Square D Co. & Subsidiaries v. Comm'r of Internal Revenue

Decision Date27 March 2002
Docket NumberNo. 6067–97.,6067–97.
Citation118 T.C. No. 15,118 T.C. 299
PartiesSQUARE D COMPANY AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
CourtU.S. Tax Court

OPINION TEXT STARTS HERE

Corporate taxpayer petitioned for redetermination of disallowed deduction for interest owed to foreign parent corporation. The Tax Court, Gale, J., held that: (1) Treasury Regulation prescribing treatment of payments to related foreign entities was valid, abrogating Tate & Lyle, Inc. v. Comm., 103 T.C. 656, and (2) Treasury Regulation did not violate treaty provision.

Decision for IRS.

Whalen, J., dissented.

Ruwe, J., dissented and filed written opinion, with which Wells, Cohen, Chiechi, and Vasquez, JJ., agreed. P, an accrual method taxpayer, is a U.S. corp. and subs. wholly owned by S, a foreign corp. P accrued but did not pay interest owed to S and another related foreign person during 1991 and 1992 and claimed deductions of such accrued interest in those years. R disallowed any deduction in a year prior to the year the interest was actually paid and relies on sec. 1.267(a)–3, Income Tax Regs., in support of his position.Held, the instant case raises the identical issue decided in Tate & Lyle, Inc. v. Commissioner, 103 T.C. 656, 1994 WL 637678 (1994), revd. and remanded 87 F.3d 99 (3d Cir.1996), of whether sec. 1.267(a)–3, Income Tax Regs., is a valid exercise of the regulatory authority granted in sec. 267(a)(3), I.R.C. In light of the reversal by the Court of Appeals for the Third Circuit, we reconsider our holding.Held, further, the two-part test of Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837, 104 S.Ct. 2778, 81 L.Ed.2d 694 (1984), applied. Under the first part of the Chevron test, sec. 267(a)(3), I.R.C., authorizing regulations applying the “matching principle” of sec. 267(a)(2), I.R.C., to foreign persons, is not clear and unambiguous. Under the second part of the Chevron test, sec. 1.267(a)–3, Income Tax Regs., is a permissible construction of, and not manifestly contrary to, sec. 267(a)(3), I.R.C. To the extent our opinion in Tate & Lyle is inconsistent with this holding, we will no longer follow it.Held, further, sec. 1.267(a)–3, Income Tax Regs., does not violate Article 24(3) of the Convention With Respect to Taxes on Income and Property, July 28, 1967, U.S.-Fr., 19 U.S.T. 5281, 5310.Robert H. Aland, Gregg D. Lemein, John D. McDonald, and Holly K. McClellan, for petitioner.

Lawrence C. Letkewicz and Dana E. Hundrieser, for respondent.

OPINION

GALE, J.

Respondent determined deficiencies in petitioner's Federal income taxes of $7,420,227, $28,971,522, and $15,285,996, for taxable years 1990, 1991, and 1992, respectively. Petitioner claims overpayments of $12,486,577 and $18,289 for taxable years 1990 and 1992, respectively. We must decide whether petitioner, an accrual method taxpayer, may deduct certain interest owed to related foreign persons during the taxable years in which the interest was accrued but not paid.1

Unless otherwise noted, all section references are to the Internal Revenue Code in effect for taxable years 1991 and 1992, and all Rule references are to the Tax Court Rules of Practice and Procedure.

Factual Background

The facts have been stipulated by the parties and are so found. We incorporate by this reference the stipulation of facts, the first supplemental stipulation of facts, and accompanying exhibits. The following summary of the facts is based on the stipulations.

Square D Company, a Delaware corporation with its principal executive offices in Palatine, Illinois, is the common parent of an affiliated group of corporations making a consolidated return (collectively, petitioner). Petitioner computes consolidated taxable income on the basis of a calendar year.

Prior to its acquisition by Schneider S.A. (discussed below), petitioner was a publicly held company whose stock was traded on the New York Stock Exchange. During the years in issue petitioner was engaged in the United States and abroad in the manufacture and sale of electrical distribution and industrial control products. During the years in issue, Schneider S.A. (Schneider), a French corporation with its principal executive offices in Paris, France, was, through its subsidiaries, a multinational manufacturer and marketer of electrical distribution and industrial control equipment, among other activities. Schneider owned, directly or indirectly, five major subsidiaries, including Merlin Gerin S.A. (MGSA) and Telemecanique S.A. (TESA), both French corporations.

Around late 1990 or early 1991, Schneider began taking steps to initiate a hostile takeover of petitioner. In connection therewith, Schneider, MGSA, and TESA (the Schneider Lenders) organized Square D Acquisition Co. (ACQ) under the laws of California (and subsequently Delaware) as a transitory entity to serve as a vehicle for the acquisition of petitioner. The Schneider Lenders together owned 100 percent of ACQ. Eventually, after agreeing to ACQ's purchase of petitioner's outstanding stock for a total purchase price of about $2.25 billion, petitioner, Schneider, and ACQ entered into a merger agreement in May 1991.

On May 30, 1991, the merger was consummated. ACQ's purchase of petitioner's stock was financed through a combination of loans from banks, capital contributions to ACQ from the Schneider Lenders, and loans from the Schneider Lenders that were required to be subordinated to the bank loans (1991 Subordinated Loans). The 1991 Subordinated Loans, which totaled $328,272,605, had a fixed maturity date of May 30, 2001, and provided for interest at an annual rate of 10.7 percent, payable quarterly beginning September 30, 1991.

Effective August 22, 1991, ACQ merged into petitioner, which assumed ACQ's obligations under the bank loans and the 1991 Subordinated Loans. After the merger, the Schneider Lenders owned 100 percent of the stock of petitioner.

On August 23, 1991, the Schneider Lenders transferred the 1991 Subordinated Loans to Merlin Gerin Services, S.N.C. (SNC), a Belgian entity, in return for a 100–percent ownership interest in SNC. SNC was classified as a partnership for U.S. Federal income tax purposes. As a result of the transfer, the notes reflecting the 1991 Subordinated Loans were replaced with new notes designating petitioner as the borrower and SNC as the lender.

A year later, on August 24, 1992, Schneider made a loan, also subordinated to the bank loans, of $80 million to petitioner (1992 Subordinated Loan). The 1992 Subordinated Loan was evidenced by a promissory note, which had a fixed maturity date of May 30, 2001, and provided for interest at an annual rate of 9.8 percent, payable quarterly beginning September 30, 1992.

Although the promissory notes for the 1991 and 1992 Subordinated Loans made interest payable quarterly commencing September 30, 1991 and 1992, respectively, the promissory notes provide for payment of principal and interest to be subordinated to payment in full of all amounts outstanding under the bank loans. The agreement for the bank loans in general prohibits any payment of principal or interest on the Subordinated Loans before January 1, 1994.

Petitioner did not make any interest payments under the 1991 or 1992 Subordinated Loans during the years in issue. Rather, petitioner accrued interest on the 1991 and 1992 Subordinated Loans during the years in issue as follows:

+---------------------------------------------------------+
                ¦Accrual year¦1991 Sub'd Loans¦1992 Sub'd Loan¦Total      ¦
                +---------------------------------------------------------¦
                ¦                                                         ¦
                +---------------------------------------------------------¦
                ¦1991        ¦$21,075,101     ¦               ¦$21,075,101¦
                +------------+----------------+---------------+-----------¦
                ¦1992        ¦35,710,584      ¦$2,831,111     ¦38,541,695 ¦
                +---------------------------------------------------------+
                

The 1991 and 1992 Subordinated Loans constituted debt for U.S. Federal income tax purposes.

Schneider, MGSA, TESA, and SNC were not engaged in a trade or business within the United States for U.S. Federal income tax purposes during the years in issue. Interest accrued by petitioner had the following characteristics: (i) It was not includible in the gross incomes of Schneider, MGSA, TESA, or SNC for U.S. Federal income tax purposes; (ii) it was from sources within the United States for U.S. Federal income tax purposes; and (iii) it was not effectively connected with the conduct of a U.S. trade or business for U.S. Federal income tax purposes. During the years in issue, petitioner and the Schneider Lenders were members of the same controlled group of corporations as defined in section 267(b)(3), (f).

During the years in issue, petitioner was a bona fide resident of the United States, and the Schneider Lenders were bona fide residents of France, within the meaning of Article 3(1a) and (2a) of the Convention With Respect to Taxes on Income and Property, July 28, 1967, U.S.-Fr., 19 U.S.T. 5281 (1967 Treaty). During the years in issue, neither the Schneider Lenders nor SNC maintained a permanent establishment in the United States within the meaning of the 1967 Treaty.

Article 10(1) of the 1967 Treaty would have applied to any payments by petitioner of the accrued interest on the 1991 and 1992 Subordinated Loans that occurred before January 1, 1996. As a result, the payments would have been exempt from taxes that otherwise would have been due under sections 881 and 1442.

Petitioner did not claim deductions for the interest accrued but unpaid with respect to the 1991 and 1992 Subordinated Loans on its returns for taxable years 1991 and 1992. During the course of the examination by respondent, petitioner informally requested that it be allowed to deduct the amounts of interest accrued in 1991 and 1992; namely, $21,075,101 and $38,541,695, respectively. In the notice of deficiency, respondent determined petitioner was...

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