Tax Law Updates | New Judicial Opinions
November 17, 2008
Third Circuit Upholds IRS' New Timely Filing Regulation
Swallows Holding, Ltd v Commissioner of Internal Revenue
No. 06-3388, U.S. Court of Appeals for the Third Circuit, 2/15/2008
In the Swallows case, the U.S. Court of Appeals for the Third Circuit issued a major decision that strengthens the discretion of administrative agencies to interpret ambiguous provisions of their enabling statutes. Specifically, the Third Circuit upheld the validity of a treasury regulation issued by the Internal Revenue Service ("IRS"), Treasury Regulation 1.882-4(a)(i), that imposes a timely tax filing requirement on foreign corporations seeking deductions and credits. The Third Circuit reasoned that the issuance of this regulation is a task properly within the powers and expertise of the IRS. The Third Circuit based its reasoning on the Chevron case, that the Third Circuit believes, recognizes the notion that the IRS is in a superior position to make judgments concerning the administration of the ambiguities in the Internal Revenue Code ("IRC"). In this case, the IRS found that eighteen months served as a balance between its desire for compliance with the federal tax laws and a foreign corporation’s desire to obtain valuable tax deductions. The Third Circuit therefore reversed the decision of the U.S. Tax Court that invalidated the questioned regulation.
The IRS has appealed a Tax Court decision that held Treas. Reg. 1.882-4(a)(3)(i) to be invalid. Opinion, p. 3. Petitioner-appellee Swallows Holdings, Ltd. (“Taxpayer” or “Swallows”) is a Barbados corporation with two principal shareholders, Raimundo Arnaiz- Rosas and Aurora Elsa Arnaiz. On September 14, 1992, Taxpayer filed its first federal income tax return. In its return, Taxpayer reported that it held real property in San Diego, California.
Between 1993 and 1996, Taxpayer generated rental income from the San Diego property. It was not until 1999, however, that Taxpayer filed returns for tax years 1993, 1994, 1995 and 1996.
A foreign corporation, engaging in trade or business in the United States, is taxed on its taxable income that is connected with the conduct of that trade or business. Id., p. 4, citing 26 U.S.C. § 882(a). Deductions from income are allowed only if they are connected with the “income which is effectively connected with the conduct of a trade or business within the United States.” Id., citing Section 882(c)(1)(a).
However, foreign corporations that do not engage in a trade or business in the United States are taxed at a flat rate of thirty percent of any amount received from sources within the United States. Id., citing Section 881(a). The IRC, generally speaking, does not allow these foreign corporations to claim deductions. Id., citing Section 882(c)(2).
Nevertheless, if a foreign corporation conducts real property activity in the United States, the foreign corporation can treat the income derived from the real property activity as income from a “trade or business,” thus qualifying the foreign corporation to claim tax deductions (e.g., interest and taxes) that are otherwise unavailable. Id., citing Section 882(d)(1).
The dispute in this case arose from the filing deadlines set forth in Treas. Reg. 1.882-4(a)(3)(i),2 which the Secretary of the Treasury promulgated to supplement section 882(c)(2). The regulation requires that a foreign corporation file a return within eighteen months of the filing deadline set in section 6072 in order to claim the real property activity tax deductions.
Here, Taxpayer filed the tax returns in question well after the expiration of the eighteen-month filing period. The Commissioner assessed tax deficiencies accordingly. Taxpayer challenged the Commissioner’s findings in the Tax Court, arguing that Treas. Reg. 1.882-4(a)(3)(i) was an invalid exercise of the Secretary’s rule-making authority. Id., p. 5, referring to Swallows Holdings, Ltd. v. C.I.R., 126 T.C. 96 (2006). The Tax Court granted judgment in favor of Taxpayer, focusing its inquiry on the plain meaning of I.R.C. § 882(c)(2). Specifically, the Tax Court held that section 882(c)(2) requires that foreign corporations file “in the manner prescribed by subtitle F . . ..” Id. at 107.
The Tax Court’s interpretation of the statute centered on the meaning of the word “manner” in the absence of any explicit textual reference to “time.” The court found it persuasive that Congress did not draft the statute with the familiar phrase “time and manner.” The Tax Court noted that Congress placed “time” and “manner” together in several IRC sections, indicating that when Congress intended a time limit to apply, it did so with the phrase “time and manner.” Id., p. 6.
Relying on its earlier opinion in Central Pa. Sav. Association & Subs. v. Commissioner, 104 T.C. 384, 392 (1995), the Tax Court determined that the standard established in National Muffler had not been replaced by Chevron and that the result under either standard would be the same. Id., p. 6. The Tax Court concluded that a consideration of the National Muffler factors demonstrated the unreasonableness of the Secretary’s interpretation of section 882(c)(2) to include the timely filing requirement. Id. , p. 6.
In Chevron, the Supreme Court reasoned that the judiciary was to afford an agency discretion to interpret ambiguous provisions of the agency’s organic enabling statute.
In this appeal, the Third Circuit, applying the Chevron case, reversed the ruling of the Tax Court .Under Chevron, if the statutory language is clear and unambiguous, a court’s inquiry ends and the plain meaning of the statute governs the action. Id., p. 16, citing 467 U.S. at 842-43.
If, however, the statutory provision is ambiguous, such ambiguity is viewed as an implicit congressional delegation of authority to an agency, allowing the agency to fill the gap with a reasonable regulation. Id., pp. 16-17, citing MCI Telecomm. Corp. v. Bell Atlantic-Pa., 271 F.3d 491, 515-16 (3d Cir. 2001).
According to the Third Circuit, the inquiry into the ambiguity of a statutory provision must begin with the text of the statute. The text of the I.R.C. § 882(c)(2) reads in pertinent part: “A foreign corporation shall receive the benefit of the deductions and credits allowed to it in this subtitle only by filing or causing to be filed with the Secretary a true and accurate return, in the manner prescribed in subtitle F, including therein all information which the Secretary may deem necessary for the calculation of such deductions and credits.”
As used in this instance, the word “manner” may be defined as “a characteristic or customary way of acting.” WEBSTER’S DICTIONARY 724 (9th Ed. 1986). Under this definition, the provision is not a clear and unambiguous expression of congressional intent, as one’s “customary way of acting” may include an element of timeliness. Id., p. 18.
Further, Congress’s use of “manner” in I.R.C. § 882(c)(2) prompts contextual ambiguity. Courts could read “manner” to refer to subtitle F, which itself includes timing elements. Id.
As a result, the Third Circuit held that Congress’s use of the word “manner” created ambiguity. Therefore, Congress has not “spoken to the precise question at issue.” Chevron, 467 U.S. at 843. Rather, because I.R.C. § 882(c)(2) is ambiguous, the Third Circuit found that the Secretary was justified in promulgating a rule that prescribed a filing deadline. Id., p. 18.
Because I.R.C. § 6072(c) already provides for a five and one-half month filing period, foreign companies have, in practice, twenty-three and one-half months to submit a “timely” return. Id., pp. 19-20. The Third Circuit thus held that it was not unreasonable for the Secretary to impose such a deadline.
The Third Circuit further held that drawing this temporal line is a task properly within the powers and expertise of the IRS. Id., p. 19. Chevron recognizes the notion that the IRS is in a superior position to make judgments concerning the administration of the ambiguities in its enabling statute.
In this case, the IRS found that eighteen months served as a balance between its desire for compliance with the federal tax laws and a foreign corporation’s desire to obtain valuable tax deductions. Therefore, the Third Circuit reversed the Tax court’s decision that invalidated the questioned treasury regulation.
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