SIH Partners LLLP, Explorer Partner Corporation, Tax Matters Partner v. Commissioner

150 T.C. No. 3UNITED STATES TAX COURT
SIH PARTNERS LLLP, EXPLORER PARTNER CORPORATION, TAX
MATTERS PARTNER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3427-15. Filed January 18, 2018.
S was the U.S. shareholder of two CFCs that guaranteed loans
made to a U.S. person. R determined that S must include in its gross
income for the tax years in issue the CFCs’ applicable earnings
pursuant to I.R.C. secs. 951(a)(1)(B) and 956(d). R’s determination
relied on regulations promulgated under I.R.C. sec. 956 (regulations).
R also determined that the amounts included in S’s gross income
should be taxed as ordinary income.
P contends that the regulations are invalid and that in the
absence of valid regulations R’s determination cannot be sustained.
If we sustain R’s determination of the amounts included under I.R.C.
secs. 951(a)(1)(B) and 956(d), P contends that the amounts should be
taxed as qualified dividend income under I.R.C. sec. 1(h)(11).
Held: The regulations are valid, and R correctly determined
that S must include in gross income the CFCs’ applicable earnings for
the tax years in issue.
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Held, further, the amounts included in P’s gross income
pursuant to I.R.C. secs. 951(a)(1)(B) and 956(d) are not qualified
dividend income under I.R.C. sec. 1(h)(11).
Mark D. Lanpher, Robert A. Rudnick, and Kristen M. Garry, for petitioner.
Jeffrey B. Fienberg, Richard A. Rappazzo, and Julie Ann P. Gasper, for
respondent.
OPINION
COHEN, Judge: On November 10, 2014, respondent issued two notices of
final partnership administrative adjustment (FPAAs) to Explorer Partner Corp.
(Explorer Corp.) as tax matters partner for SIH Partners LLLP (SIHP) for tax years
2007 and 2008. In the FPAAs respondent determined that SIHP has income
inclusions under sections 951(a)(1)(B) and 956 of $375,392,988 and $1,697,247
for 2007 and 2008, respectively. In the FPAAs respondent also determined that
the income inclusions for SIHP are not qualified dividend income eligible for the
preferential 15% tax rate under section 1(h)(11).
The issues for consideration are: (1) whether SIHP has income inclusions
under sections 951(a)(1)(B) and 956 in amounts equal to the respective applicable
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earnings of two of its controlled foreign corporations because these entities
guaranteed loans that Merrill Lynch made to Susquehanna International Group,
LLP (SIG), and (2) if SIHP has income inclusions under sections 951(a)(1)(B) and
956, whether the income inclusions are qualified dividend income under section
1(h)(11). These issues are before the Court on the parties’ cross-motions for
summary judgment pursuant to Rule 121. Unless otherwise indicated, all section
references are to the Internal Revenue Code (Code) in effect for the tax years in
issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure.
Summary judgment is intended to expedite litigation and avoid unnecessary
and expensive trials. Fla. Peach Corp. v. Commissioner, 90 T.C. 678, 681 (1988).
Summary judgment may be granted with respect to all or any part of the legal
issues in controversy “if the pleadings, answers to interrogatories, depositions,
admissions, and any other acceptable materials, together with the affidavits or
declarations, if any, show that there is no genuine dispute as to any material fact
and that a decision may be rendered as a matter of law.” Rule 121(b). Respondent
contends that no genuine issue of material fact exists with respect to either issue.
Petitioner challenges the validity of the regulations on which respondent relied in
making the determinations in the FPAAs, and it contends that if we conclude that
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the regulations are invalid then summary judgment in its favor is appropriate. If
those regulations are not invalid, then petitioner contends that issues of material
fact remain in dispute as to whether respondent properly applied the regulations to
the facts and circumstances of this case. We conclude that all facts material to the
Court’s disposition of the cross-motions for summary judgment can be drawn from
the parties’ stipulations and are not reasonably in dispute.
Background
We state the stipulated facts in greater detail than may be necessary so that
the record is complete.
Formation of SIHP
Explorer Corp., a Delaware corporation, is an S corporation for Federal
income tax purposes. During the tax years in issue Explorer Corp. had the
following shareholders: Eric Brooks (Brooks), Joel Greenberg (Greenberg),
Arthur Dantchik (Dantchik), and Jeffrey Yass (Yass).
From the beginning of 2007 through March 2007, Brooks, Greenberg,
Dantchik, Yass, and a fifth individual, Andrew Frost (Frost), were the sole
shareholders of Susquehanna International Holdings, Inc. (SIH Inc.). SIH Inc., a
Delaware corporation incorporated in 1999, was an S corporation for Federal
income tax purposes. In March 2007 SIH Inc. redeemed Frost’s shares. On or
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after March 31, 2007, Brooks, Greenberg, Dantchik, and Yass were the remaining
shareholders of SIH Inc.
On or after April 2, 2007, Brooks, Greenberg, Dantchik, and Yass
transferred the stock of SIH Inc. to Explorer Corp. Following the transfer, SIH
Inc. converted to a limited liability company, which was disregarded as an entity
separate from its owner for Federal income tax purposes, and changed its name to
Susquehanna International Holdings, LLC (SIH LLC). The steps of these
transactions were treated together as a reorganization under section 368(a)(1)(F).
On April 2, 2007, SIHP was formed as a Delaware partnership. On or about
April 3, 2007, Explorer Corp. transferred SIH LLC to SIHP in exchange for a 1%
ownership interest in SIHP. Explorer Corp. is the tax matters partner for SIHP.
From on or about April 3, 2007, through the end of tax years 2007 and 2008
five S corporations owned the remaining 99% of SIHP in varying ownership
percentages. Brooks, Greenberg, Dantchik, Yass, and a fifth individual, Mark
Dooley (Dooley), each owned 100% of one of the S corporations.
SIG US and International Affiliates
During the tax years in issue Brooks, Greenberg, Dantchik, Yass, Dooley,
and Frost owned collectively and through certain entities 100% of the interest in
SIG. SIG and its U.S. affiliates (together, SIG US) constitute an investment firm
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that trades, directly and through various affiliates, most listed financial products
and asset classes. SIG US trades these products primarily through broker-dealers
registered with the U.S. Securities and Exchange Commission. During the tax
years in issue SIHP owned indirectly certain of SIG’s international affiliates.
SIHL and SEHL
From on or about January 1, 2007, to on or about April 2, 2007, SIH Inc.
owned 100% of the stock of Susquehanna Ireland Holdings Limited (SIHL), a
corporation organized under the laws of Ireland. From on or about April 3, 2007,
to on or about December 3, 2007, SIH LLC owned 100% of SIHL’s stock.
Through SIH LLC (an entity disregarded for Federal income tax purposes) SIHP
was treated as owning 100% of SIHL’s stock.
On December 4, 2007, SIHL was acquired by Susquehanna Europe
Holdings Limited (SEHL), a corporation newly organized under the laws of
Ireland and whose tax residency was in Luxembourg. In connection with the
acquisition, SIHL elected to be classified as a disregarded entity for Federal
income tax purposes. This acquisition and election together constituted a
reorganization under section 368(a)(1)(F). From December 4, 2007, through
December 31, 2008, SIHP owned SEHL through SIH LLC and other entities
disregarded for Federal income tax purposes.
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From the beginning of tax year 2007 until its reorganization SIHL was a
controlled foreign corporation (CFC) within the meaning of section 957(a). SIHP
was a “United States shareholder” under section 951(b) with respect to SIHL that
owned within the meaning of section 958(a) 100% of SIHL’s stock. From its
organization and throughout tax years 2007 and 2008, SEHL was also a CFC.
SIHP was a U.S. shareholder of SEHL that owned 100% of SEHL’s stock. SEHL
is the successor to SIHL (together, SIHL/SEHL).
STS
From on or about January 1, 2007, to on or about April 2, 2007, SIH Inc.
owned 100% of the stock of Susquehanna Trading Services, Inc. (STS), a
company organized under the laws of the Cayman Islands that was treated as a
corporation for Federal income tax purposes. From on or about April 3, 2007,
through December 31, 2008, SIH LLC owned the stock of STS. Through SIH
LLC, SIHP was treated as owning STS’s stock.
During tax years 2007 and 2008 STS was a CFC. SIHP was a U.S.
shareholder with respect to STS that owned within the meaning of section 958(a)
100% of STS’ stock.
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Loan Received by SIG
Before 2007, SIG and its affiliates had a longstanding relationship with the
brokerage firm Merrill Lynch. Merrill Lynch acted as prime broker to SIG and its
affiliates. As prime broker, Merrill Lynch cleared securities and commodities
transactions in which SIG and its affiliates engaged, and it held as custodian for
SIG and its affiliates the resulting security and commodity positions from such
trading. Merrill Lynch provided margin loans to SIG and its affiliates, and it held
a security interest in the assets that SIG and its affiliates maintained in accounts at
Merrill Lynch.
The Notes
On October 2, 2007, SIG issued three notes payable to certain Merrill Lynch
affiliates (SIG notes): (1) the Seventh Amended and Restated Promissory Note in
the amount of $1.4 billion between SIG as borrower and Merrill Lynch
International (MLI) as lender; (2) the Amended and Restated Promissory Note in
the amount of $75 million between SIG and Merrill Lynch Professional Clearing
Corp. (ML Pro, and together with MLI, Merrill Lynch); and (3) the Second
Amended and Restated Promissory Note in the amount of $10 million between
SIG and ML Pro. The SIG notes evidenced $1.485 billion in aggregate borrowing
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separate and apart from the margin loans that Merrill Lynch provided in the
ordinary course of its role as SIG’s prime broker.
The Guaranties
On October 2, 2007, SIG also executed jointly with its affiliates the
Amended and Restated Guarantee and Security Agreement (ARGSA). Pursuant to
the ARGSA, 39 entities guaranteed the SIG notes. SIHL and STS were two of the
guarantors of the SIG notes under the ARGSA. The remaining 37 guarantors were
either domestic entities or entities disregarded for Federal income tax purposes.
On December 8, 2007, SEHL executed a Joinder Agreement, in which SEHL
acknowledged that it was a party to and guarantor under the ARGSA. Certain SIG
affiliates under the ARGSA also pledged their assets as collateral for the SIG
notes. SIHL/SEHL and STS were neither pledgors nor pledged entities under the
ARGSA.
Under the ARGSA each guarantor assumed joint and several liability for the
full payment of the SIG notes. The ARGSA included a “pro rata provision” under
which if any guarantor made any payment or suffered any loss pursuant to its
guaranty, then it became entitled to contribution payments from the remaining
guarantors. The provision stated that each nonpaying guarantor would be required
to contribute to the paying guarantor an amount equal to its “pro rata share” of any
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such payment. The ARGSA defined a given guarantor’s “pro rata share” of any
payment as the ratio of funds that the guarantor had received from affiliates since
the date of the ARGSA to the aggregate amount of all funds that all guarantors had
received from affiliates during the same period.
The SIG notes remained outstanding through December 31, 2008. As of
that date, $1.285 billion in principal remained outstanding on the SIG notes. SIG
fully repaid the SIG notes as of December 22, 2011. No guarantor was ever called
upon to pay any amount due under the SIG notes pursuant to its obligations under
the ARGSA.
CFCs’ Earnings & Profits and Distributions
SIHL/SEHL
As of January 1, 2007, SIHL had accumulated earnings and profits of
$360,694,422. Between January and March of 2007, SIHL distributed
$359,600,000 to SIH Inc., before SIH Inc.’s reorganization under section
368(a)(1)(F). For tax year 2007 SIHL/SEHL generated together current earnings
and profits of $293,565,145.
As of January 1, 2008, SEHL had accumulated earnings and profits of
$294,659,567. For tax year 2008 SEHL had a deficit in current earnings and
profits of $148,430,260. SEHL did not make any distributions in 2008.
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STS
As of January 1, 2007, STS had accumulated earnings and profits of
$84,164,022. As of that date, $3,625,469 was previously taxed earnings and
profits, as described in section 959(c)(2). For tax year 2007 STS generated current
earnings and profits of $1,426,209.
As of January 1, 2008, STS had accumulated earnings and profits of
$85,590,231. For 2008 STS generated $1,697,247 of current earnings and profits.
STS did not make any distributions in either 2007 or 2008.
Income Inclusions Determined by Respondent
Respondent determined in the FPAAs that SIHP had income inclusions
pursuant to section 951(a)(1) for the tax years in issue as a result of SIHL/SEHL’s
and STS’ guaranties of the SIG notes. The FPAAs stated that the inclusions were
from the “investment of earnings in U.S. property” by the CFCs.
Discussion
I. The Amount Included Under Sections 951(a)(1)(B) and 956
In the ordinary case, foreign source income earned by a CFC is not subject
to U.S. taxation until it is repatriated in the form of a dividend or other distribution
to the CFC’s U.S. shareholders. Secs. 881 and 882; Dave Fischbein Mfg. Co. v.
Commissioner, 59 T.C. 338, 353 (1972); see also S. Rept. No. 87-1881, at 78
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(1962), 1962-3 C.B. 703, 784. However, under section 951(a), a U.S. shareholder
must include in gross income for the current taxable year its pro rata share of
certain items attributable to the CFC, regardless of whether any distribution was
actually made. This includes “the amount determined under section 956”. See
sec. 951(a)(1)(A) and (B).
The amount determined under section 956 with respect to a U.S. shareholder
for the taxable year is the lesser of: (1) the shareholder’s pro rata share of the
average amount of “United States property” held by the CFC during the taxable
year (less the amount of any previously taxed earnings and profits described in
section 959(c)(1)(A) with respect to that shareholder) or (2) the shareholder’s pro
rata share of the CFC’s “applicable earnings” as described in section 956(b)(1).
Sec. 956(a). Generally the amount taken into account with respect to any property
that is United States property under section 956(a) is its adjusted basis, reduced by
any liability to which the property is subject. Id. (flush language).
Section 956(c) defines United States property that will cause an inclusion
for a U.S. shareholder if held directly or indirectly by the CFC during the taxable
year. United States property includes: (A) tangible property located in the United
States; (B) the stock of a domestic corporation; (C) the obligation of a United
States person; and (D) certain intangible property acquired or developed by the
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CFC for use in the United States. Sec. 956(c)(1). Section 956(c)(2) provides a list
of exceptions for items that would otherwise qualify as United States property
under section 956(c)(1). Property specifically excepted from the definition of
United States property includes, e.g., obligations of the United States and property
located in the United States which is purchased in the United States for export to,
or use in, foreign countries. See sec. 956(c)(2)(A) and (B).
Section 956(d) provides that a CFC “shall, under regulations prescribed by
the Secretary, be considered as holding an obligation of a United States person if
* * * [the CFC] is a pledgor or guarantor of such obligation.” Regulations
prescribe in general (1) when a CFC’s pledge or guaranty will be considered the
same as holding the underlying obligation and (2) the amount of any obligation
considered to be held, for purposes of determining the amount of United States
property held by the CFC as a result of its pledge or guaranty. See, e.g., secs.
1.956-1(e)(2), 1.956-2(c)(1), Income Tax Regs.
As in effect for the tax years in issue, section 1.956-2(c)(1), Income Tax
Regs., provides that “any obligation * * * of a United States person * * * with
respect to which a controlled foreign corporation is a pledgor or guarantor shall be
considered for purposes of section 956(a) * * * to be United States property held
by such controlled foreign corporation.” (Emphasis added.) Under regulations
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that address “indirect” pledges and guaranties, a CFC whose assets serve (even
though indirectly) as security for the performance of an obligation of a United
States person will be considered a pledgor or guarantor of that obligation. Sec.
1.956-2(c)(2), Income Tax Regs. A CFC is not treated as holding United States
property under the general rule of section 1.956-2(c)(1), Income Tax Regs., if it
makes a pledge or guaranty of an obligation of a United States person and that
person “is a mere conduit in a financing arrangement.” Sec. 1.956-2(c)(4), Income
Tax Regs.
Section 1.956-1(e), Income Tax Regs., provides rules for determining the
amount attributable to United States property taken into account under section
956, and section 1.956-1(e)(2), Income Tax Regs., provides the rule for pledges
and guaranties. As in effect for the tax years in issue, section 1.956-1(e)(2),
Income Tax Regs., provides that “the amount taken into account with respect to
any pledge or guarantee * * * shall be the unpaid principal amount on the
applicable determination date of the obligation with respect to which the
controlled foreign corporation is a pledgor or guarantor.” (Emphasis added.)
Respondent contends that the applicable regulations and the undisputed
facts of this case support the determined income inclusions without the need for
additional fact finding. It is undisputed that the CFCs guaranteed obligations (the
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SIG Notes) of a United States person (SIG) and that SIHP was during the tax years
in issue a U.S. shareholder that owned or was considered as owning 100% of both
CFCs’ stock. Respondent contends that the general rule of section 1.956-2(c)(1),
Income Tax Regs., applies to the CFCs’ guaranties and the CFCs are accordingly
considered to have held the underlying obligations under section 956(d).
Respondent contends that the amount of the United States property considered
held by each CFC equaled the unpaid principal amounts of the SIG notes as of the
close of each quarter for which the CFCs remained guarantors. See sec. 1.956-
1(e)(2), Income Tax Regs. The SIG notes remained outstanding and the CFCs
remained guarantors under the ARGSA from October 7, 2007, at least through
December 31, 2008.
Respondent contends that the amounts determined under section 956 that
should be included in SIHP’s gross income under section 951(a)(1)(B) are limited
in this case to the CFCs’ respective applicable earnings for the tax years in issue.
The average unpaid principal amounts of the SIG notes during the tax years in
issue exceeded the CFCs’ applicable earnings for those years as calculated under
section 956(b)(1). The parties have stipulated the CFCs’ applicable earnings for
the tax years in issue.
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Petitioner contends, and respondent does not dispute, that section 956(d) is
not self-executing and that the applicability of section 951(a)(1)(B) and the
amount of the income inclusions at issue can be determined only by reference to
regulations promulgated by the Department of the Treasury (Treasury),
specifically sections 1.956-2(c)(1) and 1.956-1(e)(2), Income Tax Regs.
Petitioner’s principal argument, on which its motion for summary judgment rests,
is that these regulations are invalid. Petitioner contends that in the absence of
valid regulations the income inclusions determined by respondent cannot be
sustained.
II. Validity of Regulations
Petitioner contends that the subject regulations are arbitrary and capricious
under principles of administrative law. It contends that in the process of
promulgating the regulations Treasury failed to engage in reasoned
decisionmaking or to provide a reasoned explanation for the agency’s actions. See
Motor Vehicle Mfrs. Ass’n of the U.S. v. State Farm Mut. Auto Ins. Co., 463 U.S.
29 (1983). It further contends that the regulations are “arbitrary and capricious in
substance” and the rules embodied therein “represent an unreasonable policy
choice in light of the delegating statute and its legislative history.” See Chevron
U.S.A. Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984). Respondent
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contends that the regulations are entitled to deference under Chevron and are
valid.
Summary judgment is an appropriate vehicle for determining the validity of
regulations. See, e.g., Altera Corp. & Subs. v. Commissioner, 145 T.C. 91 (2015).
To address petitioner’s arguments, we must review in detail the history of the
subject regulations.
A. Relevant Legislative History and Administrative Record
1. Revenue Act of 1962
Treasury promulgated the regulations at issue following the passage of the
Revenue Act of 1962 (1962 Act), Pub. L. No. 87-834, sec. 12, 76 Stat. at 1006,
which enacted sections 951 and 956 as part of subpart F of part III, subchapter N,
chapter 1 of the 1954 Code (subpart F) as amended. Pursuant to section
951(a)(1)(B) U.S. shareholders were required to include in gross income their pro
rata shares of a CFC’s “increase in earnings invested in United States property”,
with that amount determined under the provisions of section 956. United States
property was defined in section 956(b)(1) and included the same four categories of
property (including obligations of United States persons) provided for currently
under section 956(c)(1). Section 956(b)(2)(A)-(F) excepted certain items or
transactions from the definition of United States property. Section 956(c),
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concerning the treatment of CFC pledges and guaranties of obligations of United
States persons, was identical to the provision currently enacted as section 956(d).
The Code sections making up subpart F (sections 951 through 964) were
enacted in response to perceived abuses by U.S. taxpayers through the use of
CFCs. See Dougherty v. Commissioner, 60 T.C. 917, 928 (1973) (“In subpart F,
Congress has singled out a particular class of taxpayers, U.S. shareholders, whose
degree of control over their foreign corporation allows them to treat the
corporation’s undistributed earnings as they see fit.”). Generally Congress
intended that sections 951(a)(1)(B) and 956 would operate “to prevent the
repatriation of income to the United States in a manner which does not subject it to
U.S. taxation.” H.R. Rept. No. 87-1447, at 58 (1962), 1962-3 C.B. 405, 462. The
report of the Senate Finance Committee accompanying the 1962 Act noted that
“[g]enerally” untaxed CFC earnings invested in United States property are taxed to
U.S. shareholders on the grounds that the use of such funds for domestic
investment is a benefit, which “is substantially the equivalent of a dividend being
paid to them.” S. Rept. No. 87-1881, supra at 88, 1962-3 C.B. at 794. Congress
provided specific exceptions under section 956(b)(2) because in its belief these
items, although technically investments in domestic property, constituted “normal
commercial transactions without the intention to permit the [CFC’s] funds to
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remain in the United States indefinitely”. S. Rept. No. 87-1881, supra at 88,
1962-3 C.B. at 794.
2. Proposed and Final Regulations
On April 11, 1963, Treasury issued a Notice of Proposed Rulemaking,
which set forth and solicited public comment on a package of regulations
proposed under sections 955, 956, and 957(c). 28 Fed. Reg. 3515 (Apr. 11, 1963).
Written comments received in connection with the proposed rulemaking included
some relating to the proposed regulations under section 956. None of these
comments raised concerns specifically as to the rules for pledges and guaranties in
sections 1.956-2(c)(1) and 1.956-1(e)(2), Proposed Income Tax Regs., 28 Fed.
Reg. 3549, 3550 (Apr. 11, 1963). The American Bar Association Section of
Taxation submitted one comment that referenced “the general rule as to the
treatment of pledges and guaranties”, and which suggested that the proposed
exception for guaranties made pursuant to “conduit arrangements” should be
broadened. A public hearing was held on June 20, 1963.
On February 20, 1964, Treasury adopted as final the proposed regulations
under section 956, subject to certain changes. T.D. 6704, 1964-1 C.B. (Part 1)
284. The preamble to the Treasury Decision stated the final regulations were
promulgated “to conform * * * [the Income Tax Regulations] to section 956 of the
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Internal Revenue Code of 1954, as added by section 12(a) of the Revenue Act of
1962” and stated they were adopted “[a]fter consideration of all such relevant
matter as was presented by interested persons regarding the rules proposed”. Id.The Treasury Decision stated that the regulations were issued under the authority
contained in section 7805. Id., 1964-1 C.B. (Part 1) at 296. Sections 1.956-
2(c)(1) and 1.956-1(e)(2), Income Tax Regs., were adopted substantially
unchanged from the proposed regulations. The exception for CFC guaranties
made pursuant to conduit financing arrangements was extensively revised and
broadened. Compare sec. 1.956-2(c)(2), Proposed Income Tax Regs., 28 Fed.
Reg. 3550 (Apr. 11, 1963), with T.D. 6704, 1964-1 C.B. (Part 1) at 293-294.
3. Statutory Amendments
The Omnibus Budget Reconciliation Act of 1993 (OBRA), Pub. L. No. 103-
66, 107 Stat. 312, modified the “structure and operating rules” of section 956.
H.R. Rept. No. 103-111, at 692 (1993), 1993-3 C.B. 167, 268. Sections
951(a)(1)(B) and 956(a) were amended to read in their current forms. See OBRA
secs. 13232(a), (c), 107 Stat. at 501-502. OBRA did not amend substantively the
Code sections defining United States property or requiring generally that pledgors
or guarantors of obligations of United States persons be treated as holding such
property. OBRA redesignated section 956(b) (defining United States property)
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and (c) (relating to pledges and guaranties) as section 956(c) and (d), respectively,
but otherwise it reenacted those two provisions fully. For the tax years in issue the
rules under sections 1.956-2(c)(1) and 1.956-1(e)(2), Income Tax Regs., were the
same as the final rules adopted in 1964.
B. Analysis Under Principles of Administrative Law
1. Legislative Rules and APA Section 553(b)
A distinction is drawn in administrative law between interpretive and
substantive (or legislative) agency rules. An interpretive rule merely clarifies or
explains preexisting substantive law or regulations. Elizabeth Blackwell Health
Ctr. for Women v. Knoll, 61 F.3d 170, 181 (3d Cir. 1995). A legislative rule, by
contrast, “creates rights, assigns duties, or imposes obligations, the basic tenor of
which is not already outlined in the law itself”. Dia Navigation Co. v. Pomeroy,
34 F.3d 1255, 1264 (3d Cir. 1994) (quoting La Casa Del Convaleciente v.
Sullivan, 965 F.2d 1175, 1178 (1st Cir. 1992)). Legislative rules, unlike
interpretive rules, have “the force and effect of law”. Chrysler Corp. v. Brown,
441 U.S. 281, 303 (1979); see also Chao v. Rothermel, 327 F.3d 223, 227 (3d Cir.
2003).
The regulations at issue are legislative rules. The adjustments determined
for SIHP’s income can only be sustained on the basis that the regulations properly
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apply to the CFCs’ guaranties, and we would be unable to determine whether and
in what amount the guaranties should cause an income inclusion for SIHP for the
tax years in issue absent the rules expressed in the regulations. Thus they
“impose[ ] obligations” not specifically outlined in the governing statute. In
promulgating the regulations Treasury invoked section 7805, under which it is
delegated authority to “prescribe all needful rules and regulations for the
enforcement of” the Code. Such regulations carry the force of law, and the Code
imposes penalties for failing to follow them. See Altera Corp. v. Commissioner,
145 T.C. at 116.
Legislative rules, because they “create new law, rights, or duties”, are
subject to the notice and comment requirements of the Administrative Procedure
Act (APA), 5 U.S.C. sec. 553(b) (2012). SBC Inc. v. FCC, 414 F.3d 486, 497 (3d
Cir. 2005). Pursuant to APA sec. 553(b) and (c) an agency promulgating
regulations by informal rulemaking must (1) publish a notice of proposed
rulemaking in the Federal Register, (2) provide “interested persons an opportunity
to participate * * * through submission of written data, views, or arguments”, and
(3) “[a]fter consideration of the relevant matter presented, * * * incorporate in the
rules adopted a concise general statement of their basis and purpose.” These
procedures are intended to assist judicial review and “to provide fair treatment for
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persons affected by a rule.” Home Box Office, Inc. v. FCC, 567 F.2d 9, 35 (D.C.
Cir. 1977).
The administrative record reflects that Treasury’s rulemaking for the
legislative rules at issue complied with the requirements of APA sec. 553(b).
Petitioner does not dispute that the agency properly promulgated the regulations
by notice and comment. Nevertheless, we reach a determination as to this issue,
and it is relevant insofar as petitioner contends that the agency’s procedures in
promulgating the regulations were inadequate. Petitioner contends that Treasury
failed to satisfy “the reasoned decisionmaking requirement and the reasoned
explanation requirement”.
2. Procedural Requirements Beyond Notice and Comment
Congress may provide in the governing statute that rules thereunder are to
be promulgated pursuant to more formal procedures than those required under
APA sec. 553(b). See APA secs. 553(c), 556, 557; see also United States v.
Allegheny-Ludlum Steel Corp., 406 U.S. 742, 756-757 (1972). However, absent a
specific congressional directive the Supreme Court has held “that generally
speaking * * * [APA sec. 553(b)] established the maximum procedural
requirements which Congress was willing to have the courts impose upon agencies
in conducting rulemaking procedures.” Vt. Yankee Nuclear Power Corp. v.
- 24 -
Natural Res. Def. Council, Inc., 435 U.S. 519, 524 (1978); see also FCC v. Fox
Television Stations, Inc., 556 U.S. 502, 513 (2009) (the APA “sets forth the full
extent of judicial authority to review executive agency action for procedural
correctness”). There may be circumstances that “justify a court in overturning
agency action because of a failure to employ procedures beyond those required by
* * * [APA sec. 553(b)]”; however, “such circumstances * * * are extremely rare.”
Vt. Yankee, 435 U.S. at 524.
APA sec. 706(2)(A) provides that a reviewing court shall in all cases hold
unlawful and set aside agency action that is “arbitrary, capricious, an abuse of
discretion, or otherwise not in accordance with law”. Pursuant to this standard an
agency must “articulate a satisfactory explanation for its action.” State Farm, 463
U.S. at 43. We must determine in the light of that explanation whether the
agency’s decision “was based on a consideration of the relevant factors and
whether there has been a clear error of judgment.” Bowman Transp., Inc. v.
Arkansas-Best Freight Sys., Inc., 419 U.S. 281, 285 (1974) (quoting Citizens to
Pres. Overton Park, Inc. v. Volpe, 401 U.S. 402, 416 (1971), abrogated on other
grounds by Califano v. Sanders, 430 U.S. 99 (1977)). The scope of our review “is
a narrow one” and “the court is not empowered to substitute its judgment for that
of the agency.” Id. Although a court cannot provide a reasoned basis for the
- 25 -
agency’s decision if the agency itself did not provide one, a court must “uphold a
decision of less than ideal clarity if the agency’s path may reasonably be
discerned.” Id. at 286.
Petitioner relies on State Farm in arguing that an agency is bound in every
case to meet “the reasoned decisionmaking and reasoned explanation
requirements” and that Treasury’s procedures failed to satisfy these requirements
in respect of the final rules adopted for pledges and guaranties. In State Farm the
Supreme Court held that an agency’s decision to rescind a prior regulation was
arbitrary and capricious under APA sec. 706(2)(A). In so holding the Supreme
Court concluded that the agency’s action was arbitrary and capricious because it
“failed to present an adequate basis and explanation” for its decision. State Farm,
463 U.S. at 34. The Supreme Court wrote:
Normally, an agency rule would be arbitrary and capricious if the
agency has relied on factors which Congress has not intended it to
consider, entirely failed to consider an important aspect of the
problem, offered an explanation for its decision that runs counter to
the evidence before the agency, or is so implausible that it could not
be ascribed to a difference in view or the product of agency expertise.
* * * [Id. at 43.]
Treasury’s actions in promulgating the regulations at issue must be set aside
if its procedures failed to satisfy the general standard under APA sec. 706(2)(A).
However, the facts surrounding the agency action in State Farm are inapposite,
- 26 -
and the concerns that led the Court in that case to review more stringently the
agency’s process are not presented here.
The agency action in State Farm, 463 U.S. at 35, represented a clear and
abrupt reversal in agency policy, and the earlier policy was supported by a
substantial body of facts developed by the agency itself. A number of facts
continued strongly to support the initial rule over the rescission, and it was
significant in the Court’s view that Congress intended all agency findings under
the governing statute to be “supported by ‘substantial evidence on the record’”.
Id. at 43-44, 47-48. The Court stated that “an agency changing its course must
supply a reasoned analysis”. Id. at 57 (quoting Greater Boston Television Corp. v.
FCC, 444 F.2d 841, 852 (D.C. Cir. 1970)). Moreover, the Court found that the
agency’s decision to rescind the rule failed to consider an obvious modification
that would have left the rule in place and continued to promote the statute’s
purpose. See id. at 46-48. Congress had expressly stated its intention that “safety
shall be the overriding consideration in the issuance of standards” under the
governing statute, and the Court suggested the agency may have given improper
weight to other factors in its analysis. Id. at 55.
Under the circumstances in State Farm, the Supreme Court concluded that
the agency must provide a more extensive reasoned analysis and explanation in
- 27 -
order to demonstrate that its actions were not arbitrary, capricious, or otherwise
not in accordance with the law. In remanding the matter to the agency the Court
stated that in the light of specific “limitations of the record” the agency’s
explanation was “not sufficient to enable us to conclude that the rescission was the
product of reasoned decisionmaking”. Id. at 52. The Court rejected the notion
that in reviewing the agency’s action under APA sec. 706(2)(A) it was
“impos[ing] additional procedural requirements upon the agency.” State Farm,
463 U.S. at 50 (citing Vt. Yankee, 435 U.S. 519).
The regulations at issue did not reverse previously settled agency policy,
and they were not promulgated contrary to facts or analysis that supported a
different outcome. Treasury’s rulemaking in this case differs fundamentally from
the agency action in State Farm because Treasury’s decision did not (and could
not) purport to rely on findings of fact. Treasury’s actions promulgating the rules
for pledges and guaranties reflect at most the implementation of a policy
judgment. The administrative record reflects that no substantive alternatives to the
final rules were presented for Treasury’s consideration during the rulemaking
process. The agency did not act arbitrarily or capriciously by failing to address
contrary viewpoints or findings of fact that were never developed or presented.
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Petitioner contends that the regulations are not the product of reasoned
decisionmaking because Treasury failed to consider during the rulemaking
“important aspect[s] of the problem” associated with CFC pledges and guaranties.
See id. at 43. Petitioner provides a list of factors that it contends are relevant as to
“whether a given CFC guarantee can be considered a repatriation of earnings”.
Petitioner contends that the agency was obligated under the governing statute to
weigh and balance these factors (and possibly others) to promulgate rules
consistent with “the underlying purposes of section 956”.
We do not agree that an on-the-record consideration of any particular
factors is required for rulemaking under section 956(d). The plain text of the
statute does not require the agency to engage in a process of balancing or to
provide an analysis of its decisionmaking based on the factors that petitioner
identifies. Congress stated clearly in the statute that any CFC guarantor of any
obligation of a United States person “shall * * * be considered as holding” the
underlying obligation. With respect to other issues concerning guaranties that are
not addressed expressly in the statute (for example, the amount of United States
property that the CFC should be treated as holding by reason of its guaranty),
Congress used broad delegative terms in section 956(d). Generally we would not
impose additional procedural requirements on any administrative proceeding
- 29 -
without a clear indication that Congress intended additional procedures to be
observed.
Apart from the text of the statute, nothing in the statute’s legislative history
directs Treasury to promulgate rules in consideration of whether a particular
guaranty causes an effective repatriation or in consideration of “economic
realities” as petitioner sees them. The purpose underlying section 956 generally is
“to prevent the repatriation of income”, H.R. Rept. No. 87-1447, supra at 58,
1962-3 C.B. at 462, that is “substantially the equivalent of a dividend” to the U.S.
shareholder, S. Rept. No. 87-1881, supra at 88, 1962-3 C.B. at 794. However, we
find no support for the proposition that Congress intended rulemaking under
section 956(d) to focus minutely on economic factors, which may or may not
indicate in what amount a particular guaranty constitutes a repatriation of
earnings. We do not conclude that Congress intended the amount deemed
effectively repatriated to be an “important aspect of the problem” associated with
guaranties that Treasury was bound to consider or give special weight to in
promulgating rules under the statute. See State Farm, 463 U.S. at 43.
The preamble to the final rules stated that they were intended “to conform”
the Income Tax Regulations to section 956, which they clearly and
straightforwardly do. Put simply, the statute at issue and the rules adopted did not
- 30 -
require Treasury to engage in the level of detailed empirical analysis that the Court
in State Farm found was integral to the rulemaking. Petitioner’s focus on the
“reasoned decisionmaking and reasoned explanation requirements” as it
understands those requirements to be taken from State Farm is misplaced.
Treasury’s rulemaking complied with the requirements of notice and
comment under APA sec. 553(b). APA sec. 706(2)(A) imposes in addition a
“general ‘procedural’ requirement of sorts by mandating that an agency take
whatever steps it needs to provide an explanation that will enable the court to
evaluate the agency’s rationale at the time of decision.” Pension Benefit Guar.
Corp. v. LTV Corp., 496 U.S. 633, 654 (1990). We conclude that Treasury’s
procedures in this case satisfied this general requirement and were not arbitrary or
capricious. The agency’s path “may reasonably be discerned”. Bowman Transp.,
419 U.S. at 286.
Treasury’s proposed and final rules concerning CFC pledges and guaranties
sought to implement the clear wording of the statute and to equate the treatment of
these transactions with the treatment of items of United States property under the
statute. The generally applicable rule in section 1.956-2(c)(1), Income Tax Regs.,
that “any obligation” of a United States person with respect to which a CFC is a
guarantor shall be treated as United States property held by the CFC, restates in
- 31 -
essence the text of the statute. The agency made no clear error in judgment by
adopting the rule that it did, rather than undertaking to consider a more nuanced
rule of the sort petitioner advocates to govern a deemed effective repatriation. As
we have said, the statute makes no mention of an effective repatriation standard,
and we can find no grounds for imposing such a standard.
The rule for the amount of United States property considered held by reason
of a pledge or guaranty likewise adheres to the text of the statute. Under section
1.956-1(e)(2), Income Tax Regs., the amount treated as held by the CFC for its
guaranty will in most cases equal the amount the CFC would have been treated as
holding had it held the underlying obligation (i.e., the principal amount of the
obligation). The general rule under section 956(a) is that the amount of any
United States property taken into account is its adjusted basis, and ordinarily a
lender takes a basis in a loan equal to the unpaid principal amount.
Treasury’s decisionmaking was uncomplicated, but that does not mean the
administrative process was arbitrary or otherwise deficient under the standard
articulated in APA sec. 706(2)(A). No comments, significant or otherwise, were
raised by interested parties during the rulemaking. As a reviewing court, we
cannot demand that an agency engage in and document an exhaustive review of
hypothetical “aspect[s] of the problem” that no one has raised and which Congress
- 32 -
has not asked the agency to consider. So long as an agency’s rationale can
reasonably be discerned and that rationale coincides with the agency’s authority
and obligations under the relevant statute, a reviewing court may not “broadly
require an agency to consider all policy alternatives in reaching decision.” State
Farm, 463 U.S. at 51.
Petitioner cites certain agency documents, a 2002 field service advice
memorandum (FSA) and a 2015 notice of proposed rulemaking (2015 NPRM), to
argue that respondent and Treasury “have themselves recognized that the
regulations at issue are inadequate”. These documents acknowledge that the
regulations prescribe no treatment for situations in which multiple CFCs guarantee
the same obligation. The FSA noted that where multiple CFCs of the same U.S.
shareholder have guaranteed the same obligations, computing the income
inclusion under the current rules may produce “strange results”. Field Service
Advice 200216022 (Jan. 8, 2002). Similarly, the preamble to the 2015 NPRM
explains that “[t]o the extent that the CFCs have sufficient earnings and profits,
there could be multiple section 951 inclusions with respect to the same obligation
that exceed, in the aggregate, the unpaid principal amount of the obligation.” 80
Fed. Reg. 53062 (Sept. 2, 2015). The preamble also stated that Treasury and
respondent were considering prescribing new regulations “to allocate the amount
- 33 -
of the obligation among the relevant CFCs so as to eliminate the potential for
multiple inclusions and, instead, limit the aggregate inclusions to the unpaid
principal amount of the obligation.” Id. Petitioner contends that these statements
constitute “a functional admission” that whether and how regulations under
section 956(d) should apply to situations involving multiple guarantors “are
questions that were never considered by the existing regulatory scheme.” In 2016
Treasury issued final regulations without proposing or adopting any additional
provisions to limit the income inclusion in cases of multiple guarantors. T.D.
9792, 2016-48 I.R.B. 751; see Crestek, Inc. v. Commissioner, 149 T.C. __, __ n.8
(slip op. at 29-30) (July 27, 2017) (discussing 2015 NPRM and 2016 final
regulations).
The documents that petitioner cites are nonprecedential, and we would not
rely on them for a point of law even if we found their reasoning applicable and
persuasive. See sec. 6110(k)(3) (a written determination may not be used or cited
as precedent); Gen. Dynamics Corp. v. Commissioner, 108 T.C. 107, 120 (1997)
(proposed regulations accorded no more weight than a litigating position). In any
event, the specific situation addressed in both documents is distinguishable from
petitioner’s case. The income inclusions that respondent determined for SIHP do
not exceed the unpaid principal amount of the guaranteed obligations. We also
- 34 -
cannot agree that an agency’s recognition that regulations make no provision for
or may produce strange results under particular circumstances is an admission of
their “inadequacy” as a matter of administrative law. Treasury is authorized to
reconsider and revise regulations under the Code (provided that adequate
procedures are employed), and the agency’s decision to revisit the rules for
pledges and guaranties should not be taken as evidence that the current rules are in
some way procedurally defective.
On the basis of the administrative record we conclude that Treasury’s
decisionmaking was based on a consideration of relevant factors under the statute
and there was no clear error in judgment. The agency’s procedures in
promulgating the regulations at issue were sufficient. We would not invalidate
them on that basis.
3. The Agency’s Construction of the Statute
The regulations reflect Treasury’s determination that section 956(d)
supports and Congress intended a broad rule which treats any CFC guarantor of
any (nonexcepted) obligation of a United States person as holding United States
property equal to the principal value of the obligation guaranteed. Ordinarily a
court reviews an agency’s substantive construction of a statute the agency is
charged with administering under the two-step test provided in Chevron. The
- 35 -
deferential standard under Chevron is appropriate “when it appears that Congress
delegated authority to the agency generally to make rules carrying the force of law,
and that the agency interpretation claiming deference was promulgated in the
exercise of that authority.” Mayo Found. for Med. Educ. & Research v. United
States, 562 U.S. 44, 57 (2011) (quoting United States v. Mead Corp., 533 U.S.
218, 226-227 (2001)). The applicability of Chevron deference “does not turn on
whether Congress’s delegation of authority was general or specific.” Id. “[T]he
ultimate question is whether Congress would have intended, and expected, courts
to treat [the regulation] as within, or outside, its delegation to the agency of
‘gap-filling’ authority.” Id. at 58 (quoting Long Island Care at Home, Ltd. v.
Coke, 551 U.S. 158, 173-174 (2007)).
Congress intended to delegate to Treasury the authority to promulgate rules
under section 956(d) having the force and effect of law, and its rulemaking was an
exercise “within the statutory grant of authority”. Id. (quoting Long Island Care,
551 U.S. at 173). Treasury promulgated the regulations pursuant to an express
directive in the governing statute and pursuant to the general rulemaking authority
established in section 7805. As the agency was bound to do for legislative rules, it
followed procedures prescribed under APA sec. 553(b). “It is fair to assume * * *
Congress contemplates administrative action with the effect of law when it
- 36 -
provides for a relatively formal administrative procedure tending to foster * * *
fairness and deliberation”, Mead, 533 U.S. at 230, and the use of notice and
comment by the agency is “a ‘significant’ sign that a rule merits Chevron
deference”, Mayo Found., 562 U.S. at 57-58 (quoting Mead, 533 U.S. at 230-
231). The regulations are properly analyzed under Chevron.
Under step one of Chevron, 467 U.S. at 842, we ask “whether Congress has
directly spoken to the precise question at issue.” “If the intent of Congress is
clear, that is the end of the matter”. Id. Here, neither party contends that Congress
has spoken directly as to the relevant issues, i.e., when and in what amount a CFC
will be considered to hold United States property under section 956 as a result of
its guaranty of an obligation of a United States person. The statute provides only
that a pledge or guaranty shall be treated as holding the underlying obligation
“under regulations prescribed by the Secretary”. Sec. 956(d). None of the
ordinary tools of statutory construction leads us to conclude that Congress has
clearly expressed its intent as to what form those regulations should take or the
substance that should be reflected in them. See City of Arlington v. FCC, 569
U.S. 290, 296 (2013).
Where, as here, the statute does not address the question at issue, step two
of Chevron, 467 U.S. at 843, asks only whether the agency’s position “is based on
- 37 -
a permissible construction of the statute”. In respect of a legislative regulation we
will defer to the agency’s construction of the statute “unless it is ‘arbitrary and
capricious in substance, or manifestly contrary to the statute’.” Mayo Found., 562
U.S. at 53. If the agency’s choice “represents a reasonable accommodation of
conflicting policies that were committed to the agency’s care by the statute, we
should not disturb it unless it appears from the statute or its legislative history that
the accommodation is not one that Congress would have sanctioned.” Chevron,
467 U.S. at 845 (quoting United States v. Shimer, 367 U.S. 374, 383 (1961)).
Petitioner contends that the regulations under section 956(d) cannot pass the
deferential test under Chevron step two because the rules embodied therein are an
unreasonable policy choice in the light of the statute and its legislative history.
Petitioner contends that Congress “was only concerned in section 956 with
investments in U.S. property that repatriate earnings” and that a CFC’s guaranty of
an obligation of a United States person is not “necessarily a transaction that
repatriates earnings”. Petitioner argues that “whether and the degree to which any
given guarantee * * * can be considered to have repatriated earnings are
necessarily fact-specific questions, which will depend on the ‘facts and
circumstances’ of the transaction”.
- 38 -
Treasury’s regulations do not inquire whether a particular guaranty has
“effectively repatriated” earnings of the CFC to its U.S. shareholders. The
generally applicable rules treat any CFC guarantor as holding United States
property equal to the full unpaid principal amount of the obligation. Petitioner
argues that the regulations are “too blunt” and “too mechanical” and fail to
reasonably implement the “nuanced approach” for pledges and guaranties that it
contends Congress intended.
The general rules for the treatment of pledges and guaranties are not at odds
with the wording of the statute. Nothing in the plain text of section 956(d)
indicates that any particular pledge or guaranty shall not be treated as holding the
underlying obligation or directs that the amount considered to be held should be
only the amount that can be deemed to be repatriated. That Congress provided
guaranties should be treated “under regulations prescribed by the Secretary” does
not establish, as petitioner contends, that Treasury was bound to devise a more
nuanced or facts-and-circumstances approach for such transactions. Special
operating rules for the treatment of pledges and guaranties as United States
property would be required in any event, because the general rule in the statute for
the amount of United States property considered held by the CFC could not apply
- 39 -
with respect to a pledge or guaranty. See sec. 956(a) (flush language) (e.g., a
guarantor ordinarily takes no basis in the guaranty).
We also cannot conclude as petitioner contends that the rules promulgated
by the agency are contrary to Congress’ intent. Congress generally intended that
section 956 should cause income inclusions where CFC funds are directed to
invest in United States property for the benefit of its U.S. shareholders, such that
those funds are effectively repatriated for use by the shareholders. A CFC’s
guaranty of a U.S. shareholder’s (or related party’s) debt clearly benefits the U.S.
shareholder, and nothing in the statute or its legislative history suggests that
Congress expected Treasury to craft ad hoc exceptions based on some sort of
facts-and-circumstances test. From the legislative history of section 956 it appears
Congress itself thought extensively about which transactions should be treated the
same as repatriations of CFCs’ earnings.
Congress has provided for numerous exceptions to the definition of United
States property, and it has added and removed exceptions over time to reflect its
evolving conception of what should or should not require an income inclusion as
an investment of earnings in United States property. See Tax Reform Act of 1976,
Pub. L. No. 94-455, sec. 1021(a), 90 Stat. at 1618-1619; Deficit Reduction Act of
1984, Pub. L. No. 98-369, sec. 801(d)(8), 98 Stat. at 996-997; Taxpayer Relief Act
- 40 -
of 1997, Pub. L. No. 105-34, sec. 1173(a), 111 Stat. at 988-989; American Jobs
Creation Act of 2004, Pub. L. No. 108-357, sec. 407(a), 118 Stat. at 1498-1499.
Some of these exceptions effect the application of section 956(d); for example, by
providing that certain obligations are not to be included within the definition of
United States property. See sec. 956(c)(2)(C), (F), (J), (L); see also 80 Fed. Reg.
53061 (Sept. 2, 2015) (“[T]he general exceptions to the definition of United States
property would apply to the obligation treated as held by the CFC [by reason of its
guaranty].”). However, Congress has never undertaken to amend or provide
exceptions to section 956(d) directly. Congress’ decision to leave the terms of
section 956(d) unchanged may reflect its understanding that a CFC ordinarily
would not be directed by its shareholders to provide a guaranty unless the guaranty
was necessary and of value to the borrower and the shareholders.
Petitioner argues extensively that the regulations cause income inclusions
for U.S. shareholders contrary to “commercial and economic reality”. Petitioner in
particular criticizes the regulations for failing to address circumstances in which a
CFC is one of several guarantors of a single obligation. Petitioner contends that if
multiple guaranties support the underlying obligation then no one could
reasonably conclude that “the entire unpaid principal was obtained [solely] as a
result of the CFC[’s] guarantee”. Petitioner also points out that in situations where
- 41 -
(as here) multiple CFCs have guaranteed the same obligation the regulations will
treat each CFC as holding United States property equal to the full unpaid principal
amount of the obligation. The regulations therefore could allow under certain
circumstances (which are not present here) multiple, arguably duplicative income
inclusions that exceed in the aggregate the principal value of the obligation.
Even accepting petitioner’s arguments concerning economic reality and the
“strange results” that the regulations may yield under particular circumstances, it
must be said that an agency is not required to take account of and make special
accommodation for every scenario in which its rules may apply. “Regulation, like
legislation, often requires drawing lines.” Mayo Found., 562 U.S. at 59.
Undoubtedly, as petitioner has shown, alternatives exist to (and improvements
might be imagined for) the generally applicable rules for CFC pledges and
guaranties. Nevertheless, “we do not sit as a committee of revision to perfect the
administration of the tax laws”, United States v. Correll, 389 U.S. 299, 306-307
(1967), and we will uphold regulations that have a reasonable basis in the statutory
history even where the taxpayer’s challenge to a regulation’s policy has “logical
force”, Fulman v. United States, 434 U.S. 528, 536 (1978). “The role of the
judiciary in cases of this sort begins and ends with assuring that the
- 42 -
Commissioner’s regulations fall within his authority to implement the
congressional mandate in some reasonable manner.” Correll, 389 U.S. at 307.
The regulations implemented a reasonable interpretation of section 956(d),
i.e., that in the ordinary case a pledgor or guarantor should be treated as holding
the underlying obligation. Exceptions are provided for direct and indirect
transactions in the statute and in the regulations, and taken as a whole Treasury’s
rules are a reasoned approach to determining when and in what amount a guaranty
should be treated as an investment in United States property under section 956. It
is not manifestly contrary to the statute or unreasonable that the agency would
choose a broad baseline rule for pledges and guaranties as opposed to a less
administrable case-by-case approach. Certainly nothing in section 956(d)
indicates that any particular type of pledge or guaranty should not be treated as
holding the obligation or directs that the amount considered to be held should be
only the amount that can be deemed to be repatriated. On the basis of our own
exhaustive review we conclude that at no point in the extensive legislative history
of section 956 has Congress expressed a desire that inclusions for guaranties be
determined case by case.
We uphold the validity of sections 1.956-2(c)(1) and 1.956-1(e)(2), Income
Tax Regs. Treasury promulgated these regulations by procedures that satisfy the
- 43 -
requirements of the APA, and the substance of the regulations is based on a
permissible construction of section 956(d) entitled to deference under Chevron.
While “neither antiquity nor contemporaneity with [a] statute is a condition
of [a regulation’s] validity”, it is relevant to petitioner’s case that the contested
regulations had existed for nearly 50 years at the time the CFCs executed the
guaranty transaction at issue. See Smiley v. Citibank (S.D.), N. A., 517 U.S. 735,
740 (1996). Congress reenacted section 956(d) unamended in OBRA, at which
time Congress had revisited in depth the operating rules under section 956.
Congress expressed no concerns as to the current rules governing pledges and
guaranties, which strongly suggests that it did not view Treasury’s construction of
section 956(d) as unreasonable or contrary to the law’s purpose. See Cottage Sav.
Ass’n v. Commissioner, 499 U.S. 554, 561 (1991).
III. Petitioner’s Other Contentions
Petitioner contends that in the event we conclude, as we have, that the
regulations are valid, we should not grant respondent’s motion for summary
judgment. It contends that respondent’s proposed application of the regulations,
determining income inclusions of the full amount of the CFCs’ applicable
earnings, is inconsistent with the purpose of section 956. It contends that an
examination of facts and circumstances beyond those identified by respondent as
- 44 -
dispositive is necessary to determine whether “in substance” the CFCs’ guaranties
repatriated earnings in the amounts of the asserted inclusions.
Petitioner avers and submits affidavits of its officers in support of the
following facts: (1) SIG and its domestic affiliates maintained assets in accounts
at Merrill Lynch of approximately twice the value of the SIG notes; (2) Merrill
Lynch never indicated during negotiations that SIG required “additional credit
support” from entities that held assets outside of Merrill Lynch; (3) the CFCs had
combined net assets of $240 million at the time the SIG notes were executed,
which was not enough to satisfy repayment of the SIG notes; and (4) Merrill
Lynch requested that the CFCs sign the ARGSA only because it wanted to “ring
fence” the SIG affiliates from which it could seek repayment in the event of a
default and to prevent “leakage” of assets held in Merrill Lynch accounts.
Petitioner contends that these facts show the CFCs’ guaranties had no substantial
effect on SIG’s ability “as a credit matter” to receive the funds represented by the
SIG notes. Petitioner contends that the CFCs’ earnings had nothing to do with
Merrill Lynch’s decision to lend to SIG.
Neither section 956(d) nor the regulations inquire into the relative
importance that a creditor attaches to a guaranty. Crestek, Inc. v. Commissioner,
149 T.C. at __ (slip op. at 25-26). A guarantor’s precise financial condition or the
- 45 -
likelihood that it would be able to make good on its guaranty are irrelevant in
determining under the regulations whether the guaranty gives rise to an investment
in United States property. Id. at __ (slip op. at 28). The regulations applicable in
this case provide categorically that any obligation of a United States person with
respect to which the CFC is a guarantor shall be considered United States property
held by the CFC in the amount equal to the unpaid principal. They make no
provision for reducing the section 956 inclusion by reference to the guarantor’s
financial strength or its relative creditworthiness. Id. at __ & n.8 (slip op. at 29-
30).
In effect, petitioner asks us to insert into the regulations an added
requirement that the facts and circumstances should demonstrate “an actual
repatriation has occurred” in respect of the amounts guaranteed. Petitioner
contends that a facts-and-circumstances analysis is warranted because the
regulations as promulgated do not provide any special treatment for guaranties of
obligations for which there are multiple guarantors. Petitioner contends that we
are required under these circumstances “to apportion the amount of U.S. property
* * * held by each CFC guarantor among themselves and the remaining
guarantors, the pledgors, and the obligor.”
- 46 -
The rules do not allow apportioning a guaranteed obligation among
guarantors or the obligor, and the statute does not require that the rules implement
an approach focusing strictly on the amount of an obligation that a particular
guarantor effectively repatriates. The CFCs both gave their guaranties of
obligations of a United States person, and the regulations accordingly treat each as
holding United States property equal to the unpaid principal of those obligations.
We cannot ignore or alter regulations that are an authoritative and reasonable
interpretation of the governing statute. The amounts determined under section 956
are capped by the statute at the CFCs’ applicable earnings for the tax years in
issue. Those amounts are not in dispute and do not exceed the value of the
underlying obligations.
Lastly, petitioner contends that the structure of the ARGSA “and related
agreements” should affect our application of the rules to the guaranties in this
case. Petitioner argues that “the most a given CFC could be deemed to have
‘invested’ in U.S. property is that amount * * * for which it agreed to be ultimately
responsible”, and pursuant to their rights of contribution under the pro rata
provision petitioner avers that the CFCs “would have been entitled to
approximately 100% reimbursement for any amounts paid” as a result of the
- 47 -
guaranties. Petitioner fails to explain how the related agreements should affect our
analysis.
We cannot view the pro rata provision as offsetting the CFCs’ guaranties.
The CFCs undertook unlimited guaranties for full payment of the SIG notes, and
first and foremost the CFCs would have been legally obligated to make any such
payments out of their own earnings and profits. Their rights to contribution from
other guarantors were subsidiary to their obligations under the guaranties. It is
questionable whether, in the event that they had been required to make payments
pursuant to their guaranties, the CFCs would have been seriously inclined to
enforce the pro rata provision against their commonly owned affiliates.
Petitioner vigorously contends that many pledges and guaranties, and
particularly the guaranties at issue, are not necessary for the receipt of the loan by
the borrower, and for that reason a CFC guarantor should not be automatically
treated as repatriating earnings for use by its U.S. shareholders. Petitioner’s
argument, however, highlights the solution to the predicament in which it now
finds itself: If a guaranty by a CFC is unnecessary, then it need not be made; and
the application and effects of the regulations under section 956(d) will be avoided.
This Court has issued previously two opinions concerning income
inclusions determined under the provisions of section 956(d) and the subject
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regulations, Ludwig v. Commissioner, 68 T.C. 979 (1977), and Crestek, Inc. v.
Commissioner, 149 T.C. __ (July 27, 2017). In neither case did the taxpayer
challenge the validity of the regulations. The dearth of caselaw on this topic is
unsurprising, because, as petitioner acknowledges, the rules promulgated for
pledges and guaranties lend themselves to easy tax planning. Petitioner may not
undo the effects of its transaction because in this particular instance the generally
applicable rules generate an outcome that is unfavorable to it.
The regulations apply and support the income inclusions that respondent
determined for SIHP under sections 951(a)(1)(B) and 956. We sustain
respondent’s determinations in the FPAAs that SIHP has income inclusions for the
tax years in issue equal to the CFCs’ applicable earnings.
IV. Applicable Tax Rate
The remaining issue for our consideration involves the tax rate applicable to
SIHP’s income inclusions. Petitioner contends that any amount included in
SIHP’s gross income attributable to SIHL/SEHL’s guaranty should be “qualified
dividend income” under section 1(h)(11). Respondent determined in the FPAAs
that the income inclusions were not qualified dividend income and are properly
taxed as ordinary income.
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As enacted in the Jobs and Growth Tax Relief Reconciliation Act of 2003,
Pub. L. No. 108-27, sec. 302, 117 Stat. at 760, section 1(h)(11) provides
preferential tax rates for qualified dividend income. Qualified dividend income
includes dividends received during the taxable year from “qualified foreign
corporations”. Sec. 1(h)(11)(B)(i)(II). A qualified foreign corporation is
generally either a corporation incorporated in a possession of the United States or
a corporation eligible for the benefits of a comprehensive income tax treaty with
the United States. Sec. 1(h)(11)(C)(i).
STS was organized under the laws of the Cayman Islands, which has no
comprehensive income tax treaty with the United States. Respondent asserts that
STS was not a qualified foreign corporation during the tax years in issue, and
petitioner does not contend otherwise. Accordingly, we will consider only
whether any income inclusion attributable to SIHL/SEHL’s guaranty may be taxed
at the preferential rates under section 1(h)(11).
This Court has held previously that income inclusions required under
sections 951(a)(1)(B) and 956 do not constitute qualified dividend income under
section 1(h)(11). Rodriguez v. Commissioner, 137 T.C. 174 (2011), aff’d, 722
F.3d 306 (5th Cir. 2013). In Rodriguez v. Commissioner, 137 T.C. at 177, the
CFC owned real and tangible personal property located in the United States, and
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we held that an income inclusion under section 951 was not a “dividend” to the
CFC’s U.S. shareholders, as that term is defined in section 316(a). We reasoned
that the section 951 inclusion involves no change in ownership of corporate
property and the inclusion arises not from any distribution of property by the CFC
but rather from its investment of earnings in specified property. Id.Petitioner contends that our result in Rodriguez should not control here.
Petitioner contends that the holding in Rodriguez applied specifically to CFC
investments in real or tangible United States property, which did not result in any
distribution because the CFC continued to hold the property and the shareholders
received no property. Petitioner argues that in this case the justification for the
income inclusions was a “deemed investment” in property, which “necessarily
involve[d] a constructive or deemed distribution” in the form of the cash that SIG
received from Merrill Lynch. Petitioner contends that we should distinguish
Rodriguez as being decided narrowly on its facts and conclude in this case that
deemed or constructive dividends were paid out of the CFCs’ earnings and profits,
to which section 1(h)(11) may apply.
We find no merit in the distinctions that petitioner attempts to draw from
Rodriguez. There is no reason to differentiate between an investment in tangible
United States property under section 956(c)(1)(A) and what petitioner terms a
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“deemed investment” by reason of a guaranty under section 956(d). In either case
the U.S. shareholder obtains the use and benefit of domestic property through the
use of CFC earnings. When a CFC guarantees a loan, the shareholder or a related
party benefits from the use of loan proceeds; but the CFC has not distributed its
earnings any more than if it had used the earnings to purchase tangible property.
In this case, as in Rodriguez, no distribution of property occurred from the CFCs
to their U.S. shareholder. Simply put, no transfer of ownership from corporation
to shareholder occurred with respect to any property.
If we decline to interpret Rodriguez as being decided narrowly on its facts,
then petitioner contends in the alternative that Rodriguez was decided incorrectly.
Petitioner contends that in Rodriguez we disregarded our own precedent that the
taxation of undistributed CFC earnings is justified because investments in United
States property may be treated the same as deemed or constructive dividends.
Petitioner cites Dougherty v. Commissioner, 60 T.C. 917, a case in which we
upheld the constitutionality of section 951(a)(1)(B) and in which we wrote that
section 951(a)(1)(B) “has the stated objective of treating a controlled foreign
corporation’s increase in earnings invested in U.S. property as if it were a dividend
paid to the corporation’s shareholders.” Id. at 926.
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The fact that section 951 in operation treats a CFC’s investment in United
States property “as if it were a dividend” in no way establishes that the income
inclusions required for shareholders thereunder actually are dividends for general
purposes of the Code. See Rodriguez v. Commissioner, 137 T.C. at 179-180; see
also Klein v. Commissioner, 149 T.C. __, __ (slip. op. at 17-23) (October 3,
2017); Muncy v. Commissioner, T.C. Memo. 2017-83 (concluding that “the
distinction between ‘as if’ and ‘as’ is significant”). In Rodriguez v.
Commissioner, 137 T.C. at 178, we found ample reason to conclude that, absent
express provision, Congress did not intend such inclusions to be considered
dividends. We cited Code sections that provide under limited circumstances and
for limited purposes that section 951 inclusions should be treated the same as
dividends. We concluded that such careful legislative design would be rendered
superfluous and unnecessary if (contrary to well-established tenets of statutory
construction) we determined that section 951(a)(1)(B) gives rise to a dividend in
the ordinary course. Id.; see also Rodriguez v. Commissioner, 722 F.3d at 311
(“[I]f all section 951 inclusions constituted qualified dividends, then statutory
provisions specifically designating certain inclusions as dividends would amount
to surplusage.”). We also concluded that the structure of section 956, particularly
as it has evolved over time, strongly indicates that inclusions for investments in
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United States property do not constitute dividends under the Code. Rodriguez v.
Commissioner, 137 T.C. at 180; see also Rodriguez v. Commissioner, 722 F.3d at
311 (“[T]he original version of section 956 specifically stated that Congress did
not intend amounts calculated thereunder to constitute dividends. * * * It does not
appear that the omission of this language from the new version of the statute was
intended to change the treatment of amounts calculated under section 956.”).
We conclude that the rationale in Rodriguez applies with equal force to the
income inclusions at issue, which were determined under sections 951(a)(1)(B)
and 956(d). The income inclusions for the CFCs’ guaranties were not dividends
received by SIHP, and accordingly they are not qualified dividend income under
section 1(h)(11). Absent a showing that some other characterization should apply
under the Code, any income included in SIHP’s gross income for the tax years in
issue should be treated as ordinary income.
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We have considered all arguments made, and, to the extent not mentioned,
we conclude that they are moot, irrelevant, or without merit. To reflect the
foregoing,
An order and decision will be
entered granting respondent’s motion for
summary judgment and denying
petitioner’s motion for summary
judgment.