In a January 2006 decision, the Tax Court ruled for the taxpayer in Swallows Holding Ltd., 126 TC No. 6, effectively striking down the Sec. 882 requirement that entitles a foreign corporation to take deductions against its gross income, but only if it timely files a U.S. income tax return. The decision will probably have a significant effect on whether foreign corporations decide to file U.S. tax returns, especially when they are uncertain about whether they are supposed to file and/or whether they have been reluctant to file late returns.

Background

In 1990, Treasury amended the regulations under Sec. 882 to include a provision allowing foreign corporations to deduct expenses against their effectively connected income, but only if they timely filed a U.S. tax return. Under these regulations, foreign corporations that failed to timely file could be subject to income tax on their entire U.S. gross income without the benefit of deducting expenses incurred to generate gross income. Under this regime, it was possible to have no actual net income, or even a net loss, yet still incur a significant tax liability. This harsh treatment was one of the most significant factors foreign corporations considered in deciding whether they had a U.S. filing requirement. Foreign corporations that may not have been required to file or that were uncertain about whether to file often decided to file a protective U.S. tax return to avoid the possibility of being disallowed deductions if later it was determined that they should have filed. Prior to the 1990 regulations, the requirement to timely file did not exist.

Taxpayer’s Argument

In Swallows, the Tax Court ruled that Swallows could deduct expenses against its gross income in determining its U.S. tax liability, although the corporation did not timely file its return. Swallows is a Barbados corporation that was incorporated June 1, 1991. It received 160 acres of real estate in California as a capital contribution in November 1991. The corporation’s sole activity was receiving rental and option income related to the real estate.

On Sept. 14, 1992, Swallows timely filed an initial U.S. tax return for its fiscal year ending May 31, 1992. On July 23, 1999, without being contacted by the IRS, Swallows filed U.S. tax returns reporting net losses in tax years 1993–1996. The IRS issued a deficiency notice disallowing all deductions reported on the untimely filed tax returns and assessing tax on Swallow’s gross income. The basis for the disallowance was Regs. Sec. 1.882-4(a)(2), which states, “[a] foreign corporation shall receive the benefit of the deductions and credits otherwise allowed to it with respect to the income tax, only if it timely files…in the manner prescribed in subtitle F, a true and accurate return.”

Swallows argued that language in Sec. 882(c)(2), which allows deductions only if a return is filed in the “manner” prescribed in subtitle F, does not imply a timely filing requirement. Thus, regulations imposing such a requirement are invalid. The Tax Court ruled in favor of Swallows, holding that Treasury does not have the authority to impose a timely filing requirement through issuing interpretive regulations.

Tax Court’s Reasoning

In reaching its decision, the Tax Court took into account several factors. First it considered the history of Sec. 882 and prior rulings surrounding that section. For example, the phrase “in a manner prescribed” is originally found in Section 233 of the Revenue Act of 1928, which was a predecessor to Sec. 882(c)(2). It was found not to include a timely filing requirement in the case of Anglo-Am. Direct Tea Trading Co., 38 BTA 711 (1938), for instance. In that case, the Board of Tax Appeals rejected the notion that the “manner prescribed” condition means a return must be filed timely, citing no explicit reference to time in the statute. Anglo-Am. has been quoted and applied favorably in subsequent cases, with the courts consistently ruling against Treasury.

Section 233 of the Revenue Act of 1928 was reenacted verbatim through subsequent revenue acts until it was slightly modified and changed to Sec. 882 by the 1954 Code. Throughout the various revenue acts, no timely filing requirement was in effect. Unable to litigate the position successfully, Treasury issued Regs. Sec. 1.882-4(a)(2) in 1990, explicitly requiring a timely filed return as a prerequisite for receiving the benefit of deductions. However, in Swallows, the Tax Court felt it “highly improbable that Congress ever intended to include the element of time” with regard to the manner of filing a U.S. tax return; thus it invalidated the interpretive regulations.

The next factor the Tax Court considered in determining the validity of the timely filing requirement under Sec. 882 was the Supreme Court decision in National Muffler Dealers Association, 440 US 472 (1979). National Muffler established that interpretive regulations are valid when they harmonize a statute’s plain language. In Swallows, the Tax Court felt that the timely filing requirement was not part of the Code’s plain language, and thus, the regulations that created that requirement are invalid. In determining that an element of time is not included plainly in the term “manner” in Sec. 882, the Tax Court noted Congress used both the words “time” and “manner” together when it intended to include both meanings. It felt that Congress intentionally did not include the term “time” in the statute, and Treasury used the 1990 regulations to resurrect a failed litigating position.

 The third factor was the decision in National Cable & Telecomm Association v. Brand X Internet Services, 125 S. Ct. 2688 (2005). In this case, the Supreme Court held that prior judicial opinions trump agency interpretations only if a decision follows “from the unambiguous terms of the statute and thus leaves no room for agency discretion.” In Swallows, the Tax Court decided that National Cable was not controlling. In the case, there was no consideration by the Secretary of the Treasury about whether Sec. 882 contains a timely filing requirement, and the issued regulations reversed long-settled law. These were the main factors considered when determining whether new regulations will reverse prior judicial opinions.

Given the long judicial history, prior regulations and the lack of rationale behind the 1990 regulations, the Tax Court felt that established law without a timely filing requirement was unambiguous and thus did not defer to Treasury.

Not a “Blank Check”

The consequences of Swallows will most likely affect the international tax arena significantly. Without the ability to disallow deductions when failing to file timely, the IRS will lose one of its greatest deterrents to nonfiling. Foreign entities that have failed to file a U.S. tax return in the past may choose now to file protective returns, taking advantage of losses that can be carried forward as NOLs. Foreign taxpayers should note however that Swallows is not a blank check for not filing returns. For example, under Sec. 6020(b), the Secretary can prepare a substitute return for any taxpayer that fails to file any return required by law. If the IRS prepares a substitute return on a foreign taxpayer’s behalf, the taxpayer will be deemed not to have filed in the manner prescribed in Subtitle F, and thus will not be allowed deductions from gross income. This consequence should be taken into account by foreign entities that choose simply not to file until they are “caught” by the IRS. These regulations should be followed closely because the IRS will probably challenge Swallows, and Congress might amend the statute to include a timely filing requirement.

From Randall J. Janiczek, CPA, Chicago IL