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Appeals Court Adheres To Precedent, Tells IRS That It's Too Late To Issue Regulations

by Michael J. Miller
Published: February 01, 2001
Source: Canadian Tax Journal

A recent appellate court decision raises the stakes for the Internal Revenue Service (IRS) in cases of statutory construction. Deeming its earlier case law to be controlling, the court gave no weight to an IRS regulation that would have disallowed the foreign tax credits claimed by the taxpayer.

In a recent appellate decision,(1) the US Court of Appeals for the Federal Circuit (the "Court") permitted Bankers Trust New York Corporation and its subsidiaries ("BT") to claim foreign tax credits ("FTCs") for certain putative tax payments made to Brazil in 1980.(2) In so doing, the Court effectively gave no weight to an Internal Revenue Service ("IRS") regulation that would have disallowed the FTCs (the "Regulation"),(3) because the Regulation conflicted with earlier case law.(4) In the view of the Court, the legal doctrine of stare decisis precluded it from considering the merits of the IRS' case in light of the Regulation. The Court's holding placed it squarely at odds with two appellate courts, which have applied the Regulation to disallow FTCs in similar circumstances.

Background

BT had outstanding loans (the "Loans") to Brazilian customers during 1980. Pursuant to the terms of the Loans, the borrowers were required to "gross up" the interest payments for any Brazilian withholding taxes. The Brazilian tax on interest was imposed at a nominal rate of 25%. However, 85% of the tax, which was collected directly from the borrower through withholding, was immediately (if not simultaneously) returned to the borrower as a subsidy. After initially granting taxpayers favorable private letter rulings on this point,(5) the IRS ultimately changed its view, issuing a Revenue Ruling(6) and, subsequently, promulgating the Regulation in support of its new position. The Regulation would disallow FTCs to the extent that any amount, determined by reference to the tax paid, is used to provide a direct or indirect subsidy to the taxpayer; for this purpose, the provision of a subsidy to a borrower-payor would be treated as an indirect subsidy to a lender-payee.(7)

Prior to promulgation of the Regulation, a predecessor of the Court, the US Court of Claims, decided several cases (the "Mexican railcar cases"),(8) that presented substantially the same issue in the context of rental payments made by certain Mexican railroads to unrelated US rental companies.(9) Pursuant to an agreement entered into by the Mexican government, the Mexican railroads, and the American rental companies, a portion of each rental payment was withheld, paid to the Mexican government as a putative tax, and promptly refunded to the Mexican railroads. The Court of Claims considered the refund payments to be wholly an internal foreign matter, and held that FTCs should be allowed for all foreign tax "paid" by the American rental companies.

The decision of the Court of Claims in the Mexican railcar cases is difficult to reconcile with the established doctrine that a transaction should be characterized, for US tax purposes, in accordance with its substance rather than its form.(10) From a "substance-over-form" perspective, it appears that no tax was actually paid; rather, there was a circular flow of cash from the lessee to the lessor,(11) to the Mexican tax authorities, and back to the lessee.(12) It is worth noting that Mexico could have increased its withholding rate (e.g., to 35%) for the year at issue without any economic significance whatsoever, aside from the seemingly gratuitous bounty of FTCs reaped by the US taxpayer.

Taxpayer Prevails on Appeal

The Court in Bankers Trust adhered to the holding of the Mexican railcar cases, effectively ignoring the Regulation, and thus placed itself in clear conflict with two appellate courts, which have applied the regulation to disallow FTCs in similar circumstances.(13) Surprisingly, the Court arrived at this result not because it considered the reasoning of the Court of Claims in the Mexican railcar cases to be persuasive,(14) but on the basis of a broad application of the stare decisis doctrine.

The doctrine of stare decisis (often roughly translated from the Latin as "the law of the case") principally reflects the practical concession that the judicial system would be inadministrable if established common law could not be relied upon, or if every issue were open to reconsideration in each judicial proceeding. Accordingly, under stare decisis, a court will generally overrule a prior court holding on a legal issue only in rare and unusual circumstances. As previously stated by the Court:

Very weighty considerations underlie the principle that courts should not lightly overrule past decisions. Among these are the desirability that the law should furnish a clear guide for the conduct of individuals, to enable them to plan their affairs with assurance against untoward surprise; the importance of furthering fair and expeditious adjudication by eliminating the need to relitigate every relevant proposition in every case; and the necessity of maintaining public faith in the judiciary as a source of impersonal and reasoned judgments.(15)

Applying a broad view of stare decisis, the Court in Bankers Trust considered itself bound by precedent until and unless overturned by the Court en banc.(16) The Court arrived at this conclusion despite the so-called "Chevron doctrine," pursuant to which the courts generally defer to any reasonable agency interpretation of a statute set forth in a regulation, even where the agency's prior regulations have advanced an inconsistent interpretation.(17) According to the Court: "The Chevron doctrine, which requires us to defer to reasonable agency 'gap-filling' interpretations of a statute as expressed in agency regulations, is not in conflict with stare decisis as it applies to this case, which requires adherence to precedential decisions of this court and our predecessor courts."(18)

The Court also noted that the impact of its decision is limited, since Congress codified the Regulation in Section 901(i) of the Code for all foreign taxes paid or accrued in taxable years beginning after December 31, 1986. Code Section 901(i) was not applicable in Bankers Trust, because only BT's 1980 tax year was at issue.

Analysis of the Bankers Trust Decision

Several other courts have considered, in various contexts, whether an agency's regulation can trump a court's established precedent interpreting a statute, and have reached mixed conclusions.(19) Moreover, the approach of the Court of Appeals finds support in a 1996 case decided by the US Supreme Court.(20) Accordingly, it is difficult to dismiss the Court's holding in Bankers Trust as a mere aberration. Nevertheless, in the authors' view, the application of stare decisis in such circumstances is misguided on two counts.

First, to say that the issue presented in Bankers Trust was the same as that presented in the Mexican railcar cases appears too simplistic. Although in both cases the Court was ultimately required to interpret the applicable statute, the analysis required in each case was considerably different. In the Mexican railcar cases, no regulatory guidance was available; consequently, the Court was required to determine which construction of the statute (the taxpayer's or the IRS') was the better interpretation. In Bankers Trust, the Court, pursuant to the Chevron doctrine, was called upon solely to determine whether the Regulation was reasonable. Under this approach, stare decisis would appear to be inapplicable, because the Court had not previously considered the reasonableness of the Regulation.(21)

Second, even if stare decisis were applicable, the Court may nevertheless be criticized for applying the doctrine inflexibly. The term "stare decisis" does not appear in the US Constitution or any statute. Rather, the doctrine is wholly a judicial creation; and what the judiciary creates it can tear asunder.(22) Accordingly, it seems that the Court should have at least considered whether, in light of the Chevron doctrine, and in the interest of uniformity among the circuit courts, an exception might prudently be made.

Implications of the Bankers Trust Decision

Whatever its merits, the impact of the Bankers Trust decision on the IRS' ability to effectively promulgate regulations, especially in the international tax arena, is potentially enormous. For example, if the Court of Appeals for the Eighth Circuit adopts the Bankers Trust approach, the famous "Brown Group Regulations" may not fully apply in the Eighth Circuit.

In the Brown Group cases, the Tax Court and the Court of Appeals for the Eighth Circuit considered whether the aggregate or the entity theory of partnerships should apply for the purpose of determining whether the distributive share of partnership income allocated to a controlled foreign corporation ("CFC") should be classified as "subpart F income."(23) The aggregate-versus-entity issue is an important and complex one because the rules for determining whether an item of income constitutes Subpart F income frequently depend on whether the payee has certain characteristics (e.g., a relationship to the payor), and it is not clear whether such characteristics should be tested at the partner level or the partnership level. Similar aggregate-versus-entity issues arise in a host of other circumstances under US federal income tax law, not just under the rules applicable to CFCs.

In the Brown Group cases, a Cayman Islands limited partnership with a Cayman Islands CFC limited partner earned commission income from the CFC's US parent. The income clearly would have constituted Subpart F income if it had been received from a related person. Although the CFC was considered related to the payor of the commissions, the partnership was technically not considered a related person for the year at issue.(24) Accordingly, the CFC's distributive share of the partnership's commissions would have been characterized as Subpart F income under an aggregate approach, but not under an entity approach.

The Tax Court first held for the taxpayer, applying an entity approach.(25) Upon motion for reconsideration, however, a divided Tax Court withdrew its earlier opinion and adopted an aggregate approach, thus holding in favor of the IRS.(26) The Eighth Circuit, reversed the Tax Court's second decision and held for the taxpayer, finding the entity approach to have been more appropriate, for many of the reasons the Tax Court did in its first opinion.(27)

Subsequent to the Eighth Circuit's decision, the IRS issued a Notice announcing its disagreement with the decision and its intention to issue regulations (the "Brown Group Regulations") in support of the aggregate approach.(28) On September 20, 2000, the IRS proposed such regulations (which previously had been proposed and withdrawn).(29) It is anticipated that the Brown Group Regulations will soon be finalized in substantially their current form.

If the Eighth Circuit adopts the broad view of stare decisis advocated by the Court in Bankers Trust, it appears that taxpayers in that Circuit will be exempt from the Brown Group Regulations in any circumstance in which the regulations produce a result inconsistent with the entity approach taken in Brown Group III, unless the Brown Group issue is addressed by either the Eighth Circuit sitting en banc or the Supreme Court.(30) Such an inconsistency might seem at odds with the interests of sound tax policy.

Indeed, if the Bankers Trust Court's broad view of stare decisis were widely adopted, many more inconsistencies could develop, particularly in the international tax arena, where it is not uncommon for years to pass without comprehensive regulatory guidance under the Code.

For example, many of the regulations governing the treatment of "passive foreign investment companies" ("PFICs") have remained in proposed form since 1992. The proposed regulations take an exceedingly broad view of the class of transactions constituting an "indirect disposition" of PFIC shares,(31) and it is highly unlikely that a court would arrive at such a broad definition in the absence of deference to temporary or final regulations.(32) Accordingly, if a taxpayer were to litigate the "indirect disposition" issue successfully in the absence of temporary or final regulations, the court deciding the case might well disregard any regulations promulgated thereafter.(33)

Similarly, the regulations describing the operation of the "earnings-stripping" provisions have remained in proposed form since 1991. The earnings-stripping rules limit a corporation's ability to "strip away" taxable income through the payment or accrual of "excess interest expense" to a related party (and in certain other cases), where the corporation has a debt-to-equity ratio in excess of 1.5 to 1, and where the corresponding interest income is not subject to US tax. For this purpose, the Code authorizes the IRS to prescribe appropriate regulations, including regulations providing for appropriate adjustments in the case of corporations that are members of an "affiliated group."(34) The definition of "affiliated group" set forth in the proposed regulations is extremely broad, however, including corporations owned through non-US, as well as US, owners.(35) It is highly unlikely that a court would arrive at such a broad definition in the absence of deference to temporary or final regulations. Accordingly, if a taxpayer were to litigate the "affiliated group" issue successfully in the absence of temporary or final regulations, and if the court deciding the case followed Bankers Trust, the court might disregard any regulations promulgated thereafter.

Conclusion

As noted above, Section 901(i) of the Code denies FTCs in circumstances similar to those presented in Bankers Trust, for all foreign taxes paid or accrued in taxable years beginning after December 31, 1986. Accordingly, the Court's precise interpretation of the Code's pre-1987 FTC provisions should, as the Court observed, have "only limited vitality."(36)

The Court's overzealous application of stare decisis, however, may have a far more dramatic impact on the development of US tax law. Indeed, if the Court's view were to prevail, it might be difficult for the IRS to litigate issues of statutory construction effectively, since any loss could preclude the IRS from issuing regulations to reverse the decision (within the jurisdiction of the court deciding the case). In the absence of temporary or final regulations on an issue, the potential benefits of an IRS victory could outweigh the risk of an IRS defeat only in the most clear-cut cases. Presumably, the IRS will attempt to avoid such risks wherever possible by issuing temporary regulations at the earliest opportunity.(37) In the case of any dispute for a period to which temporary (or final) regulations do not apply, the IRS may be more inclined to settle on taxpayer-favorable terms.

Given the importance of this case, it seems likely that the IRS will pursue an appeal to the Supreme Court in Bankers Trust.

FOOTNOTES___________________

1. Bankers Trust New York Corp. v. United States, 225 F.3d 1368 (Fed. Cir. 2000), 2000 US App. Lexis 23503 (hereinafter "Bankers Trust"), rev'g 36 Fed. Cl. 30 (1996).

2. Subject to applicable limitations, Section 901 of the Internal Revenue Code of 1986, as amended (the "Code") generally permits a US taxpayer to claim a credit for the amount of foreign income taxes paid or accrued to a foreign country.

3. US Temp. Treas. Reg. Sec. 4.901-2(f) (1980).

4. In 1986, the US Congress amended Section 901 of the Code, adding new subsection (i) to incorporate the rule set forth in the Regulation. This amendment, however, was not applicable for the year at issue.

5. For example, PLR 761123900A (Nov. 22, 1976).

6. See Rev. Rul. 78-258, 1978-1 C.B. 239.

7. The pertinent portion of the Regulation provides as follows:

(3) Subsidies

(i) General rule. An amount is not income tax paid or accrued to a foreign country to the extent that--

(A) The amount is used directly or indirectly by the country to provide a subsidy by any means (such as through a refund or credit) to the taxpayer; and

(B) The subsidy is determined directly or indirectly by reference to the amount of income tax, or the base used to compute the amount of income tax, imposed by the country on the taxpayer.

(ii) Indirect subsidies. A foreign country is considered to provide a subsidy to a person if the country provides a subsidy to another person that --

(A) Is owned or controlled, directly or indirectly, by the same interests that own or control, directly or indirectly, the first person; or

(B) Engages in a business transaction with the first person, but only if the subsidy received by such other person is determined directly or indirectly by reference to the amount of income tax, or the base used to compute the income tax, imposed by the country on the first person with respect to such transaction.

8. See, e.g., Chicago, Burlington, & Quincy R.R. Co. v. United States, 197 Ct. Cl. 264, 455 F.2d 993 (Ct. Cl. 1972) (hereinafter, "CB&Q RR"); Missouri Pac. R.R. Co. v. United States, 204 Ct. Cl. 837, 497 F.2d 1386 (Ct. Cl. 1974).

9. For all relevant purposes, a precedent of the Court of Claims is treated in the same manner as a precedent established by the Court itself.

10. See e.g., Gregory v. Helvering, 293 US 465 (1935). It should be noted that the taxpayer is not always at liberty to assert this "substance over form" doctrine, but this limited (and often unpredictable) exception is not relevant here. For a general discussion of the topic, see Robert T. Smith, "Substance and Form: A Taxpayer's Right to Assert the Priority of Substance," 44 Tax Law. 137 (1991).

11. Although the withheld amounts were not actually transferred to the lessors, a tax collected through withholding from a payor is generally treated, for US tax purposes, as if first paid to, and then collected from, the payee when the tax is technically considered to be imposed on the payee.

12. Judge Nichols' dissenting opinion in CB&Q RR illustrates most persuasively the illusory nature of the so-called tax at issue therein. CB&Q RR, 197 Ct. Cl. at 321 (Nichols, dissenting in part).

13. Norwest Corp. v. Commissioner, 69 F.3d 1404 (8th Cir. 1995); Continental Ill. Corp. v. Commissioner, 998 F.2d 513 (7th Cir. 1993).

14. The Court conceded that it "might question the wisdom of the Court of Claims decision" in the Mexican railcar cases if it did not consider itself bound by the doctrine of stare decisis. Bankers Trust, 2000 US App. Lexis 23503 at 24.

15. South Corp. v. United States, 690 F.2d 1368 (Fed. Cir. 1982) (quoting Moragne v. States Marine Lines, Inc., 398 US 375 (1970)).

16. It is worth noting that the Court's opinion provides no indication of whether the IRS was afforded an opportunity to argue its case before the Court en banc.

17. Chevron, USA. v. Natural Resources Defense Counsel, Inc., 467 US 837 (1984).

18. Supra footnote 1, at 1376 (Fed. Cir. 2000).

19. See, e.g., Neal v. United States, 516 US 284 (1996); Mesa Verde Construction Co. v. Northern California District Council of Laborers, 861 F.2d 1124 (9th Cir. 1988) (en banc); BPS Guard Services, Inc. v. NLRB, 942 F.2d 519 (8th Cir. 1991); United States v. Joshua, 976 F.2d 844 (3d Cir. 1992).

20. In Neal, supra, the Supreme Court considered whether the interpretations of certain federal Sentencing Guidelines by the US Sentencing Commission (the "Commission") could overrule prior Supreme Court interpretations of the mandatory minimum sentencing statute. Considering "for argument's sake" that the Commission's interpretations were intended to displace the Supreme Court's prior interpretations, the Supreme Court invoked stare decisis to adhere to its prior position. In light of the extraordinary amount of authority delegated to the IRS to administer the federal tax laws, however, it is not clear that the Supreme Court would have reached the same conclusion in a tax case. In addition, it is not clear that the Supreme Court, which by necessity carefully rations its review of lower court decisions, intended to lay down a strict rule of stare decisis for the Courts of Appeals to follow.

21. The Court also implied that the Separation of Powers doctrine prohibits it from permitting an agency to "overturn" any unfavorable court decision by way of regulations, citing the seminal case of Marbury v. Madison, 5 US (1 Cranch) 137, 176 (1803), for the proposition that "[i]t is, emphatically, the province and duty of the judicial department to say what the law is." Bankers Trust, 2000 US App. Lexis 23503 at 25. In the authors' view, it is not clear why the Court's ability "to say what the law is," which may, concedably be limited under the Chevron doctrine where the court has not previously considered an issue, may not be similarly limited in other circumstances.

22. Even the US Supreme Court has departed from precedent in certain circumstances. Neal v. United States, 516 US 284 (1996), quoting Patterson v. McLean Credit Union, 491 US 164 (1989) ("We have overruled our precedents when [an] intervening development of the law has 'removed or weakened the conceptual underpinnings from the prior decision, or where the later law has rendered the decision irreconcilable with competing legal doctrines or policies.'). However one interprets the standard set forth by the Supreme Court for overruling precedent (and whether or not one considers the standard susceptible of meaningful interpretation), it is clear that the doctrine of stare decisis is not absolute. For example, perhaps the most celebrated decision in the history of the United States, Brown v. Board of Education, 347 US 483 (1954), was made possible because the Supreme Court chose to disregard a 58-year old precedent.

23. Pursuant to Subpart F of the Code, certain US persons who own shares of a CFC are generally subject to current taxation on their proportionate shares of any "Subpart F income" earned by the CFC.

24. In 1987, Congress expanded the definition of "related person" to include not only partnerships that control CFCs but also partnerships that are controlled by CFCs. See Code Sec. 954(d)(3). This expanded definition, however, was not applicable to the taxable year at issue in the Brown Group cases.

25. Brown Group, Inc. v. Commissioner, 102 T.C. 616 (1994) (Brown Group I).

26. Brown Group, Inc. v. Commissioner, 104 T.C. 105 (1995) (Brown Group II).

27. Brown Group, Inc. v. Commissioner, 77 F.3d 217 (8th Cir. 1996) (Brown Group III).

28. Notice 96-39, 1996-2 C.B. 209.

29. REG-104537 (63 FR 14613) (the originally proposed regulations); Notice 98-35, 1998-27 I.R.B. 35 (announcing the intention to withdraw the proposed regulations); REG-113909-98 (64 FR 37677) (withdrawing the proposed regulations); REG-112502-00 (Sept. 20, 2000) (reproposing the proposed regulations).

30. Once it were established fairly conclusively that the Eighth Circuit takes this position, the Tax Court would apply the entity approach in all cases appealable to the Eighth Circuit, pursuant to the Golsen doctrine. Under the doctrine established in Golsen v. Commissioner, 54 T.C. 742 (1970), aff'd, 445 F.2d 985 (10th Cir. 1971), the Tax Court will follow the rule adopted by the court of appeals to which the taxpayer would appeal an adverse decision.

31. For example, under the proposed regulations, a US shareholder of an upper-tier PFIC generally would be subject to US tax on a deemed disposition of lower-tier PFIC shares if either (1) the upper-tier PFIC sold a portion of its lower-tier PFIC shares or (2) the lower-tier PFIC issued additional shares to a new investor, thereby diminishing the US shareholder's indirect ownership interest in the lower-tier PFIC. Prop. Treas. Reg. Sec. 1.1291-3(e)(2).

32. Unlike temporary and final regulations, proposed regulations are not entitled to deference. For the purposes of this discussion, it is assumed that the PFIC regulations would be considered valid, although this may be an issue.

33. It is interesting to note that by "forum shopping" a taxpayer may be able, in effect, to effectively "elect" whether or not to apply the regulations. A taxpayer who pays the contested tax and then sues for a refund would file a petition with the Court of Claims, whereas a taxpayer who contests the tax prior to payment would file a petition with the Tax Court.

34. Code Sec. 163(j)(8)(B).

35. See Treas. Reg. Sec. 1.163(j)-5(a)(3).

36. Bankers Trust, 2000 US App. Lexis 23503 at 25.

37. Pursuant to a "sunset rule," set forth in Code Section 7805(e)(2), a temporary regulation expires three years after the date on which it is issued. Accordingly, the IRS will need to finalize any such temporary regulations within three years.