Claiming a Foreign Tax Credit—How Exhausted Do You Really Have to Be?
Missteps by taxpayers in this area can be costly and result in avoidable double taxation

The Internal Revenue Service recognizes that “foreign government audits of U.S. taxpayers have become more frequent and, at times, more aggressive.”¹ Consequently, the number of foreign tax contests and payments made by taxpayers to resolve those contests are on the rise.

The IRS has signaled through its training materials and litigating positions an increased aggressiveness in contesting foreign tax credit claims. Missteps by taxpayers in this area can be costly and result in avoidable double taxation. This article focuses on practical steps that taxpayers may take to protect their foreign tax credit claims that result from the payment of contested foreign taxes.

The Basics of Foreign Tax Credits

Section 901(b) allows a foreign tax credit for the payment of foreign taxes. However, the ability to claim this credit is not unrestricted. Among other requirements,² the foreign tax payment must be compulsory (i.e., it cannot exceed the amount of taxes owed under foreign law). The rationale for this requirement is clear: “[a] system under which the United States Treasury pays out foreign tax credits without first demanding that American companies effectively and practically reduce their foreign tax payments would create a moral hazard.”³ The IRS explains the moral hazard by saying that taxpayers would “otherwise have no incentive to challenge any foreign tax whether or not properly imposed, thereby transferring the foreign tax cost to the United States.”⁴

Payment of foreign taxes is compulsory if the taxpayer, to the extent possible, reduces its foreign tax liability by 1) reasonably interpreting and applying the foreign law and 2) exhausting all “effective and practical” remedies. There is often overlap in the analysis of these prongs by the IRS and courts.

Reasonably Interpreting and Applying Foreign Law

Determining what constitutes a “reasonable interpretation and application of foreign law” is fact-intensive and can resemble shooting at a moving target, because foreign courts and taxing authorities may change their positions (especially as those governments and their officials change). But there are some safe harbors. For example, taxpayers may rely on advice obtained in good faith from their foreign tax advisors.⁵ Taxpayers who avail themselves of this safe harbor should be prepared to provide evidence of the advice received, analysis undertaken, and avenues of relief considered and, if the advice is not pursued, the reasons for not pursuing it.⁶

A taxpayer is also “not required to alter its form of doing business, its business conduct, or the form of any business transaction in order to reduce its liability under foreign law for tax.”⁷ However, taxpayers should proceed with caution if their decision will ultimately increase their overall foreign tax liability over time. For example, the IRS determined that a surcharge paid by a taxpayer was not compulsory because the taxpayer could have avoided the surcharge by electing to pay the tax earlier than was required by law.⁸ Similarly, the decision to surrender an entity’s losses to a U.K. parent instead of a subsidiary is inconsistent with applying the foreign law in a way that would minimize foreign tax liability when such a decision resulted in the taxpayer’s incurring additional U.K. taxes.⁹

A taxpayer’s interpretation of foreign law is not reasonable “if there is actual notice or constructive notice” that the taxpayer’s interpretation or application of the law is likely wrong.¹⁰ Examples of actual notice include published foreign court decisions or other guidance, and when a taxpayer knowingly fails to charge a foreign affiliate an arm’s-length price for goods or services.¹¹ An example of constructive notice is when the IRS reallocates income from a taxpayer’s foreign affiliate to its domestic affiliate. The IRS contends that such reallocation results in actual notice to the domestic affiliate and constructive notice to the foreign affiliate that its interpretation and application of foreign law are likely wrong.¹² Therefore, the foreign tax paid on the income that was reallocated to the domestic affiliate is not “compulsory” and does not qualify for a foreign tax credit if the foreign affiliate fails to exhaust all effective and practical remedies to obtain a refund of the foreign tax paid on the reallocated income.¹³ The IRS contends that this constructive notice requires the foreign affiliate to pursue its effective and practical remedies to recover any foreign tax paid on the reallocated income.

Exhausting All “Effective and Practical” Remedies

Only a few cases address the extent to which a taxpayer must exhaust available remedies before claiming a foreign tax credit. And each of those cases is unique and fact-specific. Although this may make the waters difficult to navigate at times, the cases and IRS administrative guidance do provide some guiding lights. For example, “a taxpayer need not undertake extraordinary efforts to contest a foreign tax liability,”¹⁴ and “the statute, the regulations, and the applicable revenue rulings do not” require “a taxpayer to exhaust all litigation remedies before being entitled to a foreign tax credit.”¹⁵ Instead, the taxpayer must pursue remedies that are “effective and practical” considering “the amount at issue and likelihood of success.”¹⁶ The IRS summarizes this requirement as “taxpayers may ordinarily take a reasonable business approach, weighing costs and benefits, in settling foreign income tax issues.”¹⁷

Taxpayers who decide to pay the foreign tax because the remedies available are not effective and practical should be prepared to defend that decision. For example, it is reasonable not to pursue further remedies if the statute of limitations has passed for filing a refund claim and the applicable treaty does not provide an exception.¹⁸ Similarly, a remedy is not effective or practical if there is a real risk that the foreign tax authority will raise an offsetting or additional tax liability that may exceed the amount of relief sought.¹⁹

The evidence that taxpayers often rely on successfully to prove the availability (or lack thereof) of effective and practical remedies is an opinion from their outside tax advisors. Such an opinion should, at a minimum, include a detailed discussion of the relevant legal authorities and a conclusion that the tax at issue was properly assessed or a reasoned explanation why challenging the assessments is unlikely to succeed. For example, the court held in IBM that a foreign tax payment was compulsory even though that assessment was not challenged through competent authority proceedings or until the litigation options were completely exhausted. The IBM court relied on the foreign tax advisor’s opinion that the company’s “untested, theoretical argument against the application” of the foreign tax would be a “near certain loser.”²⁰

The Tax Court reached a similar decision in Schering. Here, the government argued that the taxpayer “should be barred from taking the foreign tax credit” on a Swiss tax payment made on the advice of Swiss counsel. The taxpayer did not challenge the Swiss tax at issue administratively with the Swiss government, in the Swiss courts, or through competent authority proceedings.²¹ The position of the Swiss authorities with respect to the tax at issue was clear, and the taxpayer’s payment of the tax was consistent with the published authorities. (One of the taxpayer’s subsidiaries even inquired into obtaining its own ruling and was informed the tax was due.) Taxpayers are “not required to take futile additional administrative steps” to pursue a reduction in foreign taxes.²² The Tax Court also excused the taxpayer’s decision not to seek competent authority relief because, among other reasons, competent authority may not have been available under the Swiss tax treaty, and the Swiss tax authorities had already refused to accept the Section 482 reallocation that gave rise to the Swiss tax at issue.

Although IBM and Schering both successfully sustained their foreign tax credits without seeking competent authority assistance, taxpayers should stay mindful that the IRS challenged the claimed credits in both cases (as well as in the Coca-Cola case discussed below). The IRS’ view remains that there are “few exceptions” to the “rule” that taxpayers must pursue competent authority assistance to exhaust their remedies in a treaty country.²³

This “rule” was discussed in the Procter & Gamble case. Procter & Gamble involved foreign tax credits claimed for a Korean and a Japanese tax on the same royalty income. With respect to the Korean tax, the taxpayer hired Korean counsel who concluded (and prepared a detailed memorandum to explain) that the Korean tax was owed under both Korean law and the Korean tax treaty, and that a challenge to the assessment was unlikely to be successful. The taxpayer then determined that there was no reasonable basis to appeal the assessment of the Korean tax or pursue competent authority relief under the Korean tax treaty. The taxpayer did not dispute the Japanese tax or seek competent authority relief with respect to that tax.

The Tax Court granted the government’s motion for summary judgment on the Korean tax. Even though the taxpayer was not precluded from claiming foreign tax credits for more than one country on a single stream of income, the court held that P&G could claim foreign tax credits only on the amount of the Korean tax for the amounts that exceeded the Japanese tax credits already received on the same royalty income. The court held that “[a]lthough P&G was required to pay Korean tax, and was reasonably advised as to the legality and accuracy of the Korean claim by its Korean counsel, P&G failed to ‘exhaust all effective and practical remedies including invocation of competent authority procedures available under applicable tax treaties’ to reduce the tax liability owed to Japan per the applicable Treasury Regulations.”²⁴ The court found that P&G should have sought a “redetermination of the source of the royalty income under Japanese law or competent authority proceedings with regards to P&G’s liability in Japan.”²⁵

The IRS summarizes this requirement as “taxpayers may ordinarily take a reasonable business approach, weighing costs and benefits, in settling foreign income tax issues.”

Noteworthy in the Procter & Gamble case is that the taxpayer’s counsel (Korean or otherwise) did not offer an opinion on the availability of competent authority review or other potential avenues for relief from the Japanese tax. The court’s decision to highlight the absence of the evidence on this issue suggests that the case may have been decided differently if P&G had produced sufficient evidence that its remedies to obtain relief from the Japanese tax, including invoking competent authority procedures, were not effective and practical. Taxpayers should keep this lesson in mind.

The recent Coca-Cola case presents an unusual fact pattern in this arena, because it was the IRS that prevented the taxpayer from seeking competent authority assistance and then attempted to use the lack of competent authority proceedings as a sword to disallow the foreign tax credits at issue in this case. Coca-Cola involves a transfer pricing adjustment proposed by the IRS that has been contested in Tax Court. A correlative issue involved whether Coca-Cola had overpaid its Mexican taxes as a result of the transfer pricing adjustment (i.e., the IRS’ reallocation of the income to the United States). Coca-Cola had determined the amount of the royalty payments that it had deducted in Mexico based on historic agreements with the IRS and the Mexican tax authority. Moreover, Mexican tax counsel had advised Coca-Cola on several occasions that the royalty deductions claimed in Mexico could not be increased.

The IRS designated its transfer pricing adjustment for litigation and refused the taxpayer’s request to participate in competent authority proceedings with respect to the amount of the Mexican royalties. Therefore, competent authority relief was neither “effective” nor “practical” for Coca-Cola. The court rejected the IRS’ argument that the Mexican taxes were not compulsory because the taxpayer may have had remedies available years into the future (presumably after completion of the transfer pricing trial).²⁶

Some taxpayers are protecting themselves against the running out of the statute of limitations by filing written protective claims for refund.

Taxpayers should also be mindful that they may claim a foreign tax credit for having paid a contested foreign tax even if they are still actively disputing the tax.²⁷ In these situations, the taxpayer will need to make any necessary adjustments if it ultimately prevails.

At bottom, taxpayers who do not participate in competent authority proceedings must be prepared to vigorously defend their decision²⁸ by showing the dispute was either de minimis or resolved through other administrative or judicial remedies, or that invoking competent authority procedures would be futile.²⁹ Taxpayers also need to identify and monitor any applicable deadlines for requesting competent authority assistance. Some treaties (for example, with Mexico and Australia) contain time limits for requesting competent authority assistance. Some of our treaty partners have taken a restrictive view on those time limits. Taxpayers should keep an eye on those deadlines and consult their foreign tax advisors to determine whether any notifications to foreign tax authorities should also be made to stay within any applicable treaty deadlines. The IRS cautions that “[a]ny acts or omissions by the taxpayer that preclude effective competent authority assistance may constitute failure to exhaust all effective and practical remedies.”30 Taxpayers need to proactively monitor their treaty deadlines and take any protective measures necessary so that the IRS cannot later contend that the taxpayer’s omissions precluded effective competent authority assistance.

Settlements With Foreign Tax Authorities, Including Amnesty Programs

Foreign tax payments made by taxpayers who resolve their foreign tax disputes through a settlement with a foreign tax authority may qualify for the credit so long as the settlement was reasonable and reached in good faith. A successful competent authority proceeding is evidence that the taxpayer has properly exhausted its remedies.

The reasonableness of a settlement made outside the competent authority process may be demonstrated through your foreign tax advisor’s advice and/or by showing that other taxpayers reached comparable settlements for similar issues. For example, the IRS has ruled that a monetary settlement reached with a foreign tax authority that was “comparable on a percentage basis” to that reached by a “similarly situated taxpayer” was creditable.³¹

It is not uncommon for an entire industry’s tax treatment of a certain item to be challenged by a taxing authority. Therefore, taxpayers should stay abreast of the settlements and actions of their fellow industry members. Those successes and failures can heavily influence opinion about whether a company has exhausted all effective and practical remedies. If other companies are having success in the courts, but a taxpayer does not pursue judicial remedies, the taxpayer’s claim for foreign tax credit may be denied due to failure to exhaust all effective and practical remedies.

Taxpayers should be prepared to provide the IRS with copies of the settlement agreement, the original assessment documents, and any correspondence with the foreign tax authority leading up to the settlement.³² In addition to reviewing the documentation, IRS Exam teams are encouraged to consult with competent authority regarding the reasonableness of the taxpayer’s settlement.³³ Settlements of more than one issue are evaluated on an overall basis rather than on an issue-by-issue basis.³⁴

A frequent question is whether a taxpayer must accept a proposed competent authority resolution. The IRS has cautioned that taxpayers who reject proposed settlements reached through the competent authority process may not be able to claim a foreign tax credit for the amount of the tax that the foreign government was willing to concede.³⁵ However, such a rule may not apply if the taxpayer reasonably believed that it could obtain a better result by continuing to dispute the amount in foreign proceedings.³⁶ Taxpayers who reject proposed competent authority settlements, or who accept or reject any other proposed settlement with a foreign tax authority, should document the advice received from foreign counsel, including the likelihood and projected cost of achieving a further reduction in foreign tax liability by continuing to contest the assessment.

The IRS training materials (specified in footnote 1) also discuss foreign amnesty programs. Specifically, the 2018 IRS training materials note that “[i]f a foreign country offers a general or partial tax amnesty, a taxpayer should ascertain whether they might be eligible for such amnesty and document the findings.”³⁷ Some of the amnesty programs previously offered by foreign jurisdictions have provided an efficient method for taxpayers to resolve their tax disputes when other avenues for relief (including competent authority and foreign administrative and judicial procedures) had failed. The IRS has determined in private letter rulings that foreign taxes paid under amnesty programs that allowed taxpayers to avoid litigation or resolve potential tax exposures for thirty cents on the dollar and abate interest and penalties qualify for foreign tax credits.³⁸

A complicating factor is that foreign amnesty programs often are available only for a limited time, and accepting a foreign tax amnesty may “deprive competent authority of the chance to negotiate a better settlement.”³⁹ To avoid this potential area of dispute, taxpayers should consider consulting with the U.S. competent authority before settling a foreign tax dispute either through amnesty or otherwise. Our experience is that the U.S. competent authority has been extremely responsive and helpful in these situations. Moreover, the resulting written communications with the U.S. competent authority have proved to be helpful in later IRS examinations of foreign tax credit claims.

An interesting note from the IRS training materials is that examiners should “[r]eview the taxpayer’s tax amnesty documentation to verify whether the taxpayer made a good faith effort to inquire into and, if applicable, reduce the tax burden in that country.”⁴⁰ This suggests that taxpayers should document their decision not to participate in a foreign tax amnesty program similar to their decision to refuse any other settlement offer, including those offered through the competent authority process.

Statute of Limitations Issues

Like tax disputes with the IRS, foreign tax disputes may take more than ten years to resolve. The statute of limitations for filing refund claims for an overpayment attributable to foreign taxes is ten years from the due date of the federal income tax return (excluding extensions) for the tax year to which the foreign tax relates.⁴¹ Taxpayers need to closely monitor the statute of limitations for claiming foreign tax credits, because those credits apply to the year for which the foreign taxes relate, not the year that tax is paid.⁴² For example, the statute of limitations for filing a refund claim for a foreign tax credit for a foreign tax dispute related to the year ended December 31, 2009, expires on March 15, 2020, even if the foreign tax is not paid until after that date.

The foreign tax credit statute of limitations is now relevant for a number of taxpayers who operate through foreign corporations. Before the Tax Cuts and Jobs Act of 2017, a foreign tax redetermination generally was taken into account through adjustments to the foreign income tax pools of foreign corporations. These adjustments were made prospectively rather than to the taxable year to which the foreign tax is relevant. However, Section 905(c) was amended so that foreign tax redeterminations for controlled foreign corporations are now taken into account in the foreign corporation’s tax year to which such taxes “relate.” Some taxpayers are protecting themselves against the running out of the statute of limitations by filing written protective claims for refund.⁴³ Protective claims can be filed through the competent authority process or separately. The protective claim must be verified by a written declaration made under penalties of perjury. The statement of grounds attached to the protective claim should identify the tax year and describe the foreign tax dispute, the amount (if known) of the dispute, the status of the dispute, any actions taken to date to contest the foreign tax, and any contingencies affecting the claim. The protective claim may also include language such as “the amount of the refund that will be requested by the company is contingent upon the resolution” of the foreign tax disputes that were described in the protective claim.

Conclusion

The lack of reported cases in this area is surprising given the fact-intensive nature of each claim. However, the cases and IRS administrative guidance available do provide some guiding lights that taxpayers should follow to protect their claim for foreign tax credits resulting from the payment of contested foreign taxes. These are:

1) find reputable foreign advisors and document in detail any advice that you may want to rely on; 2) consider all viable options for contesting foreign taxes, including requesting competent authority assistance, and document the specific reasons that any of those options is not worth pursuing; 3) evaluate all settlement options, including foreign amnesty programs, and document the reasons for accepting or declining any offers; 4) keep apprised of actions taken by fellow industry members; 5) watch your statute of limitations for filing refund claims; and 6) file protective claims.

When examining whether a taxpayer has exhausted all remedies, the IRS will consider whether 1) it is reasonably certain the payment will be returned; 2) the taxpayer pursued available means to obtain the refund; 3) there was a foreign income tax determination that could be contested administratively, judicially, or through the competent authority process; and 4) the taxpayer’s efforts to contest the foreign taxes through available channels “were adequate and comprehensive.”44 Taxpayers who follow the above guiding lights should be well prepared to defend against any claim by the IRS that their payment of contested foreign taxes was not compulsory.

Robert C. Morris is a partner with Norton Rose Fulbright. The author wishes to thank Richard Hunn for his contributions to this article.

Endnotes

1. LB&I Process Unit Knowledge Base—International, Exhaustion of Administrative Remedies, March 21, 2018 (hereinafter referred to as “2018 training materials”), p. 10, www.irs.gov/pub/int_practice_units/ftc_p_10_01_02_01.pdf.
2. The rules governing foreign tax credits are extensive, and many of them are beyond the scope of this article.
3. Procter & Gamble Co. v. United States, 2010-2 U.S.T.C. ¶ 50,593, at 85,545 (S.D. Ohio 2010).
4. LB&I Process Unit Knowledge Base—Audit, September 3, 2014 (hereinafter referred to as “2014 training materials”), p. 3.
5. Treas. Reg. Section 1.901-2(e)(5)(i). Coca-Cola Co. v. Commissioner, 149 T.C. No. 21, at 15-16 (2017).
6. Compare Vento v. Commissioner, 147 T.C. 198, 208 (2016) (foreign tax credit disallowed where “[t]he record includes no evidence that petitioners relied on the advice of competent advisers”).
7. Treas. Reg. Section 1.901-2(e)(5)(i).
8. I.R.S. Field Serv. Adv. 200049010 (Dec. 8, 2000); 2018 training materials, p. 7.
9. I.R.S. Tech. Adv. Mem. 200807015 (Feb. 15, 2008).
10. Treas. Reg. Section 1.901-2(e)(5)(i).
11. Treas. Reg. Section 1.901-2(e)(5)(i) & (ii), Ex.1.
12. Treas. Reg. Section 1.901-2(e)(5)(i) & (ii), Ex.2; Rev. Rul. 92-75, 1992-2 C.B. 197; Schering Corp v. Commissioner, 69 T.C. 579, 600-603 (1978) (IRS argued reallocation under Section 482 should have caused the taxpayer and foreign affiliate to seek competent authority assistance).
13. Id.
14. I.R.S. Field Serv. Adv. 1998-293 (April 30, 1992).
15. International Business Machine Corp. v. United States, 38 Fed. Cl. 661, 675 (1997) (emphasis added).
16. Treas. Reg. Section 1.901-2(e)(5)(i).
17. 2018 training materials, p. 6.
18. Treas. Reg. Section 1.901-2(e)(5)(i) & (ii), Ex.4.
19. Treas. Reg. Section 1.901-2(e)(5)(i).
20. IBM, 38 Fed. Cl. at 663, 673.
21. Schering, 69 T.C. at 601-602.
22. Id., at 602.
23. 2018 training materials, p. 19; see, e.g., Rev. Rul. 92-75; Treas. Reg. Section 1.901-2(e)(5)(i).
24. Procter & Gamble, 2010-2 U.S.T.C. at 85,543-44.
25. Id. at 85,544. See also Rev. Rul. 92-75 (foreign tax noncompulsory where taxpayer was aware of, but did not invoke, competent authority proceeding).
26. Coca-Cola, 149 T.C. No. 21 at 24-26.
27. Coca-Cola, 149 T.C. No. 21 at 26-27; IBM, 38 Fed. Cl. at 674-675; Revenue Ruling 70-290, 1970-1 C.B. 160; 2018 training materials, p. 10.
28. 2014 training materials, pp. 14, 19 (“The burden to prove an exhaustion of remedies without Competent Authority relief is on the taxpayer”).
29. 2018 training materials, pp. 18-19, and 2014 training materials, pp. 18-19. See also Schering, 69 T.C. at 602-603 (pursuing competent authority relief would have been futile).
30. 2018 training materials, p. 15.
31. Rev. Rul. 77-267, 1977-2 C.B. 243.
32. 2018 training materials, p. 16.
33. 2018 training materials, p. 16; see also Rev. Rul. 92-75 (in determining the amount of a payment that is noncompulsory, “the United States Competent Authority may, at its option, consult with the Competent Authority” of the foreign country).
34. Treas. Reg. Section 1.901-2(e)(5)(i).
35. I.R.S. Field Serv. Adv. 1998-293.
36. I.R.S. LAFA 20125202F (Dec. 28, 2012).
37. 2018 training materials, p. 11 (emphasis added).
38. I.R.S. Priv. Ltr. Rul. 8339036 (June 28, 1983) (allowing foreign tax credit even though taxpayer had successfully challenged tax assessments in the lower courts; although not binding, there was some adverse authority in higher courts and amnesty program would end before foreign government’s appeal and competent authority proceedings were resolved); I.R.S. Priv. Ltr. Rul. 8323094 (March 14, 1983) (allowing foreign tax credit even though the taxpayer had not been audited or assessed the foreign tax at issue; the taxpayer was aware that, if it was audited, the foreign tax authority would contend that it owed a local income tax and judicial decisions were split on the issue; amnesty program allowed the taxpayer to resolve for thirty percent of the tax exposure and abate interest and penalties).
39. 2018 training materials, p. 11.
40. 2018 training materials, p. 11.
41. Section 6511(d)(3)(A).
42. Rev. Rul. 58-55, 1958-1 C.B. 266; Cuba Railroad Company v. United States, 124 F. Supp. 182 (S.D.N.Y. 1954) (foreign tax credit taken in year accrued even though taxes were contested and paid in later year); I.R.S. LAFA 20105001F (Dec. 17, 2010) (“for purposes of the foreign tax credit, the accrual related back to . . . the years for which the taxes were assessed”); Albemarle Corp. & Subs v. United States, 797 F.3d 1011 (Fed. Cir. 2015).
43. LAFA 20125202F; Rev. Proc. 2015-40, 2015-35 I.R.B. 236, Section 11.
44. 2018 training materials, p. 3.