On January 25, 2021, the Tax Court issued its opinion in Adams Challenge UK Limited v. Commissioner (156 T.C. No. 3). The underlying issue presented in Adams Challenge UK Limited v. Commissioner was whether the IRS erred in disallowing the petitioner’s deductions and credits and whether the IRS’s action violated the business profits and the nondiscrimination articles of the bilateral income tax treaty between the United States and the U.K.
Background to Adams Challenge UK Limited v. Commissioner
The petitioner is a U.K. corporation whose sole income-producing asset for the years at issue was a multipurpose support vessel. The vessel was chartered by a U.S. firm to assist in decommissioning oil and gas wells and removing debris on portions of the U.S. Outer Continental Shelf in the Gulf of Mexico. During 2009 and 2010 P derived from the charter gross income of about $32 million, which was effectively connected with the conduct of a U.S. trade or business. You may recall this from last year’s summary of Adams Challenge (UK) Ltd. v. Commissioner, 154 T.C. 37 (2020).
The petitioner did not technically file a Federal income tax return for 2009 or 2010. In April 2014, the IRS prepared and subscribed returns for the petitioner for these years under the authority of IRC § 6020(b). In November 2014, the IRS issued the petitioner a notice of deficiency determining (among other things) that the petitioner was entitled to no deductions or credits for 2009 or 2010 because it had failed to file returns. See IRC § 882(c)(2). In February 2015, the petitioner petitioned the Tax Court for redetermination. In February 2017, the petitioner submitted protective returns for 2009 and 2010 to the IRS.
The Code generally allows a deduction for expenses incurred in the operation of a trade or business. See IRC § 162(a). The “income tax deduction is a matter of legislative grace,” designed to ensure that income is generally taxed on a net basis. See Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593 (1943). Certain expenses are expressly allowed as deductions by statute, while others are expressly disallowed. See, e.g., IRC § 280E (disallowing a deduction where the trade or business involves “trafficking in controlled substances”).
Deductions for Foreign Corporations
Foreign corporations generally are allowed deductions if and to the extent that they are connected with income which is effectively connected with the conduct of a U.S. trade or business. IRC § 882(c)(1)(A). Congress recognized, however, that it is far more difficult for the IRS to determine the correct tax liability of foreign (as opposed to U.S.) corporations.
Indeed, unless a foreign corporation is induced voluntarily to advise the Commissioner of all of its U.S. income, the IRS may never learn even of the corporation’s existence. Blenheim Co. v. Commissioner, 125 F.2d 906, 909 (4th Cir. 1942), aff’g 42 B.T.A. 1248 (1940). Since 1928 Congress has accordingly conditioned the grant of deductions to a foreign corporation upon its filing of a U.S. income tax return. Thus, a foreign taxpayer cannot “play the lottery” about whether it is engaged in a U.S. trade or business and then claim deductions significantly moderating its U.S. income tax liability.
This limitation on the allowance of deductions and credits is now set forth in section 882(c)(2). It provides in relevant part:
A foreign corporation shall receive the benefit of the deductions and credits allowed to it in this subtitle only by filing or causing to be filed with the IRS a true and accurate return, in the manner prescribed in subtitle F, including therein all the information which the IRS may deem necessary for the calculation of such deductions and credits.
A Centuries Old Question: When Must a Return be Filed?
Interestingly (for tax nerds like you and me), while conditioning the allowance of deductions and credits on the filing of a return “in the manner prescribed in subtitle F,” IRC § 882(c)(2) does not explicitly require that the foreign corporation’s return be filed timely, or that a delinquent return be filed by any particular deadline. The question the Tax Court was faced with, then, was whether IRC § 882(c)(2) establishes a cutoff point or terminal date after which it is too late for a foreign corporation to file a return and benefit from deductions and credits.
According to Judge Lauber, “this question has been the subject of judicial discussion for almost a century.”
A Long History, by Judge Lauber
As I note in other posts, brevity is not amongst Judge Lauber’s strong suits. His opinions are quite erudite and generally spot on, but if there is a chance for him to beat a dead horse with a history lesson, dang it, he’s going to do it. This opinion is a testament to that. We’ll spare you the pain of sifting through the lecture that begins one cold evening in 1928…
Sixty-four pages of history. Great for a law review article, not for a Tax Court opinion for your faithful editors to summarize…
So, in short, you’re welcome.
The Short Version
The Tax Court (well, the BTA at this point in the story) held that it was “inconceivable” that Congress contemplated that taxpayers could wait indefinitely to file returns and eventually when the IRS determined deficiencies against them they could then by filing returns obtain all the benefits to which they would have been entitled if their returns had been timely filed. Taylor Securities, Inc. v. Commissioner, 40 B.T.A. 696 (1939). Such a construction would “put a premium on evasion, since a taxpayer would have nothing to lose by not filing a return.” Id. at 703-704. The Tax Court accordingly held that a foreign corporation loses its right to deductions and credits if it does not file a return until after the IRS has prepared a return for it and notified the taxpayer of the deficiency determination.
Fast forwarding a few years, the Tax Court held that “the mere filing of a return is insufficient.” Brittingham v. Commissioner, 66 T.C. 373, 409 (1976), aff’d per curiam, 598 F.2d 1375 (5th Cir. 1979). Instead, the returns had to be “true and accurate” and prepared before the “terminal date,” which the Fourth Circuit had previously defined as the date on which the IRS prepared a return for the taxpayer. See Blenheim Co. v. Commissioner, 125 F.2d 906, 910 (4th Cir. 1942), aff’g 42 B.T.A. 1248 (1940).
The Tax Court previously dealt with the issue of deductions claimed by a nonresident alien individual, which, though analogous, was merely part of Judge Lauber’s story. In Espinosa v. Commissioner, 107 T.C. 146 (1996), the taxpayer, a Mexican national, derived U.S.-source income during 1987-1991 but filed no U.S. income tax returns. The IRS sent him letters requesting that he file returns, but he declined to do so. In March 1993 the IRS informed him that it had prepared and filed returns for him that allowed no deductions. Ibid. In October 1993 the taxpayer submitted returns reporting losses for each year. In January 1994 the IRS issued a notice of deficiency determining that he was entitled to no deductions, pursuant to IRC § 874(a).
The Tax Court held that although neither IRC § 874(a) nor IRC § 882(c)(2) contains an “express time limit,” for foreign individuals as well as foreign corporations, “there exists a terminal date, after which a taxpayer can no longer claim the benefit of deductions by filing a return.” Id. at 156. This terminal date is the date on which the IRS prepares and subscribes a return for the taxpayer under IRS § 6020(b).
Thus (after 33 pages), the Tax Court concludes that because the petitioner failed to file a return for either year within the terminal period established by IRC § 882(c)(2), it is entitled to no deductions or credits for either year.
But, But – Good Faith!
There is a very limited good faith exception that the petitioner tried to shoehorn its big corporate foot into. In a 1940s case, a taxpayer had “attempted in good faith” to file returns before the IRS prepared returns for it, but the IRS’s representative was an administrative dick and refused to accept the returns. Ardbern Co. v. Commissioner, 41 B.T.A. 910 (1940), modified and remanded, 120 F.2d 424 (4th Cir. 1941). In these unusual circumstances, the Fourth Circuit held that “elementary justice” and “fair dealing between the Government and a taxpayer” required that the filing deadline be tolled. Id. A taxpayer seeking shelter under this judicially created “good faith” exception must show “compelling equitable considerations.” Espinosa, 107 T.C. at 156.
The present petitioner, in short, did not so show these considerations.
Ye of Little (Good) Faith
The petitioner failed to identify itself to the IRS during the tax years at issue. In fact, it was discovered to be operating on the OCS only because the IRS initiated a compliance program using satellite tracking tools. The petitioner does note that it did identify itself to other U.S. agencies, including the Coast Guard – but only because petitioner needed Coast Guard permission to operate on the OCS as it wished to do. Judge Lauber is unimpressed, finding that “this action does not cut much mustard in assessing its good faith with respect to its U.S. tax obligations.” In any event, the relevant question is not whether the taxpayer displayed good faith in some abstract sense, but whether it attempted in good faith to file a U.S. income tax return before the IRS prepared a return for it.
It did not.
The Substitute for Return
IRC § 6020(b) (Execution of Return by IRS) provides that, if any person fails to make any return required by law, the IRS will create return from its own knowledge and from whatever information as it can cobble together. IRC § 6020(b)(1). In turn, IRC § 6020(b)(2) (Status of Returns) provides that any return so made and subscribed by the IRS is prima facie good and sufficient for all legal purposes.
Thus, if you want to get hosed by the IRS, let them threaten to prepare a return for you, rebuke them, and see what happens.
The Tax Court has consistently held that a return prepared and executed by the IRS under IRC § 6020(b) constitutes the taxpayer’s “return” for the year at issue, e.g., for purposes of imposing the addition to tax under IRC § 6651(a)(2) for failure to pay timely the amount shown as tax on any return. See Wheeler v. Commissioner, 127 T.C. 200, 208-09 (2006); Hyde v. Commissioner, T.C. Memo. 2011-104 (same), aff’d, 471 F. App’x 537 (8th Cir. 2012).
One Return to Rule Them All
Only one valid “return” can be filed for any given year. Goldring v. Commissioner, 20 T.C. 79, 81 (1953) (holding that the word “return” includes only “the original return”). Once the IRS has prepared and subscribed a return for the taxpayer under IRC § 6020(b), the proverbial die has been cast, and the taxpayer cannot file or cause to be filed with the IRS a true and accurate return as IRC § 882(c)(2) requires. The most the taxpayer can do is to file an amended return or a claim for refund, neither of which the IRS is obligated to accept. See Badaracco v. Commissioner, 464 U.S. 386, 393 (1984).
A (Very) Few Words on the U.S/U.K. Treaty
Where the Code and a treaty pertain to the same subject matter but manifest an irreconcilable conflict, “the last expression of the sovereign will control.” Chae Chan Ping v. United States, 130 U.S. 581, 600 (1889). However, if there is no conflict between the two, then the Code and the treaty should be read harmoniously, to give effect to each. Pekar v. Commissioner, 113 T.C. 158, 161 (1999); see IRC § 7852(d)(1) (holding that for purposes of determining the relationship between a provision of a treaty and any U.S. law, “neither the treaty nor the law shall have preferential status by reason of its being a treaty or law”).
“In short, there is no “clear repugnancy” between section 882(c)(2) and the Treaty.” Therefore, the Code controls.
Judge Lauber has a lot of damn gall using the phrase “in short” unironically.
He spent 52 pages (so far) on a history lesson 95% of which was chaff. The proverbial wheat of the opinion could have been mustered in a quarter of that. The Tax Court has held that you must file a return before the IRS files one for you in order to claim deductions. That law is settled and has been settled since the late 1920s. The treaty and the Code are not in conflict, and, therefore, the Code controls.
How freaking hard was that? Fifty-two pages, hard, it appears.
Moral of the Story
File your damn returns, or the IRS will do it for you.
If you are a foreign corporation, making a boatload of money (couldn’t help it), then this is not a good proposition.Add to favorites