## Facts

- Continental Illinois Corporation (parent of a major bank) engaged in substantial foreign lending during 1975–1979.
- The IRS assessed federal income tax deficiencies for those years, and the Tax Court issued multiple memorandum decisions, with mixed results for each side.
- Two groups of transactions were disputed on appeal: (1) “net loans” to foreign borrowers and (2) “CAP loans” involving government subsidy/guarantee arrangements.
- For “net loans,” Continental set an interest rate intended to yield a specified net return after foreign withholding tax; borrowers withheld tax from interest and remitted that tax to foreign governments.
- Continental claimed foreign tax credits under I.R.C. § 901 for withholding taxes tied to net-loan interest, often relying on borrower letters/confirmations rather than official receipts or equivalent governmental documentation.
- The IRS disallowed credits for many claimed amounts, asserting Continental had not shown the taxes were “paid or accrued” by Continental or adequately proven.
- Continental alternatively argued that if credits were unavailable, the tax component embedded in the higher contract interest rate should not be included in Continental’s taxable income because Continental bargained only for the net yield.
- For “CAP loans,” certain interest-related amounts were received or temporarily held under program rules, with disputes over whether particular sums were Continental’s taxable income or funds held for others.

## Issues

1. Whether Continental was entitled to foreign tax credits under I.R.C. § 901 for withholding taxes on net-loan interest where taxes were withheld/remitted by borrowers and documentation was incomplete or indirect.
2. If § 901 credits were unavailable, whether Continental’s taxable interest income from net loans should include the full contract-rate interest or only the net amount it bargained to retain after foreign tax.
3. Whether, and to what extent, interest-related amounts associated with CAP loans constituted taxable income to Continental versus nonincome pass-through/custodial amounts.

## Decision

- The Seventh Circuit denied Continental § 901 foreign tax credits for substantial portions of the disputed withholding taxes due to failure to satisfy “taxes paid or accrued” and proof requirements.
- The court held Continental could reduce taxable income from net loans by excluding the portion of contract interest economically set aside to satisfy foreign withholding taxes, even where no credit was allowed.
- On CAP loans, the court largely sustained the Tax Court’s approach, taxing amounts beneficially retained by Continental while excluding amounts held in a conduit or custodial capacity.
- The court affirmed in part and reversed in part and remanded for recomputation of deficiencies consistent with its holdings.

## Legal Principles

- A § 901 foreign tax credit requires the U.S. taxpayer to prove identifiable foreign income taxes that the taxpayer “paid or accrued”; indirect or nonstandard documentation may be insufficient.
- Denial of a foreign tax credit does not automatically require inclusion of the corresponding amount in gross income; income measurement turns on what the taxpayer economically realized from the transaction.
- In “net loan” structures, the portion of the contract interest rate set to cover foreign withholding tax may be excluded from income when, in substance, it is earmarked to satisfy foreign tax and not enjoyed as the lender’s gain.
- For transactions involving subsidy or guarantee programs, amounts are income when the taxpayer has beneficial enjoyment or control; amounts held as agent/conduit for another party are not income to the holder.

## Conclusion

The Seventh Circuit drew a line between eligibility for § 901 credits and the correct computation of income: Continental failed to prove many foreign withholding taxes as “paid or accrued” for credit purposes, but it could exclude the tax component embedded in net-loan pricing from taxable income because it did not represent Continental’s economic gain; CAP-loan amounts were taxed or excluded based on whether Continental held them beneficially or for others.


Continental Ill. Corp. v. Comm’r, 998 F.2d 513 (7th Cir. 1993)