Opinion ID: 185447
Heading Depth: 2
Heading Rank: 1

Heading: Withholding of Interest Payments

Text: 11 The Internal Revenue Code requires foreign corporations to pay a tax of 30 percent of the amount received from sources within the United States by a foreign corporation as interest ... to the extent the amount so received is not effectively connected with the conduct of a trade or business within the United States. 26 U.S.C. 881(a). An American taxpayer who makes such interest payments is required to deduct and withhold the tax owed by the foreign corporation. See 26 U.S.C. 1441, 1442. If the American taxpayer fails to deduct and withhold the tax, he is personally liable for the tax due. See 26 U.S.C. 1461. 12 Pursuant to the United States-Netherlands Tax Treaty, interest payments made by American taxpayers to Netherlands corporations are exempt from taxes in the United States. See Supplementary Convention on Taxes on Income and Other Taxes, Dec. 30, 1965, U.S.-Netherlands, Art. VI, 17 U.S.T. 896, 901. In contrast, under the United StatesCanada Tax Treaty, the tax on interest payments shall not exceed 15 percent of the gross amount of the interest if the recipient of the payments is the beneficial owner of such interest. Convention on Taxes on Income and Capital, Sept. 26, 1980, U.S.-Can., Art. XI, T.I.A.S. No. 11087. 13 Under the step-transaction doctrine, a particular step in a transaction is disregarded for tax purposes if the taxpayer could have achieved its objective more directly, but instead included the step for no other purpose than to avoid U.S. taxes. See Minn. Tea Co. v. Helvering, 302 U.S. 609, 613 (1938). In step-transaction cases, the existence of formal business activity is a given but the inquiry turns on the existence of a nontax business motive. ASA Investerings, 201 F.3d at 512. As we explained last year, the absence of a nontax business purpose is fatal. Id. Although taxpayers are entitled to structure their transactions in such a way as to minimize tax, there must be a purpose for the business activity ... other than tax avoidance and that purpose cannot be a facade. Id. at 513; see also N. Ind. Pub. Serv. Co. v. Commissioner (NIPSCO), 115 F.3d 506, 512 (7th Cir. 1997) (stating that the IRS cannot disregard economic transactions ... which result in actual, non-tax-related changes in economic position). 14 The Internal Revenue Service--and the courts--will ignore a step in a series of transactions if that step does  'not appreciably affect [the taxpayer's] beneficial interest except to reduce his tax.'  ASA Investerings, 201 F.3d at 514 (quoting Knetsch v. United States, 364 U.S. 361, 366 (1960) (emphasis added) (quoting Gilbert v. Commissioner, 248 F.2d 399, 411 (2d Cir. 1957) (Hand, C.J., dissenting))). In two separate revenue rulings the IRS specifically has held that an American taxpayer cannot avoid U.S. taxes merely by relying on a treaty with a foreign country. See Rev. Rul. 84-153, 1984-2 C.B. 381; Rev. Rul. 84-152, 1984-2 C.B. 383. In other words, if the sole purpose of a transaction with a foreign corporation is to dodge U.S. taxes, the treaty cannot shield the taxpayer from the fatality of the step-transaction doctrine. For the taxpayer to enjoy the treaty's tax benefits, the transaction must have a sufficient business or economic purpose. We accord these rulings Skidmore deference--that is, they are  'entitled to respect'  to the extent they have the 'power to persuade,'  Christensen v. Harris County, 529 U.S. 576, 587 (2000) (quoting Skidmore v. Swift & Co., 323 U.S. 134, 140 (1944))--and we find them persuasive given the plain meaning of 26 U.S.C. 881 and 1442, as informed by Gregory v. Helvering, 293 U.S. 465, 469 (1935). 15 From July 1992 through 1993, appellant made its loan payments directly to Delcom Financial. This fact is uncontested. Although Del BV may have recorded interest payments in its ledgers and reported them on its Dutch tax returns, there is no evidence that appellant paid anything to Del BV during this period. The U.S.-Netherlands Tax Treaty does not apply to direct transactions between a U.S. corporation and a Canadian corporation. Accordingly, appellant unquestionably should have withheld taxes on its payments to Delcom Financial beginning in July 1992. The Tax Court plainly did not err in coming to this conclusion. 16 Likewise, the Tax Court did not clearly err in concluding that the payments from appellant to Del BV were in substance payments made to Delcom Financial and that those payments only served to avoid U.S. taxes. The Tax Court's decision in Gaw v. Commissioner is instructive. T.C.M. 1995-531, Nos. 17906-92, 18268-92 (Nov. 9, 1995), aff'd, 111 F.3d 962 (D.C. Cir. 1997) (unpublished table disposition). Gaw dealt with a U.S. corporation's interest payments to a Dutch corporation that was a subsidiary of a Hong Kong corporation. The Tax Court held that the payments were subject to U.S. taxes because in substance they were directed to the Hong Kong corporation. The Tax Court explained that [u]nder the substance over form doctrine, although the form of a transaction may literally comply with the provisions of the [Internal Revenue] Code, that form will not be given effect where it has no business purpose and operates simply as a device to conceal the true character of that transaction. Id., slip op. at 96. The court reasoned that the taxpayer had not carried his burden of proving that the loans had been structured for any nontax business reason. See id. at 114. Consequently, the court treated the loan as if it had been made by the Hong Kong corporation and ruled that the loan was subject to the withholding tax. See id. at 141-43. 17 Similarly, in this case, several facts demonstrate the nexus between the original Royal Bank loan and the loan from Del BV to appellant: (1) the interest rates and repayment schedules of the two loans closely correspond; (2) Royal Bank obtained a guaranty of repayment from appellant and a security interest in appellant's real property; and (3) beginning in the third quarter of 1992, appellant made payments on the loan directly to Delcom Financial at Royal Bank's request. Like the taxpayer in Gaw, appellant has failed to carry its burden of proving that Del BV was in substance the real lender for tax purposes. If appellant had received the loan from Royal Bank or Delcom Financial directly, the interest payments would have been taxable under the U.S.Canada Tax Treaty. Appellant has not shown that Del BV served any role with a sufficient business or economic purpose to overcome the conduit nature of the transaction. Rev. Rul. 84-153, 1984-2 C.B. at 384. 18 Appellant contends that the series of transactions between Delcom Financial, Delcom Holdings, Delcom Cayman, Delcom Antilles, Del BV, and appellant was not designed solely to avoid U.S. taxes. Instead, according to appellant, by structuring the transactions as it did, Delcom Financial achieved sizable Canadian tax savings. Appellant claims that Delcom Financial was able to take advantage of a Canadian tax code provision that allows corporations to deduct interest payments. In other words, Delcom Financial was able to deduct the value of the interest payments it made to Royal Bank as part of the original loan. This deduction was particularly valuable to Delcom Financial (and thus the Affiliated Group) because it received no additional income from which to offset the deduction. In addition, appellant asserts that under Canadian law and a treaty between Canada and the Netherlands, no corporations in the Affiliated Group were required to pay taxes on amounts that were remitted by Del BV up the chain and ultimately received by [Delcom Financial] as dividends. Brief for Appellant at 7. Ultimately, appellant maintains that the Affiliated Group received substantial Canadian tax benefits relative to the U.S. taxes it avoided. 19 In Tax Court proceedings, the petitioner maintains the burden of proof. See Tax Ct. R. 142(a). In this case, appellant absolutely failed to carry its burden; it did not offer any evidence that the Affiliated Group achieved Canadian tax savings. Indeed, appellant did not submit Delcom Financial's Canadian tax returns. Nor did appellant submit any of Delcom Financial's corporate records. Without this evidence, the Tax Court could not have found that Delcom Financial reported or deducted the interest payments and dividends, or otherwise received any Canadian tax benefits. 20 In addition, appellant did not ask the Tax Court (or this Court) to take judicial notice of the relevant provisions of the Canadian tax code or the Canada-Netherlands tax treaty through which the Affiliated Group claims to have achieved tax savings--it did not even cite the provisions on which it claims to have relied. Given the state of the record, we cannot possibly conclude that appellant carried its burden before the Tax Court or that the Tax Court clearly erred in finding that the transactions served any purpose other than avoiding U.S. taxes. 21 The only evidence presented to the Tax Court concerning the transactions' supposed Canadian tax benefits is the testimony of William Christie, vice president of corporate planning and taxation at Tridel Corporation (a corporation in the Affiliated Group that provided management and executive services to the related corporations). Christie testified that I was told that the objectives of the transaction were to secure financing for appellant and to maximize [the Affiliated Group's] Canadian tax benefits. He also testified that his boss said that he wanted to finance the [appellant's] operations and to do it in a very tax efficient manner for Canada. 22 Christie's testimony concerning the objectives of the transactions is hearsay. See Fed. R. Evid. 801, 802; see also 26 U.S.C. 7453 (providing that Tax Court proceedings shall be conducted in accordance with the rules of evidence applicable in trials without a jury in the United States District Court of the District of Columbia). As a result, the Tax Court could not--and apparently did not--rely upon it for the truth of the matter asserted. 23 Likewise, the only evidence appellant offers to establish that the Affiliated Group actually achieved Canadian tax benefits from the transactions is conclusory testimony by Christie. This testimony is inadequate to carry appellant's burden of proof and certainly does not establish that the Tax Court clearly erred. 24 Appellant contends that the IRS has held that foreign tax avoidance in general is a legitimate business purpose. See Rev. Rul. 89-101, 1989-2 C.B. 67. Revenue Ruling 89-101, on which appellant relies, focused on a transaction in which a first-tier foreign subsidiary corporation distributes the stock of a second-tier foreign subsidiary corporation to the domestic parent corporation to reduce the amount of foreign withholding tax imposed on distributions by the second-tier corporation. Id. at 67. The IRS held that the transaction served a corporate business purpose within the meaning of Treasury Regulation 1.355-2(b) because it will benefit the affiliated group of corporations by reducing substantially the amount of foreign withholding tax imposed on distributions from a member of the group. Id. at 68. 25 The Commissioner does not concede that foreign tax avoidance is a legitimate business purpose, and we do not need to address that question here. While perhaps not directly applicable to this case, Treasury Regulation 1.355-2(b) is instructive. That regulation, which formed the basis for Revenue Ruling 89-101, provides that reducing non Federal taxes is not a corporate business purpose if (1) the property distribution reduces both Federal and non Federal taxes because of similarities between Federal tax law and the tax law of the other jurisdiction and (2) the reduction of Federal taxes is greater than or substantially coextensive with the reduction of non Federal taxes. Treas. Reg. 1.355-2(b)(2). Based on this regulation and the revenue ruling on which appellant relies, even if foreign tax avoidance is a sufficient business purpose, appellant failed to establish that the Affiliated Group (or any of its members) achieved foreign tax savings greater than its U.S. tax savings--or that it achieved any foreign tax savings for that matter. 26 Finally, appellant suggests that we should follow the Seventh Circuit's decision in Northern Indiana Public Service Co. v. Commissioner (NIPSCO), 115 F.3d 506 (7th Cir. 1997), which dealt with the tax treatment of an American corporation's interest payments to a Dutch corporation. We need not comment on whether we agree with NIPSCO's legal analysis or holding; its procedural posture demonstrates why it does not help appellant's cause. 27 In NIPSCO, the taxpayer won in the Tax Court, and the Commissioner appealed. The Seventh Circuit affirmed the Tax Court's judgment, holding that the lower court did not clearly err in finding that the transactions had a legitimate business purpose other than U.S. tax avoidance. See id. at 514. The appellate court explained that the Dutch corporation participated in the transactions because it could obtain funds on the Eurobond market when prevailing market conditions made the overall cost of borrowing abroad less than the cost of borrowing domestically. Id. at 511. Additionally, the Dutch corporation received a profit from its transactions with the U.S. taxpayer. This profit then was reinvested in the Eurobond market. The profit motive of the Dutch corporation was sufficient to show that the motive of the transaction was not simply tax avoidance. 28 Not only are the two cases not factually similar, but the taxpayer's evidence in NIPSCO was substantially stronger than the appellant's evidence in this case. Consequently, the NIPSCO taxpayer was able to carry its burden of proof in the Tax Court, and on appeal the Commissioner was unable to show that the Tax Court clearly erred. Even more significantly, in the case now before us, the roles of the parties are reversed. The taxpayer lost in the Tax Court, and it has appealed. Accordingly, it is the taxpayer who must establish that the Tax Court's findings were clearly erroneous, which, as we explained above, it cannot do. 29