• 'When The Swallows Return to...' Third Circuit Reverses Tax Court Decision on Foreign Corporation Return Filing Deadline
  • March 31, 2008 | Author: Leonard Schneidman
  • Law Firm: Pepper Hamilton LLP - Boston Office
  • The Third Circuit recently reversed the Tax Court’s ruling in Swallows Holding Ltd. v. Commissioner which had invalidated the return filing deadline imposed on foreign corporations by Reg. §1.882-4(a)(3)(i).1 That regulation requires that a foreign corporation engaged in a U.S. trade or business must file an income tax return within 18-months of the ordinary filing deadline set in Section 6072 in order to be able to claim any otherwise allowable deductions or credits for that year. In effect, a foreign corporation failing to meet the 18-month filing deadline is taxed at graduated rates on its gross income with no available deductions or credits.

    The technical issue before the Court was the administrative law question of the proper scope of judicial deference to be accorded to an agency’s administrative determination – here, the Service’s determination that the statutory requirement of Sec 882(c)(2) that foreign corporations file tax returns "in the manner prescribed by subpart F" permitted it to promulgate a regulation containing a filing deadline.

    Specifically, the Third Circuit held that the Service’s promulgation of Reg. §1.882-4(a)(3)(i) was entitled, in administrative law parlance, to "Chevron deference," so-named for the Supreme Court’s decision in Chevron U.S.A., Inc. v. Natural Resources Defense Counsel, Inc., 467 U.S. 837 (1984). When Chevron deference applies, it requires the agency rule to be upheld unless unreasonable.

    Under Chevron, a court must first determine whether the statute being interpreted by the agency is ambiguous so as to permit the agency to interpret it and, secondly, whether the agency’s interpretation is a permissible construction of the statute. The Third Circuit first held that the word "manner" as used in the statute is ambiguous and may include a timing element so as to permit a filing deadline to be imposed by regulation, and further held that the Service’s imposition of an 18-month window for filing was not unreasonable, particularly in light of the five-and-one-half-month period permitted under Section 6072(c) for taxpayers to timely file their tax returns.

    Pepper Perspective

    While the decision in Swallows turns on a complex analysis of administrative law, the result – that is, the upholding of the filing deadline for foreign taxpayers in order to be entitled to any business deductions – is of critical importance. With the Service’s current increased focus on whether foreign taxpayers are engaged in a U.S. trade or business and in light of the typical time frame for a tax audit, if the Service successfully raises the trade or business issue on audit it is often too late for the taxpayer to meet the filing deadline.

    For example, whether an offshore hedge fund engaged in mezzanine lending to U.S. borrowers is engaged in a U.S. trade or business is presently unclear. If a fund were determined on audit to be so engaged and had not filed a tax return within the required 18-month period, it would be taxable on its gross income with no available deductions.

    Pepper Suggestion – In circumstances where the answer is unclear to the question of whether a foreign taxpayer is engaged in a U.S. trade or business, the filing of a "protective" income tax return should be considered. Such a protective return would show no income (reflecting the taxpayer’s belief that it was not engaged in a U.S. trade or business), but would constitute a timely filing if it were subsequently determined that it was so engaged. Protective elections are specifically permitted under the regulations.


    1 Reg §1.874-2 provides a similar filing deadline for nonresident aliens engaged in a U.S. trade or business which regulation was not at issue in the Swallows case.