Guardian Industries - Foreign tax credits and Group Consolidation

I have long been trying to arrange some time to go through a recent US case (Guardian Industries) concerning the interaction of the check-the-box rules and the complex US foreign tax credit rules. But recently announced changes to the foreign tax credit rules, which can be seen as a reaction to the outcome of this case, convinced me that it would be worth wile attempting to understand the underlying issues surrounding the Guardian Industries Case (March 2005).

The issue in this case was whether Guardian was entitled to a foreign tax credit for corporate tax paid or accrued by its Luxembourg top-tier subsidiary (GIE) with respect to the taxable income of the Guardian Luxembourg Group. As they say on the London tube “mind your step” because the facts of the case involve some degree of complexity.

Basically, the facts can be summarized as follows:
- Guardian Industries, a US leading manufacturer of glass products for commercial and residential applications, conducted its manufacturing and distribution operations in a range of jurisdictions including Luxembourg;
- In Luxembourg, the Guardian group had various subsidiaries ultimately held by a US corporation. These subsidiaries were taxed under the local fiscal unity rules (i.e. consolidation), forming the so-called Guardian Luxembourg Group for Luxembourg tax purposes;
- The top tier Luxembourg company was GIE which in turn held controlling interests in the remainder Luxembourg companies;
- GIE elected under the check the box rules to be disregarded as an entity separate from its shareholder in 2001, whilst the remaining Luxembourg group companies continued to be treated as separate legal entities;
- Due to it’s check the box election and in accordance with Reg § 1.301.7701-2(a), GIE would be treated for U.S. tax purposes in the same manner as that of a branch of its US shareholder; and
- Even though it elected to be treated as a branch in the US, GIE still was in Luxembourg the top tier company of the group. In fact, GIE was responsible in 2001 for corporate income tax payments amounting approximately to Euro 3,5 million.

Apparently, in accordance with Luxembourg law, GIE was liable for, and paid or accrued the corporate income taxes for all group members (i.e. lower tier subsidiaries). On the other side of the Atlantic, the obvious happened: Guardian attempted to claim credit for all Luxembourg tax paid by GIE (its branch), but included in its US income only the income of GIE (i.e. excluding thereby income of the other Luxembourg subsidiaries).

The IRS quickly denied the claims for a direct foreign tax credit, on the basis that (1) Luxembourg law does not render GIE solely liable for the corporate tax paid or accrued with respect to the Guardian Luxembourg Group; (2) that each member of the Group becomes jointly and severally liable for the Group’s aggregate tax liability; (3) and that the US Treasury Reg. § 1.901-2(f)(3) allocate the foreign tax among them regardless of who actually remits the tax.

Guardian Group, on the other hand, held that under Luxembourg law GIE alone was legally liable for the 2001 corporate income tax, and not the other Group members. As such, Guardian US is thereby entitled to a direct foreign tax credit on the amounts paid by GIE.

Since the focus in this case was on how Luxembourg group taxation was structured, it was necessary to seek expert testimonies in order to adequately resolve this conflict. The expert testimonies from Luxembourg concluded that only the parent company is liable for the group income tax. As such, the United States Court of Federal Claims reached the decision that, since GIE was solely liable for the 2001 corporate tax payments and that there exists no joint or several liability on behalf of the members of the Group, GIE was entitled to a direct tax credit.

The Federal Claims decision was reached despite the fact that Guardian claimed a credit for the foreign taxes paid by the foreign parent without having to include the corresponding income of its subsidiaries. The tax planning scheme (probably used in European jurisdiction that provide consolidation or fiscal unity regimes) was simply vindicated on the basis of the literal interpretation of the existing rules.

The US tax authorities did not wait to long to react to this defeat and responded in the form of proposed regulations (REG-124152-06), to be applicable as of 1 January 2007. The proposed regulations establish new principles for determining who is considered a “taxpayer” for purposes of the direct and indirect foreign tax credits. The tax planning scheme explored in the Guardian case is tackled by (for example) providing that the foreign law is “considered to impose” legal liability for an income tax on the person who is required to take the underlying income into account for foreign income tax purposes.

The new rules are designed to ensure something that strangely was not previously in the law, i.e. a US foreign tax credit is only available when the income that gave rise to the tax also is subject to U.S. income tax.

The proposed regulations also set out specific rules to apply in the context of reverse hybrid entities (i.e., an entity that is a corporation for U.S. income tax purposes but is treated as a branch or pass-through entity under foreign law) and hybrid entities (i.e., an entity that is a partnership for U.S. income tax purposes but is treated as an entity under foreign law). Another ball game altogether.

Note: I first got acquainted with the issue of US foreign tax credit planning during Prof. Lokken lessons in US international Taxation in Leiden (2003). Even though coming from a tax credit country myself, the US FTC rules always astonished me not only because of their inherent complexity but also due to the degree of sophistication of the techniques for minimizing U.S. tax put in play by taxpayers. The Guardian case is perhaps a rather straightforward example of foreign tax credit planning that may be said to undermine the basic premise of the US international tax system: (i.e. taxation of worldwide income with credit for foreign income taxes) but I am sure that there is much more out there. For example to understand the underlying issues concerning the use of reverse hybrids and hybrids for FTC planning, I would perhaps suggest again the reading of Prof. Lokken, “Territorial Taxation: Why Some U.S. Multinationals May Be Less Than Enthusiastic About the Idea (and Some Ideas They Really Dislike)”.