Tate & Lyle Inc v. Commissioner IRS ( 1996 )

Opinions of the United
1996 Decisions States Court of Appeals
for the Third Circuit
6-24-1996
Tate & Lyle Inc v. Commissioner IRS
Precedential or Non-Precedential:
Docket 95-7253
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UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
___________
No. 95-7253
___________
TATE & LYLE INC. AND SUBSIDIARIES
v.
COMMISSIONER OF INTERNAL REVENUE SERVICE,
Appellant
___________
Appeal from the United States Tax Court
(No. 92-00740)
___________
Argued
April 25, 1996
Before: MANSMANN, ALITO and LEWIS, Circuit Judges.
(Filed June 24, 1996)
___________
Henry B. Miller, Esquire
Burt, Maner & Miller
1300 Eye Street, N.W.
975 East Tower
Washington, DC 20005
COUNSEL FOR APPELLEE
Gary R. Allen, Esquire
Kenneth L. Greene, Esquire
Thomas J. Clark, Esquire (ARGUED)
United States Department of Justice
Tax Division
P.O. Box 502
Washington, DC 20044
COUNSEL FOR APPELLANT
Robert H. Aland, Esquire (ARGUED)
Gregg D. Lemein, Esquire
Michael A. Pollard, Esquire
Baker & McKenzie
One Prudential Plaza
130 East Randolph Drive
Chicago, IL 60601-6384
Jeffrey M. O'Donnell, Esquire
Baker & McKenzie
815 Connecticut Avenue, N.W.
Washington, DC 20006-4078
COUNSEL FOR AMICI CURIAE
___________
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
before the United States Tax Court. 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.
The interest income received by PLC was U.S. source
income not effectively connected with a trade or business in the
United States. Under I.R.C. 881(a)(1), such income is subject
to U.S. tax at a rate of 30%. Pursuant to Article 11(1) of the
United States-United Kingdom Income Tax Convention (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.
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. 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. 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 (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 in1984
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. 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, paragraph (c)(2) requires that:
Interest that is not effectively connected
income of the related foreign person is an
amount covered by paragraph (b) of this
section, regardless of whether the related
foreign person is exempt from United States
taxation on the amount owed pursuant to a
treaty obligation of the United States.
Thus, under the regulation, a taxpayer who owes interest to a
related foreign person, where the related foreign payee is exempt
from taxation on the interest received from U.S. sources not
effectively connected with a U.S. trade or business of the
foreign payee due to a tax treaty, may not deduct the interest
owed to the related foreign person until the taxpayer actually
pays the interest to the related foreign person. Treas. Reg.
1.267(a)-3 is effective with respect to interest deductions
allowable in tax years beginning after December 31, 1983.
Treas. Reg. 1.267(a)-3(d).
The parties to this appeal agree that Treas. Reg.
1.267(a)-3 is a legislative regulation which was issued
pursuant to a clear congressional delegation of rule making
authority. In reviewing an agency's construction of a statute
which it administers, we take our lead from the Supreme Court's
opinion in Chevron U.S.A., Inc. v. Natural Resources Defense
Council, Inc., 467 U.S. 837, reh'g. denied, 468 U.S. 1227 (1984).
Under Chevron, we must first ask "whether Congress has directly
spoken to the precise question at issue." Id. at 842. If
Congress' intent is clear from the plain language of the statute,
then our inquiry ends there. Id. If we conclude, however, that
Congress has not directly addressed the precise question at issue
or that the statute is silent or ambiguous regarding the issue,
then we must determine whether the agency's interpretation "is
based on a permissible construction of the statute." Id. at 843.
Inherent in the powers of an administrative agency is
the authority to formulate policies and to promulgate rules to
fill any gaps left, either implicitly or explicitly, by Congress.
Id. (citing Morton v. Ruiz, 415 U.S. 199, 231 (1974)). Where
Congress has expressly delegated to an agency the power to
"elucidate a specific provision of the statute by regulation . .
. . [s]uch legislative regulations are given controlling weight
unless they are arbitrary, capricious, or manifestly contrary to
the statute." Id. at 844 (footnote omitted).
Applying the Chevron test, we find initially that
Congress' intent is not clear from the plain language of I.R.C.
267(a)(3). Congress specifically directed the Secretary to adopt
regulations applying the "matching principle of paragraph (2)" to
foreign related persons. If, as the Tax Court found and amici
suggest, the plain meaning of section 267(a)(3) requires the
Secretary to apply exactly the same matching principle of section
267(a)(2) to foreign persons, then the language of section
267(a)(3) is redundant. The Commissioner argues, moreover,
that if the matching principle of section 267(a)(2) was strictly
applied here, the U.S. payor would never be entitled to an
interest deduction because the related foreign payee would never
have to include interest in taxable income under a tax treaty
with the United States. This unduly harsh result is one of the
inequities Congress was attempting to rectify when it enacted
I.R.C. 267(a)(2) in 1984.
The rules of statutory construction mandate that:
. . . a statute is to be read as a whole, see
Massachusetts v. Morash, 490 U.S. 107, 115
(1989), since the meaning of statutory
language, plain or not, depends on context.
See, e.g., Shell Oil Co. v. Iowa Dept. of
Revenue, 488 U.S. 19, 26 (1988). "Words are
not pebbles in alien juxtaposition; they have
only a communal existence; and not only does
the meaning of each interpenetrate the other,
but all in their aggregate take their purport
from the setting in which they are used. . .
." NLRB v. Federbush Co., 121 F.2d 954, 957
(CA2 1941) (L. Hand, J.) (quoted in Shell
Oil, supra, at 25, n.6).10
_______________
10 See also United States v. Hartwell, 6
Wall. 385, 396 (1868) (in construing statute
court should adopt that sense of words which
best harmonizes with context and promotes
policy and objectives of legislature). . .
King v. St. Vincent's Hospital, 502 U.S. 215, 221 (1991). We do
not believe that Congress would have enacted section 267(a)(3) if
it intended to apply the same matching principle of section
267(a)(2) to foreign persons. Thus, we find that it is unclear
from the plain meaning of section 267(a)(3) how Congress intended
the matching principle of section 267(a)(2) to apply to foreign
related persons.
We turn to our second inquiry under Chevron -- whether
the Secretary's interpretation as promulgated in Treas. Reg.
1.267(a)-3 is based on a permissible construction of section
267(a)(3). The legislative history of section 267(a)(3) reveals
that Congress anticipated other reasons for the mismatch of
interest expense and income between related persons, which would
defer the deduction of interest expense until actually paid. In
the Committee Reports, Congress explained the need for section
267(a)(3), stating that section 267(a)(2), as enacted in 1984,
was unclear when the related payee was a foreign person, which
did not, "for many Code purposes," include foreign source income
that is not effectively connected with a U.S. trade or business
in gross income for U.S. tax purposes. S. Rep. No. 99-313, 99th
Cong., 2nd Sess. 959; reprinted in 1986-3 C.B. (Vol. 3) at 959;
H. Rep. No. 99-426, 99th Cong., 2nd Sess. 939, reprinted in 1986-
3 C.B. (Vol. 2) at 939.
By way of example, the Committee described a situation
where a foreign corporation, which was not engaged in a U.S.
trade or business, performed services outside the United States
for the benefit of a wholly owned U.S. subsidiary. As a result
of performing these services, the related foreign payee had
foreign source income which was not effectively connected with a
U.S. trade or business and, therefore, was not subject to U.S.
tax. In this situation, the Committee explained that the U.S.
subsidiary could be required to use the cash method of accounting
for the deduction of amounts owed to the foreign parent for the
services rendered. Id. Although in this example the facts are
slightly different than those presented in the case before us, it
is clear that Congress anticipated a situation where the required
use of the cash method of accounting by the U.S. payor is not
based on the foreign payee's accounting method since, in the
example, the foreign payee was not subject to U.S. tax on the
income received from the related U.S. payor.
In promulgating Treasury Reg. 1.267(a)-3, the
Secretary followed the directives of the House and Senate
reports. Both reports clearly indicate that Congress
contemplated that section 267(a)(3) could be applied to
situations where the foreign related payee was not ultimately
subject to tax on the amount received, and that the regulations
could require the U.S. subsidiary to use the cash method of
accounting for the deduction of interest owed to its foreign
parent. We find that the rule adopted by the Secretary,
requiring a U.S. taxpayer to use the cash method of accounting
with respect to the deduction of interest owed to a related
foreign person, is a permissible construction of section
267(a)(3).
Having so found, we must also conclude that the
regulation is not arbitrary, capricious or manifestly contrary to
section 267(a)(3). Nothing in the legislative history convinces
us to the contrary.
While the Tax Court recognized that deference must be
given to legislative regulations, it nonetheless invalidated
Treas. Reg. 1.267(a)-3 as being "manifestly beyond the mandate
of [section 267(a)(3)]." 103 T.C. 656, 671 (1994). The Tax
Court based its holding on the fact that the Commissioner
disallowed the taxpayer's interest deductions for reasons other
than the method of accounting of PLC. Both the Tax Court and
amici argued that because the plain meaning of section 267(a)(3)
was clear, there was no need to look to the legislative history.
Accordingly, the Tax Court held there was no provision that
permitted the Secretary to expand the reach of the regulations
under section 267(a)(3) beyond the matching principle of section
267(a)(2). We disagree. Recently, we reiterated the general
rule on deference:
In general, unless an issue is governed
by an unambiguous statutory provision, courts
must defer to an agency's interpretation of a
statute it has been entrusted to administer.
Thus, the function for the court is not to
impose its own interpretation of the statute,
but simply to determine whether the agency's
interpretation "is based on a permissible
construction of the statute." INS v.
Cardoza-Fonseca, 480 U.S. 421, 445 n.29, 107
S. Ct. 1207, 94 L.Ed.2d 434 (1987). The
agency's interpretation will be "given
controlling weight unless [it is] arbitrary,
capricious, or manifestly contrary to the
statute." Id.Cavert Acquisition Co. v. NLRB, ___ F.3d ___, Nos. 95-3231 and
95-3293, 1995 WL 854489, at *3 (3d Cir. May 2, 1996). Having
concluded earlier that the Secretary's interpretation was based
on a permissible construction of I.R.C. 267(a)(3), we must
reject the Tax Court's finding that Treas. Reg. 1.267(a)-3 was
manifestly beyond the mandate of the statute.
In the alternative, the amici argue that Treas. Reg.
1.267(a)-3 is not supported by the legislative history. Amici
contend that the Commissioner overlooks the fact that the
legislative history defines "matching principle" in terms of
accounting methods. They further contend that because the sole
example in the Committee reports was absent from the final
regulation, and because this example did not involve income
exempt from tax because of a treaty, we should find that the
Secretary's interpretation is not supported by the legislative
history. We believe, however, that the amici are ignoring other
statements contained in the House and Senate Committee reports
which clearly support the Secretary's interpretation.
We agree with the Commissioner that the regulation is
not manifestly contrary to section 267(a)(3). We believe the Tax
Court construed the language of section 267(a)(3) too narrowly,
especially in light of the Supreme Court's holding in Chevron.
Accordingly, we find that the Tax Court erred in holding that
Treas. Reg. 1.267(a)-3 is invalid to the extent it requires
accrual basis taxpayers to defer interest deductions owed to a
related foreign payee until the year the interest is paid.
III.
Having found that Treas. Reg. 1.267(a)-3 is a valid
interpretation of section 267(a)(3), we must now consider whether
the retroactive application of the regulation violated the Due
Process Clause of the Fifth Amendment. The four-judge
plurality found that the period of retroactivity in this case was
excessive rather than modest, and therefore was unduly harsh and
oppressive. In reaching this conclusion, the four-judge
plurality relied on the Supreme Court's decision in United States
v. Carlton, 114 S. Ct. 2018 (1994). There, the Supreme Court set
forth a two-part test for determining whether the retroactive
application of a tax statute violates due process. First, for
retroactivity to be upheld, it must be shown that the statute has
a rational legislative purpose and is not arbitrary; and second,
that the period of retroactivity is moderate, not excessive. Id.at 2022.
The Supreme Court in Carlton upheld the retroactive
application of a tax law amending a statute which had been
enacted only a year earlier, where the amendment had been
proposed by Congress within a few months of the statute's
original enactment. Id. at 2023.
Based on the Supreme Court's holding in Carlton, the
Tax Court found the six year period in this case excessive, and
thus, violative of the Due Process Clause. We find, however,
that Carlton is distinguishable: Carlton involved the
retroactive application of a statute, and here we are dealing
with the retroactive application of a regulation.
The retroactivity of treasury regulations is governed
by I.R.C. 7805(b), which states:
The Secretary may prescribe the extent, if
any, to which any ruling or regulation,
relating to the internal revenue laws, shall
be applied without retroactive effect.
Clearly Congress has determined that treasury regulations are
presumed to apply retroactively. The extent to which newly
promulgated regulations shall not apply retroactively is a matter
of discretion left to the Secretary. Automobile Club of Michigan
v. Commissioner, 353 U.S. 180, 184-85, reh'g denied, 353 U.S. 989(1957).
The amici contend that the Secretary abused his
discretion under section 7805(b) in failing to limit the period
of retroactivity. In support of this position, the amici cite
Gehl Co. v. Commissioner, 795 F.2d 1324 (7th Cir. 1986); LeCroy
Research Sys. Corp. v. Commissioner, 751 F.2d 123 (2d Cir. 1984);
and CWT Farms, Inc. v. Commissioner, 755 F.2d 790 (11th Cir.
1985), cert. denied, 477 U.S. 903 (1986). These cases, however,
are distinguishable from the facts of this case. All of the
cases cited by the amici involved a prior express representation
by the Commissioner in a DISC Handbook that the regulations,
when adopted, would apply prospectively only. In CWT Farms, the
court of appeals stated that "[a]n abuse of discretion may be
found where retroactive regulation alters settled prior law or
policy upon which the taxpayer justifiably relied and if the
change causes the taxpayer to suffer inordinate harm." 755 F.2d
at 802. The courts of appeals in these three cases found that
the Commissioner abused his discretion by applying the
regulations retroactively on the basis of their finding that the
promise in the Handbook was binding.
Here, there was no such promise by the Commissioner
regarding Treas. Reg. 1.267(a)-3. Moreover, the taxpayer had
adequate notice within a reasonable time that regulations would
be forthcoming which could alter the tax treatment of its
interest deductions. Section 267(a)(2) was enacted on July 18,
1984, effective for tax years beginning after December 31, 1983.
On October 22, 1986, section 267(a)(3) was added, also with the
same effective date. On July 31, 1989, the Secretary announced
rules in Notice 89-84, 1989-31 I.R.B. 8, which eventually became
the proposed regulations, and were released on March 19, 1991.
Then, on January 5, 1993, the Secretary released the final
regulations applicable to section 267(a)(3), retroactive to tax
years beginning after December 31, 1983. Thus, as early as
October of 1986, the taxpayer had notice that regulations would
be forthcoming which could alter the tax treatment of its
interest deductions for tax years 1985, 1986 and 1986.
Indeed, the Supreme Court has upheld the retroactive
application of tax regulations for a similar or longer period of
retroactivity. See, e.g., National Muffler Dealers Ass'n, 440
U.S. at 478-82 (upholding the validity of a regulation which was
issued six years after enactment of the statute and was
subsequently modified ten years later). In E.I. du Pont de
Nemours & Co. v. Commissioner, 41 F.3d 130, 139 & n. 37 (3d Cir.
1994), we upheld the validity of a regulation adopted thirteen
years after enactment of a statute directing the Secretary to
promulgate regulations.
We find, therefore, that the retroactive application of
Treas. Reg. 1.267(a)-3 to the tax years in question does not
violate the Due Process Clause of the Fifth Amendment. Based on
the applicable legal standards and our earlier review of the
relevant legislative history, we are unable to conclude that the
Secretary abused his discretion in failing to limit the period of
retroactivity for Treas. Reg. 1.267(a)-3.
IV.
For the reasons set forth above, we will reverse the
decision of the Tax Court and remand this cause to the Tax Court
for the entry of a decision upholding the tax deficiencies for
the years in question.