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.
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?
In the Middle East North Africa region where I am based, I frequently see Sharia law issues impacting the US tax analysis of a particular case. Yet, guidance is lacking as to how the matter should be resolved. My article, When Sharia and US Tax Law Collide, published in Tax Notes International, looks at this entire novel topic in depth. Being confronted with Sharia law issues when solving US tax matters led me to undertake research and try to understand generally how to approach the impact of a foreign country’s law on a US tax transaction.
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; whether foreign levies are eligible for the foreign tax credit under US tax law principles.
No Court or IRS Guidance
Real life 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 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 in today’s global economy.
Foreign Law May be Respected if it Aids the Application of US Tax Laws
The US courts have found that foreign law is relevant to determining the US tax consequences of a transaction. Significant 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. In Procter & Gamble Co. v. Commissioner, 95 T.C. 323 (1990), aff’d, 961 F2d 1255 (6th Cir, 1992) 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.
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 the taxpayers’ 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.
I have seen a thorny issue arise in the area of international community property regimes, when the couple is comprised of a US and non-US spouse. It can happen, for example, that the couple did not understand the community property regime in their country of domicile and as a result, failed to take action to “elect out” of the regime so that assets are treated as “separate property” of each of the spouses. This can result in onerous US tax implications for the US spouse who has failed to file US tax returns and foreign information returns reflecting one-half ownership of the foreign assets mistakenly believed to be solely owned by the non-US spouse. Some countries permit the couple to make a publicly-filed declaration with the result that the separate property regime will apply and it can be made to have retroactive effect, say to the date of the marriage or to the date the assets in question were acquired. Would the US permit such an application of foreign law to the US tax issues involved in such a case?
When Foreign Law is in Direct Conflict with US Law
Sometimes the foreign law is clearly relevant, but is at direct loggerheads with US law. Internal Revenue Code Section 6038D imposes an obligation on certain US taxpayers to make annual detailed disclosures of all “specified foreign financial assets” (the relevant tax form is Form 8938). 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 …”.
We are very recently seeing the IRS is just beginning to take note of the complexity of foreign law issues and how they impact US tax transactions in ways that are often beyond the control of the taxpayer. Much more needs to be done, but awareness of the issues by tax practitioners as well as the IRS is a critical first step.
Posted December 16, 2021
All the US tax information you need, every week –
Just follow me on Twitter @VLJeker (listed in Forbes, Top 100 Must-Follow Tax Twitter Accounts 2017-2021).
Subscribe to Virginia – US Tax Talk to receive my weekly US tax blog posts in your inbox. My blog specializes in foreign and US international tax issues.
You can access my papers on the Social Science Research Network (SSRN) at https://ssrn.com/author=2779920
Virginia - US TAX TALK 