The Treasury Department may be forced to subsidize scores of U.S. bank loans made to the Brazilian government in the 1980s.
The U.S. Court of Appeals for the District of Columbia ruled last month that Riggs National Corp. is entitled to tax deductions that could be worth millions of dollars.
The ruling establishes a precedent that more than a dozen other U.S. banks, including Chase Manhattan Corp., Bankers Trust Corp., and BankAmerica Corp., could use to receive similar tax benefits.
At issue is a complex tax plan devised by the Brazilian government, the Brazilian central bank, and U.S. banks during the height of the 1980s Latin American debt crisis.
The Brazilian government was broke during this period, and U.S. banks were forced to restructure billions of dollars in loans and suffer millions of dollars more in losses.
To soften the blow to the U.S. banks, the bailout loans were structured as "net loans." This means that the Brazilian central bank would pay all local taxes levied on the interest payments.
This benefited Riggs in three ways: It did not have to pay the taxes, did not bear the risk that the Brazilian government might raise these taxes in the future, and could deduct these interest payments from its U.S. tax bill.
The Internal Revenue Service challenged this later benefit. It argued that the Brazilian central bank is exempt from all taxes and thus could not be liable for Riggs' tax bill.
Riggs countered by citing a letter from the Brazilian Ministry of Finance, which said the central bank, despite its tax exemption, was liable for the taxes because it used the bank credit to finance loans to local companies.
In essence, the local companies were paying the tax, the Ministry of Finance said.
The U.S. Tax Court sided with the IRS, ruling that Riggs is not entitled to the credit because Brazilian law does not require its central bank to pay taxes.
It dismissed the Brazilian Finance Ministry letter as merely an advisory opinion.
Riggs appealed, arguing that the tax court violated the "act of state doctrine," which requires U.S. courts to defer to interpretations of foreign laws by foreign judges.
The federal appeals court on Jan. 12 grudgingly sided with Riggs.
It called the Brazilian minister's letter "particularly vexing" because its wording applied only to restructuring loans by foreign banks. Yet the court said it had no choice but to side with Riggs.
"Although we can visualize prophylactic regulatory measures that would prevent this device from being utilized, the commissioner has not yet fashioned a legitimate challenge to Riggs' use of the foreign tax credit in this case," the judges said.
As a result, the IRS must let Riggs deduct the Brazilian taxes from its U.S. tax bill, the court said. Several lawyers following cases said the decision, in effect, requires the Treasury to subsidize the cost of the restructuring loans, a burden they questioned whether taxpayers should have to bear.
This is the third major tax dispute to arise from these Brazilian rescue loans.
The courts first upheld that banks were entitled to tax credits on "net loans" to Brazilian corporations.
The second round centered on a subsidy the Brazilian government gave corporations to reimburse them for taxes paid on the "net loans."
The courts held that U.S. banks only could deduct the unsubsidized portion of the interest rate payments.