain his financial records from the IRS while there had been no final determination on his residency status would allow the FTA to use the IRS in order to grant itself a broader authority than would otherwise be available. The Court relies upon a Supreme Court ruling in United States v. Stuart, 489 U.S. 353 (1989), to buttress its decision to end the inquiry at the determination of good faith.

Furthermore, the Court finds that the district court did not err in denying Mazurek an opportunity for discovery and a full evidentiary hearing. Thus “district courts are afforded wide leeway in fashioning the scope of discovery in summons enforcement proceedings because ultimate issues of responsibility are not decided in these proceedings … allowing full opportunities for discovery would contravene the purpose of a summons enforcement proceeding, which is summary in nature.” [Slip op. 21]

Citation: Mazurek v. United States, No. 00-31430 (5th Cir. November 7, 2001).

Filed in: 2001 International Law Update, Issue12

In civil RICO tax case brought by Canada against U.S. tobacco companies, Second Circuit finds that common law “revenue rule,” under which courts of one sovereign will decline to enforce final tax judgments or unadjudicated tax claims of other sovereigns, barred Canada’s RICO claims

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In civil RICO tax case brought by Canada against U.S. tobacco companies, Second Circuit finds that common law “revenue rule,” under which courts of one sovereign will decline to enforce final tax judgments or unadjudicated tax claims of other sovereigns, barred Canada’s RICO claims

In 1991, Canada doubled its cigarette tax. As a result of the “sin-tax” increase, the sales of RJR-Macdonald (RJR Mac), a Canadian tobacco company, and the American cigarette companies R.J. Reynolds Tobacco Holdings, Inc. (Holdings), Northern Brands International, Inc. (NBI), and several others decreased dramatically. To get around the new tax, these companies together orchestrated an effort to export cigarettes from Canada to Foreign Trade Zones (FTZs) in upstate New York. Once inside these FTZs, the companies sold the cigarettes to smugglers, including residents of the St. Regis/Akwesasne Indian Reservation, on the New York-Canadian border. After smuggling the cigarettes into Canada, the companies knowingly sold them on the black market.

The scheme grew in complexity and scope in 1992 with the Canadian government’s institution of an additional $8 (Canadian) tax on each carton of cigarettes. To surmount this obstacle, the defendants shipped raw Canadian tobacco to RJ Reynolds Tobacco Company PR (RJR PR) in Puerto Rico. RJR PR processed the tobacco into Canadian-style cigarettes, like those made by RJR Mac in Canada. These cigarettes then reached the Reservation through the FTZs, and smuggled into Canada for illicit sale. Canada alleged that the companies cheated it out of a significant amount of tax revenue, and required spending major sums for law enforcement measures.

Plaintiff filed suit in the Northern District of New York to recover treble damages under RICO. To establish a RICO claim, one must show that (1) a violation of the RICO statute took place; (2) that there was injury to plaintiff’s business or property; and (3) that the RICO violation caused the resultant injury. The district court, however, dismissed Canada’s claims on the grounds that the common law “revenue rule” barred an American suit to enforce the tax laws of another sovereign.

The Canadian Government appealed but the U.S. Court of Appeals for the Second Circuit affirms. The District Court found that Canada does indeed qualify as a “person” for the purposes of eligibility to bring a RICO action. But this is not enough.

“In the absence of specific treaty provisions, no matter how conscious and deliberate the tax evasion, there are no judicial or administrative remedies available to the defrauded state or province outside its territorial jurisdiction.” See United States v. Harden [1963] S.C.R. 366, 371 Can. The purpose of the revenue rule is to prevent foreign sovereigns from asserting their sovereignty within the borders of other sovereign nations.

Second, “by international law, every sovereign state has no sovereignty beyond its own frontiers. The courts of other countries will not allow it to go beyond the bounds. They will not enforce any of its laws which purport to exercise sovereignty beyond the limits of its authority.” See Attorney General of New Zealand v. Ortiz [1984] A.C. 1 [H.L.]. If the United States were bound to accept and enforce Canadian tax laws within its borders, that would include the judicial enforcement of any taxes that might so elevate the price of American goods in Canada as to handicap the economy of the pertinent American industry.

Finally, the Second Circuit ruled that extraterritorial tax enforcement directly implicates relations between the US and sovereign nations. Such matters therefore lie in “forbidden waters” for the judicial branch, and are more appropriately addressed by the political branches of the government.

The dissenting judge contends that the revenue rule does not apply in this case. As for the argument that U.S. courts should not give extraterritorial effect to foreign laws, the dissenter notes that Canada is effectively enforcing RICO, a U.S. law. This concern for extra-territoriality has no meaning when the enforcement concerns damages or penalties of a domestic nature.

“As a court, we have no obligation to further Canada’s sovereign interests. But we do have an obligation to further America’s sovereign interests. That is, we are bound to entertain suits brought under federal statutes, and to award the damages that such statutes establish. In enacting RICO and its civil enforcement provision, Congress chose to create this action. It follows that, by enacting RICO, our government has determined that this suit advances our own interests, and any collateral effect furthering the governmental interests of a foreign sovereign is, therefore, necessarily incidental.” [Slip op. 96]

The dissenter also rejects any foreign policy or separation of powers concerns that the majority may have because Congress intended to create such a cause of action. “An analogy to the enforcement of foreign judgments is apt. Generally speaking, foreign judgments are not directly enforceable in United States courts because of foreign policy and separation of powers concerns. … But, the moment treaties or laws are enacted that provide for the enforcement of certain foreign judgments, the situation changes. United States courts can thereafter enforce these judgments and must do so regardless of whether our foreign policy favors or disfavors the specific judgment before the court.”

“Similarly, though foreign tax laws cannot be enforced directly, when American law renders an activity – including the violations of foreign tax laws – an American tort or crime, the issues of whether our foreign policy favors or disfavors the particular form of taxation involved or the choice of items to be taxed must disappear. As the Supreme Court has explained, the purpose of civil RICO is ‘not merely to compensate victims but to turn them into prosecutors …’ To reject the application of civil RICO to the case at hand is to hamper this congressional objective.” [Slip op. 97-98]

Finally, the dissenter concedes the difficulties which U.S. courts might have in interpreting foreign laws, but the increasingly global economy often requires the interpretation of foreign laws. Moreover, Second Circuit precedent has recognized foreign tax-related judgments.

Citation: The Attorney General of Canada v. R.J. Reynolds Tobacco Holdings, Inc., No. 00-7972 (2d Cir. October 12, 2001).

Filed in: 2001 International Law Update, Issue11