Today, the Tax Trotter is pleased to present an article by her international tax partner Douglas S. Stransky. This article is the first installment in the 2-part post focusing on the Adams Challenge case.
In today's blog, we look at the most draconian tax rule in the world and examine whether the rule is valid. In addition, we examine a recent United States Tax Court case where the court upheld this draconian rule against a UK company, Adams Challenge (UK) Ltd. v. Commissioner, 154 T.C. 37 (2020).
United States tax law subjects a foreign corporation to U.S. federal income tax on a net basis if such corporation has a U.S. trade or business and income effectively connected with that U.S. trade or business. As the Supreme Court stated in Groetzinger, the phrase "trade or business" has been in the tax code "in over 50 sections and 800 subsections and in hundreds of places in proposed and final income tax regulations [although the Code] has never contained a definition of the words 'trade or business. . . .'").[i] As such, it’s not always clear whether a foreign corporation is conducting some or all of its business in the United States.
If the foreign corporation were to have a U.S. trade or business, then like any U.S. corporation, the foreign corporation would be required 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, then, unlike a domestic corporation, U.S. tax law imposes the most draconian rule in the world on that foreign corporation—all deductions and credits are denied and the foreign corporation must pay U.S. federal income tax on gross income attributed to its U.S. business.
Code section 882(c)(2) provides that a foreign corporation is allowed deductions and credits only if it files a "true and accurate return, in the manner prescribed in subtitle F ...." The plain language of this statutory provision does not specify that the tax return must be filed within a certain time.[ii]
The U.S. Treasury and the IRS first issued regulations interpreting Section 882 in 1957, and these regulations did not require a tax return to be filed within a certain period. In 1990, the regulations were amended to specify that a foreign corporation may only take deductions and credits "if it timely files" a return "in the manner prescribed in subtitle F ...."[iii] The 1990 regulations then provide that the timely basis for filing a tax return is eighteen months after the return's statutory due date.[iv] The Preamble to the 1990 regulations incorrectly stated that, "the statute clearly provides for the denial of deductions and credits if returns are not filed in a timely manner."[v]
The 1990 regulations permit the IRS to waive the filing deadline if the foreign corporation can establish based on the facts and circumstances that it acted reasonably and in good faith in failing to timely file a return.[vi] This waiver would allow a foreign corporation to claim deductions and credits. In June 2020, the IRS reissued a memorandum that provides guidelines for handling requests for a waiver.[vii] Although a discussion of this waiver is beyond the scope of today's blog, we understand that the IRS has set the bar quite high and such waivers are difficult to obtain, 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 because the plain meaning of the statute does not include a timing element. Since Code section 882(c)(2) is clear and unambiguous, the contrary interpretation of Code section 882(c)(2) in the 1990 regulations is unreasonable, and, therefore, the relevant provisions of the regulations are invalid. Because the provisions of the 1990 regulations requiring foreign corporations to file a return within eighteen months of the return’s due date to be eligible for deductions and credits are invalid, a foreign company should be allowed to deduct its expenses effectively connected to its U.S. trade or business even though it filed its tax returns late.
The Tax Court agreed that the regulations were invalid in the 2006 case, Swallows Holding.[viii] In 2008, the Third Circuit Court of Appeals vacated the Tax Court decision.[ix] The Tax Court, in considering this regulation, analyzed it under the factors provided in National Muffler and concluded that the regulation was invalid.[x] In coming to this conclusion, the Tax Court explained that the standard established in National Muffler had not been replaced by Chevron, and that the result under either standard would be the same. The Third Circuit did not agree with the outcome reached by the Tax Court. Instead, the Third Circuit determined that the result would not be the same under Chevron analysis as it would be under National Muffler and that the regulation here should be given "Chevron deference". Chevron deference sets a pretty low bar for accepting statutory interpretation by an administrative agency. An agency's interpretation prevails as long as it is not "arbitrary, capricious, or manifestly contrary to the statute."
Thankfully, taxpayers, other than taxpayers in the Third Circuit, can continue to assert the invalidity of the regulations under the Tax Court's holding in Swallows.
In Adams Challenge, the Tax Court had an opportunity to once again consider Code section 882(c)(2), but because of the facts, the Swallows precedent was not helpful to the taxpayer.
Adams Challenge, a U.K. corporation, did not file a federal income tax return for 2009 or 2010. In 2014, the IRS concluded that Adams Challenge was engaged in a U.S. trade or business and prepared and subscribed returns for the company for those years under Code section 6020(b). Shortly thereafter, the IRS issued Adams Challenge a notice of deficiency determining (among other things) that pursuant to Code section 882(c) the company was entitled to no deductions or credits for 2009 or 2010 because it had failed to file returns. In 2015, Adams Challenge petitioned the Tax Court for a redetermination, claiming the regulation that contains the timely filing requirement was invalid. In 2017, Adams Challenge submitted protective returns for 2009 and 2010 and thereafter filed a motion for partial summary judgment, challenging the disallowance of deductions and credits. The company also claimed that the IRS's actions violated the business profits and the nondiscrimination articles of the bilateral income tax treaty between the United States and the United Kingdom.
The Tax Court held that Adams Challenge was not entitled to the benefit of deductions or credits because it did not submit "returns" for 2009 and 2010 until after the IRS had prepared and subscribed returns for it. The Tax Court did not address the validity of the regulations because here Adams Challenge never filed tax returns; they were filed by the IRS. Thus, under the plain language of the statute, Adams Challenge was not allowed deductions and credits.[xi]
The Adams Challenge case therefore continues to leave the door open for a taxpayer outside of the Third Circuit to argue under the Tax Court's prior precedent in Swallows that the 18-month filing requirement found in the regulations is invalid.
The Tax Court further held that the IRS's interpretation of Code section 882(c)(2) does not violate either the business profits article or the nondiscrimination article of the US-UK Tax Treaty.[xii]
Despite the invalidity of the regulation, the Adams Challenge case serves as a reminder of the severe punishment that a foreign corporation faces when it fails to file a U.S. federal income tax return when one is required. As noted above, it's not always clear whether a foreign corporation has a U.S. trade or business. In those cases of uncertainty, a foreign corporation can file a protective tax return to avoid the cruel result of paying U.S. tax on gross income if the IRS applies Code section 882(c)(2) to deny deductions and credits because no tax return was originally filed. When faced with paying U.S. tax on gross income, a foreign corporation does not want its only options to be arguing that the regulation is invalid or trying to get a waiver from the IRS.
[i] Commissioner v. Groetzinger, 480 U.S. 23, 27 (1987)
[ii] The predecessor to Code section 882(c)(2) was section 233 of the Revenue Act of 1928, which was substantially the same as section 882(c)(2), as it required foreign corporations to file a return "in the manner prescribed in this title" to be eligible for deductions and credits. Congress reenacted section 233 in the Revenue Acts of 1932, 1934, 1936, and 1938, and in the 1939 Code recodification. In 1954, section 233 was re-codified as section 882(c)(1), and Congress changed the section to read "in the manner prescribed in subtitle F," but the House committee report stated 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); I.R.C. Section 6072.
[v] T.D. 8322, 12/10/1990.
[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 Waiver, June 8, 2020.
[viii] Swallows Holding, Ltd. v. Comm’r, 126 T.C. 96 (2006)
[ix] Supra, citing Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 468 U.S. 837 (1984).
[x] National Muffler Dealers Ass'n v. United States, 440 U.S. 472, 477, 99 S.Ct. 1304, 59 L.Ed.2d 519 (1979)
[xi] The Tax Court stated "[w]e have no need to address the validity of the regulatory filing deadline here for the same reason that we had no need to address it in Espinosa, 107 T.C. at 158: "Under the factual circumstances here the regulation confers no additional rights on petitioner, and even if we were to hold some portion of this regulation invalid, petitioner would not prevail under our analysis of * * * [the statute] and the relevant case law."
[xii] The treaty aspects of the Third Circuit holding will be discussed in Part II of the Adams Challenge post.