The tax assessment and collection process in most foreign countries is markedly different than the process in the U.S. These differences can present a number of challenges for U.S. citizens who reside in foreign countries. In Sotiropoulos v. Commissioner, T.C. Memo. 2017-75, the court considered one of these challenges, namely, how does one determine whether they received a refund for taxes paid to a foreign government that was used to compute the U.S. foreign tax credit?
In Sotiropoulos, the taxpayer was a U.S. citizen who resided in the U.K. She received wages from her employer and she invested in film partnerships in the U.K. that generated substantial losses. The taxpayer filed U.S. income tax returns reporting a foreign tax credit for the wages withheld by her U.K. employer. On her U.K. returns, she requested the U.K. government refund most of the U.K. taxes withheld on her wages to her given the substantial tax losses. The U.K. issued refunds to the taxpayer. The IRS, through its information sharing agreement with the U.K., learned of this and audited the taxpayer’s returns. The IRS then disallowed the foreign tax credits and litigation ensued.
The question for the court was whether the refunds were actually tax refunds given that the U.K. government was actively litigating film partnerships as “tax shelters.” The taxpayer took the position that she may have to return the refunds to the U.K. given this uncertainty, but noted that she believed she would ultimately prevail if challenged in the U.K. So the question is when is a tax refund a tax refund for purposes of the U.S. foreign tax credit?
The court concluded that U.S. law principles apply in determining whether a foreign tax refund is a tax refund. The court also reasoned that “a taxpayer may ultimately have to repay the money initially refunded to her does not mean that she did not get a ‘refund.'” This seems to imply that the receipt of cash is all that matters. The accession to wealth is not what matters, but the physical receipt.
This begs the question as to what would happen if the taxpayer had asked the U.K. for a credit to some other non-income tax, such as a VAT liability or to have the amount credited to future years, rather than asking for cash back? This is a very common practice and option available in many foreign countries. The taxpayer would not have received cash in these circumstances, yet the taxpayer would be better off financially as she would have gained financially having had another tax liability satisfied.
Or what if the foreign refund was mailed to the taxpayer, but the taxpayer never cashed the check? What if it was mailed to the wrong address and not received by the taxpayer, but the taxpayer knew of the refund?
It is helpful to consider this issue in light of U.S. citizens who live in countries whose taxpayer rights and protections are not as great (and only in countries that allow for refunds, which some do not). Refunds issued by some of these countries may be recouped by the foreign governments much easier and more regularly and the disputes can take quite a long time to resolve.
This puts taxpayers in a position of having to file amended U.S. tax returns to reduce their U.S. foreign tax credits once the foreign refunds are received even though there is a certainty that the refunds will be repaid to the foreign governments and not recouped from the foreign governments for years or decades later–if ever. Then, when the disputes are finally resolved in the foreign country, the taxpayers could come back and request their foreign tax credit in the U.S. There is a longer statute of limitations for doing this in the U.S. and interest would be allowed during the interim, but for the prevailing taxpayer, he may be out the use of his money for years–if not decades or ever–before he gets credit for the foreign taxes in the U.S.
Is the mere receipt of a foreign tax refund really the best measure of what counts as a tax refund for purposes of the U.S. foreign tax credit in these situations?