Riggs Bank made “net loans” to the Brazilian central bank in the 1980’s.  The borrower agreed to “gross up” its interest payments to Riggs for any Brazilian taxes Riggs would have to pay on the interest.  Riggs claimed it was entitled to foreign tax credits in the US for Brazilian taxes paid on its behalf by the central bank.

The IRS argued that any taxes that had to be paid on the interest were purely voluntary.  The US does not allow foreign tax credits for voluntary taxes.  Interest paid on borrowing by the Brazilian central bank is normally exempted from withholding taxes, but a tax was imposed in this case by special ruling by the Brazilian tax authorities.  According to the IRS, Brazil realized that by shifting money from one pocket to another — from the central bank to the Brazilian tax collector — it might reduce Riggs’ US tax liability.  Riggs shared the benefit with the central bank by charging a lower interest rate.

The US court of appeals for the DC circuit said, “the opportunistic nature of the Brazilian government’s action is particularly vexing . . . [but the IRS] has not yet fashioned a legitimate legal challenge to Riggs’ use of the foreign tax credit in this case.”

The case was sent back to the US Tax Court to confirm the taxes were in fact paid by the central bank.