SAN FRANCISCO (MarketWatch) – Hewlett-Packard Co. has become an unlikely member of a group of companies targeted by the U.S. Internal Revenue Service in a coordinated legal assault on suspect international tax credits.
is one of roughly a half-dozen firms, nearly all in the banking and insurance industries, now ensnared in the IRS’s “three-and-out” litigation strategy targeting so-called foreign tax credit generators, experts say. The IRS has pegged a handful of such cases as promising enough to pursue, in hopes of winning at least three decisions in a row — and thereby gaining a more solid legal footing on the issue.
“Usually the government does a good job of starting with cases that are very weak for the taxpayer, and developing law,” said University of Southern California Law Professor Edward Kleinbard.
Foreign tax credit generators are investments by U.S. companies that earn income and result in taxes overseas. Companies can then claim foreign tax credits, to offset their tax payments in the U.S. However, the IRS alleges that many are designed to unnecessarily load up on foreign tax credits, and create an artificial financial benefit.
The IRS’s effort to curb foreign tax credit generators is part of a broader push to keep pace with overseas transactions. Uncollected taxes thanks to corporate offshore deals can short government coffers hundreds of billions of dollars annually, by some estimates. Clamping down has become a priority amid the troubled economy, as tax revenue thins out.
H-P, a technology giant best known for its personal computers and legendary origins in a Silicon Valley garage, doesn’t generally fit the mold of a company making extensive use of foreign tax credit generators.
Other firms now involved in related litigation with the IRS include insurance giant American International Group Inc., Wells Fargo & Co.
Bank of New York Mellon Corp.
Sovereign Bancorp Inc. and Principal Financial Group Inc.
“It’s typically always banks doing these transactions,” said USC’s Kleinbard. “For them, earning financial income is part of their core business.”
H-P is contesting $132 million in disallowed tax credits resulting from an investment in a Dutch legal entity called Foppingadreef, according to court filings. The IRS has characterized the Foppingadreef deal as “a sham that lacked economic substance and business purpose,” and the case is proceeding to trial in U.S. Tax Court, according to filings.
An IRS spokesman declined to comment.
An H-P spokeswoman said in a statement that, “We disagree with the IRS’s position and are optimistic that we will prevail in court.” A. Duane Webber, an attorney with Baker & McKenzie representing H-P, declined to comment.
In addition to its petition filed in U.S. Tax Court, H-P has filed a related suit against the IRS in federal court in California. The California proceeding has been put on hold pending the U.S. Tax Court trial scheduled for September, according to public filings.
‘The bad actor end of the spectrum’
The IRS’s three-and-out strategy aims to pursue cases in a variety of federal circuits. Losses could then be sent on to different appeals courts, while a split at that level could later theoretically be resolved by the Supreme Court, legal experts say.
The IRS has followed a similar three-and-out litigation strategy, with some success, in pursuing tax shelters.
Other foreign tax credit generator cases currently underway include Principal Financial Group’s case in Iowa, where Principal Life Insurance is a plaintiff, Wells Fargo’s case in Minnesota, and Sovereign Bancorp.’s case in Massachusetts. Bank of New York Mellon’s case is proceeding in U.S. Tax Court. Representatives of Principal Financial Group, Wells Fargo, Sovereign Bancorp and Bank of New York Mellon declined to comment.
New York-based foreign tax credit generator case has drawn the most public attention, for pitting what is now a government-backed firm against the government in an effort to recoup some $306 million in taxes. The government bailed AIG out in 2008, during the darkest days of the financial collapse, and wound up with a roughly 80% stake in the company.
An AIG spokesman said in a statement that, “AIG is taking this action to insure that it is not required to pay more than its fair share.”
H-P may seem an oddity among the insurance and financial firms litigating over foreign tax credit generators, though in one sense it blends in. The company’s financial services unit, which specializes in leasing and financing hardware and software purchases, pulled in nearly $2.7 billion in revenue in the company’s fiscal year ended last October.
The IRS has been working for years to restrict foreign tax credit generators. Its efforts are becoming more visible now, as related court cases hit the public docket.
In prepared remarks for a late 2008 speech, IRS Commissioner Douglas Shulman criticized corporate structures aimed at sparing earnings from U.S. taxation. “One of the most problematic of these structures are foreign tax credit generators,” Shulman said, adding, “FTC generator transactions are examples of situations where certain taxpayers may be trending toward the bad actor end of the spectrum.”
“It’s very popular, it’s done all over the world and the focus on them is growing,” New York University Law Professor H. David Rosenbloom said of foreign tax credit generators. In many cases, “it’s quite obvious what’s going on, [companies] are going out of their way to incur taxes” and stack up credits, Rosenbloom said. One key benefit: The credits aren’t hit with a 35% U.S. tax rate that would apply to earnings.
Foreign tax credit generators are only one of a number of international tax structures under close scrutiny by the IRS.
According to a report published by the Treasury Inspector General for Tax Administration last year, the government can lose out on over $100 billion in revenue annually that goes uncollected from international transactions. The number of individual taxpayers in the U.S. filing for foreign tax credits rose from 270,000 in 1981 to nearly 4.3 million by 2001, the report noted.
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