Amici Urge Supreme Court Review of Foreign Tax Credit Decision

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All businesses rely on the predictable and certain application of the tax laws to plan their operations in both the short and long terms. In this case, the Second Circuit adopted a broad interpretation of the "economic substance" doctrine to override the foreign tax credit provisions of the Internal Revenue Code. Creating and deepening two circuit conflicts, the Second Circuit ignored the anticipated benefits of the foreign tax credit in assessing whether the transaction at issue had economic substance, while simultaneously including the foreign taxes as a transaction expense to reduce the transaction's anticipated benefits. The Chamber and Cato submit this brief to illustrate the problems that the Second Circuit's approach would create for businesses, and to emphasize the critical need for this Court's review.²

II. The Second Circuit's decision below, however,incorrectly adopted a sweeping interpretation of the economic substance doctrine that greatly expands its proper scope, and thereby created or deepened two circuit splits that should be resolved by this Court.

A. It is undisputed that BNY executed a transaction that was effectively a large loan with a foreign lender at favorable interest rates, the proceeds of which were used as part of BNY's commercial banking business to generate net interest income. See Pet. 2. It is also undisputed that BNY paid taxes to the foreign government as part of this transaction. And it is undisputed that BNY complied with the extensive statutory and regulatory requirements entitling it to a U.S. tax credit against its foreign taxes. Finally, it is undisputed that Congress enacted the foreign tax credit to protect taxpayers from the evils of double taxation. Yet instead of ending the inquiry there and granting the tax credit, the Second Circuit invoked the economic substance doctrine and imposed on BNY the additional burden of proving that the transaction comported with congressional intent in some other, ill-defined respect.

The Second Circuit erred in imposing that additional burden on BNY. To ensure the predictable and certain application of the tax laws, this Court should grant review and hold that a taxpayer's payment of foreign taxes and compliance with the foreign tax credit statute and regulations conclusively establish that granting the credit would comport with the congressional purpose of avoiding double taxation.

B. Along with decisions from the Fifth, Eighth,and Federal Circuits, the Second Circuit's decision creates or deepens two circuit splits -- detailed in the petition for certiorari here and in the related petitions, see supra at 2 n.2 -- on whether the Commissioner may invoke the economic substance doctrine to manipulate the application of the foreign tax credit. Only by using a creative accounting method that admittedly counts BNY's foreign taxes as expenses -- while simultaneously disregarding the economic benefits of the transaction to BNY on a dubious "tax effects" theory -- was the Second Circuit able to conclude that BNY's challenged transaction lacked economic substance. Significantly, the Fifth and Eighth Circuits have rejected this analysis, whereas the Federal Circuit has adopted a similar approach to the Second Circuit -- at least with respect to how foreign taxes paid should be treated. And the Second Circuit split even from the Federal Circuit on the second question presented. This Court should grant review to eliminate the nationwide uncertainty that the Second Circuits has created and exacerbated in this important area of tax law.

III. Every participant in the Nation's economy benefits from the predictable and certain application of the Internal Revenue Code. When businesses cannot assess their tax liability in advance, they may over-report their tax burden or simply shy away from uncertain transactions altogether. Those costs are passed on to nearly every actor in the economy: to workers through lower wages and fewer jobs; to investors through lower rates of return on capital; and to consumers through higher prices. Uncertainty also stunts economic growth, discourages business expansion, and encourages investors to take their money overseas, where tax laws might be more predictable. This Court's review is warranted to avoid imposing these significant costs on American businesses and indeed the Nation's entire economy.

This Court has held that the economic substance doctrine should be invoked only when the taxpayer entered into a transaction in which there was "nothing of substance to be realized" "beyond a tax deduction." Knetsch v. United States, 364 U.S. 361, 366 (1960) (emphasis added). And while courts have taken different approaches regarding the details of the economic substance inquiry -- in particular, whether the inquiry is objective, subjective, or some combination of the two -- it is clear that, under any formulation, the inquiry must be conducted in absolute terms: For a transaction to lack economic substance, there must be "no business purposes other than obtaining tax benefits in entering the transaction," and the transaction must have "no economic substance because no reasonable possibility of a profit exists." Compaq Computer Corp. v. Comm'r, 277 F.3d 778, 781 (5th Cir. 2001) (emphasis altered; citation omitted).

The categorical formulation of these inquiries is essential to preventing the economic substance doctrine from becoming a vague and boundless exception to the Internal Revenue Code. Instead, it displaces ordinary application of the tax laws only where the purpose of the taxpayer's activity was exclusively to obtain otherwise-unavailable tax benefits.

A cautious approach to applying the economic substance doctrine is necessary because Congress never intended for the Internal Revenue Code, sub silentio, to turn on "whether alternative routes may have offered better or worse tax consequences." Boulware v. United States, 552 U.S. 421, 429 n.7(2008); see also, e.g., Founders Gen. Corp. v. Hoey, 300 U.S. 268, 275 (1937) ("To make the taxability of [a] transaction depend upon the determination whether there existed an alternative form which the statute did not tax would create burden and uncertainty.") . In other words, taxpayers are generally entitled to make business plans in reliance on the tax laws as written, without being second-guessed because of their desire to structure the transaction in a way that minimizes their tax obligations. See Gregory v. Helvering, 293 U.S. 465, 469 (1935) ("The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.").

A broad interpretation of the economic substance doctrine, in contrast, would create "alongside the Internal Revenue Code . . . an additional (and some-what autonomous) set of principles for deciding tax disputes." Joseph Isenbergh, Musings on Form and Substance in Taxation, 49 U. Chi. L. Rev. 859, 864(1982). And these additional, non-statutory principles would grant to the Commissioner and the courts a "broad mandate to attack perceived 'bad' features of transactions, however firmly anchored within the terms of the Code." Id. at 870.

To avoid such a freewheeling departure from the Internal Revenue Code, courts should take a careful approach to the economic substance doctrine, interpreting the doctrine narrowly to enable taxpayers to plan their conduct in reliance on the tax laws as written.

A. THE DECISION BELOW INCORRECTLY APPLIED THE ECONOMIC SUBSTANCE DOCTRINE TO DEFEAT THE FOREIGN TAX CREDIT'S PURPOSE OF AVOIDING DOUBLE TAXATION.

The tax benefit at issue in this case is a foreign tax credit claimed by BNY. See Pet. App. 2a. The only effect of the claimed credit was to prevent BNY from being taxed twice on its income from the STARS transaction -- once by a foreign government, and once by the United States. See Pet. 10 n.4. And that, of course, was precisely what Congress intended when it enacted the foreign tax credit: "[T]he primary design of the [foreign tax credit] was to mitigate the evil of double taxation." Burnet v. Chi. Portrait Co., 285 U.S. 1, 7 (1932). The foreign tax credit"in effect treats the taxes imposed by the foreign country as if they were imposed by the United States," H.R. Rep. No. 83-1337, at 76 (1954), and thereby "protects domestic corporations that operate through foreign subsidiaries from double taxation of the same income," United States v. Goodyear Tire & Rubber Co., 493 U.S. 132, 135 (1989).

It is undisputed that BNY complied with all statutory and regulatory requirements to receive the tax credit, including actually paying taxes on the relevant income in the foreign country. See Pet. 10. It is similarly beyond dispute that the transaction at issue had economic substance in the absence of double taxation.

Notwithstanding all of this, the Second Circuit embarked on an inquiry to determine whether granting the tax credit would fit within what the court saw as the true intent behind the tax credit. See, e.g., Pet. App. 16a-17a. Rather than end the inquiry into Congress's intent with the conclusion that applying the foreign tax credit is necessary to avoid double taxation, the Second Circuit pressed on, seeking to divine additional congressional purposes behind the foreign tax credit statute. For example, the court opined that Congress intended the credit to "prevent double taxation of taxpayers conducting business in the United States and abroad," and thusthat the relevant inquiry is whether "a transaction really is 'business.'" Ibid. The court also quoted Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966) -- a case that did not involve foreign tax credits -- for the proposition that courts should not grant foreign tax credits for transactions that are not "'purposive activity.'" Pet. App. 17a (quoting 364 F.2d at 741). Apparently influenced by these asserted congressional purposes, the court favorably quoted the Federal Circuit's conclusion that the taxpayer must show that "the transaction is the sort that Congress intended to be the beneficiary of the foreign tax credit provision." Id. at 29a (quoting Salem Fin., Inc. v. United States, 786 F.3d 932, 948 (Fed. Cir. 2015)).

This was erroneous: Congress's intent to avoid double taxation on foreign income was already fully apparent, in general and as to specific details. The general principle -- that Congress created the foreign tax credit to prevent double taxation -- is undisputed. And the specific conditions under which Congress intended to carry out that principle are fully set forth in the Internal Revenue Code and implementing regulations through a "byzantine structure of staggering complexity." Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations and Shareholders ¶ 15.21[1] [a] (7th ed. Supp. 2015).Congress specified its intent through this regime; no further speculation into congressional intent is necessary. See, e.g., Pet. 3-4.

Thus, while the economic substance doctrine may apply to some types of tax benefits, the Second Circuit's sweeping application of the doctrine was both novel and particularly inappropriate with regard to the foreign tax credit at issue here. As discussed further below, taxpayers rely on certainty and predict-ability in the tax laws to plan their future conduct. A taxpayer who (a) knows that the purpose of the foreign tax credit is to eliminate double taxation, (b) actually pays a tax on foreign income to a foreign government, and (c) complies with the extensive statutory and regulatory framework governing foreign tax credits, should be permitted to rely on receiving those tax credits. Taxpayers considering foreign transactions should not be required to second or third- guess whether Congress had some other hidden intent that would enable a court to invalidate the credits post hoc.

B. THE DECISION BELOW CREATES OR EXACERBATES TWO CIRCUIT SPLITS ON APPLYING THE ECONOMIC SUBSTANCE DOCTRINE TO FOREIGN TAX CREDITS.

Apart from the Second Circuit's erroneously broad application of the economic substance doctrine, this Court should grant review for the independent reason that the Second Circuit has admittedly deepened a wasteful and unnecessary division of authority among the courts of appeals. Indeed, as BNY notes, the Second Circuit separately created a new circuit split that itself warrants the Court's review. See Pet. 20-23.

Among other things, the Second Circuit held that, "when assessing the objective economic substance of a transaction," courts should "include the foreign taxes paid but to exclude the foreign tax credits claimed." Pet. App. 25a. Although the Federal Circuit followed this approach in Salem, the Second Circuit acknowledged that the Fifth and Eighth Circuits disagree that "it is appropriate, in calculating pre-tax profit, for a court both to include the foreign taxes paid and to exclude the foreign tax credits claimed." Id. at 38a. As the Fifth Circuit explained in Compaq:

There are high economic costs to uncertainty in the tax laws. If this Court were to decline review, and thus allow the Second and Federal Circuits to apply the economic substance doctrine in a manner that has expressly been rejected by the Fifth and Eighth Circuits, the result would be immediate and widespread uncertainty regarding the foreign tax credit and the economic substance doctrine. Among the four circuits to address the issue, application of the doctrine would turn solely on the geographic region in which the doctrine was applied. And the Commissioner would undoubtedly be emboldened to press the same analytical approach endorsed by the Second Circuit in every court of appeals that has not yet resolved the issue. This would create widespread confusion, imposing dead-weight economic losses nationwide. And that uncertainty could persist until and unless resolved by this Court. The same adverse consequences would follow if the Court leaves undisturbed the Second Circuit's novel holding -- in conflict with the Federal Circuit -- that transactions can be disregarded for lack of economic substance merely because the parties considered and "shared" anticipated tax consequences.

The need for certainty derives from the importance to taxpayers of planning their future conduct: "[M]uch tax planning must proceed on the basis of settled rules. Avoidance of risk and uncertainty are often the keys to a successful transaction." Chapman v. Comm'r, 618 F.2d 856, 874 (1st Cir.1980). Thus, the harm flowing from uncertain application of the tax laws is taxpayers' inability to plan for the future. "When courts readily undertake [the] tas[k]" of "reexamin[ing]" tax law principles, taxpayers lose their ability to "rely with assurance on what appear to be established rules." United States v. Byrum, 408 U.S. 125, 135 (1972). As economists, researchers, and other commentators have concluded, uncertainties in the tax laws impose high costs on taxpayers, and those high costs are shared by all participants in the Nation's economy.

First, uncertainty in tax law imposes substantial costs on businesses and consumers with no resulting benefits. See, e.g., Leigh Osofsky, The Case Against Strategic Tax Law Uncertainty, 64 Tax L. Rev. 489,499-501 (2011); see also Seth H. Giertz & Jacob Feldman, Mercatus Ctr., The Economic Costs of Tax Policy Uncertainty: Implications for Fundamental Tax Reform 15 (2012) ("[T]he fact that policy uncertainty adversely affects the economy is well established."). Tax uncertainty is at the root of several types of harm, including overpayment of taxes and stunting of economic growth.

When tax law is uncertain, taxpayers tend to over-report their tax burden to avoid an audit or the expense of suing for a refund. See, e.g., Marsha Blumenthal & Charles Christian, Tax Preparers, in The Crisis in Tax Administration 201, 205 (Henry J. Aaron & Joel Slemrod eds., 2004). This results in a transfer of assets away from businesses that is not required by tax law, and which would not occur if the governing rules were sufficiently clear.

In addition, "[w]hen businesses are uncertain about taxes," they "adopt a cautious stance" because "it is costly to make a . . . mistake." Steven J. Davis, et al., Am. Enter. Inst., Business Class: Policy Uncertainty Is Choking Recovery (Oct. 6, 2011). Because"investors usually look at the longer-term tax structure in making major investment decisions," increasing uncertainty in the tax laws causes businesses to withhold capital from investments that could benefit both them and the economy. Duanjie Chen & Jack Mintz, New Estimates of Effective Corporate Tax Rates on Business Investment, 64 Tax & Budget Bull.1, 2 (2011). In many cases, it may be impossible to determine in advance whether a particular investment is worthwhile if its ultimate tax consequences are unpredictable.

Finally, uncertainty in tax law increases the costs of tax planning and compliance. Faced with unpredictable standards for determining whether the tax laws and regulations will be applied as written, taxpayers must pay considerable sums for advice from accountants and attorneys, or else bear the economic cost of shying away from bona fide opportunities that are both potentially profitable and tax efficient, such as the transaction at issue in this case. These compliance and administrative costs are dead-weight losses to the economy. As the Treasury Department itself has recognized, "[t]he cost of those lawyers and accountants adds to the price of every product, but they do nothing to make our factories more efficient, our computers faster or our cars more durable." Press Release, Dep't of the Treasury, Treasury Secretary Paul O'Neill Statement on Treasury's Plan to Combat Abusive Tax Avoidance Transactions (Mar. 20, 2002).

Second, the relevant research confirms the basic economic principle that increased costs on businesses get passed on to various actors in the economy, including workers, investors, and consumers.

There is a broad consensus that globalization increases the share of tax burdens borne by workers. See Li Liu & Rosanne Altshuler, Measuring the Burden of the Corporate Income Tax Under Imperfect Competition, 66 Nat'l Tax J. 215, 233 (2013); see also David F. Bradford, Untangling the Income Tax 133-39 (1986) (increasing costs to businesses from tax uncertainty causes depressed wages for workers); Robert Carroll, Tax Found., Special Report No. 169: The Corporate Income Tax and Workers' Wages: New Evidence from the 50 States 1-5 (2009) (showing that states with higher corporate tax rates had lower worker wages).

Moreover, when businesses over-report their tax burden, those additional tax costs are also borne in part by investors in the form of diminished return on capital. See Julie Anne Cronin, et al., Distributing the Corporate Income Tax: Revised U.S. Treasury Methodology, 66 Nat'l Tax J. 239, 260 (2013); Jennifer Gravelle, Corporate Tax Incidence: Review of General Equilibrium Estimates and Analysis, 66Nat'l Tax J. 185, 211 (2013). A lower return on capital, in turn, results in less investment and a drag on economic growth. It also encourages investors to take their capital overseas. See, e.g., Kenneth Klassen, et al., Geographic Income Shifting by Multinational Corporations in Response to Tax Rate Changes, 31 J. Acct. Res. 141, 141-43 (1993 supp.); Gravelle, supra, at 211. Large multinational companies, in particular, are likely to shift investment away from the United States when domestic tax burdens increase or become less predictable. See Klassen, supra, at 170-72. In this respect, uncertainty in the tax laws' application inhibits capital investment in the United States. See R. Glenn Hubbard, et al., Have Tax Reforms Affected Investment?, in 9 Tax Policy and the Economy 131, 145 (James M. Poterba ed., 1995) (concluding that "prior knowledge of changes in tax parameters can improve forecasts of asset investment").

Finally, "corporate tax rate changes have [also] been passed on . . . to consumers in the form of higher prices." J. Richard Aronson, et al. , The Potential for Short-Run Shifting of a Corporate Profits Tax, 66Bull. of Econ. Res. 1, 2 (2014). As a result, uncertainty in tax law likely causes consumers to pay higher prices for products -- with no resulting increase in quality. In contrast, because certain and predictable application of the tax laws lowers costs to businesses, it also likely results in lower costs to consumers.

² In addition to the present petition, two other petitions have been filed raising substantially similar issues: Salem Financial, Inc. v. United States, No. 15-380, and American International Group, Inc. v. United States, No. 15-478. The Chamber has filed a materially identical amicus brief in Salem, and the Chamber and Cato also filed such a brief in American International Group (which arises from the same decision at issue here). Amici believe that all three petitions warrant the Court's review.

³ In 2010, Congress codified certain aspects of the economic substance doctrine, with prospective application only. The statute did not modify existing judge-made law regarding "whether the economic substance doctrine is relevant to a transaction." 26 U.S.C. § 7701(o)(5)(C).