Transactions now span the globe with the tap of a key on an I-Phone; families are multi-national, with many living in different parts of the world at different stages in their careers and lives; virtual currency has become official legal tender in at least one country, the United States has de facto imposed enforcement of its tax laws on foreign governments and foreign financial institutions through enactment of the “Foreign Account Tax Compliance Act” (the infamous “FATCA”) and the Intergovernmental Agreements implementing FATCA.
Given today’s global economy it comes as no surprise that US taxpayers and the Internal Revenue Service (IRS) must increasingly consider the interactions between US and foreign laws when determining the US tax consequences of a particular transaction. In today’s world, it is no longer possible for practitioners to ignore the possible implications of another country’s laws.
Today’s post will look generally at the relevance of a foreign country’s law in the world of US taxation. This is especially important since the US tax system is extremely far reaching. Its tentacles are very long and very hungry, not only for US tax dollars, but for vast amounts of information about a foreign holdings. This is so simply because the US system taxes an individual on his worldwide income and worldwide assets regardless of the place of his residence. All of the might of the US tax system falls on an individual solely because he is holding US citizenship (or a green card).
Presenting the Dilemmas
Is a foreign country’s law to be taken into account when analyzing a US tax issue? What guidance do we have to date from the IRS or the courts about the relevance of foreign law to a US tax query? How do we approach the US tax matter when foreign law is considered relevant to the analysis?
Relevance of Foreign Country’s Law to US Tax
It is well established that in various contexts, foreign law is relevant to the interpretation or application of US tax rules. A few illustrative examples are below – there are many more!
Many civil law countries embrace the legal concept of a “usufruct”. Generally, a usufruct is a right of one person (the “usufructuary”) in a property owned by another, normally for a limited period of time or until death of the usufructuary. The usufructuary is granted the full right to use the property, enjoy its fruits and income, to the complete exclusion of the underlying real/bare owner. US tax professionals will grapple with many issues including the proper US tax classification of the usufruct. Is it a “trust”? Is it a “life estate”? Depending on the answer, the tax results will differ greatly! Similar issues arise with “foundations” commonly established in European countries – are they “trusts”, or are they “associations” taxable as corporations under US law? The only way to answer these questions is to have a thorough understanding of the foreign laws under which the interest or the entity is created.
Other examples of the importance of foreign law to the US tax rules involve whether joint ownership of foreign real properties are “partnership” interests not eligible for tax-free “like-kind” exchange treatment or fractional co-ownership interests in real property (e.g., as tenants-in-common) which are so eligible; whether employee contributions into a foreign social security system can qualify as “taxes” for United States federal income tax purposes; and whether foreign levies are eligible for the foreign tax credit under US tax law principles .
No Court or IRS Guidance
Many other examples in case law and IRS rulings demonstrate the importance of foreign law to the US tax rules, yet they do not provide guidance on working through this issue. One is left with a hopscotch approach as to how to consider and treat the foreign law in the US tax analysis.
Neither the courts nor the IRS have articulated any clear standard for determining when foreign law should be considered in the US tax analysis. In fact, we have seen different courts disagreeing about the relevance of foreign law even when the courts are examining what appears as the same US tax issue.
Since this area remains substantially unaddressed to date, with a resulting willy-nilly approach, the IRS and taxpayers will continue to argue over the role of foreign law in application to US tax matters. While the issue has been important for a long time, it is becoming more and more vital as sovereign boundaries melt away with today’s global economy.
When Foreign Law Aids the Understanding of US Tax Law
The US courts have found that foreign law is relevant to determining the US tax consequences of a transaction. Some significant and helpful cases involve application of Internal Revenue Code Section 482, commonly called “transfer pricing” rules. Under Section 482, the IRS has broad authority to allocate income among commonly controlled taxpayers to prevent the artificial shifting of net incomes of controlled taxpayers and to place them on a parity with uncontrolled, unrelated taxpayers.
Foreign law that forbids the payment of certain items of income has been held to bar application of Section 482, precluding the IRS’ allocation of such blocked income to related parties. A noteworthy case is Procter & Gamble Co. v. Commissioner, 95 T.C. 323 (1990), aff’d, 961 F2d 1255 (6th Cir, 1992). There, the court refused to uphold IRS’ application of Section 482 allocating income (in this case, royalties) to a parent corporation by its Spanish subsidiary. Spanish law prohibited (under possible criminal sanction) the payment of royalties among corporations with common ownership.
Looking at the various cases and the courts’ reasoning it is apparent that the foreign law not be viewed as dictating US tax policy. Rather the foreign country’s law was viewed by the courts as a complementary adjunct to properly applying the US tax principles involved. Thus, when faced with application of a foreign country’s law to the US tax analysis, care must be taken to couch the arguments in a light that will not offend this principle.
In the Section 482 line of cases, application of this principle seems feasible, i.e., if foreign law prohibits the payment of certain income, it makes sense that the IRS should not be able to allocate that income to controlled taxpayers, as the prohibition in the foreign law is beyond their control. Section 482 is rendered simply inapplicable under such circumstances. Foreign law is not usurping the US law, but rather, serves as an aid in implementing it.
When Foreign Law Conflicts with US Law
But what about other cases when the foreign law is clearly relevant, but is at loggerheads with US law? What do we do then? I have been faced with this issue in my practice which often involves Muslim clients having some elements of Sharia in their US tax matters.
Under the US Gift and Estate tax rules, a so-called unlimited marital deduction is permitted for the making of lifetime gifts, or for the passing of assets at death, to one’s “spouse”. What might happen with the unlimited marital deduction if a US Muslim woman living in Chicago leaves all of her property to her US husband under her Will, but valuable apartment buildings are located in Dubai, United Arab Emirates (UAE) where Sharia law will govern disposition of those real property assets? As a Muslim, her Will should comply with Islamic law (which it did not since Sharia mandates forced heirship principles, and she bequeathed all of her assets to her husband, disregarding Sharia mandates). While this in itself may not result in a practical enforcement of Sharia law in the United States with regard to her US assets, it will create problems with regard to her UAE assets. The UAE courts will not enforce a Muslim’s Will (and in some instances will not enforce a non-Muslim’s Will) that is not in accordance with Sharia principles. It will not be possible to transfer title to the properties to the husband without the UAE court approval. Thus, in our example, the UAE real properties may be inherited by the rightful heirs as viewed under Sharia law. If the US husband is not a Muslim, he cannot inherit from his Muslim wife. Even if he is a Muslim, the aforementioned constraints of Sharia dictate that he cannot inherit all of her assets since this violates Sharia.
Foreign law may directly conflict with US laws in other, more serious ways. Take for example, Form 8938, governed by the tax law contained in Internal Revenue Code Section 6038D. Under that Section, an obligation is imposed on US taxpayers to make annual detailed disclosures of all “specified foreign financial assets”. Failure to disclose when required to do so, can result in an open statute of limitations with respect to all items on the taxpayer’s US income tax return until the information is supplied to the IRS. In addition, failing to disclose can result in a monetary penalty of USD 10,000 per year with the penalty increasing after IRS notification. The monetary penalty will not be applied, however, if the taxpayer can demonstrate he had “reasonable cause” for failing to make the required disclosure. Significantly, the statute itself rejects as grounds for “reasonable cause” “[t]he fact that a foreign jurisdiction would impose a civil or criminal penalty on the taxpayer (or any other person) for disclosing the required information …”.
In these kinds of instances, is it simply a case of choose your poison? How should the professional advise his or her client when faced with this conundrum? These kinds of issues are faced by the US international tax practitioner on a regular basis, but only a very small number of them are cognizant of the importance and possible US tax consequences involved. Choose your advisor most carefully.
As mentioned, Sharia law issues can certainly impact the US tax analysis of a particular case. My article, When Sharia and US Tax Law Collide, published in Tax Notes International, looks at this entire novel topic in depth.
Posted: August 15, 2019
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