Third Circuit Affirms Subpart F Income Inclusion Ruling in SIH Partners

A unanimous Third Circuit this morning affirmed the Tax Court in SIH Partners in an opinion that will please government lawyers who are increasingly dealing with APA challenges to Treasury regulations.  As explained in our previous posts here, the issue in SIH Partners was whether loan guarantees by two CFCs resulted in income exclusions, even though the guarantees were not equivalent to an actual repatriation because, among other things, there were many other guarantors.  Because the regulations on their face set forth a bright-line rule that takes no account of the individual circumstances of particular loan guarantees, the taxpayer argued that the regulations were invalid under the APA as arbitrary and capricious.

The Third Circuit noted “the Tax Court’s masterful analysis rejecting” the taxpayer’s challenge to the validity of the regulations, but it then stated that it did not need to rely on that analysis because the taxpayer’s argument failed for another reason.  The court said that the taxpayer, in arguing that a bright-line rule treating all loan guarantees the same was unreasonable, had pointed to IRS administrative guidance issued over the years that relaxed the rule depending on the circumstances.  The taxpayer, therefore, was asking the court to use “hindsight” in violation of the established rule that the validity of an agency action must be assessed based on the administrative record that was before the agency at the time.  The court did not dispute that experience under the regulation might have demonstrated that “the regulations do not always address economic reality,” but it found that fact immaterial.  The court declared:  “We cannot and will not find half-century old regulations arbitrary and capricious, based on insights gained in the decades after their promulgation, when the challenger . . . has not made a showing that those insights were known or, perhaps, at least should have been known to the agency at the time of the regulations’ promulgation.”  Indeed, the court said that the taxpayer’s argument would be better characterized as complaining about the IRS’s failure to amend the regulations to meet the “later observed economic realities,” instead of a complaint that the regulations were arbitrary when first promulgated.  Since no one requested that the IRS amend the regulations, the court said, this argument could go nowhere.

The court’s “hindsight” criticism seems unfair, as the essence of the taxpayer’s argument was not that the administrative guidance was itself a later event that called for amending the regulations, but rather evidence of an obvious flaw in the bright-line regulation as promulgated that Treasury should have recognized from the start.  The court acknowledged that the taxpayer had made this point in oral argument, but simply responded that regulations do not have to be “the most perfect solution possible.”  In the court’s view, the regulation set forth a “straight-forward” rule that comported with the statutory language and hence was not arbitrary.  The court added that no commenter at the time raised “the possibility of multiple-counting of loan guarantors being an issue with the regulations.”  That suggested that this practice was “exceedingly rare” at the time, which meant that it was hardly unreasonable for the regulation not to address it at the time.

The court then went on to make a couple more observations that may well find their way into  briefs in future cases raising APA challenges to regulations.  The taxpayer had argued that the bright-line rule of the regulation was inconsistent with the policy of the statute, which was to address loan guarantees that were effectively repatriations.  The court did not take issue with the taxpayer’s description of the statutory policy.  Instead, it remarked that “we are satisfied that the regulations are not arbitrary or capricious merely because they may not adhere to the policies embodied in the statutes in every case.”  The court also gave short shrift to the taxpayer’s contention that the regulations lacked enough explanation to satisfy the State Farm requirement of “reasoned decisionmaking.”  The court stated:  “Because the challenged regulations barely rocked the statutory boat [that is, they closely tracked the statutory language], and because of the lack of public commentary and the straight-forward nature of the regulations, little explanation was needed.”

As to the second issue in the case, the court held that the taxpayer was not entitled to the lower tax rate applicable to dividends.  Like the Fifth Circuit in Rodriguez v. Commissioner, 722 F.3d 306 (5th Cir. 2013) (see our reports here), the court held that the fact that the payment could be analogized to a dividend did not actually make it a dividend.

A petition for rehearing is due in 45 days, and, if rehearing is not sought, a petition for certiorari is due in 90 days.  The prospects for the taxpayer to get a favorable result from either of those avenues of further review are probably pretty slim.

Third Circuit Decision in SIH Partners