Tate & Lyle, Inc. v. C.I.R.

• Decision Date: 24 June 1996
• Docket Number: No. 95-7253,95-7253
• Parties: -5240, 65 USLW 2024, 96-2 USTC P 50,340 TATE & LYLE, INC. and Subsidiaries v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Appellant.
• Court: U.S. Court of Appeals — Third Circuit

Page 99

87 F.3d 99

78 A.F.T.R.2d 96-5240, 65 USLW 2024,

96-2 USTC P 50,340

TATE & LYLE, INC. and Subsidiaries v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Appellant.

No. 95-7253.

United States Court of Appeals Third Circuit.

Argued April 25, 1996.

Decided June 24, 1996.

Henry B. Miller, Burt, Maner & Miller, Washington, DC, for Appellee.

Gary R. Allen, Kenneth L. Greene, Thomas J. Clark (argued), United States Department of Justice, Tax Division, Washington, DC, for Appellant.

Robert H. Aland (argued), Gregg D. Lemein, Michael A. Pollard, Baker & McKenzie, Chicago, IL, Jeffrey M. O'Donnell, Baker & McKenzie, Washington, DC, for amici curiae.

Before: MANSMANN, ALITO and LEWIS, Circuit Judges.

OPINION OF THE COURT

MANSMANN, Circuit Judge.

In this appeal, the Commissioner has asked us to review a ruling which allowed a United States taxpayer to deduct interest owed to a related foreign payee when it was accrued rather than paid. Specifically, we must determine whether the United States Tax Court erred in holding that Treas. Reg. § 1.267(a)-3 is invalid to the extent that it requires accrual basis taxpayers to defer deductions for interest owed to a related foreign payee until the year the interest is paid. Also at issue is whether, assuming Treas. Reg. § 1.267(a)-3 is valid, retroactive application of the regulation violates the Due Process Clause of the Fifth Amendment.

Because we find that Treas. Reg. § 1.267(a)-3 is a valid exercise of the powers delegated to the Secretary under I.R.C. § 267(a)(3), and that retroactive application of the regulation to the taxpayer does not violate due process, we will reverse the decision of the Tax Court.

I.

The following facts were stipulated by the parties ¹ before the United States Tax Court. ² The taxpayer is an affiliated group of corporations of which Tate and Lyle, Inc. (TLI) is the common parent, and Refined Sugars, Inc. (RSI), is a wholly owned subsidiary. Both TLI and RSI are United States corporations and were included on the taxpayer's consolidated federal income tax returns for the tax years at issue. Tate and Lyle plc (PLC) is a United Kingdom corporation which indirectly owns 100% of TLI and RSI. The taxpayer and PLC are members of the same controlled group of corporations as defined in I.R.C. § 267(f).

PLC made interest-bearing loans to TLI and RSI, the tax consequence of which was interest expense to the taxpayer and interest income to PLC. The taxpayer and PLC report income and deductions using the accrual method of accounting. On its U.S. income tax returns, the taxpayer deducted interest expense owed to PLC by TLI and RSI in the year it accrued. The taxpayer did not pay the interest to PLC until the year following the year of accrual. ³

The interest income received by PLC was U.S. source income not effectively connected with a trade or business in the United States. ⁴ Under I.R.C. § 881(a)(1), such income is subject to U.S. tax at a rate of 30%. ⁵ Pursuant to Article 11(1) of the United States-United Kingdom Income Tax Convention ⁶ (treaty), 31 U.S.T. 5668, which was in effect at all times here, the interest income received by PLC was exempt from United States tax.

The Commissioner disallowed the taxpayer's deduction for interest expense in the years accrued and subsequently mailed to the taxpayer notices of deficiency for the tax years ended September 29, 1985, September 28, 1986, and September 26, 1987. ⁷ In response to the notices of deficiency, the taxpayer filed a petition in the United States Tax Court challenging the Commissioner's determination.

The following facts, not part of the stipulation, are evident from the record. The Commissioner asserted before the Tax Court that I.R.C. §§ 267(a)(2) and (a)(3) and Treas. Reg. § 1.267(a)-3 allow payor a deduction for interest only in the tax year when the related payee would normally report the interest as income for United States tax purposes. Normally, interest income received by a foreign corporation from sources within the United States and which is not effectively connected with a trade or business in this country, is reported on the cash basis method of accounting under I.R.C. §§ 881 and 1442. The Commissioner determined that the taxpayer was entitled to deduct interest only in the year it paid the interest to PLC.

The Tax Court held that because the accrued interest was not includable in PLC's income because of an exemption under the tax treaty rather than as a result of PLC's method of accounting, Treas. Reg. § 1.267(a)-3 was invalid because it did not apply the matching principle of I.R.C. § 267(a)(2). A four-judge plurality determined that even if the provisions of Treas. Reg. § 1.267(a)-3 were found to be within the broad regulatory authority granted by I.R.C. § 267(a)(3), the retroactive application of the regulation violated the Due Process Clause of the Fifth Amendment. ⁸ Accordingly, the Tax Court found that the taxpayer was not required to defer its interest deduction until it actually paid the interest.

The Commissioner appeals to us from the final decision of the Tax Court entered on February 13, 1995. ⁹ We have jurisdiction under I.R.C. § 7482(a). See Lerman v. Commissioner, 939 F.2d 44, 45 (3d Cir.), cert. denied, 502 U.S. 984, 112 S.Ct. 590, 116 L.Ed.2d 615 (1991).

II.

We turn first to the issue of whether Treas. Reg. § 1.267(a)-3 is a valid interpretation of I.R.C. § 267(a)(3). The validity of a treasury regulation is a question of law over which we exercise plenary review. Mazzocchi Bus Co., Inc. v. Commissioner, 14 F.3d 923, 927 (3d Cir.1994).

As amended in 1984, I.R.C. § 267(a)(2) provides for a matching of interest deductions and income where, in the case of related persons, the payor is an accrual basis taxpayer and the payee is on a cash basis method of accounting. Section 267(a)(2) specifically provides:

(2) Matching of deduction and payee income item in the case of expenses and interest.--If--

(A) by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not (unless paid) includible in the gross income of such person, and

(B) at the close of the taxable year of the taxpayer for which (but for this paragraph) the amount would be deductible under this chapter, both the taxpayer and the person to whom the payment is to be made are persons specified in any of the paragraphs of subsection (b),

then any deduction allowable under this chapter in respect of such amount shall be allowable as of the day as of which such amount is includible in the gross income of the person to whom the payment is made (or, if later, as of the day on which it would be so allowable but for this paragraph)....

Section 267(a)(2), as amended in 1984, applied to interest allowable as a deduction for taxable years beginning after December 31, 1983. Deficit Reduction Act of 1984, Pub.L. No. 98-369, § 174(c), 98 Stat. 494, 708.

The purpose behind the 1984 amendment was to require related persons "to use the same accounting method with respect to transactions between themselves in order to prevent the allowance of a deduction without the corresponding inclusion in income." H. Rep. No. 98-432, 98th Cong., 2nd Sess., reprinted in 1984 U.S.C.C.A.N. 697, 1206. The Ways and Means Committee further stated that "[t]he failure to use the same accounting method with respect to one transaction involves unwarranted tax benefits, especially where payments are delayed for a long period of time, and in fact may never be paid." Id. Congress thus amended section 267(a)(2) to require an accrual basis taxpayer to deduct interest owed to a related cash basis taxpayer when payment is made. Id. Congress explained that "[i]n other words, the deduction by the payor will be allowed no earlier than when the corresponding income is recognized by the payee." Id.

In 1986, Congress again amended section 267, this time to add subsection (a)(3) because it felt that the matching provision of section 267(a)(2) was "unclear when the related payee was a foreign person that does not, for many Code purposes, include in gross income foreign source income that is not effectively connected with a U.S. trade or business." S.Rep. No. 99-313, 99th Cong., 2nd Sess. at 959, reprinted in 1986-3 C.B. (Vol.3) 1, 959. Section 267(a)(3) reads as follows:

(3) Payments to foreign persons.--The Secretary shall by regulations apply the matching principle of paragraph (2) in cases in which the person to whom the payment is to be made is not a United States person.

Like section 267(a)(2), section 267(a)(3) was made retroactive to taxable years beginning after December 31, 1983. Tax Reform Act of 1986, Pub.L. No. 99-514, § 1881, 100 Stat.2085, 2914.

In accordance with section 267(a)(3), the Secretary issued final regulations on December 31, 1992. ¹⁰ T.D. 8465, 1992-2 C.B. 12. Treas. Reg. § 1.267(a)-3(b)(1) sets forth the following general rule:

section 267(a)(3) requires a taxpayer to use the cash method of accounting with respect to the deduction of amounts owed to a related foreign person. An amount that is owed to a related foreign person and that is otherwise deductible under Chapter 1 thus may not be deducted by the taxpayer until such amount is paid to the related foreign person.... An amount is treated as paid for purposes of this section if the amount is considered paid for purposes of section 1441 or section 1442 (including an amount taken into account pursuant to section 884(f)).

Treas. Reg. § 1.267(a)-3(c) provides certain exceptions and special rules to paragraph (b) of this section. Paragraph (c)(1), which applies to income that is effectively connected with the conduct of a United States trade or business of a related foreign person, does not apply if the related foreign person is exempt from United States income tax on the amount owed pursuant to a tax treaty. Paragraph (c)(2) addresses the treatment of items exempt from tax because of a tax treaty. Specifically, p...