Swallows Holding, Ltd. v. Comm'r of Internal Revenue

• Citation: 126 T.C. No. 6,126 T.C. 96
• Decision Date: 26 January 2006
• Docket Number: No. 8045–02.,8045–02.
• Parties: SWALLOWS HOLDING, LTD., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

126 T.C. 96

126 T.C. No. 6

SWALLOWS HOLDING, LTD., Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 8045–02.

United States Tax Court.

Jan. 26, 2006.

Held Invalid

26 C.F.R. § 1.882-4(a)(2) P is a foreign corporation whose only substantial asset is unimproved land in the United States. On its 1994, 1995, and 1996 Federal income tax returns, P recognized rent and option income and claimed deductions for taxes and licenses, the result of which was a reported loss for each year. P filed each return after its due date, but before any contact from R. R determined that sec. 882(c)(2), I.R .C., precluded P from deducting its expenses because it filed its returns untimely. In Anglo–Am. Direct Tea Trading Co. v. Commissioner, 38 B.T.A. 711 (1938), a setting similar to that here, the Board held that sec. 233 of the Revenue Act of 1928, ch. 852, 45 Stat. 849, and the Revenue Act of 1932, ch. 209, 47 Stat. 230, an almost verbatim predecessor to sec. 882(c)(2), I.R.C., did not include a timely filing requirement and rejected R's contrary interpretation. Subsequently, the Court of Appeals for the Fourth Circuit construed like predecessor text similarly, also in rejection of R's contrary interpretation. See Blenheim Co. v. Commissioner, 125 F.2d 906 (4th Cir.1942), affg. 42 B.T.A. 1248 (1940); Ardbern Co. v. Commissioner, 120 F.2d 424 (4th Cir.1941), modifying and remanding on other grounds 41 B.T.A. 910 (1940). R continues to adhere to his rejected interpretation and now attempts to support that interpretation by citing Treasury regulations issued in 1990. Those regulations interpret sec. 882(c)(2), I.R.C., to provide that a foreign corporation generally is entitled to deduct its expenses only if it files a timely return.

Held: A timely filing requirement is not found in a plain reading of sec. 882(c)(2), I.R.C.

Held, further, the timely filing requirement in the regulations is invalid in that it is unreasonable under a plain reading of sec. 882(c) (2), I.R.C., and an application of the considerations set forth in Natl. Muffler Dealers Association v. United States, 440 U.S. 472, 99 S.Ct. 1304, 59 L.Ed.2d 519 (1979).

Phillip L. Jelsma, for petitioner.

Thomas A. Dombrowski and Nina E. Chowdhry, for respondent.

LARO, J.

Petitioner petitioned the Court to redetermine respondent's determination of deficiencies in its Federal income taxes for its taxable years ended May 31, 1994, 1995, and 1996 (1994, 1995, and 1996 taxable years, respectively; collectively, subject years), and additions thereto under section 6651(a)(1). ¹ The deficiencies and additions to tax are as follows:

+-------------------------------------------------------------+
                ¦Taxable Year  ¦Deficiency  ¦Addition to tax Sec. 6651(a)(1)  ¦
                +--------------+------------+---------------------------------¦
                ¦              ¦            ¦                                 ¦
                +--------------+------------+---------------------------------¦
                ¦1994          ¦$7,200      ¦$1,800.00                        ¦
                +--------------+------------+---------------------------------¦
                ¦1995          ¦5,850       ¦1,462.50                         ¦
                +--------------+------------+---------------------------------¦
                ¦1996          ¦1,800       ¦450.00                           ¦
                +-------------------------------------------------------------+
                

We decide whether petitioner may deduct the ordinary and necessary expenses it incurred during the subject years. The expenses relate to income treated as effectively connected to the conduct of a trade or business in the United States (effectively connected income), and petitioner claimed the expenses on its Federal income tax returns, which it filed before any contact from respondent. Respondent determined in the notice of deficiency that section 882(c)(2) precludes petitioner from deducting its expenses because it did not file its returns timely. Respondent concedes that the expenses are deductible if section 882(c)(2) does not include a timely filing requirement.

In Anglo–Am. Direct Tea Trading Co. v. Commissioner, 38 B.T.A. 711 (1938), the Board of Tax Appeals (Board) held that section 233 of the the Revenue Act of 1928, ch. 852, 45 Stat. 849, and the Revenue Act of 1932, ch. 209, 47 Stat. 230, an almost verbatim predecessor to section 882(c)(2), did not include a timely filing requirement.² In so holding, the Board construed the earlier section's requirement that a foreign corporation file a true and accurate return “in the manner prescribed in this title” and rejected respondent's argument that the word “manner”, as it appeared in the quoted text, meant that the foreign corporation could deduct its expenses only if it filed its returns timely; i.e., before the time set forth in a predecessor to section 6072.³ Subsequently, the Court of Appeals for the Fourth Circuit in Ardbern Co. v. Commissioner, 120 F.2d 424 (4th Cir.1941), modifying and remanding on other grounds 41 B.T.A. 910 (1940), quoted and applied the Anglo–Am. Direct Tea Trading Co. holding favorably and without reservation. The Court of Appeals for the Fourth Circuit in Blenheim Co. v. Commissioner, 125 F.2d 906 (4th Cir.1942), affg. 42 B.T.A. 1248 (1940), also acknowledged the Anglo–Am. Direct Tea Trading Co. holding, construed the relevant text not to contain any reference to time, and stated that Congress had enacted the relevant text in 1928 intending to allow a foreign corporation to deduct its expenses upon its filing of a tax return.

In 1990, the Secretary issued section 1.882–4(a)(2) and (3)(i), Income Tax Regs. (disputed regulations). The disputed regulations interpret section 882(c)(2) to provide that a foreign corporation generally is entitled to deduct its expenses only if it files a timely return. Under the relevant part of the disputed regulations, a return is timely if it is filed before an arbitrary 18–month deadline (18–month deadline) devised by the Secretary.⁴ The Secretary issued the disputed regulations stating that section 882 (c)(2) contains a “clear” requirement that a foreign corporation file its return timely in order to deduct its expenses. The Secretary made no mention of the consistent interpretation of the relevant text by the Court of Appeals for the Fourth Circuit and the Board not to include any timely filing requirement.

Petitioner argues that section 882(c)(2) does not contain a timely filing requirement and that the disputed regulations are invalid as inconsistent with that section.⁵ Respondent argues that section 882(c)(2) provides clearly that a foreign corporation must file its return timely in order to deduct its expenses and that the disputed regulations are a proper interpretation of that provision. Respondent asks the Court now to accept his interpretation, which he acknowledges is the same as that rejected in Anglo–Am. Direct Tea Trading Co. v. Commissioner, supra, and its progeny, and to disavow all contrary interpretations expressed by the Court of Appeals for the Fourth Circuit and the Board.

We agree with petitioner that section 882(c)(2) does not contain a timely filing requirement and that the disputed regulations are invalid to the extent discussed herein. We hold that petitioner may deduct its expenses. On the basis of our holding and a concession by respondent that section 6651(a) is inapplicable if petitioner is entitled to deduct its expenses, we also hold without further discussion that petitioner is not liable for any addition to tax determined by respondent under section 6651(a).

FINDINGS OF FACT

Many facts were stipulated and are found accordingly. We incorporate herein by this reference the stipulated facts and the exhibits submitted therewith.

I. Background

Petitioner is a Barbados corporation whose mailing address was in Bridgetown, Barbados, when its petition was filed with the Court. It is an accrual method taxpayer that for Federal income tax purposes files a Form 1120–F, U.S. Income Tax Return of a Foreign Corporation (Form 1120–F), on the basis of a fiscal year ending on May 31. Its sole activity during the subject years was owning 160 acres of unimproved real estate (U.S. real estate) in San Diego County, California, and receiving option and rental income from the U.S. real estate. Petitioner has never engaged in a trade or business in the United States, and it does not have a separate business activity in Barbados.

II. Petitioner's Formation and Issuance of Additional Shares

Raimundo Arnaiz–Rosas (Rosas) is a citizen and resident of Mexico. He acquired the U.S. real estate on December 30, 1986. In June 1991, he formed petitioner as his wholly owned corporation. He transferred the U.S. real estate to petitioner on November 21, 1991.

Aurora Elsa Arnaiz (Arnaiz) is the sister of Rosas. She is a citizen and resident of Mexico. On June 1, 1992, petitioner issued additional shares of its stock to Arnaiz. Afterwards, Arnaiz owned 52 percent of petitioner's stock, and Rosas owned the remaining 48 percent.

III. Petitioner's Initial Tax Return

On September 14, 1992, petitioner filed a Form 1120–F with respondent's service center in Philadelphia, Pennsylvania (Philadelphia Service Center), for its short taxable year from June 27, 1991, through May 31, 1992 (1992 taxable year). The return (petitioner's initial return) was petitioner's first Federal income tax return. That return was prepared by Francisco A.F. Cervantes (Cervantes), petitioner's tax adviser and certified public accountant in California. As to petitioner's 1992 taxable year, petitioner's initial return reported that petitioner had no income or expense, that it had not engaged in a trade or business in the United States, and that it had no effectively connected income. Petitioner's initial return also reported that petitioner's business activity was real estate and that its product or service was investment. Petitioner's initial return also reported that petitioner was incorporated in Barbados and that petitioner was subject to income tax under the...