Commissioner of Revenue v. Franchi

• Decision Date: 21 November 1996
• Citation: 423 Mass. 817,673 N.E.2d 854
• Parties: COMMISSIONER OF REVENUE v. Anthony A. FRANCHI & another. 1
• Court: United States State Supreme Judicial Court of Massachusetts Supreme Court

Page 854

673 N.E.2d 854

423 Mass. 817

COMMISSIONER OF REVENUE v. Anthony A. FRANCHI & another. ¹

Supreme Judicial Court of Massachusetts Suffolk.

Argued Oct. 8, 1996.

Decided Nov. 21, 1996.

Don E. Gorton, III, for Commissioner of Revenue.

J. Thomas Price, Boston, for taxpayers.

Before WILKINS, C.J., and ABRAMS, GREANEY and FRIED, JJ.

GREANEY, Justice.

This is an appeal by the Commissioner of Revenue (commissioner), pursuant to G.L. c. 58A, § 13 (1994 ed.), from a decision of the Appellate Tax Board (board) granting Anthony A. Franchi and Constance Franchi (taxpayers) applications for abatement of income taxes paid by them in 1988 and 1989. We affirm the board's decision.

At issue is the Massachusetts tax treatment of income and deductions that arise pursuant to Internal Revenue Code I.R.C.) §§ 469 and 7872, ² which govern debts between a taxpayer and "passthrough entities," where the taxpayer is a partner whose participation in the partnership is a "passive activity." During the tax years in question, taxpayer Anthony A. Franchi (taxpayer partner) was a general partner in Jonathan Drive Realty Associates (partnership). In July, 1988, the taxpayer partner transferred a parcel of improved real estate to the partnership, in a way that created a debt owed to him by the partnership. Under then-existing Federal tax law, a debt of this nature gave rise to imputed interest income, which the taxpayers (who filed a joint return) reported as Part A income on their 1988 and 1989 Massachusetts tax returns, then taxable at a rate of 10%. See I.R.C. § 7872; G.L. c. 62, § 2(b )(1), as amended through St.1986, c. 488, § 26, and § 4(a ), as amended by St.1975, c. 684, § 41.

Subsequent regulations issued by the United States Treasury, with an effective date retroactive to January 1, 1987, recharacterized the imputed interest as "passive activity gross income," and allowed taxpayers reporting this income to deduct from it any "related passive activity loss" that would pass through to the taxpayer partner. This set-off procedure resulted in the calculation of net passive activity income, which was then subject to Federal tax. See I.R.C. § 469; Temp.Treas.Reg. § 1.469-7T (1991). After these regulations were issued, the taxpayers filed amended Massachusetts personal income tax returns for 1988 and 1989, applying the Federal rules to the calculation of their Massachusetts taxes. Based on the new Federal characterization of self-charged, or imputed, interest as passive activity gross income, the taxpayers listed the net passive activity income from the partnership as Part B income on their amended returns and claimed abatements in the form of refunds for both tax years.

The taxpayers' claims were denied by the commissioner, and they appealed from these denials to the board. The board reversed the decision of the commissioner and granted the taxpayers' claimed abatements in full. The commissioner appealed from the board's decision, and we transferred the case to this court on our own motion. Consistent with established principles governing the construction of tax statutes in Massachusetts, we conclude that this type of income, which would otherwise be treated as imputed interest income under Federal tax law, is now treated as "passive activity income," with the result that this income is no longer taxable under Massachusetts law as Part A interest income but instead is taxable, after being offset by passive activity losses related to that income, as Part B "other income."

1. Statutory background. The issue in this case is governed by the interaction of Massachusetts tax statutes with several provisions of the I.R.C., accompanying Treasury regulations, and a Department of Revenue (department) technical information release (TIR). A summary of these statutes, regulations, and other materials and their interconnections is provided here as background to our discussion of the merits.

The Massachusetts tax statutes and the Internal Revenue Code are inextricably interwoven. General Laws c. 62, § 2(a ), defines Massachusetts gross income as Federal gross income, adopting the definition under the I.R.C. Gross income in Massachusetts is divided into two classes, Parts A and B. G.L. c. 62, § 2(b ). Part A gross income consists of interest, dividends, and capital gain net income, subject to exclusions not pertinent here. G.L. c. 62, § 2(b )(1). Part B gross income is all other Massachusetts gross income. G.L. c. 62, § 2(b )(2). In 1988 and 1989, Part A income was taxed at a rate of 10%; Part B income was taxed at a rate of 5%. G.L. c. 62, § 4.

The definitions of the components of Part A income also follow Federal law in large part. Specifically, G.L. c. 62, § 1(i ), adopts the Federal definition of interest, stating that " '[i]nterest' shall have the same meaning as in [I.R.C. § 163], including all amounts treated as interest by virtue of the operation of any other sections of the [I.R.C.], including [sections of the I.R.C. not relevant to this inquiry]" (emphasis added).

The taxpayer partner's transfer of real estate was treated as a loan to the partnership and gave rise to interest charges under I.R.C. § 7872, which provides that, for this type of loan, "foregone interest" is calculated and then imputedly transferred, first from the lender to the borrower, and then back to the lender as interest. I.R.C. § 7872(a). The term "foregone interest" in this provision refers to an amount of interest "which would have been payable on the loan ... if interest [had] accrued ... at the applicable Federal rate." I.R.C. § 7872(e)(2)(A). This interest was not actually paid by the partnership to the taxpayer partner, but instead acted to increase the amount owed by the partnership to him. Nonetheless, this imputed interest was considered income to the taxpayer partner. This same imputed interest also resulted in an "expense" to the partnership, which, together with other partnership deductions, was then passed through to the taxpayer partner as a deduction.

The partnership involved in this case qualifies as a "passive activity" under I.R.C. § 469. Deductions for passive activity income are governed by this provision of the I.R.C., which in turn provides a broad grant of authority to the Secretary of the Treasury to prescribe regulations appropriate to carry out its purpose. I.R.C. § 469(l ). In enacting § 469, Congress recognized that, in some instances, the interest imputed to the taxpayer partner as income might result in a taxpayer's being taxed on interest paid by the taxpayer to himself. The drafters of § 469 anticipated that Treasury regulations would be issued to correct this inequitable situation. H.R.Conf.Rep. No. 841, 99th Cong., 2d Sess. II-146--II-147, reprinted in 1986 U.S.C.C.A.N. 4075, 4234-4235. ³ The Department of the Treasury subsequently adopted Temp.Treas.Reg. § 1.469-7T, which set forth rules governing lending transactions between a lending taxpayer and the passthrough entity in which the taxpayer owns a partnership interest. ⁴ These rules "[t]reat certain interest income resulting from these lending transactions as passive activity gross income ... [and] [t]reat certain deductions for interest expense that is properly allocable to such interest income as passive activity deductions...." Temp.Treas.Reg. § 1.469-7T(a )(i ), (ii ).

In 1988, the Legislature incorporated the I.R.C., as amended on January 1, 1988, applicable to all taxable years beginning on or after January 1, 1988. G.L. c. 62, § 1, (c ), (d ), and § 2(a ). See St.1988, c. 106, §§ 1, 16. In so doing, the Legislature imported both § 469 and § 7872 into the Massachusetts tax statutes. In announcing this change of law, the department issued TIR 88-12 (Jan. 23, 1989), 2 Official MassTax Guide at 372 (West 1996), which explicitly pointed out that the provisions of the Tax Reform Act of 1986 would constitute part of Massachusetts tax law. ⁵ The department then issued TIR 89-2 (April 3, 1989), 2 Official MassTax Guide at 378 (West 1996), which confirmed that the passive activity rules of I.R.C. § 469 are included in the incorporation of Federal law into Massachusetts law. ⁶

2. Discussion. We are faced with a question of statutory interpretation that arises with some frequency in the area of Massachusetts tax law, one which requires balancing the State's independent development of its individual tax code against the Legislature's consistent references to, and incorporation of, Federal tax provisions. See, e.g., Grady v. Commissioner of Revenue, 421 Mass. 374, 657 N.E.2d 751 (1995); Commissioner of Revenue v. Shafner, 392 Mass. 256, 465 N.E.2d 788 (1984); Salhanick v. Commissioner of Revenue, 391 Mass. 658, 463 N.E.2d 1163 (1984); Dow Chem. Co. v. Commissioner of Revenue, 378 Mass. 254, 391 N.E.2d 253 (1979); B.W. Co. v. State Tax Comm'n, 370 Mass. 18, 345 N.E.2d 884 (1976); Forte Inv. Fund v. State Tax Comm'n, 369 Mass. 786, 343 N.E.2d 420 (1976).

This court most recently faced an analogous tax situation in Grady, supra. We there noted that, under Massachusetts law, it is well established that "[t]he right to tax must be found within the letter of the law and is not to be extended by implication." Grady, supra at 377, 657 N.E.2d 751, quoting Commissioner of Revenue v. Molesworth, 408 Mass. 580, 581, 562 N.E.2d 478 (1990). The general rule is that tax statutes are to be strictly construed according to their plain meaning, as the State has no power to tax unless that power has been expressly conferred by statute. Commissioner of Revenue v. AMIWoodbroke, Inc., 418 Mass. 92, 94, 634 N.E.2d 114 (1994). Accordingly, tax statutes are usually construed "against the taxing authority, and all doubts resolved in favor of the taxpayer." Grady, supra, quoting AMIWoodbroke, Inc., supra.

Although the interaction of the relevant statutes is relatively complex, the applicable provisions are simple and consistent. Under G.L. c. 62, § 2(b )(1), Part A income includes...