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