SCOTUS Reports

Tag: Closing Agreements

  • Smith v. Commissioner, 159 T.C. No. 3 (2022): Validity and Enforceability of Closing Agreements under I.R.C. § 7121

    Smith v. Commissioner, 159 T. C. No. 3 (2022)

    In a significant ruling, the U. S. Tax Court upheld the validity and enforceability of a closing agreement under I. R. C. § 7121, affirming that such agreements are final and conclusive unless fraud, malfeasance, or misrepresentation of material fact is shown. Cory H. Smith, a U. S. citizen employed at Pine Gap in Australia, challenged the agreement which required him to waive his right to exclude foreign earned income. The court’s decision clarifies the authority of IRS officials to execute such agreements and the strict conditions under which they can be set aside, impacting future tax treaty interpretations and the finality of closing agreements in tax law.

    Parties

    Cory H. Smith, as the Petitioner, challenged the notice of deficiency issued by the Commissioner of Internal Revenue, as the Respondent, in the U. S. Tax Court. The case proceeded through the Tax Court’s jurisdiction, with both parties filing competing motions for partial summary judgment.

    Facts

    Cory H. Smith, a U. S. citizen and engineer, was employed by Raytheon at the Joint Defense Facility at Pine Gap in Australia. As part of his employment, he entered into a closing agreement with the IRS under I. R. C. § 7121, waiving his right to elect the foreign earned income exclusion under I. R. C. § 911(a) for the tax years 2016-2018. Despite the agreement, Smith filed amended returns claiming the exclusion for 2016 and 2017 and made the same election on his 2018 return. The Commissioner issued a notice of deficiency disallowing these elections, leading Smith to petition the U. S. Tax Court for a redetermination of the deficiencies.

    Procedural History

    The case originated with Smith’s challenge to the notice of deficiency in the U. S. Tax Court. Both parties filed motions for partial summary judgment. The Commissioner argued that the closing agreement was valid and enforceable, while Smith contended that it was invalid due to lack of authority of the IRS official who signed it and alleged malfeasance and misrepresentation by the IRS. The Tax Court, after hearing arguments, ruled on the motions, applying a de novo standard of review.

    Issue(s)

    Whether the closing agreement entered into by Cory H. Smith with the Commissioner under I. R. C. § 7121 was valid and enforceable?

    Whether the Director, Treaty Administration, had the authority to execute the closing agreement on behalf of the Commissioner?

    Whether the closing agreement could be set aside under I. R. C. § 7121(b) due to malfeasance or misrepresentation of fact?

    Rule(s) of Law

    I. R. C. § 7121 authorizes the Secretary to enter into closing agreements with taxpayers, which are “final and conclusive” once approved by the Secretary, unless set aside for fraud, malfeasance, or misrepresentation of material fact. I. R. C. § 7121(b) specifies that closing agreements cannot be annulled, modified, set aside, or disregarded in any proceeding, and any determination made in accordance with such agreements is similarly protected. The authority to enter into closing agreements has been delegated by the Secretary to the Commissioner, and further delegated within the IRS, including to the Director, Treaty Administration, under Delegation Order 4-12.

    Holding

    The U. S. Tax Court held that the closing agreement between Cory H. Smith and the Commissioner was valid and enforceable. The court found that the Director, Treaty Administration, had the requisite authority to execute the agreement on behalf of the Commissioner. Additionally, the court determined that the agreement could not be set aside under I. R. C. § 7121(b) as Smith failed to show malfeasance or misrepresentation of material fact.

    Reasoning

    The court’s reasoning centered on the interpretation of the statutory framework governing closing agreements and the delegation of authority within the IRS. The court applied principles of statutory construction to Delegation Order 4-12, concluding that the Director, Treaty Administration, had the authority to act as the competent authority under tax treaties and execute closing agreements related to specific treaty applications. The court rejected Smith’s arguments regarding the lack of authority of the IRS official, the necessity of a formal competent authority request, and the exclusivity of delegation orders. Regarding malfeasance, the court found no violation of I. R. C. § 6103 in the IRS’s handling of the closing agreement process. The court also distinguished between misrepresentations of fact and law, holding that the recitals in the agreement were legal conclusions and not misrepresentations of material fact. The court emphasized the finality intended by Congress in enacting I. R. C. § 7121, which supports the strict enforcement of closing agreements unless the statutory exceptions are met.

    Disposition

    The U. S. Tax Court granted the Commissioner’s Motion for Partial Summary Judgment and denied Smith’s competing motion. The court upheld the validity and enforceability of the closing agreement, affirming the notice of deficiency issued by the Commissioner.

    Significance/Impact

    The decision in Smith v. Commissioner reinforces the finality and conclusiveness of closing agreements under I. R. C. § 7121, impacting how such agreements are viewed in tax litigation. It clarifies the delegation of authority within the IRS for executing closing agreements, particularly in the context of international tax treaties. The ruling underscores the stringent conditions under which closing agreements can be set aside, emphasizing the need for clear evidence of fraud, malfeasance, or misrepresentation of material fact. This case has broader implications for U. S. citizens working abroad and the application of tax treaties, particularly those involving the waiver of domestic tax rights to avoid double taxation. It may influence future negotiations and interpretations of tax treaties between the U. S. and other countries, ensuring that closing agreements remain a reliable tool for resolving tax liabilities.

  • Analog Devices, Inc. & Subsidiaries v. Commissioner of Internal Revenue, 147 T.C. No. 15 (2016): Retroactive Indebtedness and the Scope of Closing Agreements in Tax Law

    Analog Devices, Inc. & Subsidiaries v. Commissioner, 147 T. C. No. 15 (2016)

    In a significant ruling on the scope of tax closing agreements, the U. S. Tax Court held that accounts receivable established under a Rev. Proc. 99-32 closing agreement do not constitute retroactive indebtedness for the purposes of reducing a taxpayer’s dividends received deduction under IRC Section 965. This decision overturned prior precedent and clarified that closing agreements are strictly construed to the issues enumerated therein, impacting how such agreements are interpreted in future tax disputes.

    Parties

    Analog Devices, Inc. & Subsidiaries (Petitioner) v. Commissioner of Internal Revenue (Respondent). The case was adjudicated at the trial level before the United States Tax Court.

    Facts

    Analog Devices, Inc. (ADI), a U. S. corporation, owned Analog Devices B. V. (ADBV), a controlled foreign corporation (CFC) incorporated in the Netherlands. ADI entered into a closing agreement with the IRS under Rev. Proc. 99-32 to reconcile cash accounts after adjusting royalties from ADBV to ADI from 2% to 6% for the years 2001-2005, pursuant to a Section 482 adjustment. ADI claimed an 85% dividends received deduction (DRD) under Section 965 for a 2005 dividend from ADBV. The IRS later contended that the accounts receivable established in the closing agreement constituted related party indebtedness under Section 965(b)(3), thereby reducing the DRD. ADI disputed this, leading to the litigation.

    Procedural History

    The IRS issued a notice of deficiency for ADI’s 2006 and 2007 tax years, asserting deficiencies of $3,997,804 and $22,112,640, respectively, due to the reduction of the DRD. ADI filed a timely petition for redetermination with the U. S. Tax Court. The case was fully stipulated under Tax Court Rule 122. The Tax Court had previously addressed a similar issue in BMC Software, Inc. v. Commissioner, which was reversed by the U. S. Court of Appeals for the Fifth Circuit. The Tax Court, influenced by the reversal, revisited its analysis in the instant case.

    Issue(s)

    Whether the accounts receivable established under a Rev. Proc. 99-32 closing agreement constitute related party indebtedness under Section 965(b)(3), thereby reducing the amount of the dividends eligible for the DRD?

    Rule(s) of Law

    Section 965 allowed a temporary 85% DRD for certain dividends received from CFCs. Section 965(b)(3) reduces the DRD by any increase in the CFC’s related party indebtedness during the testing period. Rev. Proc. 99-32 permits taxpayers to establish accounts receivable to effect secondary adjustments after a primary Section 482 allocation, avoiding deemed dividend treatment. Closing agreements under Section 7121 are final and conclusive as to the matters agreed upon and are strictly construed to encompass only the issues enumerated therein.

    Holding

    The Tax Court held that the accounts receivable did not constitute related party indebtedness under Section 965(b)(3). The closing agreement did not specifically address the treatment of the accounts receivable under Section 965, and thus, the accounts receivable did not retroactively create indebtedness during ADI’s testing period.

    Reasoning

    The court reasoned that the closing agreement’s phrase “for all Federal income tax purposes” was part of the standard boilerplate and did not extend the agreement’s scope beyond the specifically enumerated issues. The court emphasized the principle of expressio unius est exclusio alterius, stating that the specificity of the closing agreement’s provisions implied that unmentioned tax consequences, such as those under Section 965, were excluded. The court also considered the timing requirement in Section 965(b)(3), which required indebtedness to exist “as of” the close of the election year, a condition not met by the accounts receivable which were established after the testing period. The court overruled its prior decision in BMC Software I, aligning its interpretation with the Fifth Circuit’s reversal and the plain meaning of Section 965(b)(3). The court further noted that the IRS’s guidance in Notice 2005-64 lacked analysis and conflicted with the statute, thus being unpersuasive. The court rejected the IRS’s contention that extrinsic evidence indicated an intent to treat the accounts receivable as retroactive indebtedness, as such evidence was not incorporated into the closing agreement.

    Disposition

    The Tax Court entered a decision for the petitioner, ADI, allowing the full amount of the claimed DRD.

    Significance/Impact

    This case significantly clarifies the scope and interpretation of closing agreements under Section 7121, emphasizing that such agreements are strictly limited to the issues specifically enumerated. It overrules prior Tax Court precedent and aligns with the Fifth Circuit’s reversal in BMC Software II, impacting future tax disputes involving the retroactive effect of accounts receivable established under Rev. Proc. 99-32 closing agreements. The decision reinforces the necessity of clear contractual language in closing agreements and may influence the IRS’s approach to drafting such agreements. It also underscores the importance of the timing requirement under Section 965(b)(3) for determining related party indebtedness.

  • Pert v. Commissioner, 105 T.C. 370 (1995): Binding Effect of Closing Agreements on Transferees

    Pert v. Commissioner, 105 T. C. 370 (1995)

    A transferee or successor transferee is bound by a closing agreement made by the transferor under IRC Section 7121, except on grounds of fraud, malfeasance, or misrepresentation of material fact.

    Summary

    Harvey Pert, as a transferee of assets from Kathleen Pert and a successor transferee of assets from the estate of her deceased husband, Timothy Riffe, sought to contest their tax liabilities established by closing agreements. The Tax Court held that Pert, as a transferee, is bound by the closing agreements made by Kathleen Pert and the estate of Timothy Riffe, except on grounds available to the parties to the agreements. Additionally, the court ruled that the statute of limitations did not bar the assessment of transferee liability against Pert for 1986 due to fraud on the joint return. This case established that transferees are bound by transferors’ closing agreements, impacting how transferee liability cases are analyzed.

    Facts

    Timothy Riffe and Kathleen Pert filed joint tax returns for 1986, 1988, and 1989. After Timothy’s death in 1991, Kathleen, as his estate’s personal representative, entered into closing agreements with the IRS for those years, agreeing to tax deficiencies and fraud penalties for Timothy but not for herself. Kathleen later married Harvey Pert, who received assets from her and Timothy’s estate. The IRS sought to hold Pert liable as a transferee and successor transferee for the tax liabilities of Kathleen and Timothy’s estate, respectively.

    Procedural History

    The IRS issued notices of transferee liability to Pert, who then petitioned the Tax Court. The IRS moved for partial summary judgment, asserting that Pert could not contest the tax liabilities established by the closing agreements and that the statute of limitations did not bar the assessment of transferee liability for 1986. The Tax Court granted the IRS’s motions.

    Issue(s)

    1. Whether Harvey Pert, as a transferee or successor transferee, may contest the tax liabilities established by closing agreements between Kathleen Pert, the estate of Timothy Riffe, and the IRS.
    2. Whether the statute of limitations bars the assessment of transferee liability against Pert for the tax year 1986.

    Holding

    1. No, because a transferee or successor transferee is bound by a transferor’s closing agreement under IRC Section 7121, except on grounds of fraud, malfeasance, or misrepresentation of material fact.
    2. No, because the statute of limitations remains open for assessing transferee liability for 1986 due to fraud on the joint return filed by Timothy Riffe and Kathleen Pert.

    Court’s Reasoning

    The court reasoned that IRC Section 7121(b) makes closing agreements final and conclusive, except upon a showing of fraud, malfeasance, or misrepresentation of material fact. The court analogized the binding effect of closing agreements to res judicata, noting that transferees are in privity with transferors and thus bound by their agreements. The court rejected Pert’s argument that he was not in privity with Timothy’s estate, stating that as a transferee or successor transferee, he was bound by the closing agreements. Regarding the statute of limitations, the court held that the fraud on the 1986 return kept the period open indefinitely for assessing transferee liability.

    Practical Implications

    This decision clarifies that transferees and successor transferees are bound by closing agreements made by transferors, limiting their ability to contest tax liabilities established by such agreements. Attorneys should advise clients on the potential tax liabilities they may inherit as transferees and the finality of closing agreements. This ruling may influence how the IRS pursues transferee liability and how taxpayers structure asset transfers to minimize tax exposure. Subsequent cases have applied this principle, reinforcing the binding nature of closing agreements on transferees.

  • Rink v. Commissioner, 100 T.C. 319 (1993): Interpreting Closing Agreements and the Impact of Ambiguity on Taxpayer Claims

    Rink v. Commissioner, 100 T. C. 319 (1993)

    A closing agreement between the IRS and a taxpayer is interpreted using ordinary contract principles, with ambiguity resolved against the party who drafted the ambiguous language.

    Summary

    Thomas C. Rink, an experienced tax attorney, purchased lawn service trucks and claimed depreciation deductions based on a zero salvage value. The IRS disagreed, asserting the trucks had substantial salvage value. After negotiations, Rink entered into a closing agreement with the IRS, which allowed for depreciation deductions for 1980 and 1981 but disallowed them for subsequent years unless a new lease was renegotiated. Rink claimed a 1986 depreciation deduction based on a lease executed in 1986, before the closing agreement. The Tax Court held that the closing agreement was prospective and did not allow for the 1986 deduction, as the lease in question was executed prior to the agreement. Additionally, the court found the 1986 lease lacked substance for tax purposes.

    Facts

    Thomas C. Rink, an experienced tax attorney, purchased three lawn service trucks from Moore, Owen, Thomas & Co. (Moore) in 1980, which were subject to a lease with Chemlawn Corp. Rink claimed full depreciation deductions for 1980-1983 based on a zero salvage value estimate. The IRS challenged these deductions, asserting the trucks had substantial salvage value. In 1986, Rink negotiated a settlement with the IRS, resulting in a closing agreement executed in October 1987. This agreement allowed Rink depreciation deductions for 1980 and 1981 but disallowed them for subsequent years unless a new lease was renegotiated. Rink executed a lease with Moore in December 1986, which he claimed justified a 1986 depreciation deduction. However, this lease was never implemented, and a new lease was executed in 1988.

    Procedural History

    The IRS issued statutory notices of deficiency for Rink’s 1985 and 1986 tax years. Rink filed a petition with the U. S. Tax Court challenging the IRS’s determination. The Tax Court reviewed the closing agreement and the circumstances surrounding its execution, ultimately ruling in favor of the IRS and disallowing Rink’s 1986 depreciation deduction.

    Issue(s)

    1. Whether the closing agreement executed in October 1987 allowed Rink to claim a depreciation deduction for 1986 based on a lease executed in December 1986?
    2. Whether the 1986 lease between Rink and Moore had substance for tax purposes?

    Holding

    1. No, because the closing agreement was prospective and did not contemplate a lease executed prior to its execution.
    2. No, because the 1986 lease lacked substance and was designed solely for tax benefits.

    Court’s Reasoning

    The Tax Court interpreted the closing agreement using ordinary contract principles, finding the language clear and unambiguous. The court noted that the agreement’s use of “if,” “then,” and “at that time” indicated prospectivity, meaning the renegotiation of a lease had to occur after the agreement’s execution. Even if the agreement were ambiguous, Rink knew the IRS’s interpretation but did not disclose his own differing view, which under contract law principles favored the IRS’s interpretation. The court also found that the 1986 lease lacked substance, as it was never implemented and was designed solely for tax benefits. The court cited Ronnen v. Commissioner and Gefen v. Commissioner to support the principle that transactions without economic substance are disregarded for tax purposes.

    Practical Implications

    This decision emphasizes the importance of clear language in closing agreements with the IRS. Taxpayers and their attorneys must ensure that all relevant information is disclosed during negotiations to avoid unfavorable interpretations. The ruling also underscores the need for transactions to have economic substance beyond tax benefits to be recognized for tax purposes. Practitioners should advise clients to carefully review and understand the terms of closing agreements and to consider the timing and substance of related transactions. Subsequent cases involving closing agreements may reference Rink v. Commissioner when addressing issues of ambiguity and the economic substance of transactions.

  • Estate of Magarian v. Commissioner, 97 T.C. 1 (1991): Scope of Closing Agreements in Tax Disputes

    Estate of John J. Magarian, Deceased, Shirley H. Magarian, Executrix, and Shirley H. Magarian v. Commissioner of Internal Revenue, 97 T. C. 1 (1991)

    Closing agreements under I. R. C. section 7121 are binding only on the specific matters agreed upon and do not automatically preclude the IRS from assessing additions to tax or interest not explicitly included in the agreement.

    Summary

    In Estate of Magarian v. Commissioner, the U. S. Tax Court held that a closing agreement executed under I. R. C. section 7121 did not bar the IRS from determining additions to tax for the year in question. The petitioners had previously agreed to specific deductions related to a partnership. However, the closing agreement did not mention additions to tax or increased interest. The court clarified that closing agreements are final only as to the matters specifically agreed upon, and absent explicit language covering additions to tax, the IRS could still assess such penalties. This ruling underscores the importance of clear and comprehensive language in closing agreements to avoid later disputes over tax liabilities.

    Facts

    Shirley H. Magarian, executrix of John J. Magarian’s estate, and Shirley H. Magarian individually, claimed deductions on their 1981 tax return related to their partnership, White Research and Development. The IRS disallowed these deductions and proposed a deficiency, additions to tax, and increased interest. The parties then entered into a closing agreement on September 17, 1987, which allowed specific deductions for 1981 but did not address additions to tax or interest. Subsequently, on July 19, 1989, the IRS issued a notice of deficiency assessing additions to tax for 1981, which the petitioners contested based on the prior closing agreement.

    Procedural History

    The IRS initially disallowed the partnership deductions claimed by the petitioners for 1981, leading to a proposed deficiency and additions to tax. After negotiations, the parties entered into a closing agreement on September 17, 1987, which became final on September 28, 1987. Despite this, the IRS issued a notice of deficiency on July 19, 1989, asserting additions to tax for 1981. The petitioners filed a petition with the U. S. Tax Court to challenge this determination, arguing that the closing agreement barred further assessments.

    Issue(s)

    1. Whether the closing agreement executed by the parties bars the IRS from determining additions to tax for the taxable year 1981.

    Holding

    1. No, because the closing agreement did not specifically address additions to tax, and thus, the IRS is not precluded from assessing such penalties for the year in question.

    Court’s Reasoning

    The court’s decision was based on the interpretation of I. R. C. section 7121, which authorizes closing agreements but limits their finality to the matters explicitly agreed upon. The court emphasized that the closing agreement in question, a Form 906 type, related to specific deductions from the partnership but did not mention additions to tax or increased interest. The court rejected the petitioners’ argument that the agreement’s preamble, stating the parties’ intent to resolve disputes with finality, extended to additions to tax. Citing Zaentz v. Commissioner and Smith v. United States, the court noted that closing agreements do not typically cover additions to tax unless explicitly stated. The court also highlighted the need for clear language in such agreements to avoid ambiguity and potential disputes over tax liabilities. The court dismissed the petitioners’ claim regarding increased interest under I. R. C. section 6621(c) for lack of jurisdiction, consistent with prior rulings like White v. Commissioner.

    Practical Implications

    This decision emphasizes the importance of explicit language in closing agreements to cover all aspects of tax liability, including potential additions to tax and interest. Practitioners should ensure that closing agreements clearly state the scope of the settlement to avoid future disputes. The ruling also underscores the IRS’s ability to assess additions to tax post-closing agreement if not specifically precluded. This case has influenced subsequent agreements and legal practice by highlighting the need for thorough negotiation and documentation of all terms. It also serves as a reminder for taxpayers to be aware of the IRS’s policies on closing agreements and to seek explicit waivers for additions to tax if desired. Later cases have continued to apply this principle, reinforcing the need for comprehensive and unambiguous closing agreements in tax disputes.

  • Estate of Johnson v. Commissioner, 88 T.C. 225 (1987): Binding Nature of Closing Agreements in Tax Cases

    Estate of Keith Wold Johnson, Deceased, Seymour M. Klein, Betty W. Johnson, and Robert J. Mortimer, Executors, Petitioner v. Commissioner of Internal Revenue, Respondent, 88 T. C. 225 (1987); 1987 U. S. Tax Ct. LEXIS 14; 88 T. C. No. 14

    Closing agreements with the IRS are final and binding unless there is fraud, malfeasance, or misrepresentation of material facts.

    Summary

    In Estate of Johnson, the estate sought to adjust its basis in notes it held after its decedent’s death, arguing it should be increased by $4. 2 million in life insurance proceeds. However, the estate had previously entered into a closing agreement with the IRS, setting the basis at $600,000. The Tax Court held that the estate was bound by the closing agreement and could not contradict its terms by later claiming an increased basis. Additionally, the court ruled that the estate’s informal bookkeeping entries did not constitute valid income distributions to another estate, disallowing deductions for those amounts.

    Facts

    Keith Wold Johnson, the decedent, guaranteed a loan to American Video Corp. (AVC) and assigned life insurance policies as collateral. Upon his death, the bank collected $4. 2 million from the insurance policies and assigned AVC notes to the estate. The estate and the IRS entered into a closing agreement valuing the estate’s interest in the notes at $600,000 for estate and income tax purposes. Later, the estate claimed the basis should be $4. 2 million, representing the insurance proceeds. The estate also claimed income distribution deductions based on informal bookkeeping entries to Willard’s estate, another beneficiary.

    Procedural History

    The estate filed its tax returns and entered into a closing agreement with the IRS in 1979. After AVC repaid the notes in 1980 and 1981, the estate filed amended returns claiming refunds based on an increased basis. The IRS issued a notice of deficiency, rejecting these claims. The estate then petitioned the Tax Court, which held a trial and issued its opinion in 1987.

    Issue(s)

    1. Whether the estate was bound by the closing agreement and could not claim an increased basis in the AVC notes.
    2. Whether the estate was entitled to deductions for income distributions to Willard’s estate based on informal bookkeeping entries.

    Holding

    1. Yes, because the estate was bound by the terms of the closing agreement and could not later contradict its position by claiming an increased basis.
    2. No, because the informal bookkeeping entries did not constitute valid distributions beyond the estate’s recall.

    Court’s Reasoning

    The court emphasized the finality of closing agreements under IRC section 7121, stating they cannot be set aside without fraud, malfeasance, or misrepresentation of material facts. The estate’s claim for an increased basis contradicted its earlier position in the closing agreement, which the IRS had relied upon. The court found no evidence of fraud or misrepresentation, thus upholding the agreement’s terms. Regarding the income distributions, the court applied the standard that amounts must be definitively allocated beyond recall to qualify as distributions under IRC section 661(a)(2). The informal workpapers and lack of actual fund transfers did not meet this standard, as the estate could still recall the funds if needed.

    Practical Implications

    This decision reinforces the binding nature of closing agreements with the IRS, cautioning taxpayers against attempting to alter agreed-upon tax positions without clear evidence of fraud or misrepresentation. Practitioners must carefully consider all facts and potential future implications before entering such agreements. The ruling also clarifies the requirements for valid income distributions from estates, emphasizing the need for clear allocation beyond recall, which impacts estate planning and administration practices. Subsequent cases have cited Estate of Johnson when addressing the enforceability of closing agreements and the criteria for estate distributions.

  • Schering Corp. v. Commissioner, 69 T.C. 579 (1978): When Foreign Tax Credits Apply to Repatriated Income Reallocations

    Schering Corporation and Subsidiaries v. Commissioner of Internal Revenue, 69 T. C. 579 (1978); 1978 U. S. Tax Ct. LEXIS 191

    A U. S. corporation can claim a foreign tax credit for withholding taxes paid on income repatriated from a foreign subsidiary pursuant to a section 482 reallocation, even if the repatriation is treated as tax-free under a closing agreement.

    Summary

    Schering Corp. , a U. S. company, had income reallocated from its Swiss subsidiaries under section 482. It repatriated this income tax-free under Revenue Procedure 65-17 and closing agreements. Switzerland withheld taxes on this repatriation, which Schering claimed as a foreign tax credit. The Tax Court held that Schering was entitled to this credit, ruling that the Swiss withholding tax was a creditable income tax under U. S. law, and that neither the closing agreements nor section 482 barred the credit.

    Facts

    Schering Corp. , a U. S. corporation, transferred patents and licensing agreements to its Swiss subsidiary, Scherico Ltd. , in the mid-1950s. The IRS reallocated income from these transactions to Schering under section 482 for the years 1961-1963. Schering and the IRS entered into closing agreements in 1969, allowing Schering to set up accounts receivable from Scherico and another Swiss subsidiary, Essex Chemie A. G. , for the reallocated income. Schering repatriated these amounts within 90 days, treated as tax-free under Revenue Procedure 65-17. Switzerland withheld 5% of the repatriated amount as a dividend under its tax laws, and Schering claimed a foreign tax credit for this withholding.

    Procedural History

    The IRS audited Schering’s 1969 tax return and disallowed a portion of the foreign tax credit claimed for the Swiss withholding tax. Schering petitioned the U. S. Tax Court for a redetermination of the deficiency. The Tax Court ruled in favor of Schering, allowing the full amount of the foreign tax credit.

    Issue(s)

    1. Whether the Swiss withholding tax withheld on the repatriated income from Scherico and Essex is a creditable income tax under section 901 of the U. S. Internal Revenue Code.
    2. Whether the closing agreements between Schering and the IRS, which allowed for tax-free repatriation of the reallocated income, bar Schering from claiming a foreign tax credit for the Swiss withholding tax.
    3. Whether section 482 of the U. S. Internal Revenue Code allows the IRS to disallow the foreign tax credit claimed by Schering.

    Holding

    1. Yes, because the Swiss withholding tax is the substantial equivalent of an income tax as understood in the U. S. , and it was paid by Schering on income it repatriated.
    2. No, because the closing agreements only specified that the repatriation would not constitute taxable income to Schering, not that it would bar foreign tax credits.
    3. No, because section 482 does not authorize the IRS to disallow a foreign tax credit where no related entity exists to which the credit could be reallocated.

    Court’s Reasoning

    The Tax Court analyzed the Swiss withholding tax under U. S. tax principles, determining it to be a creditable income tax under section 901. The court rejected the IRS’s arguments that the closing agreements and section 482 barred the credit. The court noted that the closing agreements only addressed the tax treatment of the repatriation itself, not the foreign tax credit. Regarding section 482, the court held that it does not allow the IRS to disallow a credit where no related entity exists to which the credit could be reallocated. The court also considered but rejected the IRS’s arguments about Schering’s failure to pursue competent authority proceedings under the U. S. -Swiss tax treaty, stating that such proceedings were not required for Schering to claim the credit.

    Practical Implications

    This decision clarifies that U. S. corporations can claim foreign tax credits for withholding taxes paid on repatriated income reallocated under section 482, even if the repatriation is treated as tax-free under a closing agreement. It emphasizes that the foreign tax credit is available regardless of how the repatriation is treated under U. S. tax law, as long as the foreign tax is creditable under U. S. principles. This ruling impacts how U. S. multinational corporations should approach tax planning and treaty negotiations, particularly in cases involving section 482 reallocations and foreign tax credits. It may also influence future IRS guidance on the interaction between closing agreements, section 482, and foreign tax credits.