The United States taxes all income earned by a taxpayer, regardless of its source. To prevent double taxation of income and to encourage international trade, Congress created the “Foreign Tax Credit,” which allows a taxpayer to take a credit for any tax paid to another country on income earned abroad. This Comment discusses how the courts should apply the “pre-tax profit” test of the economic substance doctrine to challenge transactions where the taxpayer would incur a loss after paying foreign taxes, but a gain after applying the foreign tax credit. The Internal Revenue Service (IRS) has challenged these transactions, arguing that they lack economic substance. To test for economic substance, the court uses a two-prong test called the “Economic Substance Doctrine.” The first prong, commonly called the “pre-tax profit” test, asks if the transaction had a possibility of a profit absent tax consequences. The second prong, commonly called the “Business Purpose” test, asks if the transaction has a non-tax business purpose that furthers the taxpayer’s economic position. If one of the prongs is met, the transaction will usually be found to be legitimate, and the foreign tax credit will be granted. A circuit split has developed regarding whether foreign taxes should be factored into calculating profit with respect to the pre-tax profit test. The United States Court of Appeals for the Fifth and Eighth Circuits hold taxes paid to a foreign country should be excluded from the test because factoring them in would “stack the deck” against finding the transaction legitimate. The United States Court of Appeals for the First, Second and Federal Circuit hold otherwise, arguing that foreign taxes should be treated as an expense of the transaction because doing so more accurately reflects the taxpayer’s change in economic position. The correct approach is that of the First, Second, and Federal Circuits. By including foreign taxes paid as an expense of the transaction, the court remains consistent with the language of the codified economic substance doctrine, and with the underlying policies of the foreign tax credit. Including foreign taxes in the determination of profit more accurately assesses whether the transaction meaningfully changed the taxpayer’s net economic position, and furthered international trade. Since a taxpayer must pay tax on its foreign income to at least one country, the amount of the tax is implicit in the transaction. Since a prudent investor is assumed to consider those tax effects when estimating the profitability of a venture, a test that considers foreign taxes as an expense of the transaction more accurately reflects the net change in the taxpayer’s economic position. If a prudent investor would not invest in the transaction without the tax benefits that it generates, then the transaction is likely a shelter, and is not the type that Congress intended to encourage by granting the foreign tax credit.
Comment: Is the Shelter a Sham? an Analysis of the Treatment of Foreign Taxes in the Economic Substance Doctrine’s Pre-Tax Profit Test,
Idaho L. Rev.
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