Today Tax Trotter is pleased to present an article from its international tax partner Douglas S. Stransky. This article is the first in a two-part post that looks at the Fall Adams Challenge.
In today’s blog we take a look at the most draconian tax rule in the world and see if the rule is valid. We are also investigating a recent US tax court case where the court brought this draconian rule against a UK company, Adams Challenge (UK) Ltd. v Commissioner, 154 TC 37 (2020), confirmed.
U.S. tax law subjects a foreign corporation to federal income tax on a net basis if that corporation has a U.S. trade or business and income effectively related to that U.S. trade or business. As the Supreme Court found in the Groetzinger case, the term “trade or business” in tax legislation “has been used in over 50 sections and 800 subsections and in hundreds of places in proposed and final income tax rules [although the Code] never included a definition of the words “trade or business”. . . . ‘”).[i] As a result, it is not always clear whether a foreign company does some or all of its business in the United States.
If the overseas corporation had a U.S. trade or business, the overseas corporation, like any U.S. corporation, would have to file a U.S. federal income tax return and pay U.S. tax on its U.S. net income. If the foreign corporation fails to file its U.S. tax return, unlike a domestic corporation, that foreign corporation’s U.S. tax law provides the most draconian rule in the world – all deductions and credits are withheld, and the foreign corporation must pay tax on U.S. federal income Gross Income Attributed to U.S. Business.
Code section 882 (c) (2) provides that a foreign company may only receive deductions and credits if it submits a “true and accurate return in the manner prescribed in Subtitle F …”. This is the case in the clear text of this legal provision. Do not state that the tax return must be submitted within a certain period of time.[ii]
The US Treasury Department and the IRS first issued rules to interpret Section 882 in 1957, and those rules did not require that a tax return be filed within a specified time. In 1990 the regulations were changed to the effect that a foreign company may only make deductions and credits if it submits a return in the manner prescribed in Subtitle F in a timely manner.[iii] The 1990 regulations then provide that the timely basis for filing a tax return is eighteen months after the statutory tax return due date.[iv] The preamble to the 1990 ordinance erroneously states: “The law clearly provides for the denial of deductions and credits if returns are not submitted on time.”[v]
The 1990 regulations allow the IRS to waive the filing deadline if the offshore company can determine, based on the facts and circumstances, that it acted reasonably and in good faith to fail to file a return in a timely manner.[vi] This waiver would allow a foreign company to claim deductions and credits. In June 2020, the IRS re-released a memorandum containing guidelines for processing waiver requests.[vii] While it is beyond the scope of today’s blog to discuss this waiver, we understand that the IRS has set the bar pretty high and such waivers are difficult to achieve despite the reasonable and good faith language in the regulations.
As noted above, code section 882 (c) (2) itself does not contain a timely filing requirement as the simple meaning of the law does not include a time element. Because Code Section 882 (c) (2) is clear and unambiguous, the contrary interpretation of Code Section 882 (c) (2) in the 1990 Regulations is inappropriate and therefore the relevant provisions of the Regulations are void. Since the 1990 regulations requiring foreign companies to file a return within eighteen months of the return due date to be eligible for deductions and credits do not apply, a foreign company should be allowed to use its U.S. Effectively deducting trade or business related expenses even though it is late in filing its tax returns.
The tax court agreed that the rules in the 2006 Swallows Holding case were invalid.[viii] In 2008 the appellate court of the third district overturned the decision of the tax court.[ix] The tax court analyzed this ordinance, considering the factors identified in National Muffler, and concluded that the ordinance is invalid.[x] At that conclusion, the tax court stated that the standard set out in National Muffler had not been replaced by Chevron and that the outcome would be the same under both standards. The third circuit did not agree with the result of the tax court. Instead, the Third Circuit stated that the result under chevron analysis would not be the same as under National Muffler, and that the ordinance here should receive “chevron deference”. The chevron deference sets a fairly low bar for the adoption of legal interpretation by a managing authority. An agency’s interpretation takes precedence as long as it is not “arbitrary, capricious, or blatantly illegal”.
Fortunately, taxpayers who are not third circuit taxpayers can still invoke the invalidity of the regulations resulting from the tax court’s involvement in Swallows.
In the Adams Challenge, the tax court had an opportunity to re-examine Section 882 (c) (2) of the Code, but as a matter of fact, Swallows precedent was not helpful to the taxpayer.
Adams Challenge, a UK company, did not file an income tax return for 2009 or 2010. In 2014, the IRS determined that Adams Challenge was in a U.S. trade or business and prepared and signed a Code Section 6020 (b) tax return for the company for those years. Shortly thereafter, the IRS issued Adams Challenge a notice of deficiency stating, among other things, that the company was not eligible for any 2009 or 2010 deductions or credits under Code Section 882 (c) for failing to provide feedback. In 2015, Adams Challenge filed a redefinition with the tax court, claiming the regulation, which included the timely filing requirement, was invalid. In 2017, Adams Challenge filed notices of protection for 2009 and 2010, after which it filed a partial recapitulation petition contesting non-allowance of deductions and credits. The company also alleged that the IRS’s actions were in violation of corporate profits and the non-discrimination articles of the bilateral US-UK income tax treaty.
The tax court ruled that Adams Challenge was not entitled to any deductions or credits because it did not make “statements” for 2009 and 2010 after the IRS prepared and signed the statements for them. The tax court did not consider the validity of the regulations as Adams Challenge never filed tax returns here. They were filed by the IRS. Therefore, in the clear text of the law, Adams Challenge could not receive any deductions or credits.[xi]
The Adams Challenge case, therefore, continues to leave the door open for a taxpayer outside the Third Circuit to argue, under the previous Swallows Revenue Court precedent, that the 18-month filing requirement set out in the regulations is invalid.
The Tax Court also ruled that the IRS’s interpretation of Code Section 882 (c) (2) did not violate the Corporate Income Article or the Non-Discrimination Article of the United States-UK Tax Convention.[xii]
Despite the invalidity of the ordinance, the Adams Challenge case is a reminder of the severe punishment a foreign corporation faces for failing to file a U.S. income tax return when required. As mentioned above, it is not always clear whether a foreign company has a US trade or a US business. In these cases of uncertainty, a foreign corporation can file a protective tax return to avoid the gruesome outcome of paying U.S. tax on gross income if the IRS Code Section 882 (c) (2) applies to deny deductions and credits because there is no tax return originally filed. Given that US taxes are paid on gross income, a foreign company doesn’t want their only options to be to argue the regulation is invalid or try to get a waiver from the IRS.
[i] Commissioner v. Groetzinger, 480, US 23, 27 (1987)
[ii] The predecessor of Code Section 882 (c) (2) was Section 233 of the Revenue Act of 1928, which essentially corresponded to Section 882 (c) (2) as foreign corporations were required to make a return “in the manner.” “Required to file in this title” to qualify for deductions and credits. Congress amended Section 233 in the Revenue Acts of 1932, 1934, 1936, and 1938, and in the Code’s re-encoding of 1939. In 1954, Section 233 was added as a Section 882 (c) (1) re-codified, and Congress changed the section to “in the manner prescribed in Subtitle F,” but the House Committee report stated that the section would be identical to Section 233.
[iii] Treasury Regulation Section 1.882-4 (a) (2)
[iv] Treasury Regulation Section 1.882-4 (a) (3) (i); IRC section 6072.
[v] TD 8322, December 10, 1990.
[vi] Treasury Regulation Section 1.882-4 (a) (3) (ii)
[vii] IRM 4.61.14, International Examination Guidelines, Guidelines for Handling Delinquent Forms 1120-F and Requests for Exemption, June 8, 2020.
[viii] Swallows Holding, Ltd. v Comm’r, 126 TC 96 (2006)
[ix] Citing Chevron USA, Inc. v Natural Resources Defense Council, Inc., 468, US 837 (1984) above.
[x] National Muffler Dealers Ass’n v USA, 440 US 472, 477, 99 S.Ct. 1304, 59 L.Ed.2d 519 (1979)
[xi] The tax court stated “[w]We do not need to deal here with the validity of the deadline for submitting regulations, for the same reason we did not have to address them in Espinosa, 107 TC, 158: “In the real circumstances, the regulation gives the petitioner here no additional rights, and even if we were to invalidate part of this regulation, according to our analysis by * * *, the petitioner would not prevail. [the statute] and the relevant case law. “
[xii] The contractual aspects of holding the Third Circuit are discussed in Part II of the Adams Challenge post.