Tax Claims in Transnational Insolvencies: A "Revenue Rule" Approach

Editor's Note: The following article, "Tax Claims in Transnational Insolvencies: A 'Revenue Rule' Approach," won the prize for third place in the Second Annual ABI Bankruptcy Law Student Writing Competition. The article discusses issues that arise when a multi-national company files for bankruptcy, specifically when a government attempts to collect taxes from a bankrupt company that files in a foreign country. The author, Jonathan M. Weiss, is a student at UCLA Law School. In addition to recognition and publication of his article in the Bankruptcy Litigation Committee Newsletter, Mr. Weiss receives a cash award of $500 and a one-year ABI membership.

The ABI Bankruptcy Law Student Writing Competition was headed by the Hon. Judith K. Fitzgerald of the U.S. Bankruptcy Court for the Western District of Pennsylvania. Judge Fitzgerald is the Special Projects/Task Force Leader for the Bankruptcy Litigation Committee and was assisted by the committee leadership and members of the committee.

Introduction:
The past decade has brought several insolvencies of large, multinational corporations.[1] While insolvencies in the United States are neatly governed by title 11 of the United States Code, when foreign assets become involved, a conflict-of-laws problem quickly arises[2] as each country has its own, often very different, laws governing insolvency.[3]The “disparities in and, in some cases, conflicts between national laws have created unnecessary obstacles to the achievement of the basic economic and social goals of insolvency proceedings.”[4] For example, suppose that ABC Corporation, operating in both the United States and in Canada, files for bankruptcy in the United States.  Canadian lenders, employees, and the Canadian government all file claims in the U.S. bankruptcy case.  How are they to get paid, if at all?  This paper will discuss that, although lenders, employees, and most other foreign creditors will be paid, a problem arises when foreign governments file tax claims, expecting to be paid from a bankruptcy proceeding in a different country.  Because of an old doctrine known as the “revenue rule," countries are loathe to assist their neighbors in collecting taxes, and this lack of enforcement creates problems in both the bankruptcy and tax arenas.

As background, it is important to understand the four approaches to administering transnational insolvencies.  The first two approaches are pure universalism and modified universalism.[5]  Pure universalism maintains that all of a multinational corporation’s assets, wherever they may be located, must be pooled together.[6]   Those assets are then administered in a single proceeding, in the debtor’s home country and under its laws, with the rulings being effective worldwide.[7]  Modified universalism, an outgrowth of pure universalism, is similar to pure universalism in that the assets of the debtor are pooled together and administered by one court, but allows individual countries to evaluate the fairness of that proceeding, and to open their own local proceedings if necessary.[8]   The second two approaches are pure territorialism and cooperative territorialism.[9]  Pure territorialism, is a “land-grab” approach, and argues that each nation should exercise control over the assets within its borders.[10]    No foreign deference is required, as each country applies its own laws to the assets within its jurisdiction.[11]  Lastly, cooperative territorialism maintains separate proceedings in each country, but encourages cooperation between nations through protocols “on an as-needed basis,” and resolves some matters by the use of “international conventions.”[12]  

Emerging from the debate is a clear sense of the dominance of universalism.[13]   The United Nations proposed a “Model Law” of universalist guidelines to govern transnational insolvencies.[14]  The European Union has adopted universalist rules governing the transnational insolvencies of its member nations.[15]   Finally, the United States, in 2005, adopted the Model Law as the new Chapter 15 of the Bankruptcy Code to replace section 304, which had allowed for permissive recognition, but which resulted in unpredictable inconsistencies due to excessive judicial discretion.[16]  While universalism does offer increased predictability and efficiency, as explained below, those benefits are muted by the lack of enforcement with respect to foreign tax claims. 

The Problem: Foreign Tax Claims
The universalist scheme works well only with private law claims, such as those of banks or trade creditors.[17]   For example, if, in a bankruptcy case filed in the United States, a Canadian bank files a claim, the U.S. court will likely accept that claim.  However, acquiescence to foreign authority does not work well with public law claims, such as tax claims.[18]  For example, if, in the same case, the Canadian government files a claim for unpaid taxes, that claim is unlikely to be allowed by United States courts[19].  The American Law Institute’s Transnational Insolvency Project, in avoiding handling the problem of tax priorities, stated that “[t]he granting of priority to domestic tax claims in multinational cases will remain a serious problem.”[20]  The drafters of the Model Law expressed similar reservations, allowing complete discrimination and disallowance of foreign tax claims.[21]  Consider ABC Corporation doing business in Country X and Country Y, with the COMI being in Country X.  Suppose that the laws of Country X mandate universalism, which treats local and foreign tax claims similarly, and that Country X gives a high priority to tax claims.[22]  Suppose further that Country Y’s government has filed a tax claim, expecting to be paid according to Country X’s priority (i.e. “cross priority”).[23]  Should the tax claim be paid?  What if Country Y is regarded as a rogue nation which files illegal tax claims to exert corrupt political pressure?  Alternatively, suppose that Country Y is law-abiding but imposes a 75% tax on its corporations.  The ALI and Model Law do not deal with the question of whether cross-priority should be granted to tax claims, and at present, countries do not enforce such claims.[24]  This lack of enforcement of foreign tax claims presents a major problem for transnational insolvency scholars, particularly those who favor the universalist approach.  Thus, by examining the doctrine behind the refusal to enforce foreign tax claims, we can craft solutions which will fully realize the benefits of universalism by allowing for cross-priority of foreign tax claims. 

The Revenue Rule
The revenue rule, which mandates that no country should recognize the tax claims of another country, originated in England in the 1700s.[25]  It was adopted into United States law by the Court of Appeals for the Ninth Circuit in Her Majesty the Queen ex rel. British Columbia v. Gilbertson,[26] which involved an attempt by the government of British Columbia to enforce a tax on citizens of Oregon who had performed logging work in Canada.[27]  The Ninth Circuit upheld the District Court’s holding denying enforcement of the tax claims.[28]  Other countries have also refused to enforce foreign tax claims on similar grounds.[29]   There are numerous justifications for not enforcing foreign tax claims.[30]  First, Judge Learned Hand posited that requiring countries to enforce tax claims of their neighbors would require some analysis of the tax claim, and could be embarrassing to the foreign state.[31]  Additionally, United States courts may not be able to understand, evaluate, and enforce tax claims of other nations.[32]   Furthermore, supporters of the revenue rule approach argue that national sovereignty is threatened when countries satisfy foreign tax claims, against national assets, which could have strengthened the home government or its economy.[33]  Lastly, supporters of the revenue rule approach argue that, if the United States were to enforce foreign tax claims, the initiative would have to come from the executive branch, and not from the judiciary.[34]  

Despite these concerns, there would be acknowledged benefits from mutual enforcement of foreign tax claims, in contravention of the revenue rule.[35]  First, it would obviously benefit the notion of international comity, as countries would be able to cooperate and exchange information with one another.  Second, it would support the notion of justice, as tax evaders would be forced to pay their debt, and wouldn’t be allowed to shirk this obligation solely due to geographic location.  Finally, it would benefit nations as a whole, as each person would pay his or her fair share of the national tax burden.[36]  Thus, there would clearly be benefits to nations from abrogating the revenue rule, and enforcing foreign tax claims.  In addition, the enforcement of foreign tax claims would further promote bankruptcy policy under a universal scheme, as discussed below.

Three Potential Solutions:
Solution A:  The best possible solution, from both a bankruptcy and a tax perspective, would be to unilaterally mandate universal cross-priority for foreign tax claims.  While not abrogating the revenue rule completely, such a mandate would create a “bankruptcy exception,” through which the revenue rule is not recognized in the context of a transnational insolvency, and foreign tax claims are enforced.[37]  Thus, for example, in a bankruptcy case in the United States, a foreign government’s tax claim would be completely allowed and paid, just like a tax claim by the United States government.  Although, at first, this seems to be an overly ambitious and broad suggestion—since foreign tax claims have never been recognized—it is this author’s contention that, when dealing solely within the bankruptcy context, this solution ameliorates the policy concerns that the revenue rule approach had addressed, and achieves tax policy goals, which, when combined with bankruptcy policy goals, make this a clear choice as the best possible approach.  First, in terms of bankruptcy goals, this approach is the ultimate “ex ante” solution.  The United States would be unilaterally telling corporations, investors, and foreign governments, before any relationships or obligations are entered into, that foreign tax claims will be recognized in an insolvency case.  Obviously, this promotes the goal of predictability, as investors will know that taxes will be honored.  This predictability encourages investment in multinational companies, as investors are accurately able to calculate their risk, and predict the distributions in event of default.  Additionally, this solution promotes administrative efficiency, as all claims will be able to be dealt with by the home country court, and ancillary or parallel proceedings in foreign courts will not be necessary.  Furthermore, this is the ultimate achievement in fairness, as competing governments, which are similarly situated creditors, are given the same treatment in bankruptcy, and are not discriminated against based on nationality.  Lastly, debtor corporations will be less likely to “forum shop” by moving assets out of countries with large tax claims, as those tax claims will be paid regardless of where the assets actually are located.[38]  On the tax side, such an approach also produces beneficial results.  First, such a policy promotes cooperation and notions of comity, which are beneficial in any area of law,[39] as cooperation leads to increased sharing of burdens and information, which reduces costs for individual nations.[40]  Second, such a policy promotes justice, as it cracks down on would-be tax evaders, and forces them to pay lawful taxes regardless of where the assets may be located.[41]  Lastly, such a policy will protect the national interest, as non-enforcement of taxes would have created a tax burden in the claiming country, which would have to be filled by the rest of the lawful taxpayer base.  

Additionally, this approach ameliorates all of the revenue rule’s concerns.  First, Judge Hand’s concern about judicial embarrassment of other nations is no longer an issue, as judges will not be analyzing foreign tax laws; they will simply be enforcing them.  Second, judicial competence to assess foreign tax law is a non-issue.  Third, separation of powers won’t be an issue, as the enforcement will not be a direct result of judicial action, but will be a result of legislation imposed by the other branches of government, which are permitted to deal in foreign matters.  Lastly, national sovereignty concerns will hopefully be ameliorated through the inducement of reciprocity.[42]  

The obvious potential risk with this approach is that, if adopted unilaterally by the United States, other countries will not adopt the legislation, and will take advantage of the United States.  However, it is likely, due to the acceptance of this issue as a complex and disruptive problem, that many other countries will adopt similar statutes.[43]  The United States should take the first leap and implement this legislation which would provide tremendous advantages to all countries.[44]  Professor Jay Lawrence Westbrook, a staunch supporter of universalism, has noted that “acts of helpful cooperation, without an initial requirement of reciprocity, breed reciprocity,”[45] and Westbrook proves this assertion using examples from section 304, a unilateral statute which was reciprocated by certain foreign governments, despite no reciprocity requirement.[46]  Thus, despite the risk caused by unilateral action, because the goals of bankruptcy and tax law are aligned, the benefits realized by this approach are potentially vast in both disciplines, and it is the best possible solution. 

Solution B: Alternatively, a similar, yet less ambitious, approach would be to mandate universal cross-priority of foreign tax claims, but to require reciprocity—meaning, to only extend the cross-priority privilege to those nations which have adopted a similar provision.  This would solve the major problem of the first approach, in that it would give the United States some leverage in having its own tax claims recognized abroad.[47]  However, there are several problems with including such a requirement,[48] aside from the United States generally disfavoring a reciprocity requirement.[49]  In fact, “[a] reciprocity requirement was debated several times in the [United Nations’ Model Law] discussions because a small number of countries favored it, but it was defeated by a large consensus each time.”[50]  

There are two ways in which a reciprocity requirement could be enforced.[51]  Under the first version, it would be done on an ex post basis, whereby in each insolvency case in which a foreign country has filed a tax claim, the court would analyze the foreign law to determine if it meets the reciprocity requirement.[52]  However, this arrangement would bring about the same “judicial discretion” concerns that the other ex post approaches do; namely, the unpredictability that territorialism brings, and the concerns implicated by the revenue rule.  While the court would not be directly deciding whether to enforce the tax claims, requiring judges to analyze whether a law is, in fact, reciprocal, would “spawn satellite litigation over whether the requirement is satisfied by the foreign country.”[53]  The second method for enforcing a reciprocity requirement analyzes foreign law on an ex ante basis.[54]  Under this approach, the United States government would maintain a list of countries with reciprocal statutes.  This method would remove judicial discretion from the equation, and would force the judiciary to enforce or not enforce a given tax claim.  Thus, this second approach to reciprocity would, in fact, bring about the policy goals of transnational insolvency, in that it would foster ex ante predictability (if only between reciprocal nations), and of taxation, in that no judicial analysis would be necessary.  However, reciprocity requirements, in either of these two forms, have generally not been used in the United States, are not as beneficial to the goals of predictability and cooperation, and are ultimately an unnecessary requirement on the road to universal enforcement.[55]  Nevertheless, if a unilateral mandate cannot be implemented, then a mandate combined with a reciprocity requirement (preferably the second version) would be a compromise worth enacting, as it would be a step toward universal enforcement, and would provide ex ante predictability between reciprocal nations.

Solution C: Lastly, a solution encouraging the United States to enter into treaties mandating the enforcement of foreign tax claims in bankruptcy would reach the same result as an approach mandating the second version of reciprocity.  The result of a treaty approach would be nearly analogous to the previous mandate approach, in that while it is a valid solution and would foster a great deal of cooperation and predictability, the benefits would not be as great as if countries unilaterally decided to grant a universal cross-priority, without regard to reciprocity or treaty.  However, this approach would be substantially more difficult to implement,[56] as it would require significantly more effort, in the form of international cooperation—as opposed to a solution requiring each nation to act unilaterally and to qualify the law with a reciprocity requirement.[57]  In addition, tax treaties in abrogation of the revenue rule have lacked support in the United States.[58]  Thus, this approach, while also mandating reciprocity, would take significantly more effort, and is therefore less likely to be implemented.

The Public Policy Exception
Inevitably, in any potential solution, there must be a “public policy exception,” allowing the home country to refuse to enforce the foreign tax claim if the foreign claim is “manifestly contrary”[59] to the public policy of the home state.[60]   For example, suppose that a rogue nation files a large and dubious tax claim, threatening to consume much of the assets of the insolvent corporation.  Is the home court obligated to honor that claim?  Alternatively, suppose that a friendly, law-abiding nation, otherwise in concert with the United States, has a high tax rate, and is claiming a 95% tax on the corporation’s earnings, in full accordance with its tax laws.  Is the United States to honor such a claim?  These examples illustrate the need for a “public policy exception,” much like the one contained in Section 1506 of the current Bankruptcy Code.  The exception, however, must be given a narrow construction, or it will threaten to eviscerate the entire mandate, and bring the United States, and the world, back to a “discretionary” system, completely void of and predictability and efficiency.  Luckily, there is support for giving public policy exceptions a narrow construction.  Justice Benjamin Cardozo stated that U.S. Courts should not refuse to enforce judgments “unless help would violate some fundamental principle of justice . . .  [or] some deep-rooted tradition of the common weal.”[61]   Another court went even further, requiring a law “repugnant to fundamental notions of what is decent and just.”[62]   The ALI has also subscribed to this notion of narrow construction.[63]  However, despite a narrow interpretation, there are still instances where application of the public policy exception would be necessary.  The first instance, easy to apply, is where the tax claim in question is illegal or corrupt, as in In re Yukos Oil, where over $25 billion in Russian tax claims were deemed by most of the world to be illegal.[64]  Such a claim would clearly be against the public policy of the United States.  The second instance, much more difficult to apply, would be where a country’s tax rate is considered burdensome.  However, this would be a difficult standard to set—would 50% be burdensome?  90%?  100%?  Clearly such rates aren’t illegal, as just 50 years ago the top United States marginal income tax rate was 91%!  At some point, a given tax rate would probably be considered manifestly contrary to the public policy—this standard, though, must be set ex ante, in order to realize the benefits of universalism and to not implicate the revenue rule through excessive discretion.  Short of these two instances, the public policy exception would be rarely used, in order to keep judicial discretion to a minimum, and the mandate to recognize foreign tax claims, whether through Solution A, B, or C, would bring about tax benefits as well as increased efficiency and predictability in all transnational insolvencies. 

Conclusion:
In analyzing the possible solutions, a number of principles are clear:  First, a universal cross-priority system for tax claims, without the need for reciprocity or judicial discretion, accomplishes the goals of transnational insolvency, promotes and furthers the spirit of international cooperation, and minimizes the concerns of the revenue rule while promoting tax goals; Second, in enacting such a system, the public policy exception must be given a narrow interpretation, or else risk rendering the entire law impotent; and third, the issue of reciprocity is the prime concern of the unilateral granting of cross-priority.  Taking into account these ideas, the best solution is for the United States, acting unilaterally, is to mandate the universal cross-priority of tax claims, with a narrow public policy exception, with the hope that similar legislation will be adopted abroad.  The resulting increase in predictability and cooperation will benefit lenders, creditors, governments, and our increasingly global society at large.