Briefing Completed in SIH Partners

The final briefs have now been filed in the SIH Partners case.  The government’s response to the taxpayer’s opening brief is long, but hammers extensively on one point — namely, that the regulation is “categorical” in establishing that a loan guarantee issued by a CFC will be treated as taxable.  (The word “categorical” appears 29 times in the government’s brief.).  And the government maintains that this “bright-line” rule flows directly from the statutory text.  Given that premise, the government is able to give most of the taxpayer’s arguments short shrift.

In particular, the government says that the settled legal landscape made it easy for tax planners.  If the taxpayer chose to use its CFC to guarantee the loan, then it should accept the predictable tax consequences of that choice, rather than allegedly seeking a “sea change” in the governing rules that would replace a bright-line rule with a facts and circumstances inquiry.  Whether or not the loan guarantee reflects something like an “actual repatriation,” or was actually necessary for credit purposes, or is affected by other guarantors are all “wholly irrelevant” in the government’s view.  

The government similarly disposes of the taxpayer’s administrative law argument.  It states that the statutory text established a categorical rule and the commenters did not argue that Treasury should adopt a non-categorical rule; therefore, the relatively sparse explanation for the regulation was not problematic.  In the government’s words, “that an explanation is brief does not mean that it is inadequate.”  Interestingly, the government goes on to make a fallback argument that it acknowledges was not presented to the Tax Court.  It argues that, even if the regulation is invalid for failure to comply with the APA, the outcome of the case would not change because the statute is “self-executing,” and therefore the statute itself would make the loan guarantee a taxable event.

Finally, the government states that the taxpayer has provided no sound reason for the court not to follow Rodriguez and other lower court decisions that reach the same result, and therefore the taxpayer is not entitled to be taxed at the lower qualified dividend rate.

The taxpayer begins its reply brief by citing to a notice of proposed rulemaking issued 11 days before the government’s brief was filed.  The proposed regulations would “reduce the amount determined under section 956” in certain instances in light of the Tax Cuts and Jobs Act.  The taxpayer argues that the reasoning in the notice contradicts the government’s position because the notice describes the IRS’s “longstanding practice” as trying to “conform the application of section 956 to its purpose,” and thus to try to achieve symmetry between section 956 taxation and actual repatriations of earnings.

Apart from the new proposed regulations, the taxpayer argues that the statutory language governing guarantees did not establish a categorical rule, but rather left the proper tax treatment to be determined by regulation.  Therefore, Treasury had to make a choice and was required to explain the bright-line choice that it made.  And similarly, regulation was required, and the statute cannot be treated as self-executing.  

With respect to the dividend rate issue, the taxpayer urges the court not to follow Rodriguez.  In that connection, it states that the Rodriguez court mistakenly believed that Congress specifically designates when section 951 inclusions are to be treated as dividends, when in fact there are Treasury regulations that treat inclusions as dividends without specific statutory authorization.

Third Circuit to Consider Validity of Subpart F Regulations Governing Loan Guarantees

In SIH Partners v. Commissioner, the Tax Court upheld the IRS’s determination that loan guarantees by two controlled foreign corporations (CFCs) resulted in income inclusions subject to taxation in the U.S. as ordinary income under subpart F. The CFC earnings were actually distributed to the U.S. shareholder in 2010 and 2011 and reported then as qualified dividends taxable at 15 percent. But the IRS determined that, under the section 956 regulations, those earnings should have been taxed at the 35 percent ordinary income rate in 2007 and 2008 when the CFCs served as co-guarantors of loans.

The taxpayer raised three basic objections to the Commissioner’s determination. First, it argued that the regulations implementing Code section 956(d)—the regulations under which the IRS treated the loan guarantees as investments in U.S. property to be included in U.S. income—were invalid under the Administrative Procedure Act. Second, it argued that even if the regulations were valid, there should be no income inclusion under the particular facts and circumstances of the guarantees. Third, it argued that, in any event, the Subpart F income should be taxed at the lower qualified dividend rate because the underlying theory of the section 951 income inclusion is that the guarantee is deemed to be a dividend.

The Tax Court rejected all three arguments. It discussed at length the taxpayer’s argument that Treasury failed “the reasoned decisionmaking and reasoned explanation requirements” of Motor Vehicle Mfrs. Assn. v. State Farm Mut. Automobile Ins. Co., 463 U.S. 29 (1983), because it did not explain the regulatory treatment of guarantees when it issued the regulations back in 1963-64. (Compliance with State Farm has increasingly become an issue in tax cases in recent years. The Tax Court identified a State Farm problem with the cost-sharing regulations in Altera because of Treasury’s failure to address particular comments in the rulemaking (see our report on the Tax Court’s Altera decision here), and the Federal Circuit struck down on State Farm grounds a section 263A capitalization regulation in the Dominion Resources case (see our report here)).

The Tax Court found that the regulatory process for the section 956 regulations complied with State Farm’s reasoned decisionmaking requirement, describing this case as distinguishable from State Farm for several reasons, including that: (1) it “did not reverse previously settled agency policy”; (2) the regulations “were not promulgated contrary to facts or analysis that supported a different outcome”; (3) “Treasury’s decision did not (and could not) purport to rely on findings of fact”; and (4) “no substantive alternatives to the final rules were presented for Treasury’s consideration during the rulemaking process.” The Tax Court was untroubled by the lack of explanation for the regulatory determinations, rejecting the notion that “an on-the-record consideration of any particular factors is required for rulemaking under section 956(d).”

The Tax Court also ruled that the regulations were not “arbitrary and capricious” in imposing a blanket rule that treats any CFC guarantor as holding U.S. property equal to the principal value of the obligation guaranteed. The court stated that the legislative history indicated that “Congress itself thought extensively about which transactions should be treated the same as repatriations of CFCs’ earnings,” and there was nothing to suggest that “Congress expected Treasury to craft ad hoc exceptions based on some sort of facts-and-circumstances test.” Thus, even though the court acknowledged that the blanket rule led to illogical results in some cases where the full amount of the guarantee cannot reasonably be viewed as a repatriation, the court concluded that it “is not manifestly contrary to the statute or unreasonable that the agency would choose a broad baseline rule for pledges and guarantees as opposed to a less administrable case-by-case approach.” Finally, the court observed that it was “relevant,” albeit not dispositive, that the regulations in question had been on the books for nearly 50 years before the guarantee transactions.

Having upheld the validity of the regulations, the Tax Court gave short shrift to the taxpayer’s other contentions. The taxpayer argued convincingly that the circumstances of the guarantees, including the existence of other guarantors, were such that there clearly was no equivalent to an actual repatriation in the full amount of the guarantees. The court declared this evidence “irrelevant” because the regulations were categorical and made “no provision for reducing the section 956 inclusion by reference to the guarantor’s financial strength or its relative creditworthiness.” With respect to denying the lower qualified dividend rate, the court relied on its prior decision in Rodriguez v. Commissioner, 137 T.C. 174 (2011), aff’d, 722 F.3d 306 (5th Cir. 2013), which held that treating a CFC’s investment in U.S. property “as if it were a dividend” under section 956 does not mean that the tax rate for actual dividends should apply. See our prior coverage of Rodriguez here.

The taxpayer has appealed to the Third Circuit, raising the same basic three arguments. In challenging the validity of the regulations, the taxpayer argues primarily that the regulations are arbitrary and “ignore both congressional intent and economic reality” by creating “broad-brush rules” that treat “every CFC guarantor of a U.S. person’s loan as though it has made the full amount of the guaranteed loan.” The taxpayer maintains that even the IRS in its past administrative guidance had recognized that it is arbitrary to ignore particular facts and circumstances showing that a guarantee is not equivalent to a repatriation; hence, the government is staking out new ground with its current position requiring strict adherence to the letter of the regulation. Secondarily, the taxpayer argues that Treasury’s failure to provide a sufficient reasoned explanation for the regulatory rule violated State Farm principles.

Assuming that the regulations are valid, the taxpayer argues that the court of appeals should follow prior IRS guidance and remand the case to the Tax Court to examine the particular facts and circumstances “to determine whether, in substance, there was a repatriation of CFC earnings.” Finally, the taxpayer argues that the Rodriguez case was wrongly decided and therefore the included income should be taxed at no higher than the qualified dividend rate. The taxpayer points out that the government’s theory for accelerating the recognition of income from the actual repatriation date to the earlier guarantee date is that the guarantees were “an investment in U.S. property that is substantially equivalent to a dividend.” If so, the taxpayer argues, the government cannot “simultaneously argu[e] that they are not substantially equivalent to a dividend for purposes of the applicable rate.”

The government’s answering brief is due November 16.

SIH – Tax Court opinion

SIH – Taxpayer Opening Brief

Fifth Circuit Reverses Tax Court in BMC Software

The Fifth Circuit reversed the Tax Court’s decision in BMC Software yesterday. As we speculated that it might at the outset of the case here, the Fifth Circuit’s decision hinged on how far to take the legal fiction that the taxpayer’s accounts receivable created under Rev. Proc. 99-32 were deemed to have been established during the taxpayer’s testing period under section 965(b)(3). While the Tax Court treated that legal fiction as a reality that reduced the taxpayer’s section 965 deduction accordingly, the Fifth Circuit treated that legal fiction as just that—a fiction that had no effect for purposes of section 965: “The fact that the accounts receivable are backdated does nothing to alter the reality that they did not exist during the testing period.” The Fifth Circuit based its decision on a straightforward reading of the plain language of the related-party-indebtedness rule under section 965, holding that for that rule “to reduce the allowable deduction, there must have been indebtedness ‘as of the close of’ the applicable year.” And since the deemed accounts receivable were not created until after the testing period, the Fifth Circuit held that the taxpayer’s deduction “cannot be reduced under § 965(b)(3).”

The Fifth Circuit also rejected the Commissioner’s argument that his closing agreement with the taxpayer mandated treating the deemed accounts receivable as related-party indebtedness. Here, the Fifth Circuit found that the interpretive canon that “things not enumerated are excluded” governed in this case. Because the closing agreement “lists the transaction’s tax implications in considerable detail,” the absence of “a term requiring that the accounts receivable be treated as indebtedness for purposes of § 965” meant that the closing agreement did not mandate such treatment.

BMC Software Fifth Circuit Opinion

Second Circuit Summarily Affirms in Barnes

The Second Circuit did not make the parties wait very long to learn the outcome of the Barnes Group’s appeal from the Tax Court’s imposition of dividend treatment on its multi-step transaction that enabled it to use in the United States cash that was located in Singapore.  See our prior reports here and here.  Little more than a month after oral argument, the court of appeals today issued a summary order affirming the Tax Court in all respects.  The first page of such unpublished orders recites that they “do not have precedential effect,” but they can be cited in future cases pursuant to Fed. R. App. P. 32.1 (albeit only in limited circumstances in the Second Circuit, see 2d Cir. Local Rule 32.1.1).  In any event, the court issued a nine-page opinion briefly touching on the issues.

First, the court of appeals quickly agreed with the Tax Court that the IRS had not run afoul of the principle that it should not argue against its own revenue rulings.  Even though Barnes had relied on Rev. Rul. 74-503 in determining the tax consequences of a key step in the transaction, the court of appeals accepted the Tax Court’s explanation that Rev. Rul. 74-503 could be disregarded because it “addressed the tax treatment of an isolated exchange of stock, and therefore provided no guidance on when the individual steps in an integrated series of transactions will be disregarded under the step transaction doctrine.”

The court then upheld the application of the step-transaction doctrine, agreeing with the Tax Court that the intermediate steps would have been fruitless unless they were part of a single integrated plan.  The court rejected the taxpayer’s argument that the doctrine should not apply because the steps had a valid business purpose, finding that the Tax Court’s contrary finding of no valid business purpose was not clearly erroneous.  Specifically, the court of appeals stated that “any non-tax benefit of including the financing subsidiaries was, at best, a mere afterthought.”  Similarly, the court held that the Tax Court did not clearly err in premising its constructive dividend conclusion on a finding that Barnes failed to show that certain interest or preferred dividend payments were ever made.

Finally, the court of appeals upheld the imposition of the 20% accuracy-related penalty.  It ruled that its previous distinction of Rev. Rul. 74-503 as not applying to a situation involving multiple steps also made that ruling unavailable as “substantial authority” that could eliminate the penalty.  And it ruled that Barnes had no “reasonable cause and good faith” defense because the PwC opinion on which it had relied “does not advise as to the tax consequences of the entire series of transactions transferring funds from ASA to Barnes.”

Barnes – Second Circuit opinion

Briefing Completed in Barnes

All of the briefs have now been filed in the Barnes case.  The government’s response brief defends the Tax Court’s decision as a run-of-the-mill application of substance over form principles.  Quoting from True v. Commissioner, 190 F.3d 1165 (10th Cir. 1999), it argues that the step-transaction doctrine applies because the “Bermuda/Delaware exchanges did not ‘make[ ] any objective sense standing alone’ without contemplation of the other steps.”  In arguing that these steps served no business purpose, the government relies heavily on evidence that the “reinvestment plan” was based on tax planning that the taxpayer’s accountants had previously done for another client.  The government asserts that “Barnes and PwC went to great lengths to create out of whole cloth a business purpose for a tax-avoidance plan that originated in PwC’s database.”  Rather than a legitimate business plan, the government alleges that “the entire repatriation scheme consists of essentially nothing more than a circular flow of funds among Barnes and its wholly owned subsidiaries.”

The government’s brief also notes that, if the court of appeals is unpersauded by the Tax Court’s opinion, it should remand for additional factual determinations to resolve two alternative government arguments that were not reached by the Tax Court:  1) that the transaction had the principal purpose of tax evasion and therefore deductions could be disallowed under Code section 269; and (2) that the Delaware preferred stock was held under the anti-abuse rule of Treas. Reg. § 1.956-1T(b)(4).

With respect to the issue discussed in our previous post regarding the taxpayer’s argument that the government was prohibited from disavowing Rev. Rul. 74-503, the brief largely tracks the Tax Court’s discussion.  In other words, the government does not question the soundness of the principle stated in Rauenhorst that the IRS cannot argue against its Revenue Rulings.  Rather, the brief simply doubles down on the step-transaction point and argues that the taxpayer could not reasonably rely on that ruling here because this case does not involve “bona fide § 351 exchanges.”

With respect to the penalty issue, the government again criticizes PwC’s role, arguing that PwC had a “conflict of interest” in issuing an opinion regarding the transaction because it had an interest in a favorable tax result that would allow PwC to “market [the tax plan] to other corporations seeking to repatriate funds from a controlled foreign corporation.”  Accordingly, the government argues that the taxpayer could not reasonably rely on the PwC letter for “objective advice.”  The government also argues that the taxpayer could not reasonably rely on the opinion because “PwC did not opine on the integrated repatriation scheme as a whole.”

The taxpayer’s reply brief argues that the government’s brief “mischaracterizes the substance of the plan” because the Bermuda and Delaware subsidiaries did not operate as conduits for a dividend payment.  Instead, it accuses the government of making a policy-based argument that would “impermissibly convert Section 956 into an anti-abuse rule.”  The brief then disputes in detail the government’s description of the transaction and underlying facts.

With respect to the penalty issue, the reply brief states that the government “essentially rewrites the Tax Court’s factual findings” in criticizing reliance on the PwC opinion.  The brief notes that PwC was Barnes’ long-time tax advisor and did not market the transaction to Barnes.  It also states that the Tax Court held that the PwC advisor “was a competent professional who had sufficient expertise to justify reliance” and that Barnes “provided necessary and accurate information to the advisor.”  In particular, the reply brief responds to the government’s “conflict of interest” accusation against PwC by noting that the Tax Court specifically observed that there was nothing “nefarious” about PwC keeping tax planning ideas in a database and by asserting that “the government’s unfounded assertions that PwC did not provide an adverse opinion in order to sell the transaction to others is ludicrous and without any factual basis.”  The reply brief also argues that the government is incorrect in stating that the PwC opinion did not address the entire transaction, quoting the PwC opinion itself as stating that it “is premised on all steps of the proposed transaction.”

Oral argument has not yet been scheduled.

Barnes – Government’s Response Brief

Barnes – Taxpayer’s Reply Brief

Briefing Underway in Barnes as Second Circuit Considers Application of Step-Transaction Doctrine to Impose Dividend Treatment on Movement of Foreign Cash

In Barnes Group v. Commissioner, the Tax Court (Goeke, J.) looked askance at the taxpayer’s strategy for minimizing the tax consequences of a movement of foreign cash to U.S. affiliates.  As the taxpayer explained it, its foreign subsidiary in Singapore had excess cash and borrowing capacity that Barnes wanted to use to finance international acquisitions.  For the time being, however, there was no suitable acquisition target, and the cash was earning only 3% in short-term deposit accounts while it could have been used more profitably in the U.S. to reduce Barnes’s expensive long-term debt.  Barnes hired PricewaterhouseCoopers to help it develop an approach to allow the foreign cash to be used in the U.S. without incurring the adverse U.S. tax consequences of a direct loan or distribution to the U.S. parent.

The resulting “reinvestment plan” involved the creation of two new subsidiaries, one in Bermuda and one in Delaware, and two successive contributions of cash in section 351 exchanges – first from Singapore to Bermuda and second from Bermuda to Delaware.  The Delaware subsidiary then loaned the cash to Barnes.  Feel free to examine the opinion linked below for the details of the transaction, but suffice it to say here that a linchpin of the tax planning was reliance on Rev. Rul. 74-503, which concluded that when two corporations exchange their own stock under circumstances similar to the section 351 exchange between the Bermuda and Delaware subsidiaries, they take a zero basis in the stock received.  (Rev. Rul. 74-503 was revoked by Rev. Rul. 2006-2, but the earlier ruling is still relevant in this case because Rev. Rul. 2006-2 is prospective and provides that the IRS will not challenge positions already taken by a taxpayer that reasonably relied on Rev. Rul. 74-503.)  Although Bermuda’s ownership of stock in its Delaware affiliate was an investment in U.S. property under section 956 and therefore would typically result in adverse U.S. tax consequences similar to a distribution, Barnes argued that Bermuda’s basis was zero and therefore that its section 956 inclusion should be zero.

The Tax Court disagreed, holding that the U.S. tax consequences of the transaction were different from those anticipated by Barnes.  The court first determined that Rev. Rul. 74-503 did not preclude the IRS from challenging the taxpayer’s position, giving two reasons.  First, the court briefly stated that, because it believed that “the substance of the reinvestment plan was a dividend from [Singapore] to Barnes” (as it would explain later in the opinion), the court did not “respect the form of the reinvestment plan” and therefore the ruling was irrelevant.  Second, the court said that the ruling was irrelevant in any event because of the “substantial factual differences” between the ruling and this case.  The court acknowledged that the section 351 exchanges, “considered alone, do have factual similarities to the revenue ruling,” but noted that they also were different in that they involved new subsidiaries, including a controlled foreign corporation.  In addition, the Tax Court emphasized that the Barnes transaction was more complex than the one described in the ruling and listed seven “vast factual disparities” between the two situations.  The court, however, devoted  little attention to explaining why these factual differences were material to whether the principle of the ruling should apply here.  Instead, the court simply recited the factual differences and then concluded that, “because the reinvestment plan far exceeded the scope of the stock-for-stock exchange addressed in Rev. Rul. 74-503,” the IRS was not precluded from challenging the taxpayer’s position.

The court then applied a step-transaction analysis to support its holding that “the substance of the reinvestment plan was a dividend” from Singapore to Barnes and should be taxed as such.  According to the court, the step-transaction doctrine provides that “a particular step in a transaction is disregarded for tax purposes if the taxpayer could have achieved its objective more directly but instead included the step for no other purpose than to avoid tax liability.”  The court stated that the doctrine applies if any of three tests are satisfied:  (1) the binding commitment test; (2) the end result test; and (3) the interdependence test.  Finding the third test to be the most appropriate, the Tax Court concluded that the various steps were “so interdependent that the legal relations created by one step would have been fruitless without completion of the later steps.”  The key premise underlying that ultimate conclusion was the court’s determination that there was no “valid and independent economic or business purpose . . . served by the inclusion of Bermuda and Delaware in the reinvestment plan.”  This analysis is an aggressive application of the step-transaction doctrine, taking it beyond its usual sphere, given that the steps ignored by the court were not transitory and that the characterization of the transaction as a dividend did not leave the parties in an economic position consistent with their legal rights and obligations following the actual transaction.

The court further found that Barnes did not “respect the form of the reinvestment plan” as Barnes made no interest payments to Delaware on the loan (even though interest had been accrued) and did not provide sufficient evidence that Delaware made any preferred dividend payments to Bermuda.

Finally, the court rejected the taxpayer’s contention that the reinvestment plan was intended to be a temporary structure under which the Singapore funds would ultimately be invested overseas when the right target appeared, noting that Barnes did not return any funds to Singapore.

The Tax Court also upheld the government’s imposition of a 20% accuracy-related penalty.  The taxpayer raised two defenses to the penalty, arguing that its position was based on “substantial authority” and that it reasonably and in good faith relied on the PwC opinion letter.  The court gave the “substantial authority” argument short shrift, simply repeating that Rev. Rul. 74-503 was “materially distinguishable” and hence should be afforded little weight.  In response to the taxpayer’s additional citation of a 1972 General Counsel Memorandum, the court stated that GCMs “over 10 years old are afforded very little weight.”  Given that taxpayers are generally invited to rely on the legal principles set forth in revenue rulings as precedent (see Treas. Reg. § 601.601(d)(2)(v)(d)), the court’s perfunctory dismissal of the taxpayer’s reliance on Rev. Rul. 74-503 as substantial authority – and consequent imposition of a penalty – appears fairly harsh.

With respect to reliance on the PwC opinion, the court rested its decision on its finding that Barnes and its subsidiaries did not respect the structure of the reinvestment plan by failing to pay loan interest or preferred stock dividends.  In the court’s view, “by failing to respect the details of the reinvestment plan set up by PwC, . . . [the taxpayer] forfeited any defense of reliance on the opinion letter.”

The taxpayer’s opening brief contends that all of these determinations by the Tax Court are erroneous.  The first and longest section of the brief criticizes the court’s step-transaction analysis and ultimate conclusion that the transactions simply amounted to a dividend from Singapore to Barnes.  In the taxpayer’s view, the court’s analysis “invent[s] a new step” of a constructive dividend that “fails to account for all of the commercial realities that continue to this day for the four legally separate corporate entities.”  For example, the taxpayer argues that the evidence showed that Barnes intended to repay the loans and therefore it could not be a constructive dividend.  Much of this portion of the taxpayer’s brief argues that the Tax Court’s key factual findings were clearly erroneous – namely, that the two new subsidiaries lacked a non-tax business purpose; that Barnes paid no interest to Delaware; that no preferred dividends were paid; and that the reinvestment plan was not intended to be temporary.

Second, the brief argues that the government impermissibly disavowed Rev. Rul. 74-503.  The taxpayer points to Rauenhorst v. Commissioner, 119 T.C. 157 (2002), for the proposition that the IRS cannot challenge the legal principles set forth in its own revenue rulings.  It then argues that the factual differences identified by the Tax Court are irrelevant to the rationale for Rev. Rul. 74-503 and thus provide no basis for the government’s failure to abide by that rationale.

It will be interesting, and instructive for other cases, to see how the government deals with this point.  If it is true that revenue rulings are supposed to provide guidance on legal principles on which taxpayers can rely, and if the IRS is constrained to some extent by its own rulings, it would seem apparent that merely identifying factual differences is not enough of a justification for disregarding the legal principles articulated in a revenue ruling.  There are always going to be factual differences, especially when the ruling at issue contains only a brief and generic description of the facts, like Rev. Rul. 74-503.  Will the government question the premise of the taxpayer’s argument in any way?  Or will it accept the taxpayer’s statements about Rauenhorst and limit itself to defending the Tax Court’s position that the facts at issue are so materially different that the rationale of  Rev. Rul. 74-503 cannot reasonably be applied here?  Will it try to buttress the Tax Court’s reliance on the “vast factual disparities” between the two situations or will it simply focus on the argument that the tax effect of any individual step viewed in isolation is irrelevant (and therefore so is the ruling) because the transactions in substance amounted to a dividend?

Third, the taxpayer contests the court’s penalty determination.  With respect to “substantial authority” the taxpayer relies primarily on the earlier discussion in the brief and maintains that it was reasonable to rely on the revenue ruling.  With respect to the good faith argument, the taxpayer repeats its earlier discussion disputing the Tax Court’s finding that it did not respect the form of the transaction.  It also argues that the PwC opinion, in any event, did not even address the loan and preferred dividend details on which the Tax Court rested its findings, and therefore the taxpayer’s alleged failures regarding those details do not undermine its claim of reasonable reliance on the PwC opinion.  Finally, the taxpayer argues broadly that the Tax Court could not rest its good cause determination “on events that occurred after the returns were filed.”

The government’s brief is due May 15.

Barnes – Tax Court opinion

Barnes – Taxpayer Opening Brief

 

Fifth Circuit Rules for Government in Rodriguez

The Fifth Circuit has issued its opinion in Rodriguez, unanimously affirming the Tax Court in an opinion authored by Judge Prado.  As forecasted in our earlier report on the oral argument (see here), the Court saw no way for the taxpayer to get around the technical obstacle that a section 951 inclusion is neither an actual dividend nor expressly denominated by Congress to be a “deemed dividend.”  On the first point, the court stated that “actual dividends require a distribution by a corporation and receipt by the shareholder; there must be a change in ownership of something of value.”  Hence, “Section 951 inclusions do not qualify as actual dividends because no transfer occurs.”  On the second point, the court stated that the taxpayers’ “deemed dividends” argument was “unpersuasive . . . because, when Congress decides to treat certain inclusions as dividends, it explicitly states as much,” pointing to several provisions where Congress has explicitly stated that certain amounts should be treated as dividends.

The court did not express much angst over the unfairness argument made by the taxpayers — namely, that they could have obtained qualified dividend treatment through the formal declaration of a dividend had they only known that Congress was going to implement a more favorable rate for such dividends.  The court recognized that fact, but did not agree that it led to a “harsh and unjust result.”  To the contrary, the court said that the taxpayers had the opportunity to declare a dividend, or take other steps with the accumulated earnings, and those would have carried different tax implications.  But they could not “now avoid their tax obligation simply because they regret the specific decision they made.”  The court also gave short shrift to the taxpayers’ reliance on language in earlier legislative history and IRS pronouncements that described “a conceptual equivalence” between section 951 inclusions and dividend income.”  The court said that these pronouncements carried little weight because the distinction between these inclusions and formal dividends “was treated loosely at the time because it did not carry tax implications” until 2003 when the preferential rate for qualified dividends was implemented.

The taxpayers have 45 days from the July 5 date of decision to seek rehearing, and 90 days to seek certiorari, though there is no reason to believe that either of those avenues for further review would prove to be fruitful.

Rodriguez – Fifth Circuit Opinion

Both Parties Questioned Extensively at Rodriguez Oral Argument

The Fifth Circuit held oral argument in the Rodriguez case before Circuit Judges DeMoss, Dennis, and Prado.  As we have previously reported here and here, the issue in this case is whether the taxpayers can receive qualified dividend income treatment for amounts included in their income under section 951.  Taxpayers’ counsel stated that he had three main arguments:  (1) section 951 is just an anti-deferral statute, not concerned with characterizing the income as dividend or ordinary income; (2) Private Letter Rulings and other Executive Branch announcements had previously characterized section 951 inclusions as “deemed dividends”; and (3) it was unfair, akin to a penalty, to deny dividend treatment to these income inclusions when the taxpayers concededly would have received qualified dividend treatment if they had actually made the distribution that was being imputed.

The court’s questioning at first focused on challenging the taxpayers’ basic point that the section 951 inclusion is essentially indistinguishable from a dividend.  The court pointed out that at best what was involved was something “similar” to a dividend, not an actual dividend, noting that there was no actual distribution.  When taxpayers’ counsel argued that the Code deems other kinds of income to be dividends even in the absence of a distribution, the court rejoined that these examples were distinguishable because they involved explicit statutory language providing that the income should be treated as a dividend.  The taxpayers’ argument appeared to get more traction on the fairness point.  The court observed that the taxpayers probably received legal advice and ought to suffer the consequences if they failed to make a dividend distribution and instead allowed the money to stay in the CFC and be subject to section 951 inclusion.  But this position appeared to soften when taxpayers’ counsel explained that this choice would not have been apparent at the relevant time because it was not until the Bush-era tax cuts were enacted (including the reduced tax rate for qualified dividends) that it made any difference whether the inclusion was treated as a dividend or not.

Government counsel was met with questions as soon as she took the podium and overall had to entertain more questions than did taxpayers’ counsel.  The court initially focused on the fairness point, remarking that the taxpayers had just done what was normally done at the time (before the Bush-era tax cuts) and wondering why they ought not to get the same treatment as if they had actually distributed the dividend.  Government counsel acknowledged that Congress had no specific intent to impose a penalty on people in the taxpayers’ situation, but maintained that there was no basis for giving the taxpayers the relief they seek.  Congress wanted to establish a reduced rate for dividends, but this was not a dividend nor any kind of distribution; it was just imputed income.  Later, government counsel emphasized that there were other respects (apart from the reduced qualified dividend rate) in which the income included under section 951 is not treated as a dividend, such as the effect on earnings and profits.  In response to a question about Congress’s understanding, she argued that Congress did understand that section 951 inclusions were not being treated as dividends and chose not to change that, pointing to a bill that did not get very far that would have explicitly treated them as dividends.  Before the government’s argument concluded, however, the court returned to its starting point, and government counsel conceded that the taxpayers would have received the reduced tax rate if they had just formally distributed the included amount as a dividend.

On rebuttal, the court suggested to taxpayers’ counsel that the taxpayers perhaps ought to live with the consequences of their failure to take advantage of the option of declaring a dividend.  The court also confirmed that the taxpayers could not cite to any binding precedent on point, but instead relied primarily on district court decisions from other jurisdictions.

Given the relative balance in the court’s questioning, neither affirmance nor reversal would be startling.  If I were to hazard a guess, however, the most likely outcome appeared to be the conclusion that the reduced rate applies to “dividends,” and section 951 inclusions, while they may be similar, are not technically “dividends” nor have they been deemed dividends by statute.  If so, the taxpayers may be out of luck.

Supreme Court Rules for Taxpayer in PPL

[Note: Miller & Chevalier filed a brief in this case in support of PPL on behalf of American Electric Power Co.]

The Supreme Court this morning unanimously ruled in favor of PPL in its case involving the creditability of the U.K. Windfall tax.  See our prior coverage here.  The opinion was authored by Justice Thomas, with Justice Sotomayor adding a separate concurring opinion.

The Court’s opinion is fairly succinct.  Viewing the government’s position as more formalistic, the Court stated that it would “apply the predominant character test [of the foreign tax credit regulations] using a commonsense approach that considers the substantive effect of the tax.”  The Court stated that the regulatory test looks to “the normal manner is which a tax applies,” and “the way a foreign government characterizes its tax is not dispositive with respect to the U.S. creditability analysis.”

Applying this approach, the Court held that “the predominant character of the windfall tax is that of an excess profits tax,” which makes it creditable.  By contrast, the Court found that the government’s attempt to characterize the tax as being imposed on the difference between two values was unrealistic, noting that the U.K. statute’s “conception of ‘profit-making value’ as a backward-looking analysis of historic profits is not a recognized valuation method,” but instead “is a fictitious value.”  The Court agreed with PPL’s argument that the equivalency of the tax with a more typical excess profits tax could be demonstrated through an algebraic reformulation of the formula for computing the tax.  The Court addressed this point in some detail, putting this opinion near or at the top of the rankings in the category of most algebraic formulas found in a single Supreme Court opinion.  Declaring that it must look at “economic realities, not legal abstractions,” the Court concluded that it must “follow substance over form and recognize that the windfall tax is nothing more than a tax on actual profits above a threshold.”

Justice Sotomayor’s separate concurring opinion focused on an issue that featured prominently in the oral argument (see our report here) — namely, how the analysis is affected by the way the tax applied to a few “outlier” taxpayers who did not operate for the full four-year period governed by the tax.  Echoing the position taken in an amicus brief filed by a group of law school professors, Justice Sotomayor stated that the treatment of these outliers indicated that “the windfall tax is really a tax on average profits” and ought to be viewed as a tax on a company’s value, not net income.  Justice Sotomayor acknowledged, however, that her position “cannot get off the ground” unless the Tax Court was wrong in stating in Exxon Corp. v. Commissioner, 113 T.C. 338, 352 (1999), that “a tax only needs to be an income tax for ‘a substantial number of taxpayers’ and does not have to ‘satisfy the predominant character test in its application to all taxpayers.'”  Since the government indicated at oral argument that it did not disagree with the Tax Court on that point, Justice Sotomayor concluded that she should not base her analysis of the case on her “outlier” argument and instead would join the Court’s opinion.  Interestingly, Justice Kagan did not join the concurrence even though she was the Justice who appeared at the oral argument to advocate most strongly for the “outlier argument” made in the amicus brief.

For its part, the majority briefly noted this argument in a footnote at the end of its opinion, and stated that it would “express no view on its merits” since the government had not preserved the argument.  Notwithstanding that disclaimer, the body of the Court’s opinion provides ammunition for persons who might wish to oppose Justice Sotomayor’s position in future cases.  The Court stated that the predominant character test means that “a foreign tax that operates as an income, war profits, or excess profits tax in most instances is creditable, even if it may affect a handful of taxpayers differently.”  Another item in the opinion that could find its way into briefs in future foreign tax credit cases is the Court’s observation that the 1983 regulation at issue “codifies longstanding doctrine dating back to Biddle v. Commissioner, 302 U.S. 573, 578-79 (1938).”  In its court of appeals briefing in PPL, the government had denigrated the relevance of pre-regulation case law, stating that the regulations merely “incorporate certain general standards from those cases,” and arguing that PPL “cannot rely on pre-regulation case law—to the exclusion of the specific regulatory test—to make its case.”  The Court’s opinion will lend support to litigants who want to rely on pre-regulation case law in future foreign tax credit cases.

The Court’s opinion in PPL effectively resolves the Entergy case as well.  As we have reported, the government filed a protective petition for certiorari in Entergy, but it has never suggested that PPL and Entergy should be decided differently.  Thus, in the near future, probably next Tuesday, the Court can be expected to issue an order denying that certiorari petition and thereby finalizing Entergy’s victory in the Fifth Circuit.

PPL – Supreme Court opinion

Justices Explore a Variety of Topics in PPL Oral Argument

[Note: Miller & Chevalier filed a brief in this case in support of PPL on behalf of American Electric Power Co.]

Seven Justices (all but Justices Thomas and Alito) asked questions in the oral argument in PPL on February 20, but they did not obviously coalesce around any particular view of the case. Even in cases where the questioning can be more neatly categorized, it is always hazardous to try to predict the outcome based on the questioning at oral argument. At this point, the parties’ work is done, and they are reduced to waiting for a decision, which is likely to come down in May or June — certainly no later than the end of June.

Former Solicitor General Paul Clement argued first on behalf of PPL.  Justice Sotomayor began the questioning of Mr. Clement and asked him the most questions.  She pressed him on why the tax could not be regarded as a tax on value.  She also expressed “fear” over what she saw as the breadth of the taxpayer’s position, characterizing PPL as seeking a rule that a tax is creditable “anytime a tax uses estimates of profits.”  Mr. Clement responded that this “emphatically” was not the taxpayer’s position, explaining that normal valuation is prospective and hence taxes that use future estimates for valuation will always fail the realization requirement for creditability.  In response to Justice Sotomayor’s suggestion that using actual profits was a reasonable way to “find the original flotation value,” Mr. Clement responded that “you would never do that in any normal valuation” because “the first rule of thumb” for those kinds of historical valuations “is to avoid hindsight bias.”

Several other Justices also asked questions of Mr. Clement, focusing on different issues of interest to them.  Justice Kennedy asked a series of questions exploring the significance of the tax being labeled as a tax on value, or reasonably viewed in part as “a tax on low value,” notwithstanding that it is also logically seen as a tax on profits.  Mr. Clement responded that the substance of the tax is “exactly like a U.S. excess profits tax” but did not “look at a normal rubric of value” because “the only measure of value here is by looking at retrospective earnings over a 4-year period.”  Justice Ginsburg asked whether there were other examples of taxes like the U.K. Windfall Tax.  Justice Breyer asked a series of questions exploring the operation and rationale of the tax as it applied to companies that had not been in operation for the full four-year period in which historical profits were measured.  Mr. Clement stated that even these companies did not pay an amount of tax that exceeded their profits and, moreover, that creditability is to be determined by the “normal circumstances in which it applies,” not by the outliers.

One perhaps surprising aspect of the argument was the attention paid to the amicus brief filed by a group of law professors.  Justice Kagan’s extensive questioning of Mr. Clement focused on an argument introduced by that amicus brief – namely, that the tax should not be treated as an income tax because of the way it treats the “short-period” outliers by looking to their average profits, not total profits, in determining the amount of the taxable “windfall” received.  Specifically, the tax rate on those few companies who did not operate for the entire four-year period was higher than for the vast majority of the companies.  Mr. Clement noted that the reason for this was because the taxing authorities “were trying to capture the excess profits during a period in which there is a particular regulatory environment” conducive to excess profits; for the short-period taxpayers the way to do this was to “hit them with a reasonably tough tax in year one but year two, three, and four they were in a favorable regulatory environment and they get no tax at all.”  (Justice Breyer later stated that, “because time periods vary, rates will vary, but I don’t know that that matters for an income tax.”)  Mr. Clement also emphasized here, as he did later to Justice Breyer, that the outlier case does not control creditability, which is determined based on the normal circumstances in which the tax applies.  The amicus brief was also mentioned briefly by Justice Sotomayor.

After Assistant to the Solicitor General Ann O’Connell took the podium, Chief Justice Roberts engaged her on the amicus brief as well, pointing out that the argument discussed by Justice Kagan was “not an argument that you’ve made.”   When Ms. O’Connell agreed, but pointed to the amicus brief, the Chief Justice remarked that “I don’t think we should do a better job of getting money from people than the IRS does.”  In response to Justice Sotomayor, Ms. O’Connell sought to clarify the government’s position by distinguishing between two different points made in the amicus brief.  With respect to the “aspect of the amicus brief that says if it’s bad for one, it’s bad for all,” that is not the government’s position; the government agrees with PPL that outliers do not control credibility.  But with respect to the argument of the amicus that Justice Kagan had discussed in connection with the outliers – namely, that “it taxes average profits, not total profits” – Ms. O’Connell maintained that she was not saying that the argument was wrong, only that the government’s “principal argument” was that the predominant character of the tax “is not an income tax because of the way that it applies to everybody else.”  Justice Kagan took the opportunity to state that she believed the argument developed in the amicus that had formed the basis for her questioning was “the right argument.”

Apart from the amicus brief discussion, Ms. O’Connell was questioned by Justices Scalia and Breyer on whether true valuations are based on historical profits, rather than direct market evidence of value.  She responded that this was a good way to determine the value of the companies at the time of flotation.  In response to questioning from the Chief Justice about how to treat a tax laid on income, Ms. O’Connell stated that a tax just “based on last year’s income” would be an income tax regardless of its label, but if the income were multiplied by a price/earnings ratio, it would be a tax on value.  The topic of deference also made a brief appearance, with Justice Breyer suggesting that deference might be owed to the experts at the Tax Court and Justice Ginsburg wondering whether deference was owed to the government’s interpretation of its own regulations.  The Chief Justice responded to the latter point by remarking that there did not appear to be a major dispute about the meaning of the regulatory language and hence that sort of deference “does not seem to move the ball much.”

Justice Breyer chimed in with a detailed discussion of the mechanics of the tax, suggesting that this indicated that the “heart of the equation in determining this so-called present value is nothing other than taking average income over the four-year period.”  Ms. O’Connell disagreed, and after considerable back-and-forth, Justice Breyer remarked that he had “said enough” and he would go back and study the transcript to decide who was right.

Towards the end of the argument, Justice Ginsburg asked whether the regulation could be changed “so it wouldn’t happen again” if the taxpayer prevailed.  Ms. O’Connell said that perhaps it could be made “even more clear than it already is,” but Justice Breyer wondered why it should be changed to make American companies “in borderline cases have to pay tax on the same income twice.”  Ms. O’Connell disputed that characterization, stating that the taxpayer did get a foreign tax credit for payments it made of the standard British income tax and it would still get a deduction for the U.K. Windfall Tax payments if the government prevailed.  Ms. O’Connell closed her argument by stating that the tax was “written as a valuation formula, and it’s not just written that way, but that’s the substance of what it’s trying to do.”

PPL Oral Argument Transcript

 

 

« Previous Page — Next Page »