Daily Tax Update - February 19, 2008

THIRD CIRCUIT VACATES TAX COURT DECISION IN SWALLOWS HOLDING AND UPHOLDS VALIDITY OF THE TIMELY FILING REQUIREMENT OF TREAS. REG. § 1.882-4(a)(3)(i):  On February 15, 2008, the Third Circuit vacated and remanded the Tax Court decision in Swallows Holdings, Ltd. v. Commissioner, 126 T.C. 96 (2006), and upheld the validity of the timely filing requirement of Treas. Reg. § 1.882-4(a)(3)(i). The taxpayer in Swallows Holding was a foreign corporation that earned rental income from property located in the United States. On tax returns filed in 1999, the taxpayer claimed deductions arising in connection with its US rental business for the tax years 1993, 1994, 1995 and 1996. The IRS denied the deductions on the basis the foreign taxpayer failed to satisfy the timely filing requirement of Treas. Reg. § 1.882-4(a)(3)(i), which requires that a foreign taxpayer file a tax return within 18 months of the date on which tax returns are required to be filed under section 6072 in order to claim deductions to offset income effectively connected with a US trade or business. The taxpayer argued in the Tax Court that the timely filing requirement constituted an invalid exercise of rule-making authority because section 882(c)(2) only permitted the IRS to prescribe the “manner” rather than the “time and manner” in which tax returns must be filed to claim deductions to offset income effectively connected with a US trade or business.

  • The Tax Court agreed with the taxpayer and held that section 882(c)(2) did not include a timely filing requirement. The Tax Court held the timely filing requirement of Treas. Reg. § 1.882-4(a)(3)(i) to be an invalid exercise of rule-making authority by applying the standard established in National Muffler, which requires a consideration of six factors set forth in National Muffler to determine the reasonableness of agency action.
  • The Third Circuit vacated and remanded the Tax Court decision. The Third Circuit held that the Tax Court erred in not applying the standard set forth in Chevron in evaluating whether the timely filing requirement of Treas. Reg. § 1.882-4(a)(3)(i) constituted a valid exercise of rule-making authority. In general, under the Chevron standard, an administrative rule will be invalid if (i) the rule is inconsistent with statutory language that is clear and unambiguous or (ii) the administrative rule is not a permissible construction of ambiguous statutory language. Applying the Chevron standard, the Third Circuit held that language of section 882(c)(2) created an ambiguity as to whether the “manner” in which a foreign corporation must file a tax return included a filing deadline. The Third Circuit further held that the timely filing requirement of Treas. Reg. § 1.882-4(a)(3)(i) constituted a permissible construction of the statutory language of section 882(c)(2).

IRS PUBLISHES TAM THAT CHALLENGES FOREIGN TAX CREDIT GENERATOR TRANSACTION:  On February 15, 2008, the IRS published TAM 200807015, which addresses a cross-border financing arrangement that resembles a class of arrangements targeted by the IRS in proposed regulations published on March 30, 2007. The proposed regulations address so-called structured passive investment arrangements (“SPIAs”), which the IRS defines to include financing arrangements that satisfy six conditions set forth in the proposed regulations. The proposed regulations would treat foreign payments made in connection with a SPIA as a noncompulsory payment of tax for which no foreign tax credit may be claimed. The preamble to the proposed regulations provides that the IRS will challenge the claim of foreign tax credits in connection with SPIAs prior to the effective date of the proposed regulations under “all available tools” such as the substance over form doctrine, the partnership anti-abuse rule, debt-equity principles, and the economic substance doctrine. The transaction described in TAM 200807015 appears to be a transaction that the IRS considers to be a SPIA.

  • The transaction described in TAM 200807015 involved a financing arrangement between a US taxpayer and a UK counterparty (the “UK Parent”). The US taxpayer transferred cash to a subsidiary of a UK Parent (the “Issuer”) in exchange for interests that were treated as debt for UK tax purposes and equity for US tax purposes. The Issuer contributed and loaned the proceeds received from the US taxpayer along with cash and debt of the UK Parent to a newly-created subsidiary (“Subsidiary”), which loaned all of the transferred funds to the UK Parent. Issuer and Subsidiary were treated as corporations for UK tax purposes, but as a partnership and disregarded entity, respectively, for US tax purposes. The Issuer incurred losses under UK law by reason of the “interest” payments made to the US taxpayer, and surrendered its losses to the UK Parent under the UK group relief rules. The US taxpayer claimed foreign tax credits for the UK tax paid by the Subsidiary on the interest payments received from the UK Parent.
  • The IRS concluded that the foreign tax credits claimed by the US taxpayer should be disallowed under four alternative theories. First, the IRS held that the payment of UK tax constituted the noncompulsory payment of tax because the Issuer, which was the taxpayer required to minimize its tax liability, failed to do so when it surrendered its losses to the UK Parent rather than to Subsidiary. Second, the IRS concluded that the US taxpayer's interests in Issuer were debt interests rather than partnership interests. As a result, the IRS reasoned that the US taxpayer could not claim foreign tax credits for taxes incurred by Subsidiary. As an alternative approach to debt treatment, the IRS applied substance over form principles to treat the entire transaction as a debt between UK Parent and the US taxpayer with the effect that no foreign income taxes could be paid on the interest income earned by Subsidiary. Third, the IRS invoked the partnership anti-abuse rule of Treas. Reg. § 1.701-2 to recharacterize the transaction as loan from the US taxpayer to UK Parent. Finally, the IRS applied the economic substance doctrine to disallow the claimed foreign tax credits. In applying the economic substance doctrine, the IRS found that the US taxpayers did not have a valid business purpose in entering into the transaction. In addition, the IRS found that the US taxpayer did not increase its pre-tax profit as compared to a direct financing from the US taxpayer to the UK Parent, and increased its return only on an after-tax basis by reason of the foreign tax credits claimed in the transaction.
  • For additional information, contact  Phil Westpwest@steptoe.com; Stan Smilack – ssmilack@steptoe.com

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