The Tax Court ruled that certain payments received by a U.S. citizen working abroad from a foreign taxing authority were in fact refunds under the Internal Revenue Code.
Facts of the case
A U.S. citizen worked for the London office of Goldman Sachs and received employee compensation from which United Kingdom income tax was withheld. The taxpayer filed both U.S. and UK income tax returns for each year at issue. On a timely filed U.S. return for each year, she claimed a foreign tax credit in an amount equivalent to the UK tax withheld by her employer.
On her UK tax return for each year, the taxpayer claimed substantial deductions attributable to investments in UK film partnerships allowed under UK tax law. Based on these deductions, the taxpayer applied for, and received, refunds on her UK tax returns.
However, the taxpayer took the position that these payments weren’t refunds under the U.S. tax code, because her entitlement to refunds remained under investigation by the UK taxing authority. Her Majesty’s Revenue and Customs (HMRC) characterized the film partnerships in which she had invested as “tax shelters.”
Litigation on this subject was still pending in various UK courts and, in the view of the woman’s tax advisors, HMRC was likely to prevail in its challenge to the deductions generated by the film partnerships. As a result, she didn’t file amended U.S. returns reporting reduced foreign tax credits or otherwise notify the IRS.
The IRS began a review of the woman’s returns and, at some point before or during the audit, the IRS was informed by UK taxing authorities that the taxpayer had invested in film partnerships, claimed substantial deductions, and filed UK returns requesting refunds. The IRS determined that the taxpayer had received UK income tax refunds of $413,216 in 2003, $292,663 in 2004, and $239,202 in 2005. The IRS disallowed the corresponding amounts of foreign tax credits that she had claimed on her U.S. returns. The court held that the repayments of UK income tax that the taxpayer received represented previously paid foreign taxes that were “refunded in whole or in part” within the meaning of the U.S. tax code. She had indisputably received repayments of tax dollars from HMRC, and she agreed that she’d received these repayments under a claim of right. The court accepted as true her statements that HMRC was challenging these repayments and that it might likely succeed in its efforts. However, it found that that was irrelevant in determining whether the repayments of UK tax that she’d received were refunds.
The question before the court
The IRS sought summary judgment on the ground that the overpayments of the UK income tax returned to the taxpayer were refunded. The woman acknowledged that she’d received these payments, but contended that they hadn’t been refunded, because her ultimate entitlement to refunds remained under investigation in the UK. As a result, she argued, she wasn’t required to notify the IRS (by filing amended returns or otherwise). The question the Tax Court had to decide was how these amounts should be characterized for U.S. tax purposes.
The court reasoned that, for U.S. tax purposes, the term “refund” didn’t connote finality or the final determination of a tax liability. The court noted that millions of Americans file Forms 1040 every year showing an overpayment and indicating the amount of the overpayment they want refunded. Generally, the IRS pays such refunds more or less automatically. Notwithstanding the payment of these refunds, the IRS routinely examines such returns and, if it concludes that the taxpayer incorrectly computed the tax, it may assess additional tax. In short, the fact that taxpayers may ultimately have to repay the money initially refunded doesn’t mean they didn’t get a refund.
As a cash basis taxpayer, the woman in this case was entitled to claim a credit for foreign income taxes when paid. If HMRC later collects additional tax, she would be entitled to claim a credit for those taxes. On the other hand, if the credits she claimed weren’t reduced to reflect the UK tax that was previously refunded, she would in effect be allowed a double credit for the same tax.
The court wasn’t persuaded by her contention that rejection of her argument might result in double taxation, contrary to the policies underlying the foreign tax credit and the tax treaty between the United States and the United Kingdom. She based this contention on the assertion that, if she were required to repay refunds previously received from HMRC, and if such repayments were considered creditable foreign taxes in the year they were paid, she would obtain no U.S. tax benefit from the credits.
The court noted that the woman offered no explanation or factual support for this vague assertion. It concluded that, in any event, this didn’t demonstrate any structural defect in the tax code or give rise to double taxation. It often happens that taxpayers, because of individual circumstances or passage of time, are unable to derive full benefit from contingent tax assets they have booked or expect to receive, such as carryforwards of foreign tax credits, net operating losses, passive losses, or investment interest. Those circumstances simply reflect the facts that the future is unpredictable and that taxable income must be determined on an annual basis.