Can a taxpayer argue substance over form? Can Congress legislate retroactively? A recent Tax Court case has lessons for Canadian taxpayers that operate through a branch.
The recent case of Taiyo Hawaii Co., Ltd.,1 decided by Judge Joel Gerber, a thoughtful member of the Tax Court, represents the court's latest position on a number of significant and recurring tax issues.
Form Over Substance
In Taiyo, the taxpayer, a Japanese corporation with a U.S. branch, structured the receipt of certain moneys from its parent corporation in the form of loans, but tried to argue that the loans were instead capital contributions. Judge Gerber held that the taxpayer could not assert substance over form to disavow the form of the transaction chosen. Although certain taxpayers have been permitted to assert substance over form in situations where their "tax reporting and other actions have shown an honest and consistent respect for . . . the substance"2 of a transaction, the court held that the taxpayer was ineligible for this exception. In the court's view, the taxpayer's conduct did not suggest that the substance of the advances was not loans, but merely illustrated that "the parties to the transaction did not follow all of the formalities that might be considered probative that the advances were debt rather than equity."3 In support of this conclusion, the court noted that the taxpayer had treated the advances as loans "for all purposes" because the taxpayer had been instructed by its parent to accrue interest, had reported the advances as loans for tax and financial purposes, and had received a document from its home office that listed the advances and contained terms indicative of debt and interest.
In concluding that the taxpayer could not assert substance over form, the court ignored the facts that the loans were not evidenced by promissory notes, had no fixed maturity dates, had no stated rate of interest, were unsecured, and remained unpaid during the years at issue. These facts contradicted the court's statement that the taxpayer had treated the advances in substance as loans "for all purposes" and had ignored mere "formalities" (repayment of a loan is not a "formality"). If the Internal Revenue Service (IRS) had sought to have the advances recast as equity, it would have had strong arguments. Taiyo can thus be cited by the IRS to argue that taxpayers can rarely, if ever, disavow the form of their transactions, regardless of their course of conduct. Taxpayers may also be able to cite Taiyo to defend against an attempt by the IRS to recast debt as equity; especially useful is the court's statement that the equity-like characteristics of the advances did not "suggest that the substance of the advances was not loans."4 We cannot recall another case in which the taxpayer attempted to disavow the form of the transaction in a debt-equity situation.
Withholding on Excess Interest
To understand the controversy in Taiyo, one must understand the concept of "excess interest." Unlike most countries, the United States does not treat a branch of a foreign corporation as a separate taxable entity. The United States combines the activities of the corporation and permits an interest deduction against income taxable in the United States for a portion of the worldwide interest paid by the foreign corporation. The amount deductible is determined by a formula that allocates a portion of the liabilities to the United States on the basis of the assets used in the U.S. business. Interest paid by the U.S. branch is subject to withholding tax. Interest deductible under the formula that exceeds the interest paid by the branch--that is, paid by the home office--is "excess interest" and, since the home office cannot be required to withhold a U.S. tax, a fictional payment is deemed paid by the branch to the home office and subjected to tax.
Interest is allocable to the U.S. business under a three-step process contained in Treasury regulation section 1.882-5.5 The first step determines which assets are "U.S. connected" by ascertaining which assets generate effectively connected business income (ECI). In the second step, the amount of U.S. connected liabilities is determined on the basis of a "fixed" or "actual" ratio; the latter is the ratio of the foreign corporation's worldwide liabilities to its worldwide assets. In the third step, the U.S. connected liabilities are multiplied by an appropriate interest rate to arrive at the interest expense allocable to the U.S. ECI. The branch interest (actually paid) is subtracted from the interest allocable to ECI to determine the "excess interest."
The taxpayer argued that certain property owned by the U.S. branch was not an asset that produced ECI.6 Code section 864(c) governs the determination of whether an asset generates ECI. Section 864(c)(2) provides two tests: (1) whether the income is derived from assets used or held for use in the conduct of a U.S. trade or business ("the asset use test"); and (2) whether the activities of a trade or business were a material factor in the realization of the income ("the business activities test"). Section 864(c)(3) also provides that assets that produce income other than passive income and capital gains are treated as if they produce ECI if the taxpayer is otherwise engaged in a U.S. trade or business, regardless of whether any actual connection between the assets and ECI exists.
The court in Taiyo concluded that the taxpayer's real estate was "U.S. connected" under section 864(c)(3) on the basis that it produced income other than investment income and capital gain income. In the court's opinion, the taxpayer held the property with the intention of selling it, and a sale would have generated ordinary income. Although the primary purpose for which a taxpayer holds property may change, it is the primary purpose for which the property is held at the time of the sale that determines the tax treatment of the gain. However, the court also may consider a taxpayer's intent over the course of ownership to determine the primary purpose for which the property is held at the time of the sale. The court noted that the taxpayer's predecessor had acquired the property with the express intention of developing and selling it as residential property, and the taxpayer had continued these efforts. Generally, the taxpayer maintained zoning conditions and paid certain fees with respect to the property, but held the property undeveloped, and derived absolutely no revenue from it during the tax years at issue. No efforts were made to sell the property during that time, and the property was not advertised for sale or sold until four years after the tax years under consideration. Although the court noted that less frequent sales resulting in large profits tended to show that property was held for investment, the court nonetheless concluded that the taxpayer held the property primarily for sale. The court placed heavy emphasis on the descriptions of the taxpayer's activities, contained in its organizational documents and tax returns, as "real estate development and property investment" and "real estate investment and development." Taiyo appears to broaden the scope of the types of assets that are considered to constitute ECI-generating assets. It will be cited by the IRS and taxpayers alike for issues arising under sections 884, 882, 881, and 865.
Application of Retroactive Amendments
The primary controversy in Taiyo was whether the taxpayer was liable for the excess interest tax contained in section 884(f)(1)(B). For tax advisers, however, the more important issue is the treatment of retroactive amendments. As discussed above, Code section 884(f)(1)(A) generally operates to treat interest actually paid by a U.S. branch ("branch interest") as if it were instead paid by a U.S. subsidiary.7 Section 884(f)(1)(B) imposes a tax on "excess interest," which is interest expense not actually paid by the U.S. branch, but nonetheless allocated to the U.S. branch for the purposes of calculating ECI under Treasury regulation section 1.882-5. This excess interest is also taxed as if it were paid to the parent home office by a wholly owned domestic corporation. The taxpayer in Taiyo reported its interest expense to include the interest accrued to its parent, but did not withhold any U.S. tax with respect to that interest.8 The IRS determined that the interest that accrued to the parent constituted excess interest under section 884(f)(1)(B).
The taxpayer argued that, because section 267(a)(3) prohibited a deduction for its interest obligations to the parent, the excess interest tax did not apply. Section 267 generally limits the deductibility of interest by a borrower to the extent that it is not included in a related lender's gross income. Section 884, as it read during the years at issue, was at least ambiguous on this point. At that time, the statute provided that excess interest did not include amounts not "reasonably expected to be deductible under section 882 in computing the effectively connected taxable income of such foreign corporation." Unfortunately for the taxpayer, an amendment to section 884 deleted this language and replaced it with language that provided that excess interest included amounts "reasonably expected to be allocable interest." This amendment was enacted in 1996 after the trial, while the briefs were being prepared, and before Judge Gerber wrote his opinion; and the amendment was retroactive to tax years beginning after December 31, 1986 (that is, for a 10-year period). The court relied on the legislative history accompanying the amendment in concluding that the amendment was intended to address an argument similar to that made by the taxpayer in this case, and held that interest expense is taken into account for the purposes of section 884(f)(1)(B) even if it is rendered non-deductible by section 267.
If the taxpayer had consulted a tax adviser during the years at issue, the statutory language at the time would have supported the position that non-deductible interest cannot be excess interest. The amendment was enacted after the taxpayer had relied on the prior version of the statute in presenting its arguments at trial and on brief. Although the amendments were not available to the taxpayer when it structured its transaction and argued its case, they were available to Judge Gerber when he wrote his opinion. As he stated in a footnote: "Most unfortuitously for petitioner, the statute in question was retroactively amended subsequent to the trial of this matter and during the briefing pattern of the parties."9
Taiyois a warning to those tax advisers who believe that the tax law is certain and predictable. Congress has overridden treaties. Now we know that Congress can adopt retroactive legislation.
1108 TC 590 (1997).
2Federal Nat'l. Mortgage Assoc., 90 TC 405, at 426 (1988) (citing Illinois Power Company, 87 TC 1417, at 1430 (1986)), aff'd. 896 F.2d 580 (DC Cir. 1990).
3Supra footnote 1, at 596.
5Regulations to the Internal Revenue Code of 1986, as amended (herein referred to as "the Code"). Unless otherwise stated, statutory references in this article are to the Code and the regulations thereunder.
6If the taxpayer had won its argument that the property did not generate ECI, the amount of its liabilities subject to the excess interest provisions, and thus the amount of excess interest tax, would have been reduced.
7If it were not for this provision, interest paid by US branches of foreign corporations would not be US sourced interest, and would incur no US tax.
8The taxpayer did withhold US tax with respect to the interest paid to the banks.
9Supra footnote 1, at 597, footnote 13.