On 21 January 2021, the Tax Court decided Adams Challenge (UK) Ltd. v. Commissioner, 156 T.C. No. 2, 2021 BL 19487 (2021), denying deductions to a foreign corporation because it filed its returns after the IRS had prepared returns on its behalf. Adams Challenge disputed Treas. Reg. § 1.882-4(a)(3)(i), requiring “timely” returns (defined as a period of 18 months after a due date) for a foreign corporate taxpayer to claim deductions and credits. It addressed a similar legal issue as Swallows Holding, Ltd. v. Commissioner, 126 T.C. 96 (2006), vacated and remanded, 515 F.3d 162 (3d Cir. 2008), a case whose taxpayer-friendly Tax Court decision was overturned by the Court of Appeals for the Third Circuit. While the Tax Court in Adams Challenge ultimately denied deductions to the taxpayer, it declined to overrule or otherwise reconsider its prior holding in Swallows Holding.
Background on Swallows Holding
The taxpayer in Swallows Holding was a foreign-owned Barbados corporation owning a parcel of real property in California from which it derived rental and option income. The taxpayer had not filed US federal income tax returns for taxable years 1993 through 1996, even though it generated income. In 1999, the taxpayer filed returns for the 1993 to 1996 years, claiming loss deductions while also reporting no trade or business in the United States.
The Internal Revenue Service (IRS) disallowed the loss deduction on the basis that the taxpayer had not complied with the prerequisites of Code Section 882(c)(2). Section 882(c)(2) provides that a foreign corporation may “receive the benefit of the deductions and credits allowed to it … only by filing … a true and accurate return, in the manner prescribed….” Treas. Reg. § 1.882-4(a)(3)(i) elaborates on the “manner” in which the return must be filed, such as the place of filing and consistency with subtitle F (Procedure and Administration). In addition to detailing the “manner” of filing the returns, the section 882 regulations also prescribe filing deadlines for such returns, whereby deductions will be disallowed unless a return is filed “timely,” defined as within an 18-month window.
The taxpayer plainly had filed outside the period specified in the section 882 regulations. The Tax Court nevertheless granted the taxpayer the claimed deductions because the court concluded that the adoption of the “timely” requirement in the regulations was contrary to the plain language of the statute, which only granted authority to prescribe the “manner” of filing US federal income tax returns. A majority of 12 Tax Court judges agreed with this opinion, with two other judges in concurrence in result and three in dissent.
On appeal, however, the Third Circuit reversed the Tax Court’s decision and denied the taxpayer the deduction. It held the disputed regulation to the higher Chevron standard of deference and thus concluded that the 18-month filing window created by Treas. Reg. § 1.882-4(a)(3)(i) was a “reasonable exercise of the Secretary’s authority.” This reversal by the Third Circuit does not overrule the Tax Court’s opinion provided that the taxpayer does not have a right of appeal to the Third Circuit, as provided for by Treas. Reg. § 1.6662-4(d)(3)(iii).
Since the decision in Swallows Holding, there have been several changes in the law worth noting. Under Treas. Reg. § 1.882-4(a)(3)(ii), the filing deadline of 18 months after a due date can be waived if a taxpayer “acted reasonably and in good faith in failing to file a US income tax return.” This is an adjustment from the previous “rare and unusual circumstances” standard in place before the 2003 regulation revisions, and which applied to the taxpayer in Swallows Holding.
Thus, the regulations are now more favorable to the taxpayer and presumably have reduced the number of cases where taxpayers are barred from claiming deductions and credits due to untimely returns (e.g., where the taxpayer can indicate reasonable reliance on an advisor, etc.).
Additionally, the Third Circuit took jurisdiction of the appeal of Swallows Holding because Form 1120-F returns were filed with the Internal Revenue Service Center in Philadelphia, Pennsylvania before 2006. Because Form 1120-F returns are now filed with the Internal Revenue Service Center in Ogden, Utah, any future decisions on this issue will be handled by the Tenth Circuit.
The Adams Challenge Decision
The Swallows Holding issue laid dormant and was largely forgotten by the tax community until the recent Adams Challenge decision. In Adams Challenge, the taxpayer was a UK company, whose only income-producing asset in the United States from 2009 to 2011 was a ship, the M.V. Adams Challenge. The taxpayer did not report the relevant income to the IRS, which issued a Notice of Jeopardy Assessment and Right of Appeal to the taxpayer in October 2013. In response, the taxpayer filed a Form 1120-F on December 2013 for 2011. In April 2014, the IRS prepared returns for the taxpayer for the years 2009 and 2010. Later, in November 2014, the IRS issued a notice of deficiency to the taxpayer and denied taxpayer deductions and credits for 2009 and 2010 due to failure to file returns. As a result, the taxpayer petitioned the court in February 2015 and filed protective returns for the 2009 and 2010 years two years later in February 2017.
The taxpayer did not argue that it was entitled to deductions under the regulations. Instead, it argued that it was entitled to deductions because Treas. Reg. § 1.882-4(a)(3)(i) and the filing deadline set by it were invalid, citing the analysis in the Tax Court’s holding in Swallows Holding. The taxpayer ignored the Third Circuit’s holding in Swallows Holding on jurisdictional grounds, because appeal of the case did not lie in the Third Circuit. The IRS on the other hand requested that the Tax Court overrule its prior opinion in Swallows Holding and deny the taxpayer deductions.
The Tax Court declined to allow the taxpayer deductions or credits for the 2009 and 2010 years but also denied the IRS’ request to overrule its prior opinion. It found that the taxpayer had failed to file its 2009 and 2010 returns by the “terminal date established by section 882(c)(2), namely, the date on which the Commissioner exercised his authority … to prepare returns for it.”
The term “terminal date” is not found anywhere in the statute. It is instead a term coined by the Tax Court (previously known as the US Board of Tax Appeals) in Taylor Securities v. Commissioner, 40 B.T.A. 696 (1939). The “terminal date” is “the date on which the Commissioner exercises his authority to prepare and subscribe a return for the taxpayer under section 6020(b).” As such, the “terminal date” is “not fixed but variable,” and its only definition as adopted by the Tax Court remains the date on which the Commissioner files returns on behalf of a taxpayer.
The Tax Court did not reach the regulatory validity question because, even if the timeliness requirement of the regulations was ruled invalid, it would not allow the taxpayer to claim deductions or credits due to its failure to file returns before the “terminal date,” or the date on which the IRS filed returns for it.
The Tax Court’s refusal to grant the IRS’ request for the Tax Court to overturn its prior opinion in Swallows Holding suggests that the Tax Court holding in Swallows Holding is still good law and could be relied upon by a taxpayer that files returns past the 18-month window but before the “terminal date.”
Foreign taxpayers should still file protective returns, however. If the IRS files a return first, the foreign taxpayer may lose all deductions and credits for a given taxable year. Although the validity of the regulation mandating an 18-month filing deadline is not yet a settled question, the Tax Court-defined “terminal date” has long-standing precedent, and acts as a clear line in the sand that cannot be crossed. In other words, the period of limitations for foreign entities failing to file returns never runs.
Foreign taxpayers should identify income potentially subject to tax in the United States. This may be of special pertinence for tax year 2020 and 2021 because the pandemic has prevented some officers or employees of foreign companies or subsidiaries from leaving the United States, leading to temporary relief measures and unique tax questions. Failing to prepare a protective filing before the IRS files a return on behalf of a foreign company or subsidiary could result in the forfeiting of all deductions and credits for the taxable year, as Adams Challenge demonstrates.