United States: Treasury Regulation Declared Invalid in "Swallows Holding"

In Swallows Holding Ltd. v. Commissioner of Internal Revenue Service, 126 TC No. 6 (January 26, 2006) the Internal Revenue Service (IRS) attempted to disallow all deductions claimed on certain late filed tax returns by a foreign corporation because the returns were filed after the expiration of the 18-month grace period set forth in Treasury Regulation 1.882-4(a). In a detailed and well reasoned opinion, the tax court held that a timely filing requirement is not found in Section 882(c)(2) and further held that the 18-month timely filing requirement in Treasury Regulation 1.882-4(a) is invalid and therefore a foreign corporation need not comply with that requirement in order to secure deductions and credits. The court also made clear, however, that such deductions and credits could nonetheless be disallowed if the IRS files a tax return for the taxpayer because the taxpayer has failed to do so. The IRS has not yet indicated whether it will appeal the decision.

Whether a foreign corporation may claim deductions against its gross income to arrive at taxable income is governed by Section 882(c)(2). Under that section, a foreign corporation shall receive the benefit of the deductions and credits allowed to it only by filing a true and accurate return in the manner prescribed by the Internal Revenue Code. The dispute before the court involved whether the phrase "in the manner" incorporated a requirement that the return be filed within a certain predetermined time period. The case does not address the "true and accurate" requirement.

In Swallows Holding, the taxpayer voluntarily filed with the IRS a Form 1120-F for each of the years at issue (before any contact from the IRS). The court found that when the returns were filed the IRS had no knowledge that the returns were overdue.

After reviewing cases that addressed the timeliness issue under Section 882 and similar prior versions of the code, the court concluded that the use of the word "manner" was not intended by Congress to include any element of time, let alone impose a requirement that a foreign corporation file its return by a certain date in order to deduct its expenses.

The court did distinguish cases where the taxpayer filed returns after the IRS issued a tax deficiency. In such circumstances courts had not permitted any claimed deductions on those returns to offset the deficiency. Thus, even though the tax court held that the regulation imposing an 18-month rule was invalid, as discussed below, a taxpayer nonetheless may not file a tax return at any stage of a tax dispute case and necessarily obtain the benefit of claimed deductions.

In Anglo-Am. Direct Tea Trading Co. v. Commissioner, 38 B.T.A. 711 (1938), the taxpayer received gross income in the form of dividends from a wholly owned domestic corporation. In March 1935, the commissioner learned of the dividends, determined that the taxpayer had not filed federal income tax returns, and discussed this matter with one of the taxpayer’s officers. On or about April 15, 1935, without informing the taxpayer that he was doing so, the commissioner’s revenue agent prepared substitute federal income tax returns. Before the substitute returns were accepted by the commissioner, on April 18, 1935 the taxpayer filed delinquent federal income tax returns that included the dividends in its gross income and claimed corresponding deductions for dividends received. The court allowed the deductions claimed on the late filed return.

In Mills, Spence & Co., 1938 WL B.T.A.M, Oct. 5, 1938, the taxpayer was a foreign corporation that derived income from sources within the United States and was required to file federal income tax returns. On July 19, 1934, the commissioner informed the taxpayer that it had to file tax returns for the years 1930 through 1933. The taxpayer filed those returns on February 21, 1936, reporting net losses for each year. Subsequently, the commissioner issued a notice of deficiency to the taxpayer that disallowed all of the deductions claimed on the returns. On these facts, the board allowed the claimed expenses.

In Taylor Sec., Inc. v. Commissioner, 40 B.T.A. 696 (1939), the commissioner issued a notice of deficiency to a foreign corporation taxpayer. That notice reflected substitute returns that the commissioner had prepared using only the taxpayer’s income. The taxpayer then petitioned the board as to the notice of deficiency, and the commissioner answered the petition. Subsequently, the taxpayer filed its tax returns. The board held that the taxpayer was not entitled to its claimed deductions because it had not filed a return as required by the statute, and distinguished Anglo-Am. Direct Tea Trading Co. v. Commissioner on the grounds that in that case the taxpayer had filed its returns before the notice of deficiency was issued and the returns prepared by the revenue agent had never been accepted by the commissioner.

In Blenheim Co. v. Commissioner, 42 B.T.A. 1248 (1940), the board followed Taylor Sec., Inc. v. Commissioner. The taxpayer in Blenheim was a foreign corporation that filed a personal holding company return (Form 1120H) reporting income consisting only of dividends received from domestic corporations. The commissioner learned that the taxpayer had not filed a corporate income tax return for that year and asked the taxpayer to do so. The taxpayer declined. The commissioner then prepared a substitute return for the taxpayer and issued a notice of deficiency. Thereafter, the taxpayer filed a Form 1120. The board held that the taxpayer could not claim any deductions since its return was filed after both the notice of deficiency and substitute returns were filed. On appeal, the Court of Appeals affirmed. The court stated that when the commissioner allows a reasonable time to pass and then prepares a return, this terminates the period in which the taxpayer may enjoy the privilege of receiving deductions by filing its own return and is consistent with the intent of Congress and with sound administrative procedure.

Espinosa v. Commissioner, 107 T.C. 146 (1996), involved the applicability of Section 874(a) to a nonresident alien taxpayer. In Espinosa, the commissioner mailed a letter to a taxpayer asking him if he had filed returns and, if he had not, instructing him to file returns or otherwise respond. Subsequently, the commissioner wrote the taxpayer a second request, adding that "your tax liability [will be determined] based on the information we have" if the taxpayer did not respond within 20 days.

When the 20-day period expired, the commissioner notified the taxpayer that the commissioner had filed substitute returns for the taxpayer and that the substitute returns had been computed without the benefit of any deductions. The taxpayer then submitted federal income tax returns. The commissioner then issued a notice of deficiency disallowing all deductions.

The Tax Court upheld the commissioner’s determination, deciding that a nonresident alien may not avoid the sanctions of Section 874(a) by filing returns in the period between the time the commissioner has prepared returns for the taxpayer and before the commissioner has issued a notice of deficiency. The court noted that the commissioner, before preparing the substitute returns, had informed the taxpayer that he had not filed a federal income tax return and had given him a reasonable time to do so.

Finally, in Inverworld, Inc. v. Commissioner, T.C. Memo. 1996-301, the taxpayer was a foreign corporation that had not as of the time of trial filed a federal income tax return for any of the relevant years. All those years predated the effective date of the disputed regulations. The taxpayer argued that such a requirement was therefore not applicable to the relevant years. The court did not decide that argument. However, based on the case law summarized above, the court held that Section 882(c)(2) applied to deny the taxpayer the benefit of any deductions for those years because the taxpayer had never filed a return.

From the foregoing cases it is clear that, even if the 18-month rule contained in Regulation 1.882-4 is invalid, the IRS may nonetheless disallow all deductions and credits when the IRS files a return before the taxpayer does. It is not clear how much notice or warning a taxpayer must receive before the filing of such a return results in such disallowance.*

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^{* Any foreign taxpayer considering whether or not to file a tax return should also review various tax elections that must be filed with a timely filed return.}

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