Riggs National Corp. & Subsidiaries v. Commissioner

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued December 11, 1998 Decided January 12, 1999

No. 98-1039

Riggs National Corporation & Subsidiaries

Appellant

v.

Commissioner of Internal Revenue Service,

Appellee

Appeal from the United States Tax Court

(No. TAX-24368-89)

Thomas C. Durham argued the cause for appellant. With

him on the briefs were Joel V. Williamson, Kim Marie

Boylan, and Stephen M. Feldhaus.

Charles Bricken, Attorney, United States Department of

Justice, argued the cause for appellee. With him on the brief

were Loretta C. Argrett, Assistant Attorney General, and

David English Carmack, Attorney.

Stephen D. Gardner was on the brief for amicus curiae

National Foreign Trade Council, Inc.

Before: Wald, Silberman, and Tatel, Circuit Judges.

Opinion for the Court filed by Circuit Judge Silberman.

Silberman, Circuit Judge: Riggs Bank, asserting that it

had paid taxes to the Brazilian government with respect to

interest income on loans it had made to the Central Bank of

Brazil, claimed foreign tax credits under s 901 of the Internal

Revenue Code. The Commissioner disallowed the credits on

the theory that Riggs was not "legally liable" for the tax

under Brazilian law, and the Tax Court denied Riggs' petition

for relief. We reverse.

I.

A.

Riggs National Corporation's subsidiary Riggs Bank was

one of numerous banks that made loans to the Central Bank

of Brazil during the early to mid-1980s as part of a plan to

rescue Brazil from a debt crisis. Riggs' loans were so-called

"net loans." In a net loan, the borrower contractually agrees

not only to pay interest to the lender, but also to pay any

local (Brazilian) tax that the lender owes on that interest

income. Every interest payment the lender receives is then

free of local tax--the borrower has paid it. By contrast, in a

"gross loan," the lender remains subject to local tax liability.

In either type of loan, which party technically conveys the tax

payment to the local government is of little moment. In a

gross loan, either the lender could remit the tax to the local

government or the borrower could withhold that amount and

remit it to the local government on behalf of the lender. So

too in a net loan (where the concept of "withholding" does not

really apply because the interest payments are free of local

tax), either the borrower could remit the tax to the local

government or the borrower could send to the lender both the

guaranteed net loan interest payment and the appropriate

amount of tax payment on the understanding that the lender

would then remit the tax to the local government. (In

practice in Brazil, the borrower does the "withholding" of the

local tax in the gross loan situation and the "paying" of the

local tax in the net loan situation.) The real difference

between gross loans and net loans lies not in who licks the

stamp on the envelope to the Brazilian government, but in

who bears the economic burden of the tax.

The key feature of a net loan is its placement of the risk of

a change in the local tax rate on the borrower. If the local

tax rate rises after the parties have set the interest rate, the

lender continues to receive the same interest payment free of

local tax--it is the borrower who suffers. On the other hand,

if the local tax rate falls after the parties have set the interest

rate, the lender still continues to receive the same interest

payment free of local tax--but now the borrower has become

better off because his assumed tax liability is lower.

Computing the lender's tax liability on a gross loan is easy:

one simply multiplies the local tax rate by the amount of

interest income. So if the local tax rate is 25% and the

interest payment is $12 (assume a 12% interest rate and $100

principal), the lender's local tax liability is $3. Computing the

lender's local tax liability on a net loan--which, recall, is

assumed by the borrower--is slightly more complicated. The

parties' loan agreement sets forth the interest income as an

after-tax amount, which presumably would be smaller than

the before-tax amount in a gross loan because, all things

being equal, a borrower entering a net loan will get a lower

interest rate in exchange for assuming the lender's tax liabili-

ty. To maintain parity between the tax revenue from net

loans and gross loans, the Brazilian government requires that

the after-tax income specified in the parties' net loan agree-

ment be adjusted--"grossed-up"--into a hypothetical before-

tax amount. The "gross-up" adjustment requires one to look

at the interest rate selected by the parties in their net loan

agreement, then assume that the parties had chosen the gross

loan form rather than the net loan form, and extrapolate the

interest rate the parties would have agreed upon if they had

entered a gross loan.1

__________

1 We should point out that a net loan transaction between a

United States lender and a United States borrower would implicate

The foregoing is best illustrated by an example. Suppose a

lender extends a $100 net loan to a borrower, specifying a 9%

annually compounded interest rate, and assume a local tax

rate on interest income of 25%. In the first year of the loan,

the lender will receive interest income of $9 (i.e., 9% of the

$100 principal), and this income will be free of local tax. The

borrower of course pays the $9 interest payment to the

lender. How much local tax does the borrower pay--on the

lender's behalf--to the local government? We identify the

interest rate the parties would have agreed upon had they

selected the gross loan form, which is the interest rate

necessary to provide the lender with the same $9 interest

income if the lender had to pay his own local tax obligation.

The answer is 12%. That interest rate would yield interest

income of $12 to the lender in the first year of the loan; the

local tax on this income would be $3 (i.e., 25% of $12); and

the lender would be left with $9 at the end of the day.2

__________

only United States tax law and would be treated entirely different-

ly. The borrower's contractual assumption of the lender's tax

liability would not relieve the lender of tax liability, for the borrow-

er's discharge of the lender's tax liability on the interest income

would itself constitute income to the lender. Old Colony Trust Co.

v. Commissioner of Internal Revenue, 279 U.S. 716, 729 (1929); 26

U.S.C. s 61(a) (1994). If the borrower covenanted to pay not only

the interest payment to the borrower and the lender's tax liability

on the interest payment, but also the lender's tax liability on the

income resulting from the borrower's discharge of the lender's

liability on the interest payment, that additional payment would

again constitute income to the lender. And so on. For whatever

reason, Brazilian tax law does not lead us into this endless circle.

Instead, it draws a line at the borrower's discharge of the lender's

tax liability on the interest income--only the grossed-up amount of

interest income is treated as income for purposes of Brazilian tax

law.

2 Although the trial-and-error method will suffice to identify the

grossed-up interest rate, the adjustment can also be performed

more formally. The equation is rg = rn/(1--t), where rg is the

interest rate the parties would have selected had they entered a

gross loan rather than a net loan, t is the local tax rate, and rn is the

interest rate the parties actually selected in their net loan agree-

The lender's Brazilian tax liability is only half of the story.

In calculating his United States tax liability, the lender must

include in gross income the interest payment he receives from

the borrower and the Brazilian tax paid (on his behalf) by the

borrower to the Brazilian tax collector. Old Colony Trust Co.

v. Commissioner of Internal Revenue, 279 U.S. 716, 729

(1929); 26 U.S.C. s 61 (1994). But there is potentially also a

benefit to our lender under U.S. tax law: the Internal Reve-

nue Code allows a taxpayer to take as a credit against his

U.S. tax liability on income earned in a foreign country the

amount of foreign tax he has paid on that same income. Id.

s 901.

This brings us to the dispute between Riggs Bank and the

Commissioner. Riggs claims it is entitled to foreign tax

credits in the amount of the Brazilian taxes paid on its behalf

by the borrower, the Central Bank of Brazil, pursuant to a

net loan agreement. The Commissioner disagrees, arguing

that under Brazilian law, there was no obligation on either

Riggs or the Central Bank to pay a tax given the Central

Bank's tax-immune status as a governmental entity, and so

any payments made were voluntary and not a "creditable" tax

for purposes of the foreign tax credit. (The Commissioner

does not seek to "have his cake and eat it too" by denying

Riggs the foreign tax credit and by including in Riggs' gross

U.S. income the "voluntary payment" made by the Central

Bank to the Brazilian Treasury--that illogical position, once

advanced by the Commissioner, has been rejected and aban-

doned. See Continental Illinois Corp. v. Commissioner of

Internal Revenue, 998 F.2d 513, 517-18 (7th Cir. 1993).)

It is important to understand the nature of appellant's

economic incentive in seeking the foreign tax credit to appre-

ciate the Commissioner's concern. The lender's gross cash

inflow is unaffected by the availability of the credit--the

lender, pursuant to the net loan agreement, continues to

__________

ment. See Continental Illinois Corp. v. Commissioner of Internal

Revenue, 998 F.2d 513, 516 (7th Cir. 1993). Plugging in the

numbers from the example set forth in the text, we can verify our

trial-and-error calculation; rg = .09/(1--.25) = .12; i.e., 12%.

receive the same guaranteed interest rate. Nor is there any

effect on the lender's Brazilian tax liability; by definition, in a

net loan, the lender has passed his Brazilian tax obligation to

the borrower. The economic advantage stems, rather, from

the effect on the lender's U.S. tax liability. Although the

lender's U.S. tax liability increases by the U.S. tax rate

multiplied by the amount of Brazilian tax paid on his behalf

by the borrower, the lender's U.S. tax liability simultaneously

decreases by the entire amount of the Brazilian tax. The key

point is that the foreign tax credit is a credit--not a deduc-

tion. So long as the U.S. tax rate is less than 100%, the

decrease in U.S. tax liability outweighs the increase. And the

lender can then apply this excess tax credit toward offsetting

the rest of his U.S. tax liability on this same foreign source

income.

B.

In 1983, appellant and several other banks contemplating

extending net loans to the Central Bank of Brazil were well

aware of the potential tax benefit just described and that a

precondition to qualifying for the foreign tax credit was

establishing that there was indeed a Brazilian tax for which

they would be liable. Although, as we have noted, it was

undisputed that Brazil imposed a tax on interest income paid

by Brazilian borrowers to non-Brazilian lenders, the Central

Bank is no ordinary Brazilian borrower. Rather, the Central

Bank is a governmental entity and thus immune from tax on

its own income under the Federal Constitution of Brazil. It

might have been thought that the Central Bank's own tax

immunity would not bear on its obligation to pay the tax on

any loan, including a net interest loan, for in such a transac-

tion the Central Bank would not really discharge its own tax

obligation, but rather a tax obligation contractually assumed

from the lender. But there was authority in Brazilian law for

the proposition that the tax-immune status of an entity such

as the Central Bank shielded not only its own income, but

also the interest income of a foreigner who lends to that tax-

immune entity in a net loan transaction. The Brazilian

Supreme Court had so ruled, see State of Parana v. Central

Bank (cited in Riggs Nat'l Corp. v. Commissioner, 107 T.C.

301, 342 (1996) (entered by Tax Court by order dated Oct. 15,

1997)), and the Brazilian Revenue Service issued an "officio"

to the same effect, see SRF 368 (cited in Riggs, 107 T.C. at

313-14).

An on-point Brazilian Supreme Court decision and an unfa-

vorable revenue service ruling did not, however, foreclose the

Bank's hopes for a foreign tax credit. Brazil does not follow

the common law rule of stare decisis, so the Supreme Court's

prior opinion is not necessarily authoritative, and, as in the

United States, the revenue service might be persuaded to

change its view. Brazilian tax immune entities were obliged,

under Brazilian law, to withhold taxes from gross loan inter-

est payments, see Federal Gov't v. Highway Dep't of the State

of Parana (cited in Riggs, 107 T.C. at 341)--notwithstanding

their own tax immune status--so it could be contended that

the contrary treatment of net loans was anomalous. Appel-

lant and other banks requested definitive guidance on the

matter, and the Minister of Finance--the highest ranking

Brazilian authority on tax matters--obliged them with a

favorable private letter ruling, which under Brazilian law

binds the parties.

The ruling concluded that the Central Bank--notwithstand-

ing its tax-immune status--was required under Brazilian law

to pay the tax obligation assumed from lenders in the contem-

plated net loan transactions. It explicitly stated that the

Central Bank "must ... pay the income tax on the interest

paid." Riggs, 107 T.C. at 331.3 The Minister distinguished

the earlier revenue ruling. The loans to the Central Bank

were regarded as unique in that the funds advanced to the

Central Bank were--under the terms of the debt restructur-

ing plan--available for relending by the Central Bank to

private Brazilian borrowers. The Minister deemed it appro-

priate to "look through" the Central Bank to those ultimate

private borrowers--so-called "borrowers-to-be"--for pur-

__________

3 The ruling was actually prepared by the Secretaria da Receita

Federal and then adopted by the Minister. The SRF is under the

Minister of Finance in the hierarchy of Brazilian taxing authority.

poses of deciding the proper tax treatment of the loans. And

it was settled Brazilian law that a private borrower in a net

loan was required to pay the tax obligation it had contractual-

ly assumed from the lender. The Minister concluded that the

"borrowers-to-be" aspect of the loans compelled an analogy to

the garden variety private borrower situation, and that the

Central Bank must "as a substitute for such borrowers [to-be]

pay the income tax incident on the interest from January 1,

1984 to the end of the period of availability for such funds to

be relent." Id.

Riggs assumed, based on this definitive ruling from Brazil's

highest tax authority, that the Brazilian tax was a creditable

tax under s 901 and it determined its U.S. tax liability

accordingly in the years 1984-86. This involved including in

gross income the interest payments as well as the Brazilian

tax obligation discharged by the Central Bank, applying the

U.S. tax rate to that amount, and finally crediting against that

U.S. tax liability the amount of the Brazilian tax obligation

discharged by the Central Bank. The Commissioner disa-

greed that the asserted payments made by the Central Bank

to the Brazilian tax collector constituted creditable taxes for

purposes of s 901, redetermined Riggs' U.S. tax liability, and

sent Riggs a notice of deficiency.4 The Commissioner argued

that a proper interpretation of Brazilian law led to the

conclusion--notwithstanding the Minister of Finance's private

letter ruling--that no Brazilian tax is imposed on either

lender or borrower where the borrower is a tax-immune

entity; therefore, any payments made were voluntary and not

"taxes paid or accrued ... to any foreign country." 26

U.S.C. s 901(b)(1).

The Bank argued in the Tax Court that the Commissioner's

theory depended on declaring ineffectual the Minister of

Finance's private letter ruling, and that adoption of such a

theory by the Tax Court would therefore run afoul of the act

__________

4 The amounts of foreign tax credit at issue for each year are:

1984 $166,415

1985 181,272

1986 317,019

of state doctrine. The Tax Court disagreed--it viewed the

private letter ruling as nothing "more than perhaps an admin-

istrative advisory opinion"--and thereupon engaged in a com-

prehensive review of Brazilian law on the issue of whether a

tax-immune borrower in a net loan transaction is considered

to assume the lender's tax obligation as a private borrower

would, and thus whether that tax-immune borrower is re-

quired to pay that amount to the Brazilian tax collector.

Riggs, 107 T.C. at 359. The Tax Court held that under

Brazilian law, a tax-immune borrower such as the Central

Bank is not required to pay the tax, and approved the

Commissioner's determination that the asserted payments did

not constitute creditable taxes for purposes of s 901.

II.

Riggs Bank primarily relies on the act of state doctrine.

The doctrine directs United States courts to refrain from

deciding a case when the outcome turns upon the legality or

illegality (whether as a matter of U.S., foreign, or internation-

al law) of official action by a foreign sovereign performed

within its own territory. W.S. Kirkpatrick & Co., Inc. v.

Environmental Tectonics Corp., 493 U.S. 400, 406 (1990). It

stems from separation of powers concerns; it reflects " 'the

strong sense of the Judicial Branch that its engagement in

the task of passing on the validity of foreign acts of state may

hinder' the conduct of foreign affairs." Id. at 404 (quoting

Banco Nacional de Cuba v. Sabbatino, 376 U.S. 398, 423

(1964)); see generally Restatement (Third) of the Foreign

Relations Law of the United States s 443 cmt. a (1986).5

The government suggests that a foreign administrative

official's interpretation of foreign law is not the type of act of

__________

5 The doctrine does not operate by depriving courts of jurisdic-

tion; rather it functions as a doctrine of abstention. See In re

Minister Papandreou, 139 F.3d 247, 256 (D.C. Cir. 1998). The

party invoking the act of state doctrine has the burden of establish-

ing the factual predicate for the doctrine's applicability. Lamb v.

Phillip Morris, Inc., 915 F.2d 1024, 1026 & n.4 (6th Cir. 1990).

state contemplated by the doctrine.6 To be sure, the doctrine

has been applied principally to more "tangible" acts. See,

e.g., Sabbatino, 376 U.S. at 403-04 (expropriation of proper-

ty); Ricaud v. American Metal Co., 246 U.S. 304, 310 (1918)

(same); Underhill v. Hernandez, 168 U.S. 250, 254 (1897)

(detention of person by sovereign official); Credit Suisse v.

United States Dist. Court for the Cent. Dist. of Calif., 130

F.3d 1342, 1347 (9th Cir. 1997) (asset freeze orders); Callejo

v. Bancomer, S.A., 764 F.2d 1101, 1114 (5th Cir. 1985) (pro-

mulgation of exchange control regulations). That we are

unaware of cases treating an interpretation of law as an act of

state, of course, does not foreclose the doctrine's applicability.

We are, however, hesitant to treat an interpretation of law as

an act of state, for such a view might be in tension with rules

of procedure directing U.S. courts to conduct a de novo

review of foreign law when an issue of foreign law is raised.

See Fed. R. Civ. P. 44.1; Tax Court R. 146.

But, whether or not it can be said that the Brazilian

Minister of Finance's interpretation of Brazilian law qualifies

as an act of state, the Minister's order to the Central Bank to

withhold and pay the income tax on the interest paid to the

Bank goes beyond a mere interpretation of law. The Minis-

ter, after all, ordered that the Central Bank "must, in substi-

tution of the future not yet identified debtors of the tax [i.e.,

the borrowers-to-be], pay the income tax on the interest paid

__________

6 The government does not contend that the act of state doctrine

is inapplicable here because one of the litigants, the Commissioner,

is an executive branch official. Insofar as the Commissioner is an

executive branch official, it might be thought that the separation of

powers concerns underlying the doctrine are not present. While

not yet endorsed by a majority of the Supreme Court, some justices

have suggested an exception to the doctrine for cases in which the

executive branch has represented in a so-called "Bernstein" letter,

see Bernstein v. N.V. Nederlandsche-Amerikaansche Stoomvaart-

Maatschappij, 210 F.2d 375 (2d Cir. 1954), that it has no objection

to denying validity to the foreign sovereign act. See First National

City Bank v. Banco Nacional de Cuba, 406 U.S. 759, 768-770 (1972)

(opinion of Rehnquist, J., joined by Burger, C.J., and White, J.); see

generally Restatement s 443 Reporter's Note 8.

during the period in which the funds remained available for

relending." Riggs, 107 T.C. at 331. Such an order has been

treated as an act of state. See Credit Suisse, 130 F.3d at

1347 (asset freeze orders); Callejo, 764 F.2d at 1114 (ex-

change control regulations). The Tax Court's conclusion on

Brazilian law--that no tax is imposed on a net loan transac-

tion involving a governmental entity as borrower--implicitly

declared "non-compulsory," i.e., invalid, the Minister's order

to the Central Bank to pay the taxes. The act of state

doctrine requires courts to abstain from even engaging in

such an inquiry.

The Commissioner nevertheless argues, and the Tax Court

agreed, that the Minister's order to the Central Bank was not

actually a compulsory order and thus not a "definitive" act of

state. The Tax Court reasoned that Riggs' "experts did not

elaborate on whether the Central Bank, under Brazilian law,

was legally compelled to accept and follow the ruling," and

speculated that the Central Bank would likely succeed in

overturning the ruling if it sought an appeal in the Brazilian

courts. Riggs, 107 T.C. at 359. Here the Tax Court simply

misread the record. See Commissioner of Internal Revenue

v. Duberstein, 363 U.S. 278, 289-91 (1960). Both parties'

experts testified that acts of an executive official such as the

Minister are valid and binding until declared invalid by a

Brazilian court, Bekin Dep. (cited in Joint Appendix ("J.A.")

353-54); Pedreira Aff. p 7 (cited in J.A. 1156), and it is

undisputed that no such invalidation has occurred. Moreover,

appellant had no standing under Brazilian law to litigate the

validity of the Minister's ruling; only the Central Bank had

that right, and it declined to do so.

* * * *

The Commissioner argues that if the act of state doctrine

requires courts to treat the Minister's ruling as binding, it

would jeopardize the Commissioner's ability to determine

when taxpayers are eligible for the foreign tax credit. That

is not so. The Commissioner's challenge focused entirely on

whether Brazilian law required the Central Bank to pay

taxes on these loans to the Brazilian government. The

Commissioner might have conceded the legitimacy of the

Minister of Finance's order, but contended that under U.S.

tax principles, the payments should not be considered a

creditable tax under s 901. That alternative argument, if

accepted by the Tax Court, would not run afoul of the act of

state doctrine because it would not require the Tax Court to

declare invalid the Minister's order to the Central Bank to

make the payments; it would only require the Tax Court to

interpret the U.S. tax consequences of those concededly

mandated payments. See Kirkpatrick, 493 U.S. at 405. In-

quiry into the U.S. tax consequences of foreign levies is what

this area of tax law is all about, and is the premise of the

Supreme Court's dictum in Biddle v. Commissioner of Inter-

nal Revenue, 302 U.S. 573, 579 (1938):

The phrase "income taxes paid," as used in our own

revenue laws, has for most practical purposes a well-

understood meaning to be derived from an examination

of the statutes which provide for the laying and collection

of income taxes. It is that meaning which must be

attributed to it as used in section [901].

The Treasury's own regulation acknowledges the distinction

between the Commissioner's claim in this case, which impli-

cates the act of state doctrine, and the ordinary Biddle-type

inquiry, which does not. The regulation provides, in relevant

part: "Whether a foreign levy [is creditable for purposes of

s 901] is determined by principles of U.S. law and not by

principles of the law of the foreign country." 26 C.F.R.

s 1.901-2(a)(2)(i) (1998). Ordinarily, the Commissioner takes

the foreign country's laws and requirements as given and

determines their U.S. tax consequences "by principles of U.S.

law and not by principles of the law of the foreign country."

Id. In this case, by contrast, the Commissioner focused on

the foreign country's laws and requirements themselves and

presented arguments based on foreign law that no payment

requirement existed.

We think we understand why the Commissioner was so

troubled by this transaction. The government's brief hinted

that to allow the Bank to take the tax credit in this situation

was to give it virtually "a free lunch"--at the American

Treasury's expense. A national governmental borrower is

different than a private borrower or a state borrower: al-

though the Central Bank has assumed the lender's tax obli-

gation in the net loan agreement, that transaction just re-

quires the federal government to take a bit of money from

one of its pockets and put it in the other. Whereas a private,

or even a state borrower, in a net loan arrangement bears a

real economic risk when it assumes the lender's tax liability

and the loan transaction's terms--possibly through lower

interest rates--presumably reflect that economic risk. But in

this situation the economic risk seems artificial. According to

both counsel, however, Treasury regulations do not admit of a

distinction between the foreign tax credit treatment of a net

loan with a central government entity as borrower and any

other entities as borrowers. See 26 C.F.R. s 1.901-2(f)(2)(ii)

Ex. 3; see generally II Joseph Isenbergh, International

Taxation p 29.12.3 (2d ed. 1997).

Of course, the opportunistic nature of the Brazilian govern-

ment's action is particularly vexing. The Minister's ruling

essentially accomplished a one-time increase in Brazilian tax-

es from 0% to 25%, applicable, by virtue of the narrowly

targeted borrowers-to-be-theory, only to the transaction be-

tween Riggs (and other foreign banks) and the Central Bank

of Brazil; it had no effect on other Brazilian borrowers. But

although we can visualize prophylactic regulatory measures

that would prevent this device from being utilized, the Com-

missioner has not yet fashioned a legitimate legal challenge to

Riggs' use of the foreign tax credit in this case.

* * * *

For the foregoing reasons, we reverse the decision of the

Tax Court and remand the case so that the Tax Court may

determine in the first instance which of Riggs' loans were

subject to the Minister's ruling, whether the taxes were in

fact paid by the Central Bank, and whether Riggs' credits

must be reduced by the amount of any subsidies that the

Central Bank may have received.

So ordered.