Cert Denied in SIH Partners

As expected, the Supreme Court this morning declined to review the Third Circuit’s decision in SIH Partners, thus bringing the litigation to a close.

Supreme Court Poised to Rule on SIH Partners Cert Petition

We noted in our prior coverage of this case that SIH Partners was likely to seek Supreme Court review of the adverse decision it received in the Third Circuit regarding loan guarantees issued by a CFC, even if a grant of certiorari was a longshot.  The Court is now scheduled to consider the taxpayer’s cert petition at its January 10 conference and will likely announce its determination on January 13.

In an effort to interest the Court in the case, the taxpayer chose to focus entirely on the administrative law issues presented by the case, not on the substantive tax issues.  The only questions presented in the cert petition are: “1. Whether the Third Circuit erred in deferring to the IRS regulation under Chevron” and “2. Whether the Third Circuit erred in holding that the IRS is not bound by its own published Revenue Rulings.”

The taxpayer states that these are questions of broad importance in administrative law and argues that the courts of appeals are in conflict in addressing them.  As to the first question, the taxpayer asserts that “the Third Circuit stretched Chevron deference past the point any other court has gone.”  As to the second, the taxpayer quotes the Third Circuit’s statement that a Revenue Ruling “does not bind the IRS” and asserts that other courts have held that the IRS is bound by its own Revenue Rulings.

The government in response asserts that the case does not present any issue warranting the Supreme Court’s attention.  Its brief in opposition shifts the focus away from the broad administrative law questions set forth by the taxpayer and devotes more attention to the substantive tax issues, suggesting that the outcome would have been the same even if the court had agreed with the taxpayer’s Chevron position.  It notes that the court of appeals “devoted only a single paragraph of its opinion” to a recitation of Chevron principles and simply held that Treasury did not act arbitrarily in failing to adopt the regulatory exception sought by the taxpayer.  In any event, the government disputes the assertion of a circuit conflict regarding Chevron, stating that the cases cited by the taxpayer simply reflect different results attributable to different facts.  As to the Revenue Ruling, the government does not take issue with the principle that Revenue Rulings are generally binding on the IRS, arguing that the Third Circuit’s decision should be understood as stating that the Revenue Ruling cited by the taxpayer was “inapposite” in the circumstances of this case because the regulation leaves no room for the facts and circumstances inquiry sought by the taxpayer.  Finally, to the extent the Third Circuit’s view on Revenue Rulings is in tension with other courts of appeals, the government contends that this case “is a poor vehicle” for the Supreme Court to consider that question.

The taxpayer’s reply brief seeks to cut through the complexity of the government’s response, stating that “the IRS tries to defeat certiorari by ignoring what the other circuits have actually said and rewriting both the agency’s explanation for the Regulation and the Third Circuit’s opinion.”

The three Supreme Court filings are linked below.

SIH Petition for Certiorari

Government Brief in Opposition

SIH Reply Brief in Support of Petition

Rehearing Denied in SIH Partners

The Third Circuit today denied a petition for rehearing en banc in SIH Partners.  See our prior reports here.  The taxpayer now has 90 days to file a petition for certiorari.

The petition for rehearing focused more on general administrative law principles than on the substantive section 956(d) issue in the case.  In particular, the petition criticized the panel for applying Chevron deference to a regulation that did little more than parrot the statutory language.  It also argued that the panel erred in stating that the IRS was not bound by a previously published Revenue Ruling.  Given the Supreme Court’s recent interest in regulatory deference issues (and the lack of any reason to believe that it has any particular interest in the taxation of controlled foreign corporations), one can expect that a cert petition, if one is filed, would have a similar focus.  The Court, however, will have many other opportunities to explore Chevron deference further if it so desires, so it is hard to say that the outlook for Supreme Court review in this case is very promising.

SIH Partners – Taxpayer Petition for Rehearing

 

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

Oral Argument Scheduled in SIH Partners

The Third Circuit has scheduled oral argument in the SIH Partners case for Friday March 8, 2019.

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